Comment: Strategies for Pruning Back Excessive Capital

First of Two Parts

Too much capital - it can start your stockholders agitating for improved returns, and it can stop a potential acquirer from offering a premium.

In the increasingly hostile environment for financial institutions, boards of directors are becoming more aware of the importance of meeting the expectations of their shareholders.

As was reported recently in the cases of two thrifts in the Northeast, professional investors are becoming more willing to take large positions in community-oriented financial institutions with the intention of pushing them into a sale.

What do shareholders want?

Bank and thrift investors generally expect annual returns of at least 15%

As successful managers know, the keys to meeting shareholders' long-term expectations include steady growth, wide spreads, low operating costs, and excellent asset quality.

However, as the financial institution industry has enjoyed several years of strong earnings, capital management has become increasingly important.

For years, financial institutions struggled just to meet the minimum regulatory capital requirements, with the idea of having to much capital being almost unimaginable. That is no longer the case.

The change is especially noticeable in today's heated thrift-conversion market. Almost every thrift has been forced to raised significantly more capital than needed. At current conversion pricing levels, mutual thrifts that convert with equity of 8% usually end up with equity levels in excess of 20%.

Effective capital management has thus become a significant challenge to many financial institutions. Too much capital can be bad for shareholders because it reduces the company's leverage. Although a high capital level may generate a high return on assets, it usually generates a lower return on equity than is acceptable to shareholders.

If an overcapitalized company is unable to earn a competitive ROE, its shareholders may decide this excess capital can be put to better use elsewhere. That makes the company vulnerable to takeover. Directors who realize this and effectively manage their capital will be in a better position to remain independent.

However, it is extremely important to note that capital management in and of itself does not create value, but merely changes the timing of returns to shareholders. True value can be created only through, among other things, growth, asset quality, profitable spreads, and cost management.

Internal growth is one option available to increase leverage and improve return on equity. However, it is highly unlikely that a significantly overcapitalized company will be able to grow quickly enough to effectively use its equity. A company with capital levels in excess of 20% of assets, for instance, would have to triple in asset size to reduce its capital level to 7%.

External growth through acquisitions provides a more likely avenue to successfully leverage excess capital, because of the opportunity to grow rapidly. However, this too could increase the risk profile of a company, if acquisitions were made solely to achieve growth targets.

If a suitable target is found, an overcapitalized company will want to offer only cash in the acquisition, because issuing shares of stock will do little to help reduce the excess capital and will also dilute the value for existing stockholders. However, a cash-only offer may not prevail against bids that offer tax-free stock.

A stock repurchase program is a favorite capital management tool that can be very beneficial to a company's stock. It allows a company to use its capital and also increases the liquidity of the stock.

However, the benefits of stock repurchases can be often a problem. Available shares dry up quickly in many small financial institutions. Further, repurchases may place upward pressure on the stock price. As the price rises, the program competes with stock-based benefit plans, which may also be looking for available shares at a reasonable price.

Finally, even if the shares are available at a reasonable price, regulatory restrictions and time considerations may prevent repurchases from making a significant impact on a company's equity level quickly enough to satisfy stockholders.

A variation of the stock repurchase program is a self-tender program in which a company sets a date and determines a price range above the current trading price in which it will purchase its shares.

One type of self-tender is a "modified Dutch auction" in which stockholders select a price within a range at which they are willing to sell their shares.

The company aggregates all the shares tendered and determines the lowest price at which it can purchase the number it desires. Shares tendered above the designated price are returned. (In the alternative, the company would pay an average price based upon the shares tendered.)

Under a self-tender program, a company pays a premium for its stock repurchase program. The downside is that the program could invite an unwanted offer - from an acquirer willing to pay stockholders a slightly higher premium than the company is offering.

A company can also establish an above-average cash dividend in order to reduce its capital level. In a highly capitalized company, the dividend payout can reach 100% of earnings. A regular dividend should be established at an initial level that is readily sustainable and would allow for a regular pattern of increases.

Given the limitations of the above strategies, the use of special cash dividends become increasingly attractive to overcapitalized companies.

A special dividend is typically a separate payment to shareholders that is larger than the regular dividend and nonrecurring in nature.

The attraction is the immediate reduction of equity. With a single payment, equity can be reduced to a level that would otherwise take years to achieve. As a result, a company can dramatically improve its financial performance without significantly changing its risk profile.

It is important to note that special dividends affect a company's value very differently than growth strategies do.

A special dividend changes only the time of returns to shareholders; they receive the value of the excess capital today rather than when the company is sold.

In the long run, shareholders should be satisfied with a special dividend only if the company can earn a competitive return on the remaining equity. Otherwise, they would do better to sell the entire company and reinvest their capital at a more competitive rate.

For this reason, a special dividend should be considered only by companies with the financial ability to remain independent.

Next: Implications of a special cash dividend

Mr. Wagner is a vice prescent with Trident Financial Corp., Raleigh, N.C. Mr. Borja is a lawyer in Washington with Reinhart Boerner, Van Duren Norris & Rieselbach.

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