Recently at an investor conference, the CEO of a bank was walking me and a couple other investors through their investor deck. We got to a page that showed deposit share in their market and how that had been changed by M&A over time (its a pretty standard type of page that you see fairly frequently). They operate in an attractive market where there has been a lot of consolidation. The page showed what I (and, I am going to guess, the other investors) already knew: out of market banks had bought a lot of the banks in their market and they were one of the few remaining banks that was more or less entirely based in that market and the only one that is publicly traded. The CEO’s commentary on this page was something along the lines of “as you can see, we have a lot of scarcity value.” He didn’t wink when he said it, but he might as well have.
I don’t think that I am telling any secrets when I say that, for many people, a significant component of investing in small cap banks is a play on consolidation. More than anything else, consolidation of the still very fragmented US banking landscape has been the industry’s defining trend for close to forty years. Obviously, for the biggest banks, consolidation has effectively reached its end state, but there are still more than 5500 FDIC insured banks in the United States, most of which are pretty small. In the Russell 2000 Index, which is basically the public small cap market, there are over 250 banks. In other words, despite the tremendous amount of consolidation that has already occurred in the US banking industry, this is a trend that still has a lot of room to run.
I think it is fair to say that anyone who has spent any time looking at or investing in small cap banks is well aware of this dynamic. I also think that it is fair to say that, for a lot of people, part of the decision of whether to buy the stock of a particular small cap bank is whether or not the investor thinks there is a reasonable chance that the bank will be acquired within a reasonable timeframe. Based on that, my view is that there is some amount of takeover premium that is already baked into the price of most small cap banks. Put another way, I think that investors’ collective expectations that a particular small cap bank will sell is generally reflected (to a greater or lesser degree) in that bank’s stock price, which can explain why some banks trade at higher multiples than their historical or expected results might suggest.
Now when this bank CEO told me that his bank had “scarcity value,” what I understood (taken together with the investor deck slide) him to mean was that they were the only publicly traded bank left in an attractive market that could be bought as a pure play on that market. I don’t think that interpretation is much of a stretch. Basically, my view was that this guy was saying “buy stock in my bank because we will have the opportunity to sell the bank at a big premium.”
I have three problems with this.
First, I think it is kind of a bush league move. Generally people at bank investor conferences have a pretty decent understanding of industry dynamics. They also generally have access to the service that used to be known as SNL and have a pretty decent understanding of what banks in what markets might have “scarcity value.” Obviously, it would be tremendously useful to investors to know whether or not a particular bank is considering selling in the near term (and a lot of time at investor conferences is spent dancing around that issue, with investors never actually asking the question and management teams studiously avoiding answering the unasked question), but it is not particularly useful for a management team to hint that, were they to sell, their bank might command a premium. Which leads me to my second problem.
My view is that, when a bank management team spends a lot of time talking about their bank’s “scarcity value,” it is done to intentionally increase investors’ collective expectation that the bank will sell in the near to medium term. I also think that bank management teams understand that those expectations are reflected in their stock price and by increasing those expectations, any takeover premium baked into their stock price will be increased as well. My problem is that, to the extent the takeover premium that is baked into a bank’s stock price is increased, it most likely decreases the actual premium that an acquirer might pay, which is why it is not particularly uncommon for banks that have been the subject of widespread takeover speculation to be bought at a nominal premium (or even a discount) to their stock price the day before the acquisition is announced. Put another way, investor expectations that a bank will sell (which can be fueled by management teams talking about scarcity value), can lead to stock prices and valuation multiples that are not only in excess of what a buyer might play but may also unsupported by the bank’s fundamentals or prospects.
That is why, in my experience, the bank CEOs who are actually likely to sell in the nearish term tend to keep it pretty close to the vest. I think this type of CEO (who may have already sold a bank or two and are usually pretty canny) avoids or downplays discussion of “scarcity value” or other signifiers that a sale is likely for two reasons. First, they want to minimize any implied takeover premium in their stock because they are still getting stock as part of their compensation and would, naturally, rather have that takeover premium baked into their stock price at the time they sell their stock (i.e., when they sell the bank), not when they buy it (i.e., when they receive stock or stock option grants). Second, these CEOs want to avoid the issue of “outkicking their coverage”—they don’t want any implied takeover premiums to inflate their stock price and valuation multiples beyond what a buyer might reasonably pay, thereby jeopardizing any possible sale.
This leads me to my third problem: the existence of “scarcity value” is only relevant to me if (i) I think a bank is actually going to sell and (ii) there is a buyer for it. Dealing with the issue of buyers first (which I will probably elaborate on further in a future post), there is not an obvious buyer for every bank. Even when one or more obvious buyers exist, it may be the case that, when the target bank is ready to sell, one or more (or all) of those obvious buyers will not actually be able to buy the target bank for any number of reasons (regulatory time out, their priorities have changed, they themselves have been bought, etc.).
More importantly, I think that “scarcity value” only really means something if the management team is thinking of (or is open to thinking of) selling the bank. To the extent that management is not thinking of (or is open to thinking of) selling the bank (particularly if they are committed to remaining independent), I think it is pretty bush league for a management team to, intentionally or not (and I think in most cases it is pretty intentional), talk about “scarcity value” and try to inflate their stock price with an implied takeover premium. Unfortunately, despite the fact the he highlighted his bank’s “scarcity value,” nothing else would suggest that this particular bank CEO is likely to sell (or even entertain a discussion on the topic), so whether or not this particular bank has any scarcity value would seem to be an entirely theoretical question.
Most banks are pretty boring: the products are all the same, the management teams are usually fairly bland, risk taking and innovation are generally discouraged and a pervasive herd mentality seems to dominate. It is an industry that largely marches in lockstep and rewards conservatism. Thankfully, most banks have pretty simple models and, particularly if you can gather a lot of really cheap deposits, boring and conservative can still be pretty profitable. Nevertheless, I like a little excitement every now and then, which why I was pretty excited by the prospects of a proxy fight at HomeStreet (NASDAQ:HMST).
Unfortunately, so far, my reaction has been ¯\_(ツ)_/¯ and I don’t think I am alone. Based on how things have unfolded to date, I don’t think that it will really make any difference to investors who wins because, as a practical matter, I don’t think much will change. I have a few theories as to why this proxy contest seems like such an non-event and some suggestions for each side that could lead to better outcomes for investors.
For starters, something is really wrong with Roaring Blue Lion’s approach (and I don’t mean any procedural deficiencies). Basically, as far as I can tell, Roaring Blue Lion is unhappy because (i) HomeStreet’s stock has been a perennial dog, (ii) due to obvious shortcomings relative to peers in key performance and operating metrics, (iii) caused by issues with their business model and some, according to Roaring Blue Lion, ill-advised M&A. All that makes sense and is hard to dispute.
Where Roaring Blue Lion starts to lose me, however, is that all this has been apparent for some time. I don’t necessarily follow HomeStreet all that carefully, but my sense is that HomeStreet has operated this way since its IPO in 2012. Since Roaring Blue Lion claims that is has been a HomeStreet stockholder since then, I don’t know why any of this is particularly revealing. I also don’t quite understand why Roaring Blue Lion feels particularly compelled to try to do anything about it now.
If I had to guess, I would attribute Roaring Blue Lion’s new found activist zeal to that old standby of “enough is enough.” I get it—I mean if it were me, I might just have sold the stock when I first identified all these issues, but whatever—some times investors need to take drastic steps.
That, however, is my real issue with Roaring Blue Lion’s approach—the steps they are taking are not drastic enough. I don’t know anything about the two directors that Roaring Blue Lion wants to nominate, but they don’t really seem like a huge improvement over the current members of HomeStreet’s board. That is not meant as a knock on HomeStreet’s current directors—they all look suitably independent and accomplished—or Roaring Blue Lion’s potential nominees, but none of them seem like they really have the answer to HomeStreet’s issues.
To the extent that Roaring Blue Lion has issues with HomeStreet’s strategy and the execution of that strategy, those issues are more properly with HomeStreet’s management, not its board. Obviously, selecting, compensating and, when needed, firing a CEO is perhaps the most critical function of a board of directors, but to the extent that Roaring Blue Lion feels that HomeStreet’s board has not adequately exercised its fiduciary duties in this respect, Roaring Blue Lion should base its proxy contest on that, not the need for “fresh perspective.”
Another issue with Roaring Blue Lion’s approach is that, even if it were able to succeed in electing two directors, the tangible benefits to stockholders are likely well in the future and clearly not certain. Changes to business and operating models take time and come with a certain amount of risk. One of the main reasons for, what I feel, is pretty strong investor apathy to this proxy contest is the lack of potential payoff for investors, particularly compared to the obvious alternative, which is to sell. I would expect that there are a number of buyers for whom HomeStreet would be an excellent strategic fit and a well negotiated transaction should provide (relatively) immediate and certain value to HomeStreet stockholders.
Finally, HomeStreet has just out maneuvered Roaring Blue Lion. Even the controversy over the validity of Roaring Blue Lion’s nomination of directors has been masterfully handled by HomeStreet. Regardless of whatever other shortcomings HomeStreet management and directors might have, they sure seem to have great tactical sense.
In terms of advice to each side, I think it is pretty clear that Roaring Blue Lion needs to refine its approach and offer investors more than “fresh perspective”—they should either campaign to replace HomeStreet’s CEO or for a sale (I like the latter)—to garner investor support. As for HomeStreet, they can easily blunt Roaring Blue Lion’s efforts by swapping out a few directors or just appointing a few more if their organizational documents permit. If “fresh perspective” is all that Roaring Blue Lion seeks, I am sure HomeStreet can find a few capable individuals who could colorably provide that fresh perspective.
As a general matter, I think the US banking industry is ripe for activism. Chronic underperformance is far too often indulged by investors and boards and there are just too many banks in general. My view is that wholesale consolidation in the banking sector would not only be better for investors and consumers, but make the overall banking system safer and sounder. Unfortunately, most activists tend to avoid the banking sector (despite a number of obvious opportunities), so my inclination is to be supportive when a long time bank investor turn activist in the face of clear and persistant underperformance. However, as someone who tries to look dispassionately at these types of things, I can’t help but be impressed with how HomeStreet, Inc. (NASDAQ:HMST) has outmaneuvered Roaring Blue Lion Capital Management, L.P.
Based on HomeStreet’s responses to Roaring Blue Lion, I offer you “How to Finesse an Activist Investor in Three Easy Steps”:
First, address obvious issues proactively:
HomeStreet has a real issue: it is overly dependent on its mortgage business. Roaring Blue Lion does a great job explaining why HomeStreet’s dependence on its mortgage business is an issue and, to be fair, HomeStreet has had a number of missteps with their mortgage business that should concern investors. However, for as far back as I cared to look in HomeStreet’s investor presentations, they have said that their strategy was to diversify away from mortgages by expanding commercial and consumer banking. Unfortunately, building out a commercial and consumer bank is easier said than done—it takes time and there are number of other banks in HomeStreet’s west coast markets (Banc of California, Opus Bank and Banner Corporation are just a few that come to mind) that are aggressively trying to build commercial businesses. The other thing is that the mortgage business generates earnings: they may be “very interest rate sensitive, seasonal and volatile” as Roaring Blue Lion notes, and investors may put a smaller multiple on those earnings than those from a commercial bank, again as Roaring Blue Lion notes, but they are earnings nonetheless and it is hard to exit or shrink a business that has generated the type of earnings that the mortgage business has over the past few years. Also, assuming that HomeStreet trades more on a tangible book value (rather than forward earnings) multiple, those earnings are vital for growing book value. With interest rates rising, HomeStreet (and a number of other banks that have become dependent on mortgage earnings) will no doubt face the type of reckoning predicted by Roaring Blue Lion, but HomeStreet seems to have clearly anticipated the issues raised by Roaring Blue Lion and has at least articulated a plan to change their business accordingly.
Second, request a detailed plan from the activist:
This feels like an easy one, especially if you have followed step one. Given that HomeStreet has already clearly stated that it wants to lessen its dependence on its mortgage business and grow its commercial and consumer bank, which, as noted, is easier said than done, why not invite Roaring Blue Lion to meet with the board and get a detailed plan from them? I am fairly confident that if Roaring Blue Lion could present a detailed and actionable plan on how to effect the changes they desire (which are all pretty reasonable and would benefit all investors), HomeStreet would act on it. Unfortunately, Roaring Blue Lion’s plan was heavy on broad strokes and short on details.
That said, I am pretty sympathetic to Roaring Blue Lion since there is no way I could come up with a detailed plan for making the type of transformation they are looking for, which is why my detailed plan would have been as follows: sell. There are a number of banks who need greater scale in HomeStreet’s markets and who are further down the path of building out their commercial and consumer banks. In addition, while mortgage would still have its issues, if it was a smaller part of a larger bank’s earnings, its inherent challenges would be more manageable. In addition, if HomeStreet’s mortgage business were in a larger bank, the related earnings might get a higher multiple from investors. Finally, addressing another one of Roaring Blue Lion’s points, drastically cutting HomeStreet’s expenses would offer any acquirer the opportunity for significant earnings accretion.
Third, appoint a director with legitimate “investor friendly” bona fides.
I am not familiar with HomeStreet’s board and assume they take their duties seriously and perform them in good faith, so this is not intend to be a slight to them, but appointing the former head of financial services investments at one of HomeStreet’s biggest institutional investors to the board seems like a tactical masterstroke. I am sure that this newly appointed director would be an excellent addition to the board under any set of circumstances, but in terms of stealing Roaring Blue Lion’s thunder (or roar) ahead of a proxy contest, this feels like a real winner.
In conclusion, as a student of these things, my hat is off to HomeStreet for, so far, conducting a master class in dealing with an activist investor. In this situation, I think it is clear that HomeStreet has the upper hand, even though I generally agree with all the points that Roaring Blue Lion has made. Whether HomeStreet retains the upperhand, however, may depend on whether Roaring Blue Lion refashions its objective into something more direct and immediately obtainable.
There are a lot of banks in the United States. As of the end of 2017, there were 5,670 FDIC insured depositary institutions. While most of those are privately held and pretty small, there are also a lot of publicly traded banks. Within the Russell 3000, there are 298 companies with an ICB Sector classification of “Bank.” There are more “Banks” in the Russell 3000 than any other ICB Sector and that does not include companies like Bank of New York, Northern Trust, Morgan Stanley, Goldman Sachs or CIT, which are classified as “Financial Services.”
Given how many banks there are, it should come as no surprise that there is a pretty wide discrepancy in performance. There are some high performers, there are some real dogs and there are a lot in between. Given that most banks more or less produce the same product (loans) from the same materials (deposits), my view is that variance in performance basically comes down to the quality of the management team. Again, it should come as no surprise that there are some real rock star management teams and some total duds. After years of study, one conclusion that I have come to is that while the duds might not be great at running a bank, they seem to excel at the art of mushroom management when it comes to their boards.
One surprising thing (at least to me) about the banking industry is that there is so little activism relative to the amount that occurs in the rest of corporate America. Given the size of the industry, how comparable all banks are, the wealth of data that is available on each bank and the wide variance of performance, I would have expected that more activists would appear to hold underperforming banks (particularly where the underperformance is chronic or there are obvious governance issues), their management teams and boards accountable. I understand that activists might have concerns about the regulatory overlay and might not have the industry knowledge, but there are some pretty clear examples of activism working (even if it doesn’t quite work until the second time), so it feels like there should be more activism.
Between the absence of activism and excellence at mushroom management, the natural state for banks that are chronic underperformers, have governance issues or are otherwise generally blind to obvious problems is that of inertia. Absent some external force, the existing state continues. Occasionally, however, no external force is needed and those boards that had been treated like mushrooms by their CEOs (usually for far too long) take matters in to their own hands and demand accountability.
Two great recent examples of this are American River Bankshares (NASDAQ—AMRB) and MidSouth Bancorp (NYSE—MSL). I had followed both these banks for a number of years and, candidly, had viewed the boards of each as in thrall to their CEOs. I also had strong suspicions that, in each case, the CEO was not giving his board and accurate assessment of the bank, its prospects and the issues facing it. I was, therefore, (very pleasantly) shocked when each fired their CEO, evidencing, to my mind, a vigorous embrace of their fiduciary duties and responsibilities.
In the case of American River, it is a pretty simple story: they just didn’t make enough loans. I also think they made some serious mistakes in terms of capital deployment/return, but that was just the insult--the real injury to performance and stockholder value was a chronic inability to make enough loans. Just as simple and obvious as the problem, was the solution: fire the CEO and bring in a new CEO who will do things differently. I can’t link to it, but I will quote the new CEO, David Ritchie, from his first earnings call in January:
"My plan for American River Bank is growth. We are very well positioned with our
capital and liquidity. Now, we need to start deploying that capital. We need to build
upon our 34 years of excellent reputation, expanding existing relationships and
bringing new relationships to the bank."
Again, pretty simple—fire the guy who couldn’t make loans and bring in someone who at least understands that is the priority—and great work by the American River board. I assume and hope that they will give the new CEO the time and resources that he needs to be successful while remaining open to all opportunities to maximize stockholder value.
With MidSouth, it is all a little more complicated and dramatic. In the first instance, it wasn’t just the CEO that was fired, it was the founder, single largest individual stockholder and, basically, personification of the bank. Also, it wasn’t just the CEO who got the axe, his son, the bank’s president, also got chopped. Adding to the drama is the fact that the guy who seemed to be swinging the axe was a football star who had only recently been appointed chairman of the board. In addition, as far as I can tell from published reports, Jake Delhomme, the football star, and Troy Cloutier, the CEO’s son, were close personal friends. Taking all that into consideration, I have tremendous respect for the MidSouth board, since it must have taken enormous fortitude to do what they did, even if it was sorely needed (and maybe prompted by regulators).
As to the reasons for this drastic action, my view is that it basically comes down blindness on the part of the CEO. One obvious blind spot was the impact of having a large concentration of oil field service loans. I don’t necessarily think that was a bad business decision given the market that MidSouth operates in, but it was a bad decision not to acknowledge the issues caused in that portfolio by declining oil prices and address those issues aggressively. Another was the impact of appointing your son to a senior management role when the bank was under duress. Troy Cloutier may be a great bank executive (I don’t really know either way) but it wasn’t the time to do it. A third was the need for additional capital. Less obvious are other blind spots, like being too fond of a branch network that cost too much.
Finally, unlike with American River, the fix is not so easy or obvious. My gut instinct is that Rusty Cloutier was probably a pretty good banker, all things considered, even if firing him was the right thing to do. However, one obvious question is how much business was he responsible for and what happens to that business now that he is not there? Raising additional capital, aggressively dealing with problem energy loans and scaling back the energy business are also all good things, but how to replace the earnings that previously came from energy loans and any deposits that came from those relationships? Similarly, rationalizing their branch network makes sense, but can they actually get their cost base to the right level on their own?
Just as with American River, I assume and hope that the MidSouth board gives its management team the time and resources that they need to be successful while remaining open to all opportunities to maximize stockholder value. However, for MidSouth, the path forward might be better with a partner.
There are probably a bunch of ways a former bank CEO winds up on a bank board. Two and a half ways spring to mind and this is how I feel about each of them (with the obvious caveat that ultimately it depends on who that former bank CEO is).
The first way is in reaction to some issue at the bank. A recent example of this is Opus Bank (NASDAQ—OPB). In 2017, Opus experienced some real credit issues in segments of its commercial business. As part of what I consider to be an aggressive reaction to these issues, they named a former bank CEO as lead independent director and later promoted him, I guess, to chairman of the board. As a general matter, I like when this happens for two reasons.
The first reason is because I generally assume that former bank CEOs have a very well developed understanding of the potential liability that comes from serving on a bank board as well as the ability of regulators to make life hell for bank directors if they choose. I also generally assume that former bank CEOs don’t need or want that type of aggravation, so they will not take a board seat without doing significant due diligence to understand the scope of the issue, whether it is or on its way to being under control and whether or not there are additional shoes that are going to drop. Finally, I generally assume that former bank CEOs know how to diligence a bank, its loan portfolio, liquidity, risk controls, etc. far better than I ever will. In sum, my general view is that they are a proxy for any diligence I might do (and then some) and, by accepting the board seat, are essentially signaling that the issue is under control.
The second reason has to do with why I think it is pretty rare for former bank CEOs to be appointed to bank boards, which is that the current CEO doesn’t generally want someone looking over him and second guessing what he is doing. I am pretty sympathetic to that sentiment, which is why I like seeing a former bank CEO appointed to a bank board after some issue with the bank. It suggests one (or a combination) of two things: either the rest of the board is acting pro-actively to bring in knowledgeable oversight or the existing CEO is open to having (and hopefully taking advantage of) an experienced bank executive on the board. Either or both are great by me and evidence a company that is proactively facing its issues.
The second way a former bank CEO might wind up on the board of a bank is if he is a founder or part of the founding group. I don’t necessarily love this situation. Sometimes, it seems like the former bank CEO wants to act like the CEO in terms of controlling the bank and its strategic decision without actually being CEO and therefore responsible for performance, etc. In those cases, it seems to me, you wind up with a weakened management team overall, issues with accountability and a difficulty in attracting and retaining talented bankers.
In other cases, it feels like the former bank CEO is window dressing. I don’t know if that causes as much harm as the former bank CEO trying to control things, but I worry that other directors might be, consciously or not, relying on the former bank CEO to effectively take the lead in terms of supervising the business giving his experience. If the former bank CEO is really just mailing it in, problems could develop.
The second and a half way a former bank CEO might wind up on the board of a bank is if he retires and doesn’t leave the board. Again, all this is subject to the caveat that it ultimately depends on who the former bank CEO is, but I really don’t like this situation. A CEO transition is the perfect time for a bank to take a wholesale look at its business, prospects, etc and make appropriate changes. It is pretty hard to make any meaningful and/or directional changes with the former CEO on the board, particularly if any of those changes might be construed as a repudiation of actions taken (or not taken) by the former CEO. CEO turnover at banks is pretty rare as it is—when it happens, the new CEO should be free to set his own direction and not be constrained by the continued presence of the previous CEO.