Anatomy of a Second-Step Conversion

The final step of a thrift converting to the more recognizable bank structure

Happy Saturday! In last week’s issue, I reviewed the first-step conversion. We left off at the point where a thrift has partially converted and is left in a state of ownership that is both public (shareholders) and private (the MHC). Today, we’re concluding the mini-series with coverage of the “second-step conversion”. This process takes a partially converted thrift with its arcane ownership structure and results in the much more straightforward, public holding company.

It may not be a perfect analogy, but I think of the second-step somewhat like the standard conversion. There is a pre-conversion entity which raises capital, adds the proceeds to the existing equity base, and results in a normal bank holding company listed on a public exchange. The route taken to get there is just slightly different.

To begin with, there is the majority ownership stake held at the MHC. These are the shares now being offered to the public in the second-step and the demand for these new shares is the driver for the valuation at which the conversion occurs. From the perspective of a participant in a first-step conversion, this is theoretically where you can get into trouble because you do not know in advance (at least until the prospectus is released), at which valuation the conversion will occur at. The higher the demand for the shares sold, the higher valuation in a second-step conversion. It would not be uncommon to own pre-converted shares at a discount to book value, only to have them emerge from the second-step at a modest premium to book value. In the end however, a new bank holding company is created that will own the entirety of the publicly offered shares.

There are also the minority public shares outstanding to deal with. In addition to the shares that are sold in the offering, these already public shares will be exchanged for newly created shares based on an exchange ratio that will result in existing public shareholders retaining the same ownership percentage in the new bank as they held prior to the conversion. Being the visual person that I am, I find the below graphics from recent second-step conversion Ponce Financial Group helpful.

Before:

After:

In short, the MHC is completely eliminated and what’s left is a recognizable, publicly-traded bank structure. You can then evaluate its competitive positioning, operating results, and valuation just like you would any other bank. One can easily wait until the second-step conversion occurs if they don’t want to lock up their capital with a partially converted thrift and risk the dilution that may come from a second-step. All the moving pieces including the valuation, exchange ratio, and pro-forma capitalization will be provided for you right in the prospectus on SEC’s EDGAR database.

Unlike the standard conversion, you typically shouldn’t expect near as much of a share price increase on the first day of trading. Because there are already publicly traded shares, these in combination with the exchange ratio, can be used to anticipate and capture some of the expected upside in advance of the conversion.

One last point to remember. The second-step conversion is what initiates the countdown until a thrift can repurchase shares and/or merge with another bank. At the one year anniversary, management is allowed to repurchase shares. This is almost always a good use of capital because newly converted thrifts tend to trade at a discount to book value and are often over-capitalized. After three years of being public, the bank is able to sell itself. This is typically the ideal exit strategy for thrift investing as take-outs occur at a relatively predictable range of multiples to tangible book value and/or core deposit premiums.

That’s all for this week folks. I’ll have to check my idea list, but perhaps next week I’ll return to a previously profiled bank. I hope reading through my three posts on the standard, first-step, and second-step conversion have helped you gain a better understanding of the underlying mechanics in these transactions. I know working through it all has helped me. As always, don’t hesitate to leave a comment or reach out directly if anything comes to mind. Thanks for reading!