Executive Summary: The FDIC continues to close failed banks. However, many bankers and private equity executives believe the investment opportunity has changed substantially over the past year. More small deals may mean even more work for acquirers.
The three banks closed by the FDIC last week bring 2010’s total to 149. As reported by thestreet.com, 25 banks and thrifts failed in 2008 and another 137 in 2009. Total assets of failed institutions exceed $638 Billion. Certainly there will be many more bank closing (perhaps hundreds more) before this present downturn runs its course.
Yet, two private equity (PE) executives in separate conversations said that they felt the “trade was over” in this area. What they meant was that the opportunity for PEs to buy, refurbish, and sell off failed banks had passed. Basically, we think they are right. Some of the first large deals and the juiciest (for the PE investor, not for the taxpayer) were lead by PE investors. As more banks evaluated and understood the attractiveness of FDIC-sponsored transactions, banks became tough competitors.
Banks at an advantage.
Today, banks operate with a strong advantage in winning failed bank bids. The FDIC appears to prefer to work with banks that operate with a commitment to a community; banks with their longer term horizon and, in most cases, lower return requirements, can outbid PEs; in the near term many banks believe they need to “buy growth” in the face of limited organic growth opportunities, making them aggressive bidders. PEs and shelf registration companies may still win some bids, but we see more of their focus shifting to open bank versus assisted deals.
While PEs may be looking elsewhere for the next trade, regional and, in particular, community banks remain very engaged in evaluating and bidding on deals. Last week’s three deals are typical of the smaller deals that we expect to see going forward:
* Gulf State Community bank ($112 MM of assets) was bought by Centennial Bank of Conway, Arkansas, a subsidiary of HomeBancShares.
* VIST Bank purchased Allegiance Bank of Bala Cynwyd, Pa. ($107 MM in assets).
* First Michigan purchased First Banking Center ($751 MM in assets) of Burlington, Wisconsin. This is one of the larger recent deals completed.
Most of the large ($1 B+) deals have been completed, and most future failed banks are relatively small community players that overextended on commercial real estate loans and lacked the capital to survive. Many of those weakened banks are now attempting to raise capital (often through PEs or hedge funds) and recapitalize themselves to avoid failure.
Smaller Deals…More Work and Poorer Results?
Smaller deals and small banks buying other small banks result in both near-term management issues and longer-term systemic problems for the industry.
* Bad portfolios. Evaluating the portfolios of any failed bank quickly illustrates why the bank crashed. While it is no surprise that portfolio management (including underwriting and file maintenance) is bad, smaller failed banks often seem to be particularly weak in the required skills and discipline. The portfolios these banks leave behind are a mess and need major work.
* Limited talent and time within the acquiring bank. We continue to see acquiring banks manage the shared-loss process “off the side of their desks” rather than giving it the commitment of time and focus required. We have worked with multiple banks in assisting them in developing a shared-loss system. This involves establishing an approach to evaluate loans purchased, improve the quality of the files (often no small task), determine which loans should receive priority for submission to the FDIC for payment, and develop an action plan for managing the loans in the future. We are finding that even banks that have completed several transactions do not have in place a system for managing them.
* The management process is multi-year. Buying an FDIC-sponsored bank means that you have a partner for the next five-ten years. Appropriately, that partner has some demands related to the guaranty they have provided. Managing the regular soundness and supervisory audits as well as the DRR audits is time consuming and requires significant planning. Our clients’ experience is that internal communications between these two FDIC groups is irregular, if at all; in some cases their requests even appear inconsistent with one another.
Banks will likely be audited twice a year by DRR, either by an outside contractor or FDIC staff. Preparing for those visits, managing the visit, and responding to the “report card” provided after the visit all require a great deal of work. While we have seen some community banks do a great job in this area, many smaller banks are simply not up to this task.
* Weak banks buying weak banks. We are finding that larger banks simply do not wish to buy these small players. They view the pain of integrating a small bank outweighing its value. This leaves smaller banks as buyers. In several cases clients have expressed concern about the stability and longevity of the banks that have acquired other banks in their communities. They think that the acquiring management lacks the necessary depth of management skill. These executives literally and figuratively shake their heads at these deals and believe that the new combined bank may ultimately become a failed bank in the future.
Concluding thought.
The FDIC deal landscape has changed significantly over the last 12-18 months. At one point PE firms were going to change the banking industry; now, their role is declining rather than accelerating. Large and regional banks will do few deals in the future. The market is largely left to community banks, both as targets and acquirers. We see some community banks transforming themselves because of shared loss transactions. We expect the next year will see more community bank involvement in this arena, perhaps as well as some buyer’s remorse.