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Bank size, credit limits, and investors’ exit options

And why credit staff must worry about all three

Eventually every bank investor will need an exit strategy. But how that plays out, as renewed interest in M&A grows,  will affect lenders’ own mindset and daily life, says blogger Ed O’Leary. Eventually every bank investor will need an exit strategy. But how that plays out, as renewed interest in M&A grows, will affect lenders’ own mindset and daily life, says blogger Ed O’Leary.

Most stock investors, regardless of their specific holdings, usually have an exit strategy in mind at the time of their initial investment.

Some might set a price target as a percentage of, say, 20% and sell when the stock gets to that level.

Others may be operating on a hunch and be less specific in the target price.

But everyone has to be thinking about, “How do I get out?”

My thinking began running down this path the other day after a conversation with a consultant who is working with a young community bank.  Before I get to our conversation, let’s think a moment about community bank ownership.

Why own the local bank’s shares?

Community banks often offer different challenges in the investment sphere. Quite typically, the operative objective of de novo bank investors is to have a community bank that will be responsive to local needs and conditions. Ownership with a hometown focus is more important to many than a sharp pencil strategy of how and when do they cash out.

That’s not to say that making a decent total return, either by the dividend or a combination of the dividend and price appreciation, is not important. But, community bank investors are often more patient investors who aren’t obsessed with stock price or other sharp pencil analytics.  (At least, at the outset.)

If one of your customers and shareholders is typical of the “patient money” investors, when should he or she get out? Why should anyone continue to hold?  The answers to those questions are often both gratifying and disturbing.  

Gratifying, I mean, in the sense that the ultimate objective is a well-run bank, responsive to the local community and the economic development needs of marketplace.

Disturbing, I mean, in the sense that at some point, each investor needs to be able to sell for a myriad of possible reasons—and the exit is difficult due to liquidity reasons. A second generation patient investor often does not share the original investment objectives of the first owner(s).

This is a phenomenon that agricultural bankers have dealt with in recent years. The children of the original farmers, husband and wife, have long since moved to town or to distant locales and have no interest in the local town where they grew up. They often need to sell to pay college tuitions or to support an urban lifestyle quite unrelated to life on the farm.  

Can bankers count on investor inertia anymore?

But what if the local market affords no reasonably liquid way of exiting?

What if the local bank president depends on personal knowledge of persons willing to buy shares more for traditional investment reasons than for community development reasons that have long since been validated and proven? It probably means that so-called patient money in the hands of second- or third-generation investors is less patient than in the hand of their predecessors.

What are the implications of this for the success of community banks that want to grow their business and need both the reinvestment of earnings and occasional access to external equity capital to properly capitalize growth and stability into the future? 

And then there’s the tension between those dependent on or expecting a healthy dividend and the institution’s need for a balanced approach to balance sheet growth.  

Why the investors’ exit options can be a credit issue

None of these concerns or circumstances are new to many of us and all community bankers have to respond to their external realities as they find them. What makes this question come into focus is the conversation I had the other day with a consultant who is working with the president/founder of a de novo bank that is now six years old. It has grown to about a couple of hundred million in footings and has recently begun declaring a regular dividend.  

The directors are pleased with the introduction of a reliable stream of dividends and they are resisting the CEO’s push to continue to grow the bank to the range of half a billion dollars in assets. The CEO had this as his target asset range for an exit strategy but suddenly his ownership thinks a third of that total is just fine and is sufficient for the foreseeable future. They are protective of the dividend.  

This wouldn’t be a remarkable subject of conversation except for this credit-based argument: The CEO feels that a bank of less than $500 million in assets and deliberately not growing is not being responsive to its customers and its local community.

Suddenly the owners/directors are conflicted with one of the original concepts of incorporation—community service and responsiveness. How can the bank continue to serve the borrowing needs of its customers whom it has helped to grow but who are increasingly having needs that are being outstripped by the bank’s ability to satisfy with a static lending limit?.

I have to say that this is the first time I’ve really thought about this dilemma. It’s up to the owners of the bank, of course, to figure out what they want to do. But it certainly seems to be in conflict with that “ideal” of having a community bank available to meet local demands in ways that the big city regional banks are normally insensitive to.  

What’s really at stake is this, in the bigger picture: How do we as an economic society fund the growth of our community’s credit needs? 

This is not a casual question, especially as we enter a “brave new world” of shrinking community banks due to issues of scale, capacity, and economic expansion as our economic recovery continues.  

The principal issue seems to be a classic one—how do investors cash out efficiently and effectively? 

At some point, each will and must. And the barriers to that, depending on their severity, may create a significant drag on community bank investment attractiveness. An attractive yield on bank stocks means a reliable and more or less generous dividend stream. Occasionally, capital to address growth will require tapping external equity sources (or will inhibit the size of the dividend payout).

What can lenders do?

Those of us who are credit people within our banks can’t be expected to solve those problems singlehandedly but there are two ways we can significantly affect the outcome.  

• First, we must limit credit risk.

That includes anything that negatively impacts net interest income and reputation risk. Community banks are more fragile than regional and larger banks in that sense.  

Second, we must simply be the best that we can be, in terms of how we underwrite credit and train future generations of lenders.

We are entering an environment of severely limited second chances. What we don’t get done, or what we fail to do properly, now will negatively impact our economic prospects for survival as independent entities or as attractive acquisitions.  

We have leverage in the entire process if we do it right.

We have none if we screw this up.

Ed O’Leary

Banking Exchange Contributing Editor Ed O'Leary, a veteran lender and workout expert, spent nearly 50 years in bank commercial credit and related functions, working with both major banks as well as community banking institutions. His last job before retiring was as the CEO of a regional bank headquartered in Alburquerque, N.M. He earned his workout spurs in the dark days of the 1980s and early 1990s in both oil patch and commercial real estate lending. O'Leary began his banking career at The Bank of New York in 1964, and worked at banks in Florida, Texas, Oklahoma, and New Mexico. He served as a faculty member and thesis advisor at ABA's Stonier Graduate School of Banking for more than two decades, and served as long as a faculty member for ABA's undergraduate and graduate commercial lending schools. Today he works as a consultant and expert witness, and serves as instructor for ABA e-learning courses. You can e-mail him at [email protected]. O'Leary's website can be found at

In mid-2016 O'Leary's "Talking Credit" blog received a bronze excellence award for the Northeastern Region from the American Society of Business Publication Editors.

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