Joshua Siegel has been busy lately. The managing principal of StoneCastle Partners LLC hosted a daylong workshop in New York this month on how private-equity firms can find and acquire community banks. Last month he gave pointers to 50 Pennsylvania state bank examiners on analyzing risk at banks.
Siegel, a former Salomon Brothers investment banker, co-founded StoneCastle in 2003 to target the banking sector, and he has invested in more than 200 small and midsize banks and thrifts since then. The asset management firm, which is backed by private equity, has more than $3.1 billion in bank assets.
Siegel is familiar with the private-equity business from another perspective as well. Two years ago, StoneCastle sold a minority stake to the Boston private-equity firm Charlesbank Capital Partners in order to expand its business.
Investment Dealers' Digest spoke with Siegel to get his take on the intricacies of investing in banks. Following are excerpts from the interview.
What do you think about private-equity firms investing in banks?
Most private-equity firms want control, either by themselves or via a group. You typically will only see three types of banks willing to sell control: a start-up, distressed or fully priced bank. That has made it very difficult for private-equity firms to make investments in very well-run institutions. There are exceptions, of course. We've seen Carlyle Group with Boston Private [Financial Holdings Inc.], a great, great call; MatlinPatterson with Flagstar [Bancorp Inc.], though that's a thrift.
The challenge will be that in order to grow a bank at a very high rate … let's say 25% per annum, if your local market is only growing at 5% or 10%, how do you do that? The only way you can do it consistently is to underprice your loans or take loans that other banks are rejecting. If you are willing to get into a bank for the long term, you can make a very nice return.
But to try and make a very high return for a very short period of time, say three to five to seven years, it can be done but it's very difficult. You have to take risks to get there.
If you need three predictors that cause bank failures, it is moving your loan book to high-risk loans without first increasing your capital, growing too quickly and especially growing into markets where the median home price to median income went out of whack with historical measures.
Some private-equity firms seem to think that regulators haven't gone far enough in easing ownership restrictions. Do you agree or disagree?
I agree, because the rules under the Bank Holding Company Act were drafted in 1956. If you think about the mid-'50s, first of all there were no computers. Risk management was done by going loan file to loan file. The idea of data mining in terms of seeing concentrations in your book and spotting trends, these concepts didn't exist. There were no cell phones, no e-mail, so if you're a regulator in Washington in the 1950s and you are worried about who's doing what with a bank in Kansas, you're going to want to have a lot of restrictions because you're not able to get there often to understand what's going on.
If you own 51% [of a bank], you have control, but if you're under 50% there's definitely a person or group of investors who is larger than you, so you really can't just do what you want. To arbitrarily draw a line in the sand today whether it's 4.9%, 14.9%, 24.9% or 33%, I don't know that has much meaning.
I would say you throw out the Bank Holding Company Act and draft a new one. It's always more difficult to amend a legal document than approach one from scratch.
Given that we have many brilliant minds in Washington, I would love to see them bring that accumulated knowledge to bear on a fresh Bank Holding Company Act that accomplishes the two things that they want. It brings in new capital but makes sure that safety and soundness remains.
We haven't seen too many banks involved in rescues of other banks, some for obvious reasons.
No. But you'd be surprised. There's still probably north of 6,000 banks that are in perfect health. Their NPAs [nonperforming assets] are extremely low, their capital is extremely high, and they're profitable. …
In fact, if you look at 1940 to 1980 — not an insignificant period in American history, with a couple of world wars, regional wars, oil embargoes, real estate crises and recessions — the average bank failure during that period was 3 basis points. The highest one year was 5 basis points, leading up to the S&L crisis, which was really a deregulation followed by five regional recessions.
What have you heard from the banking executives that you've been speaking with these days?
Banks are concerned about short-term rates rising higher than expected, which would put them in a funding concern. People are worried about over-regulation. You have a concern about growth expectations. Many public bank CEOs would like to have pressure taken off to grow. If you look at quality, public banks are definitely faring worse than private banks and that is mostly geared toward the fact that the CEOs either put themselves under pressure or face pressure from boards and investors.
Measured growth is good; very high growth is risky. Washington needs to address that we went from a culture, probably from the '50s through the '70s, where you would always hear the phrase 'I'm going to save for college.' But somehow in our generation, it went to 'I'm going to charge it.'
That epitomizes why we're here. Corporations borrowed too much, private equity borrowed too much, the government is borrowing too much, consumers are borrowing too much … everyone has become reliant on leverage to make up for a shortfall in income. You saw that through the '80s with credit cards and the '90s with home equity.
Now you have a deleveraging that is painful, but needed. The answer is not to releverage America. I hear 'the banks should be lending more.' No, I beg to differ.
I don't think the banks should be lending more. People should be borrowing less. It may not sell well in Washington or in the general press, but the reality is: measured growth is good. Unrestrained growth always overheats economies.
People need to be more patient. The new president comes into office, and they expect that within a month solutions are met.
This is 30 years in the making at least. It doesn't get solved in a quarter.
What sort of banks is your firm interested in and how do you go about identifying potential targets for investment?
We invest in healthy banks, and we have earned a reputation in the banking market as an acceptable partner. You can't just show up with money when people are admitting you into one of the classic private clubs. To own a bank is still very prestigious in America.
Acquisitions and growth capital tends to be what we look at. We find targets through a large network of referral sources built over a decade. We typically don't search for opportunities as much as evaluate opportunities that come to us.
The processes that we've built in-house are very institutional. We look at economic factors down to every single county in America, crime rates, bankruptcy filings, median home price to median income, average age, average education level … we're tracking these statistics because when you look at a bank for investment there are really three things you have to evaluate: the management, the local economy and the current balance sheet.
We marry very hard-core credit bottom-up analysis with a top-down macro view. The two combined give you the full picture. I want to know what the future is going to bring because at an average bank the loan book changes every four to five years. In five years that loan book will have changed, and only two things will govern what goes in it: management and the health of the local economy. I want to know that the loans are properly documented and to take a look at the portfolio to make sure there is not a gaping hole not being accounted for. It's OK if there are losses. In fact, I get suspicious if I don't see nonperforming assets. Banks are supposed to take losses, just not too many.
What markets will present the most attractive investment opportunities for private-equity investors?
It's a hard question to answer because I'm a big believer that out of the 8,300-odd banks in the U.S., given that over 98% have less than $10 billion in assets, great markets exist across this country. There are more than 40 states where the median home price to median income hasn't changed since 1980.
What type of returns are you aiming to generate?
We target basically high teens to low 20s. We don't target 30s; we're not trying to push that hard.
Why did you recently hire former Moody's Investors Service senior credit officer Jim Brennan?
We invest in a fair amount of secondary securities, and some of the secondary securities are in bonds backed by portfolios of bank investments. That is what he [Brennan] specialized in for seven years.
It's also what I invented in the '90s at Salomon. We've been managing those assets since 2003. It is a market that is in aggregate between $30 billion and $40 billion.
How is your portfolio holding up?
It's holding up fine, but has not performed as well as expected because no one expected a collapse of the banking system. That said, approximately 90% of the investments we have made are still current on their interest payments. It's been reasonably good. This has been an extremely stressful period.
We have not gone unscathed, but we have outperformed many peers and public equity indices.
You mentioned that your portfolio hasn't been without problems. What sort of lessons have you learned during this time?
We've learned a lot. Banks that grow too quickly present risk. The local market and management are better predictors of the future health of a bank than just its current balance sheet. We've learned that capital and liquidity, having an excess of both, gives a bank more time to withstand a stressful period. You can't just rely on statistical analysis.