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Welcome to de novo country, where capital is king

In terms of the actual number of startups through the first half of the year, 2005 would appear to be a strong but by no means banner year for de novo banks, proof positive that looks can be deceiving.

from de novo banks.com

In terms of the actual number of startups through the first half of the year, 2005 would appear to be a strong but by no means banner year for de novo banks, proof positive that looks can be deceiving.

That's because, based on growing initial capital positions, aided in large part by a renaissance in investor interest, the startup bank phenomenon clearly continues to build momentum. Through the first two quarters, 2005 is on pace to see roughly 118 new banks formed, putting this year ahead of the past four years in terms of the number of banks formed annually, though that tally falls far short of the heady period of 1997 to 2000, which peaked in 1999 with the formation of 200 banks, according to the SNL DataSource.

In one very important way though, today's startups are well ahead of their peers from that recent record-setting period. The capital raised to finance these banks has grown tremendously, from $1.30 billion of total equity raised in 1999, or an average of $6.5 million per bank, to $1.15 billion, or $10.8 million per bank, in 2004, and an estimated $1.71 billion, or $14.5 million per bank, in 2005.

Capital is the true measuring stick for the de novo bank phenomenon, according to Dan Hudson, CEO of San Luis Obispo, Calif.-based BankMark, a consulting company that focuses specifically on starting new banks.

"It is the most primary driving force of the four forces that drive the chartering process in the eyes of the regulators, a diverse group of competent businesspeople from the market, a sound and proven management team, a viable market, and capital, and capital is king," Hudson told SNL Financial. "It is the one thing that you can never have enough of or have more of and get compensating balances in other places, where there may be a deficiency. Capital is forgiving, it is always forgiving."

And even if the absolute number of startups is off the high-water mark of 1999, "business is booming" by Hudson's account. He said his firm has 20 bank startup clients signed and going, with 40 more in the queue, and these days he is turning down a third of the prospective clients that approach BankMark, which he sees as a sign that 2005 and the coming years could well prove even stronger than available data would indicate.

Part of the difficulty in getting a true gauge of the de novo movement is the lag in time, Hudson said. Because "the de novo process is 18 months at minimum from start to finish, a lot of the numbers don't fall in an annual category, so that the next year you see the previous year's hard work." Plus, it's difficult to truly assess the real number of banks in the various stages of the formation process at any one point time. But based on anecdotal evidence and his own firm's success, Hudson sees the phenomenon, at least in the near term, as continuing to pick up steam.

Russ Hunt, President of Tampa, Fla.-based independent investment bank Kendrick Pierce & Co., agrees. "From a highlights standpoint, I think the last couple of years have been highlights in new banks." Hunt's firm specializes in capital raising, M&A and financial advisory services and is no stranger to de novo banking. Kendrick Pierce most recently served as sole manager and adviser in the formation of Bradenton, Fla.-based Freedom Bank in April 2005, raising $15.5 million to start the bank.

Hunt's home state is known for producing a bumper annual crop of startup banks, and he said that even though absolute levels of de novo banks may rise and fall from year to year, the clear trend is toward banks starting out with more of everything. "I've never seen anything like it, in terms of the amount of capital, who is willing to invest in a de novo bank, and what management teams are willing to start a new bank," he said.

A number of factors are driving the latest de novo boom, according to the industry observers with whom SNL spoke.

Continued consolidation within the fractured banking industry has created conditions that are conducive to de novo formations, namely executives looking for a new gig and consumers and businesses in the local market looking for a new community bank. Hudson sees the incidence of de novo banks sprouting up in the wake of a merger as a natural, market-based solution.

"The [local] bank goes away, there is a market that is underserved, and the market comes together and decides, 'We can do this ourselves,'" Hudson said. "And this is an important point, the market is not always driven by a group that just made a lot of money on a merger and acquisition or a group of unemployed bankers. It is just the natural dynamics of the market."

For example, Hudson said that key to the success of de novo banks is the fact that they almost always serve the 'under-the-radar businesses' of a community, those that a larger bank moving into the area via acquisition is not as interested in serving given the lesser borrowing needs. "The large banks can't really dip down and be responsive to the market, so the market is driving need," he said.

Anthony Costa, a veteran banker who helped start Empire State Bank NA and who serves as chairman and CEO of the Newburgh, N.Y.-based company, which IPO'd in April 2004, said that for local consumers and small businesses alike, the need for a community bank is clear.

"A lot of people miss being able to walk into a bank branch, and while they may know the teller or the manager, they're not people who can make any decisions. They have to go to Buffalo or Albany (N.Y.) or Charlotte (N.C.) to get a decision. You don't have to do that in a local bank. You can walk in and talk to the president or CEO or chief lending officer, and people like that, they like talking to somebody who can make a decision."

The career of Costa, a colorful character with banking in his blood, is not all that atypical of many of the executives forming banks today. He is the former CEO of Fishkill, N.Y.-based Mid-Hudson Savings Bank, which sold to First Fidelity Bancorp of Lawrence, N.J., in August 1994, only to have the acquirer become the acquired when First Fidelity agreed to sell to Charlotte-based First Union (now Wachovia Corp.) a year later. Though he no doubt made out financially on a "double dip" from the two deals, Costa did not find being part of such a large banking organization as enjoyable as his days with a smaller bank and departed when he was able.

In fact, according to Jeff Hunt, a principal with Kendrick Pierce and brother of Russ, his firm has observed that new banks often start up once the noncompete agreements of executives working for a larger bank to which they sold their former institution have expired. "You have the management team of the target company wanting to get out and start a new company but not wanting to forfeit any compensation, so they wait that year or two and then come out and start again."

This process is a real draw for investors. "Both myself and (COO) Phil Guarnieri came out of merger deals where we made a lot of money for our shareholders, so people related the fact that they invested before with me and they made a lot of money. And there is a certain amount of coattail investing there," Costa said. "I was quick to point out that past performance is no guarantee of future results, as they are fond of saying on Wall Street, but I do think there is a certain effect there."

"You are going to pick up bankers who are unemployed and looking for new opportunity and investors that scored well and are going to be pushing for new opportunities," Hudson concurred.

Michael Weinstock, founder of Portfolio Placements & Resumes LLC, an executive placement firm focusing on the portfolio and money management industry, and a private investor with a significant number of investments in de novo banks, said finding executives with experience building and selling a bank goes a long way. "If someone has had experience doing it once, that's a great incentive to invest even more money," he said.

The chart below, which tracks the annual number of whole-bank and -thrift deals against the annual number of de novo formations, helps illustrate the correlation between deal and de novo activity. "I think there is a correlation. My correlation internally is that for every one I start and that ultimately sells, I get two more. So if I plant one today and in seven years it sells, it will split off into two different groups. That is our formula, and we've found over the years that that seems to be true," Hudson said.

And here is where the "planarian principal" or domino effect of de novo banks can perhaps be seen most clearly. Bank executives who start a bank, sell it and then build again, serial startup artists in other words, draw interest from investors. Costa may explain it best when he describes the way in which he took his startup bank proposal to investors in the community.

"One thing I told them all, I said, 'Look, let's not get confused here. At the end of the day, we're here to make money, to build value. We're not here to be your local community bank. That works fine, and it's great, but if we make it valuable enough that somebody offers us a lot of money, we're going to go to the stockholders and ask what they want to do. Don't get confused,'" Costa said.

"If that happens, and we would prefer that it doesn't, but if it did and it was the best bang for our buck, then I'm going to take it to the shareholders, and if they say 'Let's sell,' then we're going to sell. And I said, 'We can do this again. We did it once. Next time, we won't make all the mistakes we made this time.'"

Savvy investors in turn consistently put money into these executive's projects, as well as the splinter projects of other related executives, so that those like Weinstock and his wife, a retail executive, can over time flip their investment in one bank into several. It goes without saying that as a result, investment bankers like the Hunts and consultants like Hudson have more and more projects to work on as well.

"What I always tell people and what my wife and I subscribe to is that we mentally look to stick it in a drawer for 10 years," said Weinstock. "The reality has been that we see our investment, no pun intended, pay huge dividends, usually by years four or five. So what we've been seeing with many of the investments is that right around the five-year mark there seems to be a great deal of activity with regard to mergers or acquisitions, where the small bank is absorbed into a much larger entity because they are making huge inroads into the larger entity's domain, or mergers of equals, which recently happened with one of our investments, and right around that time we decide whether to stick with it."

That investment was Westfield, N.J.-based Town Bank, which in August agreed to merge with Two River Community Bank. Weinstock estimates that in the five years he has held the investment in Town Bank, its value has appreciated 135%. "So now, because we are looking to invest in other banks, what we will probably do is take our initial investment off the table and leave the house money to play with, maybe even take half the profits and invest in two other banks," he said.

"So as the years go on, we'll continue to have this domino effect where one turns into three and three turns into seven, seven turns into 15, and by the time I'm 60, I hope to have investments probably in anywhere between 100 and 200 small community banks."

Investing in banks in a general sense has a number of other things going for it. Costa points to a nostalgia factor, because banks are a traditional, conservative, safe investment. "People like the idea of investing in a bank, because when was the last time that you really heard of a bank going down?" he asked.

Weinstock also sees the safety as a draw, such that the "downside risk [is] a lot more minimized than investing in the stock market with any company that goes public, whatever they may do, whatever service they provide. You're not going to get a big bang for your buck initially, but if you amortize it out over five, six, seven years and are willing to stick it in a drawer, most of our investments have been running clearly on an annualized basis at over 20%. You just have to be a little patient with it."

The Hunts believe that investors see banks as an attractive investment, in that they offer lower volatility and typically pay long-term rewards. But both are cautious about the realities of investing in de novo banks. "Let's not forget though that banking is cyclical, and you go through good and bad times. Some of these de novos unfortunately will have some stumbles, and when that starts happening I think you might see a pull-back in individual investor enthusiasm," said Russ Hunt. "But for the foreseeable future, hopefully that's on a one-off basis and not widespread."

Adds Jeff Hunt, "I think the one thing we cringe about is the investor who thinks that if he invests in a bank, it's going to sell for 4x book value. There are a lot of people that think that way, especially down here in Florida. That doesn't always happen, and percentage-wise it doesn't happen to a lot more banks than it does happen to."

But investing in startup banks, particularly those that intend to trade publicly, can also be ideal in that individual investors can take self-directed retirement funds like IRAs and put money from them toward an ownership stake in a de novo bank. Costa said he was surprised at the number of community investors Empire State garnered through IRA contributions. "We had quite a few," he said, adding that he even consolidated some of his own IRAs and put the funds toward an investment in the bank.

Weinstock said he and his wife plan on using IRA funds for future de novo investments. "More and more I've heard, I've seen and now my wife and I are in the process of doing that ourselves, because [otherwise] you can take a hit on your ready cash or in the need to be liquid."

Institutional investors have also proved a fertile base for investing in startup banks, and Jeff Hunt said that the level of institutional participation has increased in recent years from a period when "we hardly saw any institutional interest.

"I think for the institutional guys, it's not that there is a de novo that is going to start and be a sleepy bank but that there are really good management teams they want to back, and I think that's been a really important part of attracting sophisticated bank stock investors," he said.

So what does the future hold for de novo banking?

Costa said that advances in affordable technology have in many ways leveled the playing field between small community banks and larger regional institutions, and he expects this to provide future succor to the de novo movement. The Hunts said the level of sophistication of de novos today should continue into the future, creating even stiffer competition for larger, more established banking foes.

"Due to the fact that management teams are a lot more experienced and aggressive and are backed by a lot more capital, you're not seeing a de novo start off with a branch and then have two or three by year five or six. Now, you're seeing de novos starting off sometimes with two or three branches right away," said Russ Hunt. He believes that because of this stronger starting position, de novos are able to more quickly grab market share, and he sees that as a trend that should continue in the future.

For his part, Hudson is looking to new banking segments. The de novo banking phenomenon is at present focused on a community banking model, but Hudson said there is room for others to enter the space, including financial entrepreneurs already operating in a financial services-related field who see starting a bank as a natural next step, as well as specialty areas like ethnic banking that could themselves include niches, like African-American church companies.

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