Through the first quarter of 2009, a leading issue that continues to haunt equipment financing and leasing companies, as well as other finance companies of all types and sizes, is the substantial dearth of funding availability. It’s a frustrating market to say the least: small- and medium-sized businesses have never been in such dire need of financing, yet the lenders that exist to serve that purpose don’t have the funding to provide such financing to those who need it. Competitors have exited the market and will continue to do so. Others have cut back their new originations in order to deal with mounting delinquencies and charge-offs, or to appease their funding providers. What’s left is a market with substantial opportunity to fund equipment purchases by borrowers with pristine credit, and at higher yields than have been achieved for years — if only there was liquidity for equipment finance companies.

Until the last 12 to 18 months, the equipment lending sector was characterized by significant leverage in the form of revolving credit facilities and asset-backed commercial paper conduits, vehicles used to spur asset securitization. The providers of these funding facilities were easy to find; indeed most CEOs and CFOs had been pitched by every major commercial bank, money center bank and investment bank with the biggest challenge — to find enough credit exposure for these banks to take on. But as has been well documented, the credit crisis has taken its toll on independent finance companies, whether consumer oriented or commercially oriented.

Today, the providers of senior debt financing to equipment leasing and lending companies can be counted on one hand, it seems. The asset securitization market is essentially shut down with very few deals making their way through the market. While the Federal Reserve Board’s Term Asset-Backed Securities Loan Facility (TALF) is a step in the right direction, the jury is still out on just how the program will work and how effective it will be.

As a result, equipment lending businesses of all sizes have been forced to consider different ways to find funding. In fact, we are working with a number of our clients to help them ascertain two alternatives to traditional debt funding — buying a bank or merging their company and its stock into a bank.

Buying a Bank
The first idea — acquiring a depository — is not a new one. We’ve seen a multitude of companies look to acquire banks or thrifts in recent months as a way to use the bank charter to obtain cheaper, more reliable funding through deposits. Companies such as CapitalSource, Tygris Commercial Finance and NewStar Financial have either announced or completed acquisitions of financial institutions in the last six months. The concept isn’t difficult to follow, but the execution of a bank acquisition and subsequent scrutiny by the banking regulators can often be enough to turn off a potential suitor. But in this environment, independent finance companies must not only look to survive, but also must look at contingency planning in the event funding does not improve in the near term. Or even worse — what would happen if this type of credit crunch hits again, which is quite possible given the cyclical nature of the financial services sector.

The challenge in seeking a bank target to acquire is understanding how the process works and figuring out what a potential target should look like. There are a variety of approaches to take, but a few key points hold true with the regulators regardless of target size. First and foremost, the proposed management team of the bank must have banking experience, particularly with the asset class that will be a significant component of the bank’s origination. The management team from an acquired institution could stay on or you can bring in executives from outside the bank, but either way, the management team’s experience and expertise will be of the utmost importance for the regulators.

Second, you must have a tight business plan that does not exhibit aggressive asset growth. The regulators typically like to see a reigned in approach to growth that demonstrates the prudent underwriting principles of management. A three-year plan with successive years showing 200% asset growth generally is not looked upon favorably. Note that it is often an option to keep parts of the finance business outside of the bank and under a holding company. That way, you can look to manage assets outside of the bank subsidiary and use the bank only for intelligent, deliberate fundings.

Lastly, the regulators will need to see sufficient capital in the bank. A common approach for a nonbank buyer looking to acquire a depository is to try to find a small institution with a small capital base in order to limit the upfront investment. After all, logic says, you really just need the charter to get into the game. While true to some degree, the capital need can perhaps hinge less upon the upfront purchase price and more upon the capital needed to execute the growth plan. A business plan exhibiting significant growth will likely require enough capital upfront to support the entire three-year growth plan in order to appease the regulators.

There are plenty of bank targets today given the credit issues that have infiltrated many bank balance sheets. Several banks are forced to consider a sale as a last resort before potentially being taken over by the FDIC. Valuation is often not an issue for these types of acquisitions. Rather, the challenge is determining what the bank’s true book value is since future net loan charge-offs will directly impact the actual book value of the bank. Complicating matters further is that it’s anyone’s guess what ultimate losses will be and when credit quality will begin to rebound.

As an acquirer of a bank, it is important to factor in an estimate of future credit losses to make sure that you are taking over a balance sheet with insulated capital. In some cases, this estimate of future losses will result in book value being completely wiped out. But there are certainly targets available today with lower nonperformers and motivated shareholders where a deal can be had. Those are the perfect targets to explore.

Merging With a Bank
A separate alternative, which to date has been far less explored, is the concept of merging your independent leasing company into a depository. The key in this type of transaction is that both parties — the bank buyer and the leasing company seller — have something to gain from a business combination, if the transaction is structured correctly.

The sale or merger of a finance company to a bank is the last thing an entrepreneur or CEO is considering in this volatile economic climate. Valuations are off dramatically from the highs of 2005 through 2007 with portfolios of assets trading for discounts to par, if not substantial discounts to the tune of 40% to 60%. And many banks, the natural buyer for equipment lending and leasing companies, are in no condition to look at acquisitions given their own credit quality issues and lack of capital. But therein lies the opportunity.

As banks work through credit issues and mark-to-market accounting, their regulatory capital (generally common equity, preferred equity and trust preferred securities) diminishes as assets are charged-off or reserves are bolstered. The banking regulators are particularly focused on a bank’s tangible capital as a percentage of tangible assets as well as risk-based capital ratios that take into account a bank’s asset mix and the perceived risk associated with those assets. The lower a bank’s capital ratios go, the more concerned the regulators become.

A transaction structured as a stock-for-stock transaction valued at or near book value could potentially solve problems for both a bank buyer and finance company seller. In a transaction of this nature, the bank would get capital to add to its balance sheet, while the selling finance company has the opportunity to plug into the bank’s reliable, efficient low-cost deposits as a source of financing. In some situations, the bank also gains a valuable management team that potentially brings expertise in a specific line of business and assets that generate solid net interest margins when paired with attractive deposit financing.

The beauty of this type of transaction lies in the details. The bank buyer does not have to use its common stock as consideration. Rather, the bank could use preferred stock, convertible preferred, trust preferred or even subordinated debt as consideration, all of which will count towards total risk-based capital for the bank. And, within certain limitations, any preferred or trust preferred will count as valuable Tier 1 capital for the bank. These consideration options provide both buyer and seller with a multitude of choices when it comes to structuring a deal.

The shareholders of the selling finance company might prefer to take common stock as consideration since they’re trading in their stock at depressed values. They’d perhaps like to receive common stock in a bank at likewise depressed valuations in order to ride the potential uptick in value as bank stocks rebound. The bank may not want to issue shares at their depressed values, however, so they may prefer to issue preferred stock with a coupon and/or conversion feature, giving the selling shareholders a chance to earn a steady return with potential equity upside. The potential combinations go on, and can be combined based upon structural and economic needs. In the end, however, the bank needs and wants the capital to improve its risk-based capital ratios, and the sellers need access to more reliable debt financing to be able to add new loans and leases.

The capital markets continue to be largely shuttered and any positive changes from TALF or other programs will likely be slow to affect the broader securitization markets. And when the markets do return, the viability of finance companies operating independently will likely remain challenged. Access to efficient financing is the lifeblood of independent equipment lenders, and while not ideal, more acquisitions of, or mergers into, banks will come to pass in 2009 and 2010.

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Timothy W. Stute is a managing director of Milestone Advisors, LLC, an investment banking firm headquartered in Washington, D.C., which provides merger and acquisition advisory and corporate finance services to financial services companies, with a particular emphasis on the specialty finance sector. Milestone’s principals have completed over 300 M&A and corporate finance transactions. Milestone was ranked the #1 M&A advisor to the Specialty Finance Industry for the years 2004 through 2008, based on number of transactions announced. (Data gathered from SNL Financial, LC.)