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Bob's Blog

Salvage Efforts In The Skittish Landscape of Community Banking

Early this year I began a search for metro Atlanta community banks with good market demographics, a strong deposit base and non-performing assets (NPA’s) that have been written down to a level such that the bank’s remaining capital plus ½ of the loan loss allowance would serve as sufficient cushion against any "burn" on newly invested capital.  My investment premise has been that new capital can be injected into qualified targets at a fraction of book value, and that cost efficiencies in combination with a focused business plan could yield compelling returns for a targeted set of community banks over the coming 3-5 years (investment premise available in a separate document).  The parameters that I employed revealed several “de novo” institutions and several banks with moderately distressed loan portfolios—or “on the bubble” banks that fit my criteria.  “Bubble” banks in my definition are those which can be recapitalized---but first need to submit to a diligence review to validate tangible net worth and then demonstrate marginal profitability to justify investment.  I also began to model banks that would fit well into a north metro ATL franchise---some by acquisition at failure...others by rehab/capital injection.
 
I reached out to institutional investors that I know...but the general response was that my project was “too small” to warrant consideration: the effort necessary to underwrite a $10-$20MM equity deal in order to “start the ball rolling” was not worth the risk/return when much larger projects in other industries are available with potentially large-scale results.  I continued to plug away through my networking contacts, and was eventually introduced to two investors that had interest and appetite for my initiative.  Encouraged by their interest--and capacity--I approached two open banks on my target list.  I explained my approach and requested the opportunity to undertake a summary diligence review in order to attest to each bank’s intrinsic value.  
 
Bankers are cautious, incredulous people—especially in this market, and so both institutions were skeptical.  “How can we ask our boards to spend money” they responded, “without first meeting the investors and validating their capacity and interest to invest?”  I discussed this concern with the investors: both expressed a willingness to front diligence costs for failed bank acquisitions, but both expected open banks to demonstrate their viability on their own nickel.  One of the two investors, however, offered an introductory meeting in order to “break the ice”. 
 
I returned to the banks in early May and requested execution of a one-page, non-circumvention agreement that would protect my interests in the event that a deal might eventually be consummated.  If my investors are willing to reach out solely on the basis of my recommendation—without prior diligence, I wanted the banks to commit that they wouldn’t shut me out from any ultimate deal.  Curiously, one of the banks refused.  The other committed to a negotiated document after several rounds of minor edits. 
 
By now it was summer.  The investor who offered a meeting encountered a serious health crisis in early June that required extended hospitalization.  As of mid-July he has still not returned to work.  The other investor remained intrigued with my ongoing efforts, but was not willing to meet on anything less than a validated opportunity.  After taking time to refine what I feel is a compelling investment case, I approached the (healthy) investor in early July with a plan that includes both failed and open bank acquisitions.  The investor controls a Florida charter with significant excess capital.  After considering my plan, the investor became interested to bid on a targeted failing GA bank in order to establish a base of operations in Georgia.  Unfortunately, legal counsel for the Florida institution convinced the owner to delay submission of a bid because their OTC charter is in process of converting to OCC as of July.  The investor asked me to hold tight for 60 days.  We will resume discussions in late August.  It seems apparent that this investor will want to start with a failed bank target because of the likely up-front gains.  
 
In the meantime, I was offered a meeting with the stricken investor’s portfolio strategist (this investor does not control a charter and is interested in open bank acquisitions).  Without the benefit of a qualified diligence review, the portfolio manager contacted Renova Partners (an Atlanta based loss-share/financial advisory firm)  and solicited a valuation opinion (using the 3-31-2011 Call report) on the bank that signed the non-circ agreement.  Renova’s valuation: Negative $15MM.  Needless to say, the portfolio manager was unimpressed.  At least he offered to pay for lunch.
 
I puzzled over Renova’s valuation—and hope soon to have opportunity to speak with the analyst that constructed the valuation.  But here is what I think I know: 
 
Institutional investors are applying huge discounts when valuing open banks—especially those with any measurable level of asset challenges.  Large investors are not equipped to give these institutions the benefit of the doubt---and the underwriting size is often below their minimum.  Further, the lucrative gains available for failed bank acquisitions are effectively accomplished with a “post-bankruptcy” cleansing that is unavailable with an open bank acquisition.  There is no warranty period when acquiring an open bank.  Unless an open bank in search of capital is willing to undertake a no-holds-barred approach toward convincing an interested investor of its merits, the likelihood of attracting capital seems to be small indeed.  Short of a strong, independently verified diligence review by a reputable firm, my experience shows that the bank’s chances are seemingly slim.  
 
I believe the bank in question (the one that signed the non-circ agreement) is realistically worth somewhere between $1MM and $-4MM.  At 3/31/11, the bank reported Tier 1 capital of $4.1MM and a loan loss allowance of $1.6MM.  The bank holds $9MM of ORE and contends that it has stabilized its remaining troubled loans.  Past dues reportedly declined during the second quarter.  The bank was profitable Q1 and will reportedly be profitable Q2.  Internal controls are seemingly strong, and an active director has told me he is convinced that the bank has favorable momentum in its markets. 
 
Here’s my point: in conjunction with a new capital injection, this bank can write down its ORE from $9MM to $5MM.  If currently priced at market, selling the ORE at $5MM upon recap will yield a $4MM recovery gain to the acquirer.  Even if the NPAs require another $2MM write-down, there is still a $2MM disposition gain available to be captured.  These gains are independent of accretive returns accomplished by acquiring shares at a fraction of book value.  Institutional investors might possibly be tracking such deals on their radar---but the size of most individual deals doesn’t merit the risk of underwriting and execution, because after all, they don’t know the institution up close.  As a further admission of reality, there aren’t many “scratch-and-dent” banks in Georgia where this math actually works.   
 
There will come a day soon when FDIC-enriched failures will slow…and then stop.  As this happens, the value of these precious few “bubble banks” will become apparent.  I can only hope that I find a way to capture some of the opportunity before it becomes obvious.

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