Understanding Your Bank’s Capital Alternatives

capital-10-18-17.pngIt is crucial for executive management to engage their boards in practical conversations surrounding the raising of capital. Important questions include what form of capital is best from a strategic perspective, how much dilution to earnings per share (EPS) is acceptable and how soon can the dilution be earned back. To answer these questions, management must first have a solid understanding of each type of capital.

Common Equity
Common equity tends to receive the most favorable treatment from a regulatory perspective and is fully included in Tier 1 capital. This, however, comes at a cost beyond the 5 to 7 percent fee paid to your investment banker. A common equity raise increases the number of shares outstanding. This translates to dilution of earnings per share and existing ownership until the new capital is leveraged, or put to work.

When a bank undergoes a common equity raise, it also gives up ownership and voting rights. If the bank is unable to raise common equity at or above current tangible book value per share (TBVS), or is concerned with existing ownership dilution, it should seriously consider an alternative source of capital. Banks must have clearly defined parameters in place for raising capital, particularly its impact on TBVS and EPS.

When evaluating a common offering, two key considerations are: (1) whether to conduct a private offering or undergo an IPO, and (2) whether to raise capital internally or externally. Having a strategic plan in place is critical to ensure that the bank can execute on deploying capital and earning back the initial shareholder dilution.

IPO or No?
Not everyone needs to conduct an initial public offering (IPO), but for larger institutions or institutions seeking liquidity, it is an excellent option. An IPO provides liquidity for stockholders, generates capital to accelerate growth, and depending on trading volume establishes currency that can be utilized in acquisitions. Once an institution undergoes an IPO it has also created access to capital markets for follow-on offerings to continue to raise capital as needed. While IPOs provide a faster vehicle to raise capital, they also require more time from key management, detracting from their role in day-to-day operations.

Subchapter-S corporations must consider ramifications of increasing their shareholder base before triggering a requirement to convert to a stock corporation. Once an S-corporation exceeds 100 stockholders, it must convert to a C-corporation, which has immediate tax implications and changes in reporting requirements.

Private Placements
For smaller banks or institutions that are closely held, private placements may be preferable to an IPO. Although the timeframe for a private placement may be longer, less time is required from management. Private placements are limited to existing stockholders, accredited investors and qualified institutional buyers. While private placements are generally smaller and less dilutive to EPS, it can also may be difficult to raise larger amounts of capital using this vehicle. The bank will be able to remain private with less pressure to immediately leverage capital, allowing greater autonomy in strategic decisions.

Alternative Sources of Capital
Noncumulative perpetual preferred stock can be counted towards Tier 1 capital and can be used to increase tangible equity. Banks with a clean risk profile may be willing to operate with lower levels of tangible common equity and focus on bolstering tangible equity. Preferred stock is generally less expensive to raise, although there is a post-tax dividend that can range from 5 to 9 percent.

For banks with a holding company, another form of capital—debt—can be down-streamed in its entirety to common equity at the bank level. Debt is the least expensive form of capital, costing approximately 3 percent to raise with no dividends and tax-exempt interest expense.

Regardless of the approach used to raise capital, be realistic in how much you can effectively leverage. Excess capital may be viewed favorably from a regulatory perspective but can become a value detractor if not effectively deployed. This is particularly true for banks entertaining the possibility of a sale. Over-capitalized targets are likely to be priced on a leveraged capital approach, meaning that tangible common equity in excess of a certain percentage of average assets will be priced at 100 percent TBVS and only the leveraged portion of capital will receive a premium.

When raising capital in any form, proactively communicate with regulators and stockholders remembering that neither party likes surprises. Work with your financial advisor to run pro forma analyses on multiple scenarios and establish parameters for EPS and ownership dilution to maximize the impact of your capital raise.

A Risk Checklist for M&A

3-26-13_Jack.pngThere was a general consensus among most of the investment bankers and attorneys I spoke with at our Acquire or Be Acquired conference last January that takeovers of healthy banks will accelerate this year because an increasing number of institutions will see this as their best option for growth in the face of poor loan demand from business borrowers and shrinking net interest margins. Sounds good in theory, but one of the problems with this strategy is that acquisitions don’t always achieve their primary objective, which is earnings-per-share (EPS) accretion for the buyer’s shareholders.

Indeed, there are probably many more things that can go wrong in an acquisition than go right, and this places enormous pressure on the acquirer to hit the bull’s eye on each one of its assumptions about asset quality, cost reductions and revenue enhancements. If a buyer misses any of those targets by a wide enough margin, it will essentially have overpaid—and that means it will miss the projected increase post-merger earnings per share that it used to justify the merger in the first place. Few bank chief executive officers want to risk angering their institutional investors by overpaying for a deal.

Recently I asked Stephen Figliuolo, the executive vice president and corporate risk officer at Citizens Republic Bancorp in Flint, Michigan, for a list of questions that every bank chief risk officer (CRO) should be asking in any acquisition. Figliuolo has been on both sides of an M&A deal—transactions that Citizens has done as the acquirer and, of course, the bank’s own sale last year to FirstMerit Corp. Here are his questions, which have been organized into five categories:

  • Loan portfolio: “What is the credit mark on the portfolio? How much is the loan portfolio really worth? This is dependent on the quality of the loans, so you look at loan concentration levels and ask whether the various types of loans fit your strategic need? Are the loans supported with appropriate loan documentation? Is the seller’s credit rating system similar to yours or more liberal? Are there any major reporting discrepancies to impaired loans, nonperforming loan designations or charge-offs? Are they sufficiently reserved? What is the quality of the portfolio monitoring and can it detect deteriorating credits?” These are all good questions and CROs should wave a red flag if they aren’t satisfied with the answers they get back because if you miss big on your analysis of the target’s asset quality, the deal will probably be a bust. All of these categories of risk are important, but gauging the target’s asset quality correctly is probably most important.
  • Balance sheet: “What are the components of the balance sheet? What is the quality and duration of the securities portfolio? What steps will you as a buyer have to take to unwind investments that don’t fit your strategy from a duration, interest rate or risk perspective? How does the target fund itself? Does it rely more on high-cost deposits including brokered versus low-cost core deposits, in which case you will need a plan to eliminate those high-cost deposits over time?”
  • Regulation: “What are the regulatory risks? The hot items in banking today are anti-money laundering/Bank Secrecy Act laws, consumer add-on products, fair lending and consumer compliance. You buy those issues as they exist at the acquired bank and you will need a plan to fix them.” An example of a consumer add-on product would be a situation where an individual takes out a loan to buy, say, a boat and the bank agrees to fund the loan for 5 percent more than the purchase price. The borrower could then use this extra money for some purpose unrelated to the boat purchase itself. “The Consumer Financial Protection Agency is all over this,” he says. “They ask, ‘Does the borrower have the ability to repay that loan?’”
  • Pending legal actions: “Not only do you get an idea of prospective legal costs involving the acquired institution, but an idea on how well the company is managed.”
  • Strategic fit: “What exactly are you buying and why? Is it the deposit base as a source of funding, or are you buying it for market share or to acquire an annuity-like revenue stream, to name a few of the factors? And how much expense can you take out through improved efficiencies?” This might be an especially important concern if the bank is doing an acquisition because it can’t find much organic growth in its market. A bank that feels a self-imposed pressure to do a deal might not exercise as much caution as it should. “Do you understand the strategic fit?” asks Figliuolo. “Does the deal make business sense?”

CROs will normally be an important participant in the due diligence process that precedes an acquisition, but the extent of their involvement probably depends on where they rank in the institutional pecking order. “It depends on the status and experience of the CRO in the organization,” says Figliuolo. “At some banks, the CRO leads the due diligence process. At others, it might be the chief financial officer, and the CRO only contributes to those things under his purview.”

Either way, CROs have a vital role to play when their banks are vetting a possible merger—and they could be the difference between a successful deal and one that blows up?if they ask the right questions.