First Defiance Financial Corp. executives were skeptical when an investment bank approached the company about the possibility of acquiring Pavilion Bancorp Inc. in Adrian, Mich.
The executives said they were wary of buying a bank in Michigan, which has been in a terrible economic slump as a result of weak auto sales, high unemployment, and a flagging real estate market.
Ultimately, though, the Defiance, Ohio, company decided to acquire Pavilion, the $290 million-asset parent of Bank of Lenawee, in part because it would be a geographic fit and would accelerate First Defiance's transition from a thrift to a commercial banking company.
"We know some of the problems the state is going through, but we felt it was close enough that we needed to take a look at it, and once we did, we overcame our concerns," William J. Small, First Defiance's chairman, president, and chief executive, said in an interview last week.
The company's $55.7 million deal for Pavilion was announced this month and is expected to close late in the first quarter. At that time the $1.5 billion-asset First Defiance plans to convert its thrift subsidiary, First Federal Bank of the Midwest, to a federally chartered commercial bank.
The deal is the fifth announced for a Michigan bank or thrift this year, but the first in which the buyer is from outside the state. In-state mergers and acquisitions have been fairly common of late as bankers there look for scale, but outsiders have seemed reluctant to deal in Michigan until the state's economy shows signs of a turnaround.
Pavilion has not escaped what Mr. Small calls the "Michigan blanket." Its credit quality, like that of many other community banking companies there, has deteriorated steadily in recent quarters.
Still, he said that there are compelling reasons to acquire Pavilion, starting with the fact that it operates in southeast Michigan markets that border First Defiance's markets in northwest Ohio.
Pavilion also would be a good philosophical and strategic fit, he said. "The biggest segment of their portfolio is their agriculture segment, and that's a piece of business that we do a fair amount of also."
He said he was "amazed" at how similar some of Pavilion's marketing materials, as well as the internal materials it uses for employee development, were to First Defiance's.
"We felt that was a very good cultural fit along with the geographic location." Mr. Small said.
The acquisition would be First Defiance's first since early 2005, when it made two in quick succession. In January of that year it acquired Combanc Inc. of Delphos, Ohio, and three months later it bought Genoa Savings Bank.
First Defiance would have preferred not to have made two acquisitions so close together, but "you can't always time them the best," Mr. Small said. The Combanc deal came up suddenly when the Genoa one was already in the works.
Bank of Lenawee, founded in 1869, is one of Michigan's oldest banks. Richard DeVries, the president and CEO of the bank and its parent, said last week that Pavilion decided to sell itself for the same reasons many other community banks are selling these days: fierce competition for loans and deposits, shrinking net interest margins, and the inability to match the offerings of large banking companies.
For example, First Defiance has a subsidiary that offers both wealth management and insurance to retail and commercial customers, he said. "We have none of those in our portfolio, yet we have a very large customer base, many of whom will need access to those products and services."
Pavilion has been affected by Michigan's weak economy, but it has "virtually no direct exposure to the automobile industry," Mr. DeVries said. "Our commercial customers are not providers to the automobile industry."
Also, Bank of Lenawee's mortgage exposure is "fairly modest," he said. Many of its mortgages are on lakefront properties that tend to hold their value and "stabilize an economy that otherwise might be a little more volatile."
Christopher W. Marinac, an analyst with FIG Partners LLC in Atlanta, said in an interview last week that First Defiance is "definitely inheriting some asset problems."
In a research note published Oct. 3, Mr. Marinac wrote that Pavilion's nonperforming loan rate was 1.45% of total loans as of the end of June — well above the industry average for companies its size.
"The company is of course well aware of that, and they're claiming these are issues that they can work through," he wrote. First Defiance's management team has a "very good track record for integrating acquisitions."
Mr. Small agreed that Pavilion's troubles with asset quality are manageable. "We're very pleased with what we've seen with their underwriting and credit standards."
He expects the deal for Pavilion to be a "much cleaner transaction," than the Combanc and Genoa acquisitions were. Both of those companies had some credit issues that had preoccupied First Defiance's management and kept it from looking at other potential acquisitions, he said.
"That stretched us pretty good," Mr. Small said. "Doing two of them that close together, we needed to catch our breath a little bit."
Bank of Lenawee has eight branches, all of which would be converted to branches of First Federal Bank of the Midwest. The First Defiance unit was founded in the 1920s as a thrift, but for the last decade or so it has been moving away from residential lending and making more commercial and commercial real estate loans. At June 30, residential loans made up less than 29% of its $1.2 billion loan portfolio, versus about 40% five years earlier, according to Federal Deposit Insurance Corp. data.
Mr. Small said that First Federal has applied for a national bank charter, and that First Defiance expects to complete the conversion around the same time the deal for Pavilion closes.
"We've continued to operate with the thrift charter with no compelling reason to make a change," he said. "But now we've grown the commercial side of the business to the extent that we think it's time to make that switchover."
