Community Bank Investment Outlook

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Community Banks represent and extremely attractive asset class at this stage of the cycle. They are an important engine of economic growth and are almost entirely overlooked by private equity investors.
While credit quality has improved significantly,community banks continue to need equity capital to fund strategic and assisted acquisitions, recapitalizations,TARP re-payments and growth initiatives. Over 800 of these smaller players are on the FDIC\'s Problem Institutions list. The 761 banks with $500 million to $5 billion at year end had $944 billion in aggregate assets and 3.9% non-performing assets. The healthiest of these companies have good franchise value and are trading right around book value. We think target returns are mid-20% plus.

Please see our recent report for additional information.

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Community Bank Investment Outlook

  1. 1. Community Bank Investment Outlook Community Bank Investment Outlook Selective equity investments in high quality community banks represent an attractive asset class with target internal rates of return in the mid- 20% range as the economy improves and small banks consolidate.Mindi McCluremmcclure@thebearco.com703.894.6011March 2012 Page 1
  2. 2. Community Bank Investment OutlookExecutive SummaryAt this stage in the economic cycle, selective equity investments in high qualitycommunity banks represent an attractive asset class with target internal rates of returnin the mid-20% range as the economy improves and small banks consolidate. Whilecommunity banks represent an attractive investment opportunity, structuringinvestments that optimize investor returns while adhering to relevant regulatoryframeworks is highly complex and beyond the interest of institutional quality privateequity funds as investment positions are generally too small. While the communitybanking industry continues to need additional capital from strong private equitypartners who can offer strategic assistance in addition to capital, the universe ofinvestors is extremely limited, creating attractive investment opportunities for aninstitutional quality investors with the resources and experience to structure highlycomplex securities and transactions for strategic, recapitalization and growthinitiatives.Community banks play an important role in the US economy, providing credit andliquidity to local communities and fueling economic and job growth. The communitybanking industry is highly fragmented and unlike money-center, super-regional andregional institutions has limited access to capital to fund strategic acquisitions,recapitalization transactions and other strategic opportunities. Community banks havesignificant opportunity to capitalize on continued industry dislocation during the nextseveral years, creating enormous franchise and shareholder value.Investment ThesisBALANCE SHEET STABELIZATION AND EARNINGS VISIBLITY - After four years offinancial uncertainty, economic conditions and asset values have stabilized in manymarkets and many community banks have stabilized their loan portfolios, havingearned sufficient pre-tax, pre-provision core income to adequately reserve forproblem loans and REO, setting the stage for a return to core profitability, increasedmerger activity, restructurings and strategic growth opportunities. Page 2
  3. 3. Community Bank Investment OutlookDuring 2011 non-performing assets (NPAs) declined for the first time since 2006.During 2011, reserves as a percentage of NPAs began to increase for the first time, thetwo indicators together indicating that reserve levels may be adequate for the first timein four years; setting the stage for lower future provision levels and improvedprofitability (Figure 1). During 2011, the universe of companies in the SNL Micro CapU.S. Bank & Thrift Index (936 on average from 1995-2011) returned to profitability forthe first time since 2007. In addition, loan loss provision levels were less than netcharge offs, an early potential indicator of adequate reserve levels (Figure 2).Figure 1 Asset Quality Metrics SNL Micro Cap U.S. Banks & Thrifts 6.00% 160% 147% 144% 143% 140% 5.00% 131% 131% 134% 4.90% 126% 126% 128% 4.73% 120% 111% 4.00% 100% 89% 3.35% 3.43% 3.00% 80% 76% 57% 60% 2.00% 1.57% 39% 40%40% 35% 34% 1.00% 1.10% 0.89% 0.67% 0.57% 20% 0.51% 0.51% 0.60% 0.63% 0.59% 0.50% 0.45% 0.52% 0.00% 0% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 NPAs/Assets Reserves/NPAs source: SNL Financial Page 3
  4. 4. Community Bank Investment OutlookFigure 2 Earnings Quality Metrics SNL Micro Cap U.S. Banks and Thrifts 1.50% 180% 168% 167% 160% 1.00% 0.95% 0.92% 1.03% 149% 0.91% 0.92% 141% 145% 0.88% 0.90% 0.92% 0.86% 0.88% 140% 0.72% 135% 0.76% 134% 126% 0.50% 120% 122% 121% 122% 0.46% 120% 108% 0.36% 106% 108% 100% 100% 0.00% 84%80% -0.50% 60% -0.59% -0.83% 40% -1.00% -1.20% 20% -1.50% 0% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 source: SNL Financial ROAA Loan Loss Provisions/NCOATTRACTIVE VALUATION METRICS - While community bank balance sheets haveimproved or at least stabilized, financial valuations for smaller institutions havecontinued to lag their historical multiple levels and the valuations currently awardedregional, super regional and money center banks. Current low community bankvaluation metrics should improve as the economy continues to improve and as assetquality and earnings ratios improve. While 813 FDIC insured institutions remained onthe FDICs Problem Institution list and non-performing assets remain at elevated levels,most institutions have greater transparency in troubled asset portfolios as inflows havedeclined and portfolios have seasoned and been subjected to management, auditorand regulatory review. Current pricing levels do not fully reflect improvements infundamentals (Figures 3 and 4).Mergers and acquisitions activity has declined significantly since 2007, with averagedeal volume and premiums to tangible book value reflecting the uncertain credit andoperating environment. Since 1983, average price to tangible book value ratios haveranged widely, but have averaged 221% of tangible book value for 1,700 M&A Page 4
  5. 5. Community Bank Investment Outlooktransactions comprising $315 billion of transaction value announced and completed byinstitutions with assets between $250 million and $10 billion (Figure 5).Figure 3 Historical Tangible Book Value Multiples 450% 400% 350% 300% 250% 200% 150% 100% 50% SNL U.S. Bank and Thrift SNL Small Cap U.S. Bank & Thrift SNL Micro Cap U.S. Bank source: SNL Financial Page 5
  6. 6. Community Bank Investment OutlookFigure 4 Index Price Performance 700 600 500 400 300 200 100 - SNL U.S. Bank and Thrift SNL Small Cap U.S. Bank & Thrift SNL Micro Cap U.S. Bank source: SNL FinancialFigure 5 Bank and Thrift M&A Activity 1983- 2012 Target Company Assets $250 million - $10 billion $30 600% $25 500% $20 400% $15 300% $10 200% $5 100% $0 0% 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 Aggregate Deal Value Annual Average Price/TBV source: SNL Financial Page 6
  7. 7. Community Bank Investment OutlookLIMITED INVESTOR UNIVERSE DUE TO SMALL INVESTMENT SIZE AND COMPLEXITY OFREGULATORY FRAMEWORKS - Investing in community banks at this stage in the cyclerepresents one of the best investment opportunities available. Indentifying, analyzing,evaluating and structuring investments that meet bank objectives and optimizeinvestor returns while satisfying regulatory requirements is highly complex. Bankinvestment structuring requires in-depth knowledge of regulatory frameworks andcomplex securities as well as the ability to evaluate asset and earnings quality. TBCand its principals have structured billions of dollars of equity, mezzanine and fixedincome transactions for community banks. Since 2009, TBC has evaluated loanportfolios of 38 banks with total assets of $35 billion for the FDIC and private sectorclients and is a prime contractor for in the FDIC structured loan sale program.Limited Natural Investors Creates OpportunityThe universe of potential investors in smaller capitalization banks is extremely limited.Most traditional mutual fund and hedge fund investors require more liquidity than isavailable from a investments in small and micro-cap bank stocks. Moreover, most arenot able, by charter, to invest in the thousands of private banks in the United States.Many private equity funds will not invest in banks because of the complex regulatoryframeworks limiting ownership concentrations and control structures. The few privateequity investors specializing in bank investments have minimum size requirementsthat (coupled with ownership concentration limits) foreclose their ability to invest morebroadly in community banks (Figure 6). Page 7
  8. 8. Community Bank Investment OutlookFigure 6 - Limited Investors Creates Opportunity Mutual Fund and Hedge Retail Investors Fund Investors are Inefficient Require Liquidity Limited Bank Private Equity Private Equity Requires Investors Control Require SizePotential Return AnalysisThe following table illustrates the targeted returns for Community Bank Investments.The analysis assumes an equity investment in a $2 billion bank with 7% pro formatangible equity capital at 95% of tangible book value on day one. The five yearassumptions include 6% annual asset growth and an increase in return on assets from20 basis points to 90 basis points. Exit price assumptions take into account the areversion to historical average trading and M&A multiples. Page 8
  9. 9. Community Bank Investment OutlookFigure 7 At or for the year ended (projected)dollars in millions, except per share amounts 12/31/12 12/31/13 12/31/14 12/31/15 12/31/16 12/31/17 Assets $ 2,000 2,120 2,247 2,382 2,525 2,676 Equity $ 140 $ 144 $ 157 $ 177 $ 198 $ 221 ROA 0.20% 0.40% 0.60% 0.90% 0.90% 0.90% Earnings $ 4.0 $ 12.7 $ 20.2 $ 21.4 $ 22.7 TBV/per share $ 10.00 $ 10.29 $ 11.19 $ 12.64 $ 14.17 $ 15.79 Investment price $ 9.50 Investment price/TBV 95% Book Value Trading Multiple M&A Multiple 100% TBV Average Average Price/TBV 100% 176% 221% 5-year IRR 10.7% 23.9% 29.7% Multiple of invested capital 1.66 2.93 3.67Investment CatalystsWhile the banking industry has stabilized to a large extent since the beginning of thefinancial crisis, 813 institutions with $319 billion in total assets remained on the FDICsProblem Institutions list at December 31, 2011, representing 11% of bankinginstitutions. The resolution of these smaller institutions will take place over the courseof the next several years and will be in the form of private sector recapitalizationtransactions and assisted and private sector merger transactions. This continueddislocation in the community banking market will create significant opportunities forconsolidating institutions and banks seeking organic growth taking advantage of theirweaker peers.TARP repayment - While $185 billion or 91% of the total principal balance of capitalissued to banks under The U.S. Department of Treasurys Troubled Asset ReliefProgram ("TARP") has been successfully repaid or converted, $16.5 billion or 9% oftotal TARP preferred remains outstanding, primarily to smaller institutions (USDepartment of Treasury). The primary source of capital used to repay TARP has beenpublic equity offerings, typically through underwritten offerings to large mutual fundinvestors who do not typically invest in small cap or private community banks. Whilemany of the institutions are considering repaying their TARP preferred, viable sourcesof secondary capital are extremely limited. Page 9
  10. 10. Community Bank Investment OutlookSummaryAt this stage in the economic cycle, selective equity investments in high qualitycommunity banks represent an attractive asset class with target internal rates of returnin the mid-20% range as the economy improves and small banks consolidate. Whilecommunity banks represent an attractive investment opportunity, structuringinvestments that optimize investor returns while adhering to relevant regulatoryframeworks is highly complex and beyond the interest of institutional quality privateequity funds as investment positions are generally too small. While the communitybanking industry continues to need additional capital from strong private equitypartners who can offer strategic assistance in addition to capital, the universe ofinvestors is extremely limited, creating attractive investment opportunities for aninstitutional quality investors with the resources and experience to structure highlycomplex securities and transactions for strategic, recapitalization and growthinitiatives.About the Author: Mindi McClure is Managing Principal of The Bear Companies aninvestment banking and advisory firm located in the Washington, DC area. Ms.McClure and The Bear Companies principals have completed numerous bankrecapitalizations and restructurings during the past 24 years. Page 10
  11. 11. Community Bank Investment OutlookDisclaimerThis presentation is intended solely for the use of the party to whom The Bear Companies(“TBC”) or its agent has provided it, and is not to be reprinted or redistributed without thepermission of TBC. This material is presented solely for purposes of discussion. Participationin any transactions described are not guaranteed and are subject to meeting certain terms andconditions. Under no circumstances is this presentation to be used or considered as an offer tosell, or a solicitation of any offer to buy and security. Page 11

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