Say It Ain't So Doug! Square 1 Bank Sells to PacWest

In the name of head scratchers, Square 1 Financial of Durham, NC, one of the most successful startup banks in a generation, is turning over the keys to PacWest, a California bank. The deal left me scratching my head, because at first glance it made little sense that a bank with Square 1's earnings trajectory would sell.

Niche banks are a growing part of our financial institutions landscape. I often cited Square 1 for their focus and success. In their own words, "Square 1 is a financial service company focused primarily on serving entrepreneurs and their investors." A bank with a focused strategy! Brings a tear of joy to my eye.

It had one banking office (in Durham), and twelve loan production offices located in key innovation hubs across the US. Its Chairman and CEO, Doug Bowers, was a 30-year BofA vet and more recently a member of a private equity firm. So the niche Square 1 adopted made sense.

But why sell Doug?

An industry reporter hypothesized that it was the price... 22x earnings, 262% of tangible book... c'mon?! But that was close to where Square 1 was trading at announcement. So there was no price premium. In fact, the below chart demonstrates that if Square 1 remained independent, their stock price would soar past the value received in this merger.

Like most projected performance, the devil's in the details. What I did was assume Square 1's 3-year compound annual growth rate in EPS (86%) linearly came down to earth to 12% by the end of the projection period, which is PacWest's 3-year EPS CAGR. I assumed PacWest's 12% would continue throughout the projection period. If all were true, it would have been more beneficial for Square 1 to go it alone. It is what I term "earning their right to remain independent."

So if future valuation wasn't the reason, then why? Perhaps they are receiving an outsized portion of the resulting bank than their current contribution. As I mentioned above, Square 1 did not receive a price premium from PacWest. So their pro forma ownership of PacWest is pretty much in line with their contribution (see table). Usually in a merger the seller receives a larger pro forma ownership stake because they receive a premium on their stock and they are relinquishing control. Not so, in this case.

So why did they sell? Here is what Bowers said in the press release: "Joining PacWest will be a terrific opportunity for our clients, employees, and stockholders. Square 1 offers PacWest a complementary line of business and significant core deposit growth. As part of PacWest, we will maintain our steadfast commitment to the entrepreneurial and venture communities, will be able to offer clients a wider array of products and will be well-positioned to continue to serve them through all stages of their growth."

That seems to tell us why PacWest bought Square 1, not why Square 1 sold to PacWest. So with Doug silent on the issue, here are my opinions on why one of my darling niche banks turned over the keys:

1. Institutional Ownership - Square 1 went public last March, raising $52 million at $18 per share from primarily institutional owners. The company was 70% institutionally owned with such names as Patriot Financial Partners, Castle Creek Capital, Endicott Opportunity Partners and other notables. Some had 5%-10% stakes, or about two million shares. Square 1 traded about 30,000-40,000 shares per day until around February 24th, when volumes soared (a fact that will not be lost on FINRA, although increased volumes prior to a merger announcement are not uncommon due to speculation). With such significant institutional ownership and relatively light normal trading volume, it would have been very difficult for those investors to lock in the trading gains experienced by Square 1 from November-February. How do you lock it in.... sell. Even if you are paid no premium. You can still lock in the price appreciation since you bought into the IPO.

2. Law of Large Numbers - As Square 1 grew larger, it would have to generate larger and larger amounts of business volume just to keep pace. For example, they had a $1.3 billion loan portfolio, the vast majority of which was commercial business loans. If 25% of that portfolio turned over every year, and I suspect it was more because business loans churn faster than commercial real estate loans, they would have to originate >$400 million of new/renewed loans per year to keep pace. Never mind growth. Which brings me to my third potential reason for selling...

3. Growth Trajectory - Square 1 was trading at 22x earnings when they sold. Banks their size typically trade around 13x-14x earnings. The premium was most likely the result of their balance sheet and earnings growth. Perhaps Doug and his senior management team were staring down the barrel of normalized growth. As investors began to recognize the slower growth, multiples would intuitively come down to the planet earth, suppressing stock price appreciation until the multiple normalized. That could have meant trading in a tight price range for a number of years. Why not lock in your tremendous gain since the IPO, and move on?

Square 1 was truly an extraordinary financial institution and I am sorry to see them go because I held them up as a premier example of how focused effort can lead to superior results.

If Doug Bowers and team were facing normalized growth and stock price appreciation, they could have decided to "cash cow" the bank, turning over a significant part of their earnings to investors in the form of dividends. In 2014, they enjoyed a 1.25% ROA and a 12.85% ROE. A great candidate for a cash cow. 

But alas that ship may have sailed when they backed up the truck to the institutional investor loading dock. They were numbers on a spreadsheet and were supposed to deliver the fund managers a big win. 

They did.

What else could Square 1 have done to satisfy their investors?

~ Jeff

Where will banks get their next dollar of capital?

Retained earnings.

I make a living helping financial institutions be as profitable as feasible. Why? To perpetuate their business model. This is how I feed my family.

But profits have been under pressure since 2008. First, FIs experienced pressure in their investment portfolios, purchasing Fannie Mae preferred's and other FIs trust preferred securities. Next, our over-exposure to construction and land development loans came to roost. Then commercial real estate fell under pressure as the economy teetered and rent roles declined.

Many banks had to replenish lost capital. The government stepped in to help, and taught us to ignore the guy/gal that knocks on our door and says "I'm from the government, I'm here to help." Absent or in concurrence with government-injected capital, FIs sought fresh capital.

But retail investors were nowhere to be found. This was one of the points made by Lisa Schultz of Stifel, Nicolaus, Weisel, an investment banking firm that specializes in FIs, at a recent Pennsylvania bankers conference.

Ms Schultz said retail investors were absent for all industries, not just FIs. She opined that they opt instead to invest in mutual funds, hedge funds, etc. Therefore, all of the action to attract capital was in the institutional market. I made this point in a past blog post, opining that the change in our shareholder base would be a significant factor driving future bank consolidation.

The change in shareholder focus, as presented by Ms. Schultz, is represented in the tables below. But this changing focus is from the institutional shareholder perspective... not the retail investor. The future investor will be concerned with quality growth that enhances shareholder value, combined with dividend policies that are mindful of capital preservation. I'm not sure how an FI will meet the 20%-30% capital appreciation, combined with sufficient liquidity, to meet "future", i.e. institutional, investor demand.

As if the shifting focus of the institutional investor wasn't challenging enough, what about the difference in what retail versus institutional investors value, and how they plan to exit their investment (see table below).

Tough luck finding your institutional investor at the local coffee shop bragging that they own stock in your institution. They could care less about how much resources your FI dedicated to the local food bank.

Here is what I think community FIs can do now to prepare for this shift in attitude:

1. Maximize retained earnings to reduce the need to visit the capital markets.

We have gotten a multi-year pass in generating profits because of the financial crisis and the subsequent teetering economy. Now it's time to cowboy up. How productive are your front line employees? How efficient is your back office? How well have you leveraged technology? Have you over-reached with your compliance program? If you don't have the answers, you better start looking for them.

2. Get a real investor relations program.

Investor relations is marketing. Marketing is much more than advertising. And your marketing message must be delivered long before you ever need capital. You must spin a story that gets locals excited about your bank. Yes, financial performance will play a significant role, but a supporting role to the story you tell about how your FI is a critical component to local communities. Retail investors may have shifted to investing in mutual funds, but the local community bank is probably one of few chances locals can invest in a company down the street.

3. If you must tap the institutional market, choose your partners carefully.

Ms. Schultz specifically addressed this issue in her presentation. Search for institutional investors that share your FIs objectives. Where did this fund invest? How long did it hold the investment? How did it exit?

4. Prepare for the exit strategy from the time of investment.

Receiving significant institutional investor dollars does not mean a fait accompli in terms of having to sell your FI so the investor can get out of the stock. However, if you don't plan for the investor's exit when they make their investment, the clock may run out when they are ready to go. Make evaluating strategic alternatives a regular part of your strategic planning, developing financial projections for a stretch case, base case, and stress case. See my post on this subject here. Also, make financial performance, investor relations, and stock trading liquidity a part of your strategy from the git go. If not, you'll find your FI might have up and went.

Where will your FI get it's next dollar of capital? I would like to know.

~ Jeff