The Capital Challenge

CAPITAL FUNDING

Five steps to help raise new capital in today’s competitive markets

By Greg Dingens and Shawn O’Brien

The maxim that “Capital is King” certainly applies in today’s banking environment, and will only become more accurate in the near future, thanks to pending regulatory changes.

For most community banks, the need for more capital is either urgently required, desired for defensive or offensive purposes, or potentially looming in the future. Despite an improving economy, the current environment for most community banks raising capital through public stock offerings remains challenging.

Fortunately, signs of a capital market thaw are appearing after a very long and arduous winter. However, just as hope is not a strategy, neither is neglect. Every community bank should understand the current dynamics of and opportunities in today’s capital markets. Preparing for pending regulatory changes that could impact public capital raises should be an important component of every community bank’s planning process.

Pending regulation

In particular, the final outcome of defining the Basel III capital standards will likely have the greatest influence on whether and how your community bank may need to raise additional capital in the months ahead. If the proposed Basel III rules are implemented as currently proposed, many community banks, especially those with a large portfolio of non-conforming mortgages, may need 10 to 25 percent more capital. However, the final Basel III regulations, thanks in large part to efforts by ICBA members, are expected to provide community banks with at least some relief from what would otherwise be industrywide capital standards.

Nevertheless, it is highly likely that the core principles behind Basel III proposed capital requirements for the largest banks could survive in some form for community banks. If that happens, the average community bank will need more common equity, and the regulatory bodies seem very intent on reducing some forms of Tier 1 capital used by community banks, such as trust preferred securities.

Fortunately, a few new useful capital-raising tools may be available to community banks in the near future, thanks to the JOBS Act that Congress enacted last spring. An important ICBA-advocated amendment in the law increased the number of shareholders a company can have before it is forced to register with the SEC, allowing hundreds of community banks to avoid significant expenses.  

However, two other provisions in the JOBS Act awaiting action by the Securities and Exchange Commission should aid many community banks in raising capital. The first will loosen restrictions on marketing a private placement of securities, permitting community banks to more openly market securities to reach the broadest possible pool of potential investors. Such securities offerings would still be limited to accredited investors, as they are today, but the marketing of those offerings can be more comprehensive, effective and efficient.

Second, the expansion of the little-used Regulation A exemption to offering securities—in what could be called a semi-public offering of stock—might be a great new capital-raising tool for community banks. The pending SEC rules will expand the amount of stock that can be publicly offered for sale under Regulation A from $5 million to $50 million, a more useful range for most community banks.

Under the Regulation A exemptions, securities offered for sale have to be reviewed and approved by the SEC, similar to any other public offering. But unlike a traditional public stock offering, the issuer does not have ongoing public reporting requirements. This presents community banks with an ideal avenue for raising capital: the ability to sell unrestricted securities that can be broadly offered to any investors without ongoing disclosure requirements.

Know your audience

A natural and important source of capital for community banks is its own insiders and local investors, who often are motivated to invest in a community bank for many reasons beyond purely maximizing their investment returns. However, once a bank decides to seek investors beyond this immediate local market base, it often must work with a new set of investors that place more focus on maximizing their investment returns. These out-of-market investors are primarily specialty investment funds that either focus exclusively on investing in banks or have developed an expertise for investing in banks.

With these new regulatory changes and opportunities in the public capital markets in mind, here are five steps your community bank can take to position itself well in what is likely to remain a competitive buyer’s market for bank securities in the months ahead.

1. It starts inside. New investors typically take great comfort from insider participation in a community bank’s public securities offerings. This dynamic is important because it aligns new investors on the same terms with the insiders who control the company. If insider investors do not participate in a bank’s securities offering, other investors may reasonably ask, “What do they know that I do not know?”

So as your community bank prepares for a public offering, it should both strongly encourage inside participation and have a clear story around why insider investors are doing whatever they are doing.

2. Know your story. While it is easy to generalize that most community banks have simple and similar business models, investors will spend tremendous energy trying to determine exactly how your community bank is similar to or different from the many other investment opportunities they can access. So be prepared to clearly articulate your bank’s overall operational and marketing strategy, but also be able to compare its strategy and its results to those of its competitors. And consider writing an investor presentation highlighting your community bank’s strategies and results before you even begin to raise capital. Know your bank’s strengths and weaknesses. These are excellent exercises to conduct to better plan and manage your bank’s success for any securities offering.

3. Pretend you are public. Investors discount securities for risk, and uncertainly is risk. Even if your community bank is not a publicly traded company, it should emulate the spirit and content of quarterly and annual disclosures to its investors. Taking such steps in promoting greater transparency will permit investors to make more-informed decisions to reduce their investment risk, but it also will inspire confidence in investors that your bank’s management and board of directors are attentive in serving the needs of its shareholders. As your community bank courts new investors, having a track record of shareholder focus will be very valuable in establishing greater credibility with them.

4. Nurture a lead investor. Most community bank public offerings don’t take place in a liquid marketplace, which can hinder how fair pricing of securities is discovered for both the issuing bank and for new investors. If your community bank embarks on an offering with a large investor that has already conducted diligence and agreed upon a stock price, this will validate both the bank and the pricing, creating substantial positive momentum that can draw in other new investors.

Work to create relationships with local or professional investors who can play this role before your community bank begins an offering.

5. Be reasonable on terms. If your community bank needs to go beyond insiders and local investors to raise capital, know that most other investors it approaches have many opportunities to invest in other banks, either in the open public markets or through other offerings. Nothing will deter new investors faster than an unreasonable asking price for your bank’s stock. Be honest and reasonable about your own prospects, and understand that most sophisticated investors must see a way to earn double-digit returns on their investments to commit to a stock purchase.

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