Why flurry of mutual fund conversions will continue.

Thrifts that recently converted to stock from depositor ownership face heightened profiles as takeover targets, boosting the potential for investor windfalls and further conversions.

The lucrative potential of so-called mutual conversions, in which depositor-owned thrifts are sold to shareholders through initial public offerings, was proven this summer with three buyouts of converted mutuals.

In the richest deal, Interfirst Bankcorp, Michigan, fetched an amount equaling 1,364% of its initial public offering price when it agreed in May to be bought out by Standard Federal Bank.

Also, United Postal Bancorp. of St. Louis, in August fetched six times its IPO price in just over a year when it agreed to be purchased by Mercantile Bancorp. Finally, Cragin Financial Corp. in Chicago, locked in 570% of its IPO price when it agreed in July to be bought out by ABN Amro North America.

Market Isn't Saturated

Given this recent history, it is little wonder that roughly three dozen mutuals have converted to stock ownership in 1993. Even though some skeptics believe the conversion market is saturated, several trends indicate the opposite.

For one thing, the market for thrift stocks is strong. The average price/book ratio for publicly traded thrift stocks has risen in 1993, climbing to about 100% at the end of September from 70% a year earlier. Given the forgiving low rate environment, this market support probably will continue in the near term.

Consolidation also remains an impetus for mutual conversions. With mergers looming as a long-term trend, many thrifts will be positioned to reward shareholders with buyout offers.

Acquirers looking to build market share have found thrifts, which generally sell at lower multiples of price-to-earnings and price-to-book value than commercial banks, a cost-effective means of expansion as long as targets are not battling asset-quality problems.

Savings and Revenues

Moreover, an in-market deal for a clean thrift can yield cost savings and new revenues as commercial bank products are marketed to thrift customers.

Just as important for conversion investors, the market has responded voraciously to most recent mutual conversions. The average first-week stock gain for thrifts converting in the first nine months of 1993 is 34%.

The generally healthy premiums in these transactions are as much a function of the lucrative nature of a conversion as they are related to a company's financial performance. That means all-star performance is not an absolute prerequisite for a stellar investment return.

Here is why that is possible: In a standard conversion, investors purchase shares of a mutual thrift as it goes public. The stock sales proceeds generally flow straight into the thrift's equity coffers, increasing the book value of the shares purchased by the investors. That means the IPO price is only a fraction of book value (provided the thrift does not suffer subsequent erosion from asset quality problems).

If the thrift later agrees to be acquired, even modest premiums over book and market values can represent a substantial premium over the IPO price.

For example, Chicago-based St. Paul Bancorp's bid for Elm Financial -- priced at a relatively modest 104% of book -- still represents a 125% gain for those who purchased shares at Elm's initial public offering.

A review of 14 mutuals that converted to stock ownership since January 1990 and then agreed to be acquired shows that Cragin, Interfirst, and United Postal are not alone in delivering rich returns to investors.

They were joined by two other thrifts in crossing the 500% takeover price/IPO price plane in the past three years. FirstSouth Bancorp, Pittsburgh, elicited a buyout contract from BT Financial Corp. in a March deal priced at 592% of its split-adjusted IPO price of $5.40. Bellefontaine. Ohio-based Colonial Federal Savings Bank agreed to be acquired by Mid Am for 550% of its $ 10 per share IPO price.

Of the nine remaining deals in the peer group, five were valued at 300% to 500% of the target thrift's IPO price. Only four thrifts received an offer beneath 300% of their IPO price.

Only one of those -- Catano Federal Savings Bank of Puerto Rico -- drew an offer priced at less than 100% of its IPO price. The thrift's problem assets were in the neighborhood of 7% of total assets when it announced its merger agreement.

Mortgage Operations

Other circumstances can boost the price of thrifts. For instance, those with substantial mortgage banking operations may command higher prices because of their higher potential for fee income.

Such was the case with Interfirst. The unit originated and purchased $1.3 billion of residential mortgages in 1992, while posting a 1.81% ROA.

Overall, financial performance was mixed at the 14 thrifts in the peer group. Only Catano had nonperforming assets exceeding 2% of total assets when its acquisition was announced, indicating that asset quality generally was acceptable when these units were sold.

However, just eight of the 14 thrifts were delivering annualized return on assets exceeding 1% when their buyouts were announced. That means about half of the targets were relatively unspectacular earners.

Location, Location, Location

What made these middling thrifts attractive targets is geography: They were located in active merger markets.

Four were based in North Carolina, where midsize bank holding companies are gobbling up thrifts; and two were based in Chicago. Still others were based in Pittsburgh. Maryland. Missouri, Hawaii, Indiana, and Ohio -- all markets that have seen their share of mergers.

Of course, the road from conversion to acquisition is not necessarily an easy one. Office of Thrift Supervision regulations prohibit a thrift from being acquired within a three-year period after it converts to stock ownership. And many thrifts have charter provisions blocking a sale within a specified number of years following a conversion.

But attorney Eric Luse, with the Washington law firm of Luse, Lehman, Pomerenck & Schick, said that such issues can be overcome. If a thrift's board of directors supports a merger. he explained, the OTS will probably approve a petition to waive the three-year sales prohibition.

As for anti-takeover provisions in a thrift charter, Mr. Luse says the provisions generally are there to give directors bargaining power in takeover negotiations. Once they have served their purpose, he says, the provisions can be rescinded through a directors' vote.

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