Financed By Creativity

Before the crisis, bank mergers were put together in simple fashion: one bank gave cash or stock to the owners of another bank, and everything was good to go, assuming the combination didn’t add up to some regulator-rattling monopoly.

Settling on a fair price was relatively easy, so long as you could answer two big questions—what is the seller's stock worth, and how many bad loans are in the portfolio. Things are trickier today, with the wild swings in the equity market and the persistence of a lethargic jobs market making a riddle out of many banks' true value and health. That uncertainty is the chief reason why few banks are changing hands. But a handful of community banks have begun rewriting the industry's merger playbook with novel deals attempting to solve pricing and loan valuation questions.

An unusual acquisition strategy involving a debt-to-equity swap is getting attention from a small number of banks. Other institutions are inking deals with final prices that hinge on future loan losses and profits of the acquired bank. While the specific approaches may remain rare, creative deal-making in general is becoming more common, with would-be buyers angling for a first-mover advantage deciding that they must think outside of the box to get deals done.

Not surprisingly, banks at the forefront of the trend tend to be backed by the type of investors famous for clever and aggressive wheeling-and-dealing: private equity shops and hedge funds. Those investors have the know-how to help their holdings put deals together, in some instances guiding decisions from a seat on the board.

Take Tennessee Commerce Bancorp of Franklin, Tenn., which in July announced that it was taking over two small Tennessee banks by forgiving an overdue $30 million loan it had made to their owner, Citizens Corp., in exchange for each banks' shares. Tennessee Commerce has two years to decide whether to keep the banks or to sell them. Until then, it does not need regulatory approval for the deal.

Debt-to-equity swapping is a legitimate method for one company to temporarily take control of another one. It is rare in banking. One place it isn't rare at all? The hedge fund world, where taking over a distressed institution through its debt is a classic play.

Bank analyst and financier Tom Brown’s New York hedge fund Second Curve Capital owns about 10 percent of Tennessee Commerce, according to Bloomberg data.

While Brown is not on the board of the $1.5 billion-asset Tennessee Commerce, another financier with deep transactional experience is: William McInness, co-founder and managing director of Nashville merchant bank Caroland McInnes, which advises companies on mergers and offerings and makes its money by investing in those deals.

Pay-for-performance is the guiding philosophy of how people at firms like McInness's get compensated at their day jobs. It also is the underlying principle of some recent deals negotiated by another private equity-backed bank, Wintrust Financial of Lake Forest Ill. WinTrust in 2008 raised $50 million from Chicago buyout firm CIVC Partners, and one of the firm’s partners, Christopher Perry, sits on Winstrust's board. In its proxy filed in April, Wintrust said that Perry's job at CIVC "gives him insight into complex capital structures… and all aspects of transactions."

In July, the $15 billion-asset lender agreed put together a relatively complex deal for Elgin Sate Bancorp of Elgin, Ill. It is paying $13.75 million in cash and stock upfront, and may dole out another $1.5 million in cash should Elgin's loans perform well over the next three years.

Wintrust negotiated a similar deal in April for certain liabilities of mortgage bank River City Mortgage in Bloomington, Minn. A press release announcing the deal noted that "a significant portion" of the undisclosed purchase price "is conditioned upon certain future profitability measures."

First PacTrust Bancorp of Chula Vista, Calif., took a similar approach in its $17 million deal in June for Gateway Bancorp in Cerritos, Calif. If First PacTrust winds up having to spend big sums to repurchase potentially bad mortgages over the next three years, Gateway will get $2.5 million less than the anticipated purchase price. (That's how much was placed in escrow when the deal was struck.)

Much of First PacTrust's equity is controlled by three private investors from which it raised $60 million in a private stock placement in 2010. One of them, Santa Monica financier Steven Sugarman, has a 5 percent interest in First PacTrust, and a seat on its board.