The Profit of Banking

The Profit of Banking

The profitability of investing in a de novo bank needs to be understood.

There is a great deal of misinformation received by prospective investors from disgruntled bankers whose territory has been shaken up by regulators, wealth advisors who lack knowledge of bank stocks or are reluctant to lose control over their clients, and perceptions of inaccuracy and bias in the media fueled in part by skepticism about what is read on social media.  

So, here is lots of material directly from the mouths of those who understand it.

Community Banking's Big Investors    This includes Ed Carpenter in California who has been organizing banks 8 years longer than I have.  He is 70 years-old, is the largest player in bank consulting in America having launched more than 500 banks.  American Banker Magazine will not permit non-subscribers to see the entire article, but go to picture #9 for as brief description of Ed Carpenter).

Carpenter & Co. Seeks Approval for New Bank in Southern California
JUN 25, 2015 
Approval to proceed was granted November 20, 2015.  Core Commercial Bank will be the third new bank to open in the U.S. since the financial crisis. This brilliant, extremely wealthy man would not be starting a bank in today’s environment if timing is wrong.  

Look at Ed Carpenter’s Web site.

What level of return on equity is common for a company in the banking sector?  

It’s a wonderful investment: 140% return in three years

Regional, Community Bank Stocks the Next Big Thing  

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Western Alliance picks up $1.4B loan portfolio from GE 

Trade of the Decade Update, First Place and Good Times 

David B. Moore 
This is a 236 page book, so I pulled from it what I feel is the most significant information. I underscored the importance of a second round of capital for a bank. 

My personal experience is that boards that recognize the need to raise capital in the third year of operation will cause the stock value to multiply substantially.  Those that ignore the need for third year capital cause the value of the stock to drop below book value and limit salability.

“A de novo’s initial equity is, by definition, raised at the bank’s book value less any start-up costs. Most de novo banks don’t turn a profit for 2 to 3 years and eat up 15%-20% of their starting capital in the interim. It takes time, after all, for a de novo bank’s balance sheet to grow into its capital base and earn enough spread income to cover the required overhead costs (e.g., personnel, lease expense, etc.). Nevertheless, a small minority of de novos reach profitability in as little as 12 to 18 months and lose as little as 5%-10% of their initial capital. Regardless of the timing, these losses eat into the bank’s capital base. Consequently, purely from the standpoint of growth in earnings and book value, investors in de novo banks lose money during the start-up phase. During this phase, however, the bank’s franchise value should be increasing if it’s being run reasonably well. Thus, from the standpoint of economic value, a de novo bank’s value may be increasing even as the bank continues to lose money. Some community bank investors employ a strategy that relies heavily on investing in de novo banks. Their logic is that if they can invest at what will turn out to be 125% of book value (after including start-up costs and the losses incurred during the first few years) in a bank that generates a 12%-15% ROE within five years of its IPO, and then sells out at 200% or more of book value another five years out, the math works out favorably from a return standpoint. To illustrate, let’s say you invest in a de novo at $8.00 per share (we’ll assume 1 million shares are issued in the IPO). Let’s further assume that the bank (1) breaks even at the beginning of year 3 with $6.50 in per share book value remaining, (2) averages a 12% ROE over the following eight years, (3) pays no dividends, and (4) is acquired for 2x book value ten years following its IPO. An investor in the IPO that holds onto their shares until the bank is acquired will have realized an internal rate of return of roughly 15% over the 10-year period. Many community bank investors, however, refuse on principle to invest in the IPOs of de novo banks. These investors simply can’t stomach investing at book value in a company that is likely to take 2-3 years to reach break-even. These same banks, after all, often raise money in a secondary offering after their growth has outstripped their startup capital and they’re no longer losing money. Consequently, many bank investors wait to invest in de novos through such secondary offerings, which often take place at small premiums to pro forma book value. (Although in recent years many such secondary offerings have taken place at substantial premiums to book value. This is definitely a case-by-case issue.) Four key issues to consider when evaluating a de novo bank are the market area, management, management options, and start-up costs. As with any bank, a de novo bank’s proposed market area will play a critical role in its success or failure. If the market is growing rapidly and is populated with entrepreneurial business people (e.g., Southern California) then the bank’s odds of success are greater than if it is located in a slow-growth market populated largely with old-line businesses (e.g., Western Illinois). In addition, the bank will be more successful if its market has a dearth of community banks relative to regional banks. Small businesses tend to favor service-oriented community banks over larger, less personalized regional and national banks. Consequently, there’s an advantage to being one of the only games in town from a small-business lending standpoint. For obvious reasons, a good management team is the sine qua non of superior long-term profitability and, thus, of superior long-term returns for a de novo bank’s shareholders. Good managers, after all, will keep start-up costs and operating expenses low, and will grow the bank’s balance sheet rapidly and prudently by utilizing existing relationships. The issue of existing relationships is crucial. De novo banks need to grow quickly in order to generate enough spread income to cover the initial operating overhead. The most successful de novo managers are typically those that have solid existing relationships with both the business community – so that they can quickly get plenty of high-quality loans and low-cost deposits on the balance sheet – and other experienced commercial lenders – so that they can hire such lenders away from other banks. Without these existing relationships, it’s difficult for de novos to grow to profitability quickly. Needless to say, managers love stock options. In the case of de novo banks, the management team will typically award itself options equivalent to 10%-20% of the company’s fully-diluted outstanding shares. To my way of thinking, 10% is a pretty big number, but 20% is an egregious number. Thus, it’s important to note in the start-up’s prospectus how many options management are awarding themselves. Importantly, start-up costs can vary dramatically among banks. Some de novos have very seasoned management teams that have built up enough goodwill in the business and investment communities that allows them to raise the required start-up capital without using an investment bank (and paying the associated fees). These more experienced operators also tend to need less assistance in the legal and consulting areas.” 
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