November 26, 2012
Interviewed by: David Snow
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Investing in the Banking Sector

How can private equity investors make money in the banking sector? It first helps to have deep industry expertise, advises W. Kirk Wycoff, Managing Partner of Patriot Financial Partners, a Philadelphia-based firm that specializes in investing in small- to medium-sized community banks.

In a fascinating conversation with Privcap, Wycoff gives an authoritative overview of the state of the banking sector today, with its 8,000 individual bank holding companies. Wycoff shares his analysis on how banks are being valued in the current market, why more banks have not failed, why consolidation has not taken place to the degree once expected, the paths to exit for bank investors, how new regulations will hit small banks hardest, and why finding sophisticated CEOs is difficult at Patriot’s targeted end of the banking spectrum.

How can private equity investors make money in the banking sector? It first helps to have deep industry expertise, advises W. Kirk Wycoff, Managing Partner of Patriot Financial Partners, a Philadelphia-based firm that specializes in investing in small- to medium-sized community banks.

In a fascinating conversation with Privcap, Wycoff gives an authoritative overview of the state of the banking sector today, with its 8,000 individual bank holding companies. Wycoff shares his analysis on how banks are being valued in the current market, why more banks have not failed, why consolidation has not taken place to the degree once expected, the paths to exit for bank investors, how new regulations will hit small banks hardest, and why finding sophisticated CEOs is difficult at Patriot’s targeted end of the banking spectrum.

David Snow, Privcap: Kirk Wycoff from Patriot Financial Partners, welcome to Privcap today. How are you?

So we’re going to be talking all about investing in the banking sector. That’s something that you do and have been doing for a very long time. I guess we could start with the most obvious question, which is, why invest in banks? It sounds like either an obscure or very risky thing to do. But what do I know?

Kirk Wycoff, Patriot Financial Partners: Well, it’s certainly a very narrow and specialized industry. But there are 8,000 banks in this country. Banking has been a very stable industry to invest in for a long period of time.

What’s happened in the last five years during the financial crisis, because it was driven by large banks, valuations in all banks have come down to historic lows. So when we invest in the banking sector, we invest in banks between $1 billion and $3 billion. And we typically invest at tangible book value or less. Therefore, from a risk or return standpoint, we’re able to generate significant alpha with very low risk of principal loss.

Snow: Can you describe what happens when you invest in a community bank and the investment goes as planned? What are the drivers of the success of the deal?

Wycoff: So we tend to invest in banks that are in metropolitan markets and have very good deposit and customer bases. 80% of the deposits in this country are located around the top 50 metropolitan markets. When we invest in a bank that can grow, it grows about 10% per year during our 5-year holding period. And as it achieves scale, either from going to $1 billion to $1.5 billion in assets, or $2 billion to $3 billion in assets, it becomes much more efficient, return on equity goes up. And therefore, when it’s time to exit, either through an IPO or a sale to a strategic, we’re able to maximize our returns at an exit price of about two times investment value, or two times book.

Snow: And what’s a typical exit for you? Is it to another bank? Is there another route?

Wycoff: There are two routes. We do both private and publicly-traded banks, depending on where the valuations lie. About 4/5 of our companies will be exited by a sale to a strategic buyer.

In the banking industry, the multiples are pretty straightforward because strategics can take out costs. There’s no need for two presidents, two CFOs, two data operating systems. So it’s standard for an acquirer to get a 30% to 40% cost advantage on top of the pre-tax earnings. The other quarter to 20% of our banks will go public. And we may exit in the IPO of a secondary.

Snow: What are some risks that people should be aware of when investing in this sector?

Wycoff: Two external risks that we can’t control, the economy and GDP growth and interest rates. So we strive to have our banks be top quartile performers in any interest rate environment. There’s a myth in investors’ minds that low interest rates are good for banks and high interest rates aren’t. In fact, it’s exactly the opposite.

In a low interest rate environment, the free checking, the free funding isn’t worth as much, because loans don’t yield as much. So we are positioned in all our banks for rising rates. And that gives us good leverage to that external economic factor.

The internal factors that are most important in due diligence and success of investment are two-fold. They’re the credit quality of the bank, the loans they make whether they’re in construction, business lending, health care lending, leasing, commercial real estate. So we do extensive due diligence on those portfolios prior to investing.

And second is the management talent. With 8,000 banks in the country, 7,000 of them are small, under $500 million in assets. There really isn’t a tremendous amount of super bank CEOs. And so we look very hard around the country to find those people.

Snow: Well, I mean here’s a risk, management screwing up the bank. I mean, how often is that an issue and what is the variance across the pool of managerial talent in banking?

Wycoff: Well, it’s a wide variance, because in the last 20 years the bigger banks, as that consolidation has taken place and everyone’s rolled up into Bank of America and Wells Fargo, the training programs that for instance I was trained at at Girard Trust Company or my partner Jim Lynch was trained at at Sovereign Bank Corp have gone away. So the breadth of talent among CEOs, where they need to know credit, operations, deposit gathering, and regulatory, is a bit thin.

Snow: Obviously, we’ve been through interesting times in the financial world. And I’m wondering if there are any potential regulations that lie ahead that would affect the way that you would invest.

Wycoff: It’s really more, David, the regulatory environment. So funds that invest in banks today are not bank holding companies, which means under the Federal Reserve rules, none of us can acquire, no individual fund can acquire more than 24.9% of a bank. If you do, the Fed determines you’re a bank holding company and puts you at risk for every bank you invest in loan portfolio. So that regulation has been difficult to work through over the past five years.

Patriot has done more transactions in the banking space than anyone else in the past four years. And eight of those transactions have been approved by the Federal Reserve for a determination of non-control. So that’s important to investors, that they don’t get drawn into bank regulation.

The biggest thing on the horizon is Dodd-Frank. It’s 2,000 pages of legislation. The ABA, the American Bankers Association, suggests that it’ll be 20,000 pages when implemented of new regulations. And it’s incredibly burdensome on the banks the size that we invest in and the smaller banks, because the regulators come in and they want you to comply with, frankly, a statute they’re not even entirely familiar with.

Snow: There are a lot of failing banks across the US. And I’m wondering if those are targets of yours or if you are going to avoid distressed banks.

Wycoff: So let’s break the industry down. 8,000 banks. There are 800, give or take, 20 on the FDIC’s June 30 list of troubled institutions. In this cycle, only about 200 have failed, 250 maybe. I should have the exact number.

But just like the last cycle, any time you have a down credit cycle– ’89, ’90, ’91, the industry was 15,000, 750 banks failed. Now we are 8,000, about 400 will fail. So there really aren’t very many failing banks. And the FDIC has done a great job of making sure banks that don’t have enough capital can’t loan or pay high deposit rates.

As to Patriot, we don’t invest in distressed banks. And the reason is the J curve or the hockey stick. If we invest in a bank and in the first two or three years sustain significant capital losses, it’s very hard for us to reach our target exit and returns for investors.

Snow: Many people in the wake of the financial crisis expected a huge amount of consolidation in the banking sector. Has that happened to the extent that people originally expected, or to the extent that you originally expected? And if not, why not?

Wycoff: Well it hasn’t happened. Each year for the past three years the major investment banks in this industry have predicted between 200 and 300 transactions, sales of banks each year. That number in each of those years has been about 50 or 60.

The reason it hasn’t happened is two-fold. One is buyers’ expectations for their banks, even if they had problems, never really came down from the pre-banking-crisis levels. They still want two times their invested capital.

And then buyers, on the other hand, have their own regulatory problems. And their stocks have traded down. So for a buyer to successfully do an acquisition at a reasonable premium to make the seller happy, they need to have a currency that allows them to pay a fair price. And in fact, we don’t think there will be significant consolidation in this industry until ’14 and ’15, because we hear the conversations as directors that are going on at banks. And the gap between bid and asked is still the sellers want 175 of book and the buyers want to pay 125.

Snow: Is it psychological? Why is it that seller expectations have not changed much given what’s happened in the world?

Wycoff: Again the community banking industry on some levels isn’t particularly sophisticated. And managements and boards expect things to return to the way they are. We think there’s been a paradigm shift in the industry. And the banks have to learn how to operate in a low interest rate environment and take costs out.

And frankly, making a loan at 3 and 1/2% today to a good credit is a good loan. But many bankers and boards still have in their minds that they ought to charge 5% or 6%. So to the extent they’re waiting for the good old days to return, they’re not willing to take today’s pricing to sell their bank.

Snow: Kirk, why don’t you talk about a recent deal that you’ve done that really exemplifies what’s going on in the market?

Wycoff: So we announced about 30 days ago that we became one of the largest shareholders in Provident Bank of New York. It’s run by a very good and exciting new management team. It’s about $3 and 1/2 billion. They had just on August 13 closed the acquisition of Gotham Bank in downtown Manhattan.

And that was kind of right in our sweet spot, because it’s a bank that’s growing. It’s a bank whose stock price had not yet reflected the fact that they’re doing a really good job. So we were able to enter that investment at tangible book value.

And we think that bank is in a metropolitan area, obviously New York, the economy has come back.  San Francisco has come back. And so we expected that management team to be able to grow that bank through acquisition several billion dollars over the next few years. One of our partners, Jim Deutsch, will go on the board, we hope, of Provident in New York. And we expect it to be a great investment.

Snow: What will be the drivers of success to make that investment work?

Wycoff: So loan quality is always the number one driver of success once management’s in place. And this management team is very talented. So they’re morphing their business portfolio into more business lending and less real estate and apartment lending. And that generates more core deposits and a wider margin. So those will be the tell-tales of success as they build the company.

Snow: Well, Kirk, thanks so much for joining Privcap today. Much appreciated.

Wycoff: Thanks for having me.

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