Private equity is expected to continue to seek investment opportunities in the struggling US banking industry in 2011, particularly with respect to the over 7,000 community banks with assets of up to USD1 billion, according to this report by Gregory J Lyons (pictured) and Gregory V Gooding, partners in Debevoise & Plimpton’s New York office.
At the beginning of the financial crisis, private equity firms focused almost exclusively in failed bank opportunities, as a result of various factors that included uncertainty as to the true condition of targets and the favorable terms available under Federal Deposit Insurance Corporation (“FDIC”) loss-sharing agreements. More recently, however, greater comfort with target bank balance sheets, the geographic concentration of most failed bank opportunities, frustration with the uncertainty of the FDIC failed bank process, and more willing sellers have caused private equity firms to show an increasing interest in live banks. This article discusses the current state of these markets, as well as regulatory considerations for private equity firms considering these opportunities in 2011.
Failed Bank Market
Failed banks remain a significant part of the market for bank acquisitions, in the case of both private equity and traditional (so-called “strategic”) buyers. The numbers are striking – while only 52 banks failed in total between 2000-2008, there were 140 failures in 2009, and 157 failures in 2010. Moreover, with 860, or over 11%, of all FDIC-insured banks on the troubled bank list as of the FDIC’s September 30 quarterly report (the highest number since March, 1993), failed bank opportunities will almost certainly continue in 2011. Approximately 80% of these failed banks since the outset of the crisis had less than USD1 billion of assets, and approximately 60% had less than USD500 million of assets.
In addition to the continued availability of failed bank targets, FDIC loss-sharing arrangements remain an attractive incentive for private equity firms to pursue failed bank deals. The FDIC has historically protected acquirors of failed banks against 80% of the losses incurred by a defined set of assets up to a maximum loss threshold, and 95% of the losses thereafter. The increase in stock price that often follows the announcement of a failed bank deal by a publicly traded acquiring bank – such as East West Bancorp’s 55% increase following its acquisition of failed United Commercial Bank – demonstrate the economic benefits of these arrangements. In addition, serial acquisitions of a number of small banks can allow private equity-backed institutions to grow quite large. For example, Community and Southern in Georgia has primarily used failed bank acquisitions, including three in September 2010, to become the fourth largest bank in Georgia with approximately USD2.5 billion of assets.
However, despite several notable successes, private equity firms are increasingly looking beyond the failed bank market. Part of this is borne of regulatory burdens. In September 2009, the FDIC published its Statement of Policy on Failed Bank Acquisitions (the “Failed Bank Policy Statement”). While not quite as harsh as its July 2009 proposal, the Failed Bank Policy Statement imposes a number of requirements, including heightened bank capital requirements and three-year investment holding periods, on private equity acquirors. Similar requirements are not imposed on strategic buyers. Moreover, the FDIC has published two sets of Q&As since the Failed Bank Policy Statement (all available at http://fdic.gov/regulations/laws/ faqfbqual.html), which have not eased the burdens for these investments.
In addition, a number of private equity bidders perceive themselves at a disadvantage to strategic bidders in the failed bank market, believing that if a fully qualified consortium of private equity buyers and a strategic buyer are bidding on the same failed bank, the FDIC will likely favor the strategic buyer. Given the substantial cost, effort and urgency involved in these bids, the prospect – and in some cases the experience – of consistently losing auctions has discouraged some private equity firms. Despite these perceptions, though, it should be noted that private equity firms have had greater success more recently and may be expected to win a larger percentage of these bids in 2011, as failed banks continue to be located within a limited range of states (approximately 60% of all recent failures have occurred in Florida, Georgia, Illinois, California or Washington) and strategic buyers seem to be showing declining interest in seeking market share via acquisitions of failed community banks in these markets.
Moreover, as bidders for failed banks have increased, the attractiveness of failed bank acquisitions has decreased: bids have become higher and FDIC protections have decreased. Until this past spring, for example, winning bids for failed banks rarely had a deposit premium, and FDIC loss-sharing agreements almost invariably were set at the 80%/95% levels described above. However, starting with TD Bank’s acquisition of three failed banks in Florida in April, including USD3.4 billion asset Riverside National Bank, leverage has increasingly shifted to the FDIC, with TD Bank agreeing to assume 50% of the losses on the assets as part of its winning bid. While most winning bids since that deal have maintained an 80% initial FDIC loss protection, 95% protection for greater losses generally is no longer available. Moreover, winning bidders are more often paying premiums for deposits of the failed institutions.
Live Bank Market
While failed bank deals will undoubtedly remain in the bank merger headlines during 2011, acquisitions of “live,” often distressed, community banks should be the focus of bank M&A activity. Indeed, even in 2010 almost 90% of all (i.e., live and failed) bank deals involved targets with assets of less than USD1 billion. Given the need for large banks to increase capital over the coming years in light of the Dodd-Frank Wall Street Reform legislation of last year and Basel Committee proposals to be implemented in 2013, among other things, community banks are likely to be the predominant merger parties in 2011.
In addition to the lessened attractiveness of failed banks deals noted above, several supply side factors can be expected to drive significant acquisitions of live community banks in 2011. Community banks generally are struggling to find areas to generate returns. Loan demand is not significant given the continued lull in the markets that have been the historical focus of much community bank lending activity, the commercial real estate and construction markets. Indeed, the Financial Times recently reported that over half of the USD1.5 trillion commercial real estate loans coming due over the next four years have mortgages in excess of property values and community banks hold the lion’s share of property loans. Because community banks also tend to have fewer fee generating operations than larger institutions, this inability to deploy capital has had an increasingly adverse impact on income statements. The poor asset quality and weak growth prospects in turn make it very difficult for many of these banks to raise capital.
Moreover, Dodd-Frank, while focusing on the “too big to fail” banks, will also adversely affect community banks. Trust preferred securities have been eliminated as a source of new Tier 1 capital. The new Consumer Financial Protection Bureau is expected to make residential and consumer loans more costly to originate. The sheer compliance requirements of Dodd-
Frank and its anticipated 5,000 pages of regulations will place significant demands on their limited compliance staffs. Finally, at a personal level, directors and management of distressed banks are increasingly realizing the risks presented by a bank failure. The FDIC recently announced 50 criminal investigations of former employees and directors at failed US banks, and the filing of lawsuits against more than 100 of the same to recover approximately USD2.5 billion. Both numbers are expected to increase.
These factors have led a number of private equity firms across the country over the past year to focus on acquiring and/or recapitalizing distressed live community banks. For example, in the Northeast, Lazares & Company completed the acquisition of USD235 million of the assets of Domestic Bank, and FHB Formation LLC acquired 60 percent of the stock of USD612 million Northwest Bancorp. On the West Coast, Grandpoint Capital first acquired USD25 million Santa Ana Bank and then acquired USD336 million First Commerce Bancorp at year-end. Bay Cities National Bank was recapitalized with USD460 million. In the Midwest, Texas-based Carlile Bancshares raised USD325 million and entered into deals with USD120 million Treaty Oak Bancorp and USD32 million Community State Bank. More recently, Cascade Bancorp, a Northwest bank, received a USD177 million private equity recapitalization. Moreover, in a new structure designed to avoid the historical impediment to private equity investment posed by a distressed bank having a holding company with trust preferred securities outstanding, a group of private equity investors recently utilized a bankruptcy proceeding to acquire AmericanWest bank. The pricing of live community bank deals depends in large part on the health of the bank and the desirability of its marketplace. With distressed live banks, deals can still be priced around, or even at a discount to, book. In the Northeast, where community banks generally have been healthier, the American Banker has reported deals occurring at premiums (125%–165%) to book. The current buyer’s market is driven, in part, by the recognition that target prices are likely to increase in 2011.
Structuring the Deals
Investors must be cognizant of the significant regulatory hurdles that accompany any failed or live bank initiative. While larger investments, up to 24.9%, allow benefits such as warrants, reimbursement of fees and expenses and board representation, the burdens of such a voting stock investment also are more significant. A less than 5% investment generally avoids regulatory burdens. A 5% to 9.9% investment will subject an investor to the Failed Bank Policy Statement. Above 9.9%, the investor often also is subject to the federal Change in Bank Control Act, which imposes materially higher disclosure requirements on the investor (including biographical and financial reports, and fingerprint cards). Because the general focus of the banking laws is acquisition of voting stock, an investor wanting somewhat greater economics while maintaining more modest bank regulatory burdens often may be able to bridge the difference by acquiring non-voting stock. Care also must be taken to ensure investors are not deemed to be “acting in concert” which can result in the holdings of separate investors being aggregated for purposes of these thresholds.
In addition to the investment structure, regulators also focus intensively on the business plan of the target bank. The regulators prefer a business plan that demonstrates that the target community bank (whether live or failed) has retained its fundamental character as a community bank, and offers products and services typical for such a bank. As to overall asset growth, the regulators are focused on ensuring that organic growth occurs consistent with the market in which the bank resides, resulting in reasonably slow growth, particularly if the target is under any type of regulatory order. Greater growth can occur through live or failed community bank acquisitions, as those are generally deemed to be less risky market extensions. In all events, the regulators wish to see the targets populated to a significant extent at the board and management levels by seasoned bankers with community bank experience.
Despite these regulatory hurdles – which show no sign of moderating in the near future – both demand and supply side factors can be expected to continue to present private equity investors with significant bank acquisition opportunities. While failed bank deals are by no means going away, we expect an increasing focus of this activity in 2011 will be in the live community bank market.
Gregory J. Lyons and Gregory V. Gooding are partners in Debevoise & Plimpton LLP’s New York office.
