Anatomy of the First-Step Conversion

The internal workings of a thrift turned one part public, one part private

Greetings, and welcome to another edition of Conversion Confidential! Back in January, I wrote about the standard thrift conversion. It highlighted one of two ways a thrift can turn public, “standard” and “two-step conversions”. A standard conversion is the more straightforward process of the two. It also tends to raise a larger amount of capital, and all in one clean swoop. Today however, we’re discussing two-step conversions, or more accurately, the first-half of a two-step conversion, otherwise known as a “first-step conversion”.

As the name suggests, a first-step conversion implies the process is not entirely completed. When a thrift decides to undertake a two-step conversion, they offer their shares to the public (in an IPO) just as in a standard conversion, but importantly, not all of their shares. In fact, in a first-step conversion, the offering to the public will always be limited to minority stake (less than 50%), and traditionally settles in around 45% ownership. The majority ownership stake remains in what’s known as a mutual holding company, or MHC.

After the first-step conversion is completed, the thrift is often referred to as a partially converted thrift. A visual from the prospectus of CFSB Bancorp, which completed it’s first-step conversion two months ago may help convey the moving parts and ultimate ownership structures involved.

As you can see, there are a few entities/parties involved. We’ll start at the bottom of the graphic and work our way up:

• Colonial Federal Savings Bank - the subsidiary bank responsible for running the day-to-day operations

• CFSB Bancorp Inc. - the bank holding company which publicly trades on a stock exchange

• 15 Beach, MHC - the mutual holding company designed to represent the interests of the depositor-owners of the original thrift. The MHC maintains majority ownership in CFSB Bancorp, and in this case, 55% ownership.

• Public Stockholders - buyers of CFSB in the IPO or after it begins trading on public markets. Their cumulative interests only represent 45% total ownership.

In this partially converted state, thrifts can be considered one lesser-part public, and one greater-part, private. It can remain in this uncertain state for many years until management decides to undertake the “second-step conversion” (the topic of next week’s issue). According to Jim Royal’s book, The Zen of Thrift Conversions and analysis by Piper Jaffray, between 1988 and 2015, the average first-step thrift conversion remained in this limbo condition for an average of five years.

Why a First-Step Conversion

Royal also gives a number of reasons why a thrift may decide to go the route of a partial conversion as opposed to a standard conversion. The first is that it typically raises less capital than a standard conversion, so the bank isn’t as over-capitalized and therefore feeling the pressure to effectively deploy the new proceeds as quickly as possible. Then, once management requires additional capital in the future, they can raise it by completing the second-step of the conversion. Another reason is that a partial conversion helps ease the management team into public-company life without the threat of being acquired and less likely to face activist scrutiny. Note however, that partially converted thrifts can merge with other mutually owned thrifts.

The last reason, and I suspect this one is a driving factor, is that it extends management’s tenure. Many banking executives are loathe to give up their positions of power, status, and very often, high compensation. By completing a first-step conversion, they buy themselves as much time as they’d like in partial conversion limbo. They also guarantee themselves at least another three years at the helm before an acquirer can come calling subsequent to the second-step conversion.

Valuation Considerations

You should be aware that partially converted thrifts (those that have completed a first-step conversion) usually trade at significant discounts to their standard and second-step conversion brethren. They are also less likely to trade up towards liquidation value, or tangible book value. There are a number of valid concerns, including the timing and uncertainty of a future second-step conversion. Because the MHC controls a majority stake in the bank, it is difficult to force them, or management, to do anything. The longer a thrift waits to realize its full value via the second step conversion, the lower an investor’s returns, or IRR will be. There is also the risk that the future offering of the majority stake could come at a valuation that would dilute current owners.

I mentioned above that partially converted thrifts will usually trade at the lowest valuations of tangible equity, often around the 50% mark and sometimes lower. However, they won’t optically appear as such. The trick relates to the ownership stakes we discussed in the beginning as well as GAAP accounting rules.

The financials and operating results of the bank itself are not impacted, but the reported share count of a partially converted thrift is. Accounting rules dictate that a partially converted thrift must report as if all its shares (including the MHC majority stake) are publicly traded. From our example above however, we know that only a minority of shares are actually publicly traded and therefore have a claim on the results of the bank. Therein lies the distortion and the opportunity.

In short, the denominator in any of the per share metrics - such as TBV or EPS - will be bloated. This has the effect of artificially lowering the resulting figure and makes valuation metrics look much higher/more expensive than they truly are. To correct for this distortion, you must adjust for the minority stake that is publicly-traded.

The simplest way to do so is to take the reported valuation (unadjusted) and multiply it by the minority ownership percentage of public shareholders. For example, if the reported valuation of a partially converted thrift is 130% of TBV and the minority stake is 45%, the real underlying valuation is ~58.5%. Note that the lower the ownership percentage of the public stockholders, the greater the distortion. To use our same example of of a valuation at 130% of TBV, a 30% public stake would equate to an underlying valuation of 39% of TBV!

By inverting the public ownership percentage you can derive the degree to which a partially converted thrift will look more expensive than it really is. A 40% ownership would show a valuation 2.5x (1 / 0.40) more expensive than it should and a 33% ownership would appear 3x more expensive. Make sure to adjust for this if you are reviewing banks that trade at optically high multiples despite showing no real signs of impressive quality or returns! It could be a partially converted thrift whose valuation metrics are thrown off by the MHC ownership stake.

One final note about first-step conversions. Dividends can be paid to public shareholders of a partially converted thrift, but only if MHC depositor-owners vote and agree to waive their right to receive a distribution. This vote must be conducted on an annual basis, but it is my understanding that the vote is usually approved.

So there you have it, the essentials of a first-step conversion. I have yet to personally invest in a partially converted thrift, but if you have, please leave a comment and highlight your experience(s) (success or failures…either can be learned from). That’s all for this week folks, thanks for reading!