Publications & Resources

March/April 2009
Focus: Got Capital?

 

Private Equity – Another Capital Option

As bankers search for ways to increase capital, looking to private equity firms has become an attractive option for an increasing number of community banks.  WIB asked two firms specializing in this arena to give you an snapshot of two different approaches to these investments.  Both firms have investments in WIB member banks.

Considerations for Non-Control Private Equity Investors During a Credit Crisis

By Joshua Siegel

I’m writing this article from seat 12D on what is now our second flight this evening from Atlanta. On my way to Arizona to speak at the CSBS (Conference of State Bank Supervisors) symposium, the first attempt to depart began with a rather frightening tire explosion on takeoff. The plane landed back in Atlanta, after hours of circling to decrease the fuel load, and was met by the 9th Battalion of emergency service vehicles. Fortunately, the 9th Battalion was not needed as the pilots were able to land the plane safely, and emergency preparations kept all the passengers safe.  

This evening’s events bear lessons that are consistent with some of the most important factors that private equity firms consider when evaluating non-control investments in banks during a stressed market. These lessons are: (1) emergencies always occur, it is just a question of “when”; (2) make sure your contingency plans are up-to-date and that your team is regularly drilled and prepared to execute the contingency plans; and (3) when an emergency occurs, make additional preparations to withstand a worst-case scenario, whether you think it is necessary or not.  You can never be over-prepared for an emergency and the severity is by definition unknown until it is over.

Belvedere Capital: Private Investors Providing Capital

By Alison Davis

Belvedere Capital, founded in 1994, is one of the only private equity firms in the U.S. that focuses on investing in community banks and is structured as a bank holding company. Belvedere actively seeks investment opportunities that are underappreciated by other investors and have operating potential over five to seven years that can be uniquely unlocked through Belvedere’s capital and oversight.

The current market environment is creating opportunities for many community banks and exceptional opportunities exist to invest in the sector. It also is important to understand the challenges faced by bank CEOs and the need for support beyond capital, such as attracting employee talent, driving strategic change, improving regulatory relationships, restructuring the balance sheet and evaluating growth opportunities.

Consistent with that approach, two of Belvedere’s core investment strategies are single bank investments with significant operating potential (including turnarounds, public-to-private transactions, and growth investments) and depository aggregation platforms (which may include one or many subsequent acquisitions). Correctly addressing these opportunities and challenges can yield exceptional results for customers, management, employees and shareholders.

No investment is too small or too large for Belvedere and there is no prescribed formula for an investment, but there are several characteristics which define great banks which are common to each of our investments:

High potential markets – Large target markets with attractive competitive landscapes and growth potential.

Profitable business model – Highly differentiated opportunity with significant profit potential or with strong “annuity stream” revenues (e.g. from fees, core deposits, other recurring “relationship driven” revenues), diversified customers, and strong credit portfolios and asset/liability management.

Opportunity to improve operations – Operating metrics that can be improved (NIM, non-interest income, efficiency ratio) to best-in-class levels with disciplined revenue and cost strategies.

Outstanding executive team – Typically proven executives with a strong focus on value creation; can be existing management, or new management teams introduced by Belvedere to build franchise value.

Attractive buy-in price – Belvedere seeks attractive buy-in prices through creative deal structuring, privileged access to deal flow, and its unique position as a financial investor with Bank Holding Company status. In addition, the large majority of Belvedere’s transactions are sole-sourced directly by the firm and Belvedere will rarely engage in auction processes.

Many liquidity alternatives – Belvedere typically seeks to sell an investment when the value of the bank is greatest, typically five to seven years from the initial investment. Each of the characteristics above can help to generate exit alternatives, such as a sale to a strategic investor, a public offering or through a recapitalization process.

These characteristics have been at the core of Belvedere’s community bank investments over the past 15 years. Now is an exceptional time to be investing in the community banking sector and working with management teams to build valuable franchises.

Alison Davis is managing partner for Belvedere Capital in San Francisco. She can be reached at 415-434-1236 or adavis@belvederecapital.com.

A non-control private equity investor seeks to partner with current management to achieve its goals. By contrast, a control investor seeks to achieve their own goals, which may not be the same as those of management. Given this difference, non-control private equity investors must consider additional factors when evaluating a potential investment, especially given their lack of explicit control.

First, investors want to ensure that management expects a credit or liquidity crisis to occur at any point in time, and management understands the risks embedded in its balance sheet. Banking is cyclical and only institutions that are prepared will survive the most severe crises. Does the bank have the proper risk management systems to identify problems before they arise, and specific strategies to avoid more serious problems? In today’s rapidly changing environment and ever more complex world of securities and derivatives, management needs to be nimble and flexible. Does the bank systematically review and improve its risk management systems as well as provide continuous risk management training? Just because asset problems have not occurred in 20 years does not mean that the risk management system purchased in 1988 is still suitable in today’s marketplace. The sooner a bank can detect risks such as (i) problem assets, (ii) over-concentrations to higher risk loan categories or (iii) negative micro-economic trends (e.g., local employers under financial pressure, increase in bankruptcy filings, median income decreasing), the faster and better it can react appropriately.

Investors want to know that the bank has sufficient liquidity and capital to manage through economic cycles. Banking is a confidence sensitive business and institutions should maintain adequate liquidity, capital and access to funds to meet all obligations as they come due, without disrupting the daily business. Active asset-liability management is essential in assessing a bank’s interest rate risk and exposure to changing asset prices. Investors want to know that a bank’s liability structure is continuously adjusted to match changes in asset composition, and makes efficient use of all funding sources. Also, the cash flow element to bank management (e.g., stable pre-provision income) must be sustainable to ensure ongoing operations and provide for loan loss absorption. Is the bank analyzing the crossover between borrowers and depositors (i.e., requiring that more funds be deposited by loan customers)?

Investors want to know that a bank invests in its credit monitoring and workout processes. Proper oversight of the loan portfolio, including close client relationships and updating financial information, leads to the early identification of asset quality problems. Strict oversight can help reduce the severity of potential credit losses in the portfolio, as can a capable asset workout team. When did the bank last review LTVs and asset coverage on real estate and other collateralized loans? Has the bank recently verified the financial standing of its borrowers and updated its loan collateral coverage?  Investors think about these points now more than ever and are trying to assess the effectiveness of a bank’s monitoring process in managing risk.

Once there is an emergency, make sure you act immediately and prepare to survive. Management should take every precaution to survive a credit or liquidity emergency, because you will only know what was actually necessary after the emergency ends. This lesson is very clear to investors: make sure you have sufficient capital and liquidity to support unexpected losses and diminished access to capital. Shockingly, even after the market began to crack, many bank management teams seemed unwilling to acknowledge the stress and take the necessary precautions. We have heard management teams say “asset quality is fine and we are already well reserved” or “we only need this amount of capital”, when to an outsider it was clear that the bank would need substantial capital. Banks that insist they are not headed for an emergency, and therefore are not preparing for trouble, will turn off prospective investors. Investors respond better to a management team that expresses a sense of realism, and explains the proactive steps they are taking to address the market stress, less you risk loosing investor confidence.

In summary, private equity investors are looking for one of two types of investments: (1) inexpensive banks that require restructuring, substantial capital and replacement of management, or (2) well managed banks that can weather difficult markets and gain market share when other competitors are floundering. You do not want to be the first type of bank, but rather strive to become the second type by (i) being prepared for the unexpected emergency, (ii) ensuring your risk management systems are current and in working order, and (iii) demonstrating to investors that if an emergency occurs, your bank is ‘equipped’ to take action to ensure survival. Investors will respond favorably if you demonstrate that you are realistic about the situation and proactively preparing for what could potentially be a difficult time for your bank.

Joshua S. Siegel is the Managing Principal of StoneCastle Partners, LLC (www.stonecastlepartners.com), a non-control private equity investor specializing in community banks throughout the United States. He can be reached in 212-354-6500 or at jsiegel@stonecastlepartners.com.

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