When Converting Mutuals, Consider a Merger

Although mutuals are in theory owned by their depositors, there is in fact no tangible expression of ownership.

In such institutions, property rights are transformed into the privileges of management. And managers often operate like the heads of a feudal estate, with hereditary succession.

This being the case, well-run and well-capitalized mutuals are like unclaimed pots of gold.

But there is a solution. The wealth can be distributed through a public conversion to stock form, in which depositors and management are offered a subscription sale of stock. The attraction of the arrangement for both groups is the hope of realizing a profit through appreciation when the stock is publicly traded.

Management's Standpoint

A straight conversion runs the risks of any publicly traded company. Foremost among these risks is the possibility of irritating stockholders to the point of provoking changes in the managerial aristocracy.

But managers usually do well. When Craigin Financial converted in June, chief executive officer Adam A. Jahn's net worth grew by $2.9 million in a single day.

For management, a merger-conversion, in which the mutual is simultaneously converted to stock form and merged into another company, offers an incentive beyond making ownership of the pot of gold tangible. The advantage is that managers can negotiate an agreement with the acquiring company that protects their perks.

Acquiring banks realize an enormous economic advantage in merger-conversions:

They acquire the mutual for a fraction of its real value.

A Hypothetical Deal

Exactly why and how can be illustrated by comparing two hypothetical acquisitions, one a merger-conversion and the other purchase of a healthy stockholder-owned institution.

Assume that Acquiring Bank, with $200 million in assets, $15 million in equity, and three million shares outstanding, trading at $5, or 100% of book value, is considering two acquisitions: a merger-conversion with Mutual Federal and a stock offer for Second Savings.

Both Mutual Federal and Second Savings have $100 million in assets and $7 million in equity.

Mutual Federal has, of course, no shares outstanding; it is "owned" by its depositors.

Second Savings has two million shares outstanding trading at $3.50 - 100% of book.

For the purposes of this example, we have assumed that Acquiring Bank could acquire Mutual Federal by offering $1.4 million of its shares at the current market price of $5 to the mutual's depositors.

Alternatively, it could pay a 42% premium over book to acquire the shareholder-owned Second Savings.

After a merger-conversion with Mutual Federal, Acquiring Bank would have $300 million in assets, $29 million in equity (its original $15 million plus Mutual Federal's $7 million and an additional $7 million raised from the stock sale), and 4.4 million shares outstanding.

The transaction would be antidilutive, actually increasing book value by 32%, to $6.59 a share.

If the stock continue to trade at book, shareholders of Acquiring Bank, including the depositors and managers of Mutual Federal, would enjoy a 32% increase in the value of their shares.

An acquisition of Second Savings is less attractive.

Let's say Acquiring Bank offers a share-for-share trade (a 42% premium at the trading price prior to the deal) and issues two million new shares to Second Savings shareholders.

Acquiring Bank would have $300 million in assets but only $22 million in equity and five million shares outstanding, resulting in a book value of $4.40.

Acquiring Bank's stock value would have been diluted 12%. And, if the stock continued to trade at book, the former shareholders of Second Savings would realized only a 25% premium on their stock trade.

The table accompanying this article lists the 16 most attractive candidates for a merger-conversion, as selected by SNL Securities.

The ingredients for a successful merger-conversion are identical to those for a successful conversion: a strong balance sheet with a proven record of profitability, and a desire to convert.

As regards the desire to convert, many mutual managers enjoy the lifestyle and serenity of mutuality and have no desire to wrestle with the unknowns of stock price performance and corporate independence.

A merger-conversion, though, in contrast to a straight conversion, does offer the certainties of a negotiated partnership.

Defining Low Risks

To determine viability for conversion, we have made several assumptions, among them that the marketplace would permit only low-risk mutuals to convert. For the purposes of this analysis, a low-risk mutual is defined as one whose high-risk loans do not exceed 10% and whose other troubled assets do not exceed 2% of total assets.

We also excluded all institutions with assets of less than $500 million, or a 1990 return on assets of less than 0.5%.

A total of 16 institutions met all these criteria.

Some large mutuals did not make the list, usually owing to inadequate return on assets, or risk loans greater than 10% of assets, or troubled assets collectively greater than 2%.

For the other institutions, the estimated ratio of core income to conversion proceeds is high, ranging from 28.08% for $1.2 billion-asset Ridgewood Savings Bank in New York City to 43.7% for $3 billion-asset Third Federal Savings and Loan Association in Cleveland. These are good returns at a time when the Treasury bills yield less than 6% before taxes. (The ratios represent 1990 core income plus a 5% return on conversion proceeds, all divided by the sale price, estimated at 35% of book.)

The issue with all the institutions on the list is not the attractiveness of conversion or merger-conversion, but rather whether the management has the desire or willingness to convert into stock form.

PHOTO : Mr. McRae is a contributing editor of Bank Mergers and Acquisitions, a newsletter published by SNL Securities. The data base and publishing firm, based in Charlottesville, Va., specializes in the banking and thrift industries.

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