Monday, December 22, 2014

Lessons For Community Bank Investors

In the December 14, 2014 Sunday Edition of the New York Times, there was an article titled, “Population 686 – A Tiny Town in Banking’s Fast Lane.”
The article describes how the couple, Suresh Ramamurthi, a former Google executive and his wife, Suchitra Padmanabhan, a former investment banker, purchased a small bank, Citizens Bank of Weir, in the decaying city of Weir, Kansas in late 2009. Citizens Bank of Weir at the time of the of the purchase had about $6.3 million in assets, $5.7 million in deposits, total equity capital of $0.5 million and three employees. During the next six years, the couple implemented a few innovative approaches using technology, and turned around a bank that over a matter of time, would have ceased operations.
The article, which was given a full page spread in the print edition, was interesting and insightful.  Bank investors, entrepreneurs, venture capital, and private equity including operating managers can take away four critical lessons from this article, which, from my perspective, are: patience; as-is where-is; innovation and risk layering; and capital.
Why are these four lessons important? Return-On-Investment expectations. For any ROI calculation, the key question is: How much is enough and how soon? Investing in a bank is a long-term investment.  Therefore, a bank investor should seek long-term capital appreciation. It is a marathon, not a sprint.  Far too many investors expect unrealistic financial and growth results within a short time frame.
I have encountered entrepreneurs, venture capitalists, and private equity, all of which wanted to start a bank or acquire a bank, especially after the financial crisis. Most expected speedy regulatory approvals, thought that they could acquire a bank on the cheap and provide as little capital as possible, while proposing to layer on significant risk in the quest for the immediate ROI.
Patience. Starting or acquiring a bank in today’s regulatory environment is not impossible but it is a long and arduous process, not for the faint of heart or he impatient. It took Mr. Ramamurthi ten months to get through the regulatory process for the bank acquisition. That was in 2009, at the tail end of the crisis, for a very small bank. Now, it can take 12 to 18 months, even longer, for a bank acquisition and in the case of a start-up bank, it can take 36 months or more to receive regulatory approval. As the article stated, “Getting a bank charter isn’t easy. Start-ups and giants like Walmart have been turned down by regulators.” There are myriad of reasons why applicants get turned down. There are only 8,000 or so banking licenses in the United States and those licenses are dwindling every Friday. Ask yourself, how bad do you want one and how long are you willing to stand in line and answer questions to get one? In addition, investors cannot expect immediate returns on capital.  In short,  bank investors need to have a much longer timeframe. It took Mr. Ramamurthi six years to get the bank from negative earnings to profitability.
As-Is Where-is. One of the most critical components of the Mr. Ramamurthi’s acquisition of the Bank was that he and his wife said they would keep the bank exactly where it was allowing it to continue to service its market…all 686 of them. In my experience, this was probably the most favorable accord in their acquisition application. Regulators are not particularly keen on allowing a bank license to relocate just because an investor doesn’t like the local market. The banking license gives the financial institution a national customer base in addition to the local customers. So, it doesn’t really matter where the main banking office is located. But for most investors, this does not make sense, and who the heck would want to work in a bank in the middle of “sticksville”. Well, Mr. Ramamurthi and his wife did just that. In the first year, they stayed in a hotel in the next town that was a short 20-minute drive to the Bank. As the situation got better, Mr. Ramamurthi was able to extend his commute to two hours, one way, from Lawrence, a more metropolitan town. I worked with a group of investors where the principals were unwilling to make a daily one-hour drive to the bank. Ultimately, the deal did not go forward because the principals couldn’t get over the location of the bank. The drive was way out of their way and the management team, which consisted of some of the principals, did not want to reside in the town where the bank was located. Not for a day, not for a month, not for the opportunity.
Innovation and Risk Layering. Although, the couple set out to work on a big ticket item called payments, they didn’t loose sight of the smaller innovations such as check scanners, a new phone system, computers and a cheaper core processing system because these smaller items were non-existent or outdated. Many small banks across the United States like Citizens Bank of Weir are operating on antiquated systems or none at all. I remember working on a project for a client in 2009 where the bank kept its book on paper financial ledgers. It was a scene right of “It’s a Wonderful Life.” After making small incremental improvements in the operations of the bank, that Mr. Ramamurthi turned his focus to payments, his passion. The payment business is not new, but it is a very significant industry. In 2011, global payments were $1.34 trillion and will increase as we continue to grow as the world becomes a cash-less society. Although Mr. Ramamurthi is doing something innovative for the bank and unique in approach, from the regulators’ perspective, Mr. Ramamurthi is not doing anything significantly new and unknown to them. Rather, by focusing on a small segment of the payments market, international remittances using existing credit/debit card rails, he has layered a small amount of financial and transaction risk in the bank. The true innovation is the software he is developing to assess the transaction risk.
Capital.  There is always a need for additional capital in bank acquisition.  Don’t expect to buy a bank or start a bank without adequate levels of capital to put into bank on top of the purchase price which regulators often require.  In Mr. Ramamurthi’s case, the bank’s equity book value was about $0.5 million. He and his wife probably paid, more or less, a half million dollars for the bank. I venture that he paid a little less than half million because the bank had some issues that probably helped Mr. Ramamurthi achieve a discount on the book value. But what is important and not mentioned in the article, is that there was an additional half million of capital added to the balance sheet after the acquisition which increased the bank’s equity capital from half million to one million. The additional capital that that Mr. Ramamurthi put in the bank was the amount that was needed to execute on his business plan. It gives the bank room to grow it balance sheet and it provides a backstop for risk. But Mr. Ramamurthi invested much more capital that is not reflected in the Bank’s equity accounts. Mr. Ramamurthi’s and his wife incurred other capital costs to win the regulatory approval such as consulting fees, legal fees, and living expenses just outside Weir while the imbedded themselves in the bank in year one. Mr. Ramamurthi has also incurred additional capital outlays such as the engineers in Topeka to build the back-end transaction system and Yantra, his software company, housed in bookstore in Lawrence, KS.
So what does it all mean? According to the article, the bank in the last quarter earned $60,000 in interest income on loans and $720,000 from the rest of the business. So, I looked closely at the financials and this is the full story: Since Mr. Ramamurthi’s acquisition of the bank in late 2009, the bank’s net interest income ratio as percentage of assets (net interest margin) has decreased by 24 percent even though assets has doubled. But that is expected. Every Bank in America has seen net interest margin compression as a result of the current rate environment. But the Bank’s non-interest income has increased by a whopping 4690 percent from $27,000 in 2009 to $2.2 million in 2014. The Bank’s year-to-date net income at the end of the third quarter of 2014 was $819,000 compared to a net loss of $52,000 at the same time period in 2009. Assuming a simple run rate, the bank is on pace for $1 million net by year-end. The question is whether the Bank and Mr. Ramamurthi can sustain and grow the earnings. I certainly think so. With a $1.34 trillion global payments market, just capturing a mere fraction of the market can generate significant returns for the bank and Mr. Ramamurthi.
Ultimately Mr. Ramamurthi is an investor-entrepreneur. He is not doing this for altruistic reasons. A million dollar plus investment is a million dollar plus investment. He has a passion; he found a platform that will help him realize his passion. The platform he chose is highly regulated and subject to scrutiny, which meant he had to show patience, take the platform as-is where is, innovate, and put up capital, direct and indirect. The value of his bank is appreciating. Maybe Google will take a small equity stake in his bank.
These are the learning lessons for any outside investor seeking a bank…big or small!