It is unsurprising that capital remains king for community banks, especially those seeking to maintain good standing with regulators.
I’ve lately spoken with a number of community banks who are working on, or considering, deals that would need extra capital for their institution.
Acquisitions made in accordance with today’s rules and with today’s money
Assume that your community bank holding company decides to make an acquisition. It will employ cash as a currency, stocks as a currency, or a combination of cash and stocks as a currency.
Of course, if you combine the two, you must issue at least 40% of the acquisition price in stock in order for the stock acquired to be tax-free, but that’s a topic for another article.
If your community bank holding company is involved in an acquisition deal and you can persuade the seller to accept the holding company’s equity that is normally a positive thing.
If you can’t, and the holding company needs funds, it’s ultimately up to the community bank holding company board to figure out how to get that cash.
Raising cash today
Under the new law, leveraging of the holding company is still a very real option for bank holding companies, especially if your holding company has less than $1 billion in consolidated assets. As you may know, the Small Bank Holding Company Policy Statement was recently expanded from applicable exclusively to banks with less than $500 million in consolidated assets to institutions with less than $1 billion in consolidated assets.
So, what options does the board have when it comes to raising funds for an acquisition, a major share redemption, or bank growth?
There are essentially two options for the community bank holding company to produce funds under $1 billion: sale of stock or sale of debt.
- Equity the selling of stock is rather simple. It often entails passing the hat around the board table, then going to current shareholders, then going out to non-shareholders, and ultimately considering equity investments from private equity companies.
- Debt, on the other hand, is a little different. Debt is sometimes attributed to a wealthy, astute director who may have just sold his or her firm and is sitting on a large sum of cash that he or she would rather lend to the community bank holding company than invest in a CD. The board member will get a considerably better interest rate on the loan.
Investigating the relaunched bank stock loan
The second most conventional method of leveraging the firm is via a classic stock based loan, which the community bank holding company board should be relieved to discover is back in style.
It’s exactly what it sounds like: a bank stock loan. It is a loan obtained by the holding company from an independent third-party institutional lender who takes as collateral the holding company’s major asset, bank shares. Bank stock lenders (mainly bankers’ banks, other correspondents, and some of your community bank pals) have been the primary providers of bank stock loans post-recession.
Looking at it from the lender’s perspective, that’s a fairly decent bargain. A sum of money is loaned to the holding company by the lender. The holding firm injects it into the bank to fund an acquisition or to increase capital. Since collateral, the lender receives bank stock, which includes the amount of money loaned, as it has now been added to the bank’s equity.
The terms of bank stock loans have changed in recent years. During the Great Recession, a holding company, like equity, could not get a bank stock loan unless it did not need one (or it could simply not get one at all).
The bank stock lenders have returned, but the offers differ. You may acquire a short fixed rate, a longer-term variable rate, a 10 or 12 year amortisation… the list goes on. However, you must keep in mind the Small Bank Holding Company Policy Statement, which states that the debt-to-equity ratio must be decreased to at least 30% at the end of 12 years.
The easiest strategy to get a bank stock loan on favourable conditions is to provide the bank stock lender (who may be a fellow community banker) with a set of predictions outlining how the loan will be repaid.
Keep in mind that bank stock loans are comparable to other major commercial loans. They have made agreements. Payment conditions, for example, require you to repay the loan on a regular basis. Non-payment covenants, such as minimum capital ratios, asset quality ratios, and so on, are also included in bank stock loans.
Bank stock loans, on the other hand, make a lot of sense.
Remember the “internal bank stock loan.”
Finally, while thinking about raising money for your holding company, don’t forget about your employee stock ownership plan or 401(k) employee stock ownership plan.
These are also entities that may take a mirror loan from the holding company as part of their bank stock loans or leverage directly from an institutional lender or person. The advantage of ESOP leverage is that an ESOP loan is paid back with tax-deductible monies (i.e. compensation expenditure), thus both principle and interest are tax-deductible in practise.
Planning for capital growth
Consider stock loans while thinking about ways to obtain cash for the holding company.
My usual recommendation to customers is to utilise leverage first, then equity created by passing the hat around the board table, then equity from current shareholders, then equity from new shareholders, and finally, as a last option, stock from private equity firms.
The source of capital is actually a matter of whether you want to maintain your bank independent, which I will discuss in a future article.