Trust Preferred Securities - A Primer on the State of the Market

Many community banking companies are experiencing growth, repurchasing stock or desiring to engage in a merger. Such companies all have capital needs. Certainly, such companies could address such needs by bringing in a new shareholder or two.

Selling common equity, however, is the most expensive way to raise funds because it reduces the existing shareholders’ ownership percentages. For instance, assume a company with $150 million in assets and a 6.0% capital ratio is generating a return on common equity (“ROE”) of 15%. Assume also that company issues $3 million of common stock with an offering price of 1.25 x book value. As a result of the offering (unless the company leverages that capital into substantial higher earnings), the company's ROE will fall to 12% and its preoffering shareholders will have their earnings per share diluted.

Trust preferred securities may enable companies that have such opportunities to meet their capital needs while increasing both ROE and earnings per share.

Trust Preferred Securities – Overview

Trust preferred securities are securities that are treated as debt for tax purposes, but which count as Tier I capital, within limits, for regulatory purposes. A trust preferred securities issuance would not reduce an existing shareholder’s ownership interest. In essence, an issuance of trust preferred securities is a borrowing. The payment of interest on trust preferred securities is generally deductible for tax purposes, yet such securities, within limits, raise capital as discussed below.

Structure

In order to issue trust preferred securities, a bank holding company (“BHC”) would create a special purpose vehicle (“SPV”). The BHC would purchase 100% of the common interest in the SPV. Typically, the common interest represents 3% of the overall equity of the SPV. The SPV would issue preferred securities to investors. The SPV would take the proceeds of the preferred security issuance and loan such funds to the BHC. The BHC would issue debentures as evidence of its indebtedness to the SPV. See the diagrams below.

The debentures and the preferred securities would have identical terms. In general, trust preferred securities are long-term (30+ years) instruments. Typically, trust preferred securities will have a fixed interest rate, with interest payable quarterly (this is more a matter of investor choice than a requirement). The entire principal will be due at maturity. Such securities are “noncallable” by the issuer (SPV) of such securities, for a minimum of five years after issuance. The issuer of such securities must retain the right to defer the payment of interest for five years. Distributions on such securities, however, are typically cumulative. Accordingly, the obligation to pay the distributions does not go away; it simply is deferred.

Debt Aspects

For tax purposes, the transaction is treated as the issuance of subordinated debentures. Because the debentures have characteristics that are sufficiently “debt like,” such securities are not considered equity by the Internal Revenue Service (the “IRS”). Such features include a reasonable, foreseeable maturity date, at which a sum certain will be paid. Typically, such debentures provide no participation in management and rights that are consistent with that of a creditor. Assuming the appropriate characteristics of the SPV, a Subchapter S company can form a SPV to achieve the tax benefits discussed above.

Capital Treatment

Under generally accepted accounting principles (“GAAP”), the SPV is consolidated with the parent BHC. This is because the BHC owns 100% of the common interest in the SPV. Under GAAP, the debenture is eliminated as an intra-company transaction. Thus, the GAAP treatment of the structure discussed above is the issuance of preferred securities by the BHC.

Under the regulations of the Federal Reserve Board, perpetual preferred stock is treated as Tier I capital. The Federal Reserve Board has determined that securities that are a long-term, are noncallable for a period of time and provide the issuer with the ability to defer distributions, are sufficiently “equity” to qualify as Tier I capital.

The limit of trust preferred securities, when coupled with all other preferred-type instruments issued by a BHC, that can count toward Tier I capital is 25% of pro forma capital. In other words, the preferred securities can represent 25% of Tier I capital elements after the securities issuance. Mathematically, the preferred securities can represent up to 33% of preissuance common equity and count as Tier 1 capital.

Drawbacks

The structure discussed above provides any company, including a Subchapter S corporation, with the ability to raise Tier I capital, without diluting the existing ownership interests of the common shareholders. Even better, such securities are deductible for tax purposes. Regional and national bank holding companies have found trust preferred securities to be an attractive alternative for raising capital exactly because of such benefits. In light of these benefits, why haven’t more community banking organizations issued trust preferred securities?

The reasons are because of market receptivity and cost. To issue any security, an issuer needs to find investors who are willing to purchase such securities at an acceptable price. Investment bankers have been very active in placing trust preferred securities for regional and national bank holding company organizations. Such investment banking firms have shied away from the smaller community banking organizations because there is not very much liquidity in such securities issuances. Accordingly, investment banking firms have found investors to be less receptive to such stand-alone offerings.

The other part of working with an investment banker is one of cost. Investment banking firms typically charge approximately 4% of the amount of the issuance as a fee for placing the securities with investors. The cost of a stand-alone trust preferred issuance, consisting of the investment banker fees, as well as the legal, accounting and printing costs, can make such a securities issuance prohibitively expensive for smaller community banking organizations. In light of the liquidity issues to the investment community and the costs to community banking organizations, my experience has been that the larger investment banking firms will not be involved in a trust preferred issuance, on a stand-alone basis, of less than $25-50 million. Certain of the regional investment banking firms and the niche investment banking firms that emphasize the banking industry will place smaller single issuer offerings. It has been my experience that the smallest offerings by stand-alone issuers placed by such firms are in the $10-15 million range.

Alternatives

Issuers who desire to raise capital above these thresholds can, and should, consider public offerings of trust preferred securities, using an investment banking firm. In such scenarios, the BHC (if it is not already) becomes a “public company,” which means it must make quarterly and annual filings with the Securities and Exchange Commission. In addition, the BHC would need to comply with the federal securities laws. Alternatively, the BHC could still use an investment banker to market its securities, but engage in an exempt offering to institutional investors. The BHC would not become a “public company” as a result of such an offering.

Another possibility is a pooled offering. In a pooled offering, a number of BHCs would work together with an investment banker. These BHCs would issue their own trust preferred securities into a “pool” (a foreign limited liability company). The pool would then issue its own securities. In this manner, the costs of the structure are spread over a number of issues. Moreover, such a fund would be sizable enough to provide investors with the liquidity needed to make them willing to acquire such securities.

The typical qualifications for issuers interested in participating in a pool include that the BHC has $100 million in deposits, has a BHC Tier I to risk-based capital ratio of 10% on a pro forma basis and will issue $2.0 million of trust preferred securities. Of course, all three of these “qualifications” may be modified for companies at the margin.

Another possibility is for the BHC to engage in a nonpublic offering either to “accredited investors,” or an offering which is otherwise exempt from registration. Accredited investors are: (i) investors with a net worth of one million dollars, (ii) investors with earnings each of the last two years of $200,000 ($300,000 if joint earnings) and expected earnings of $200,000 the coming year or (iii) certain types of entities. In such cases, our clients have either found their own investors or used one investment banking firm that is willing to work on smaller, exempt offerings. We also know of private investors who purchase trust preferred securities from BHCs that are not pool eligible or that choose not to issue securities in a pool.

Comparison

Stand-alone Issuance. There are now alternatives for community banking companies that are interested in issuing trust preferred securities. If such issuers are willing and able to engage in an offering of at least $10-$15 million, then a stand-alone offering still may be the best alternative. The issuer can obtain four benefits from its own offering. First and foremost is pricing. Stand-alone transactions have had better execution, and have been marketed at lower interest rates than pooled securities. This is especially the case for fixed rate offerings. On $10-$15 million, 75-125 basis points a year certainly is substantial. Second, the “deal costs” spread over $15 million and amortized over a 30-year period are much less of an impediment than on a smaller issuance. Third, the issuer will have the leverage to negotiate certain important features, change in control provisions. Fourth is timing. A stand-alone issuer has control (if the debt markets are receptive) over the timing of its issuance. Pools take time to get together. These advantages are diminished as the size of the issuance shrinks and are eliminated altogether for issuances of under $10 million.

Pooled offerings. “Pools” are structured in order that no single issuer represents too large a portion of the pool. As a result, no single issuer is engaging in a “public offering,” for which it would have to effect a registration, by issuing into the pool. The two other advantages of a pool are that: (i) out-of-pocket costs are lower than in a stand-alone offering and (ii) the size of each single issuance can be smaller than in a stand-alone offering. For those that meet the qualifications of a pool, some of which are discussed above, they still need to understand the disadvantages of pools.

First, pooled securities are typically issued at higher rates than stand-alone public issuances. Second, the out-of-pocket costs and the annual fees, while not as high as in an underwritten stand-alone offering, can still be considerable. Third, there are timing issues with a pool. Again, it takes time to get all the issuers on the same page. The placement agents have been able to mitigate each of these drawbacks of late, but they still exist to some extent.

Stand-alone exempt offering with or without an underwriter. The absolute best alternative is for a BHC to engage in its own exempt offering without an investment banking firm. Such an offering offers tremendous advantages with few disadvantages. If a BHC were able to market the preferred securities itself, without the help of an investment banking firm, then the BHC would be able to save considerable amounts in two respects. First and foremost, the BHC would save the investment banking fee and printing fees and a portion of the legal and accounting fees. Second, and less obvious, is the interest carry associated with the securities themselves.

My experience is that the investors that investment banking firms work with have alternative investment opportunities at attractive yields. Accordingly, for such institutional investors and active retail investors, the investment banking firm must negotiate a yield that would be attractive in light of such other opportunities. In contrast, my experience is that noninstitutional investors may not have access to such opportunities. Thus, individuals with investable funds may not be able to find the yields that are made available to institutional investors, such as insurance companies. Generally, the coupon needed to attract individual investors to preferred securities is less than that which would be required to attract an institutional investor. Thus, the BHC may be able to save significant sums on the “interest carry” associated with the trust preferred securities.

Another advantage is that the BHC has considerable flexibility. First, the BHC may be able to issue a floating rate security. Second, the BHC can match the timing of its issuance to when it needs the funding. Third, the BHC can structure the issuance to enable itself to redeem the securities in the event of a change in control without penalty, if it desired to do so.

Of course, if issuers could readily place their own securities, then they would not need investment bankers. Investment bankers serve two important purposes. First, to find the investors. Second, they may provide (or should provide in the case of some) financial advisory services. Among other things, (at least in a stand-alone issuance with the help of an investment banker), the investment banker works with the BHC on the terms investors desire, timing in terms of market receptivity and “packaging” of the issuance to tap the market at the best price. Nonetheless, if the BHC can find the investors, it is still most cost effective to work without an investment banker.

There are also other alternatives our clients have engaged in to find investors willing to purchase their issuances. We have also worked with some investors, that are willing to purchase exempt, $5 million and under issuances, from smaller companies. These investors have their own particular underwriting criteria. Among other things, it is important that such issuances be structured to minimize the securities risk of such issuances.

Summary

In summary, trust preferred securities may present community banks with an attractive vehicle for raising capital. Such securities count, within limits, in Tier I capital. Moreover, interest payments are deductible. These advantages are available to S corporations.

Traditionally, smaller community banking organizations could not issue trust preferred securities simply because they could not interest an investment banking firm in a small issuance. The size of such offerings has fallen. A BHC considering a $10-$15 million issuance may desire to engage in a stand-alone, underwritten offering. For BHCs considering at least a $3 million issuance and which meet certain qualifications issuing trust preferred securities in a pool with other BHCs is an option. Alternatively, issuers could consider a private placement to local investors or other investors interested in such offerings, thereby saving the costs of the investment banking fee, as well as saving on the rate to be paid.