In the first part of this interview, Doug and Jeff Cardone discussed the process, requirements, and questions credit unions should address before entering into a merger or acquisition (M&A) transaction. In the second part of the “C.U. on the Show” episode, Doug and Jeff delve into the acquiring or buying side of M&As and what credit unions should consider first as the acquiring institution.

The show’s guest, Jeff, is a partner at Luse Gorman specializing in representing credit unions in M&A transactions with other credit unions, banks, and fee-based businesses, as well as secondary capital or subordinated debt transactions. He explains the types of credit unions that may or may not be optimally positioned as an acquirer, the required process and documents, and an alternative capital funding option gaining more popularity within credit union M&A transactions.

Rather than relying on organic growth, Jeff cites scaling quickly, enhancing service lines and technology, and expanding membership as generally the biggest “why” or motivators behind a credit union wanting to acquire another credit union or bank.

When it comes to being ready to acquire another financial institution, Jeff explains credit unions should feel confident in a few areas: asset size, infrastructure, and safety and soundness from a regulatory standpoint. All of these elements speak to a credit union’s capability to successfully merge with another financial institution, which requires capital for bank transactions, regulatory approval, and a myriad of other moving pieces such as human resources, risk management, and other functions. 

Jeff also talks about how subordinated debt or secondary capital could be an alternative option for credit unions without excess capital. This attractive funding tool enables credit unions to increase their net worth and meet regulatory standards with low risk and interest rates in the current market.

Hear the full episode to learn:

  • The net worth percentage credit unions should target before becoming an acquiring institution and how sub-debt options could offer additional leverage
  • How long a typical M&A may take, and the required documents and steps that credit unions should evaluate sooner rather than later, such as addressing regulatory issues and working with a financial professional
  • The economic and cultural differences between a credit union acquiring another credit union versus a bank

All in all, Jeff encourages credit unions seeking an acquisition to be open-minded and explore the new and changing agreement terms and regulations that could help them be successful. Stream the episode to hear more.

Jeff Cardone and Luse Gorman are not affiliated with or endorsed by ACT Advisors, LLC. 

Audio Transcription

Doug (00:03):

Hello credit union executives. Welcome to “C.U. on the Show,” where we give you up-to-date information on how you can reduce risk, keep key talent, and take a strategic approach to your personal financial wellness hosted by me, Doug English, a CERTIFIED FINANCIAL PLANNER™ and former credit union insider with Act Advisors. Back with me to continue our conversation on mergers and acquisitions is Jeff Cardone. Jeff is a partner at Luse Gorman, and in this episode, we focus on the acquirer in an M&A transaction. We talk about what to consider before you pursue a merger, how you might consider using subordinated debt and what documents you need to have in order before you get into acquisition. Hi Jeff. So tell us from a credit union standpoint, what would cause a credit union to want to look to merge or acquire another and what would cause one to not?

Jeff (01:09):

Well, first of all, what would cause a credit union to do this? We kind of need to take a step back. If you look at the asset size of credit unions, going back to the early 1980s, the average size of a credit union was about roughly $30 million in assets. Fast forward to today, that number has increased to roughly $300 million in assets. So credit unions are growing. Scale’s important. I would say that’s probably the biggest why in terms of being an acquirer, because you can sort of enhance or grow more quickly, vis-a-vis an acquisition, then try to do things organically. You can get into different lines of business, sort of re-imagine the credit union’s business model span, feel the membership. I mean, those are sort of the whys. Why would a credit union want to grow? Certainly having more scale, they could invest in technology, attract members, and so on and so forth. You know, in terms of the credit unions that I would caution against an acquisition, really of the primary two hurdles, one would be size. Do you have the size and the infrastructure to successfully execute on a deal and successfully integrate another institution into your organization? And two, from a regulatory standpoint, do you have any safety and soundness issues? Because that’s certainly something that would have to be addressed before undertaking any type of transaction to credit unions that sort of fall into that bucket. 

Doug (02:35):

Okay, so you said size and infrastructure. So is there any kind of a ratio or anything between the scale of an acquisition partner and the smaller one that you know of, or is it related to your asset makeup?

Jeff (02:49):

Well, I think it depends. I mean, certainly if you’re a credit union and you’re looking for another credit union, a seismic disparity between the two parties is less important because the credit union, the acquirer, is not paying anything from the quote unquote selling credit union, conversely to that. We’ve been involved in a substantial number of credit unions looking to acquire banks and in that situation, credit unions have to actually pay the bank. So certainly they got to have the capital and scale to execute on that. So generally what we typically see for that, I mean, there’s no real rule of thumb, but generally the bank asset size relative to the credit union is roughly in that 10, 15, 20% range.

Doug (03:29):

Excellent. So in one of our other podcasts, we interviewed a CEO who had been involved in a lot of transactions on both credit unions buying credit unions and credit unions buying banks. So that ratio is one that we did not capture before. So did you say at 10 to 20%, correct?

Jeff (03:48):

Yeah. So I would say really, the bottom line is what’s going to drive that ratio is going to be the credit union’s sort of net worth and capital to execute on that because the one benefit for credit union mergers is the acquiring credit union doesn’t have to pay anything. The downside to exploring credit union mergers is finding a really attractive candidate, a real healthy credit union. What’s the real incentive for that credit union? To join with your organization, how would you incentivize that credit union? Why would they want to merge? There’s a lot of ways it happens. It’s a credit union that may have some runoff or may have some safety and soundness issues. So it’s not necessarily, even if it doesn’t rise to the level of like a supervisory merger, you may not actually be a real attractive merger from an acquire credit union standpoint. Conversely, when you’re buying a bank, yes, you have to pay for it.

Jeff (04:38):

At the end of the day, price is going to sort of drive the attractiveness of the acquisition more so than even the social issues, not saying they aren’t important. So that kind of leads to the assets disparity with having to pay. You really are going to have to look at the credit union’s net worth. And do they have the capital? What are they going to look like on a forma capital basis following an acquisition of a bank? Because you remember when you buy a bank, you’re buying out the shareholders, you’re buying out the equity of the institution. So that equity is going to go away, which is going to sort of affect your credit, the acquiring credit union’s network, on day one. Now you hope over time, the creativeness of the transaction, the earnings you’re picking up, the ability to enter into two markets, for example, enhanced commercial lending, CRE, CNI, et cetera, that would sort of offset that initial dilution in net worth. And that’s the real track of newness for credit unions in terms of looking at banks or acquiring banks.

Doug (05:31):

Yeah. What we heard in our other podcast on M&A was that the bank transaction, as you said, is all about price. It’s a business transaction. It’s just come up with the cash to pay for the institution and the stockholders are happy, but the credit union merging with another credit union is a much more a connection, natural fit, interconnected, the field of membership kind of transaction, where there’s a lot more human to it. And maybe not as much economic element.

Jeff (06:00):

A hundred percent. Yes. I don’t want to downplay the importance of that on the banking side as well, but certainly on the credit union side, I mean the social issues are paramount. If you’re the acquiring credit union and you want to attract a healthy, very viable selling credit union, what are you going to offer, for example, ensuring their members are treated the same as the acquiring credit union. So I’m working on a transaction right now where for selling credit union, what’s of great importance to them is they have a lot of relationships with schools and universities, and they do a lot of grants and scholarships and so on and so forth. And so we’ve spent a lot of time negotiating as part of the definitive merger agreement, real covenants and promises of the acquiring credit union that they’re going to preserve that for the foreseeable future. So, you know, things of that sort, the culture piece, is I wouldn’t say more important. It’s more of an emphasis in credit union transactions than bank transactions. Because again, you’re not paying it because even for banks, look, they may not love the culture. They may say, look, we don’t love partnering up with a credit union, but your price is so much better than what’s out there. I mean, that’s ultimately gonna be the deciding factor and what we’ve seen.

Doug (07:11):

Do you have any feelings for trends in the transaction area? Are credit unions mostly buying credit unions, or is it more credit unions merging and other credit unions versus the credit unions merging with banks?

Jeff (07:23):

I would say credit unions acquiring other credit unions is more common, but credit unions acquiring banks is certainly picking up steam. And we were involved in the first credit union acquisition of a stock bank. This was back in 2012. So there was only one at that time. Fast-forward like pre-COVID. It was up to 20. We’ve been involved in a substantial number of these deals in 2021. So that’s certainly picking up steam because again, what’s happening too is the way the market is, these selling banks, particularly smaller, closely held banks are looking for cash and a liquidity event rather than another acquiring institution’s currency vis-a-vis a stock acquisition or merger. And so credit unions are quite attractive because they have the scale. They have the capital and no longer is that the path of least resistance selling to a credit union or a credit union acquiring a bank because these deals have gotten done. There’s a regulatory framework to getting it done in both the NCUA and with the bank regulators as well. So I think that’s going to lead to more deals between credit unions and banks going forward.

Doug (08:23):

That is perfect. Tee up for the next question. You, the credit union leadership, have you determined that you’re going to be interested in looking to acquire either banks or merging credit unions? What do you need to do to get your ducks in a row? And you’re determined asset wise, you’re big enough. You’ve got the infrastructure, you’ve got the capability. 

Jeff (08:44):

What I would say, number one, if you are particularly looking for banks, the most important thing from a safety and soundness perspective is going to be your capital, your net worth. And so to the extent that you’re overly capitalized, that’s great. If you’re hovering around that seven, 8% range, you should very much be exploring secondary capital or subordinated debt, which if you’re a low-income designated credit union, you can do that right away. If you’re not, and your assets are greater than $500 million, you can start exploring the sub-debt markets starting in 2022. And the one thing to keep in mind with sub-debt and secondary capital, which banks are doing this hand over fist, and low-income designated credit use have been doing this since it was in place, the onus is on the credit union side. You need pre-approval from the NCUA before you can issue it.

Jeff (09:32):

So it’s about a five-, six-month process. So I always advise boards of credit unions if you really want to maximize your tools in the tool chest, even if you don’t have a tremendous desire to do sub-debt or secondary capital, at the very least get pre-approved by the NCUA, and they allow you a period of time thereafter to actually go ahead and issue the secondary capital or decide not to do it. Starting on January 1, 2022, it’s two years. So that way, you avoid what we call just-in-time caps. So if you find a very attractive bank and you’re looking at your capital ratios, you can say, okay, we can do this deal because we can go out and access the capital markets to do it, or at the very least we do the deal.

Jeff (10:17):

And then subsequent to the deal we replenish that loss network. Maybe get us back to that eight, nine, 10%, whatever the comfort level is. I would say the capital number one, number two, if you have any regulatory issues, any MRAs MRIs from the NCUA or state regulators, really addressing that is important as well, because certainly once you sign up a deal, whether it’s another credit union or bank, you’re going to have to get regulatory approval. And then thirdly is just making sure you have the proper team in place to execute on. Do we have to hire? Do we have to ramp up our risk management function or personnel, our HR function? I mean, because there’s a lot of pieces to a deal beyond purely like pricing, particularly on the bank side. So I think that’s going to be important, too.

Jeff (11:03):

And then lastly, start thinking about it from a cultural fit, thinking about, okay, what areas we want to expand and grow, who are potential banks that are out there or credit unions. Also, we strongly recommend credit unions work with investment bankers or financial advisors who can find deals to ensure you’re on the list. Because a lot of times, particularly on the bank side, if a bank’s going to put themselves up for sale, they’ll market themselves to acquiring credit unions. And you want to make sure you’re on that list. If you are, that doesn’t mean you’re going to move forward, but at the very least you’d have an option to look at it, assess the potential transaction, and make a bid if it makes sense. So I think those are kind of the things to be thinking about as an acquirer in terms of growth and expansion. 

Doug (11:52):

Interesting. This idea of credit unions leveraging themselves through subordinated debt is a new one to me. Talk to us a bit more about it? Who is doing that now? 

Jeff (12:03):

If you think about sub-debt, it’s sort of a fancy word, but it’s all it really is as a borrowing credit union is borrowing money from investors and the terms of the borrowing are structured in a way so it’s accorded favorable regulatory capital treatment. So for right now, low-income designated credit unions could issue subordinated debt or as the SOA calls it secondary capital, because the regulatory capital rules for larger credit unions changed on January 1, 2022. What the NCUA did was they opened the sub-debt market beyond low-income designated credit unions and expanded it to what they call complex credit unions. These are credit unions with assets of $500 million or greater. And so opening that will enable or allow credit unions to sort of lever sub-debt to sort of enhance or grow the regulatory capital.

Jeff (12:54):

Now, as I reiterate what I said before, banks have been doing this hand over fist, I mean, the most prevalent capital raising tool for community banks over the last three, four years has been subordinated debt. But the difference from banks versus credit unions is banks don’t need preapproval from the regulators. Credit unions, however, have to get pre-approval from the NCUA. So that’s going to lengthen the process. So that’s why when we’re talking about capital, get that pre-approval, because that way there you can then move quickly because that takes a five-, six-month process down to like a three-, four-week process, because then you can just go access the markets you chose. And by the way, the other thing too is you always get the question, who’s going to buy or want sub-debt of a credit union. The primary investor is going to be other credit unions because they have access to liquidity. It’s not a bad investment on their balance sheet. So, I mean, you can certainly expand beyond that, but the primary investors are going to be credit unions. These deals get done rather quickly, but yeah, I mean, it was sort of a game changer with the NCUA sort of broadening the pool of credit unions who could access those markets.

Doug (13:56):

Very interesting idea. From my standpoint, thinking about it from an interest rate lock-in, how long are the terms of a sub-debt interest rate?

Jeff (14:06):

To get favorable regulatory capital treatment, the instrument has to be in place for at least five years. It can’t be callable for at least five years. So generally the way these are structured, it’s in ten-year terms. Your interest rate is fixed for five years. And then after five years, it kind of converts to a variable rate. But I’ll just tell you right now, because interest rates are still low, it’s really, really cheap capital. We’ve done deals in the 3%, 4% range. And you know, the nice thing is, when a credit union decides they want to do it, they can kind of set the market parameters. Like we’ll do it, but we’re not going to pay interest above a certain amount. And then they work with a placement agent or an investment banker to go out and sell it. And they kind of build their book and they can determine, okay, is the market there for the interest rate we’re looking for? And generally speaking, I think that would be yes, because it’s just, these deals have just been happening and it’s been a very favorable market for sub-debt generally. 

Doug (15:00):

That makes sense. Cause it’s a low-risk loan with a nice little interest rate compared to what you can get in the private market right now. But the ability to fix the rate is only in the five-year range generally.

Jeff (15:13):

Yeah. I mean, it depends on the market. The sort of the general term is 5%. And then a conversive flood, because think about if you’re an investor, do you want to be locked in at 3%, for 15 years? And a lot of these terms get sort of institutionalized. I know on the bank side, you generally don’t see fixed rates beyond five; it’s generally standard of five. And then it converts to a floating rate thereafter or the general terms, but you can’t call or redeem the debt for at least five years. So you’re sort of locked in once you do it. But as I said, the benefit to it is that if you’re low-income designated, it’s purely creative to your net worth. If you’re not low-income designated to creative, new regulatory capital ratios on a risk-based basis. So it’s a very attractive tool; we have about three or four of these going on right now. 

Doug (16:07):

Yeah. I would think it would be something primarily used by the larger institutions.

Jeff (16:12):

Oh, you’d be surprised. The few that we’re working with now are small. I mean, they just want to get their net worth ratio up. There’s no safety and soundness issues, but you know, they’re hovering around that seven, 8% they want to grow and they feel like the market’s right and rates are low and let’s explore.

Doug (16:27):

If you decide to proceed and get NCUA pre-approval for sub-debt, how much should you think about?

Jeff (16:34):

Yeah, that’s a great question. And the answer is that it’s really a balance. So number one, you want to go in with an amount because once you get pre-approved, you could always issue less, you cannot issue more. So for example, we’re working with the credit union that was thinking about doing 2 to 3 million. We recommended they just go in for three because they could always issue the two. So you’re balancing that piece of it versus what the NCUA is going to assess when you go in for the pre-approval. Can your institution service the debt? So you can’t go in with too high of a number. So that’s kind of a balance there. So they’re going to be assessing, can we service that debt? Do our earnings support us taking on this debt instrument that we’re going to be issuing to our investors? So that’s really kind of the balance when you’re signing up: assess the amount. You’re also going to look at your debt to equity ratios as well. I know on the banking side, generally, if you get above one-to-one that could raise safety and soundness concerns from the bank regulators. So we’ve generally been counseling credit unions in terms of the amount you roughly want to be about no more than like 25, 30% of your net worth. I think it’s sort of a good marker as well from a safety perspective.

Doug (17:38):

I love a good ratio. Jeff, 25 to 30% of your net worth is a number to think about as far as how much you might get a pre-approval for.

Jeff (17:48):

Yeah. If you want to go higher, that’s fine. But as part of the pre-approval process, you’re going to have a business plan. What do you intend to use? What are they going to use the proceeds for? And so if you can support going higher, you can certainly do it. It’s not like if you go higher than that, the NCUA is going to say no. You just have to be able to support what you’re doing to buy back. I said, it’s a real balance. And on the one hand, you don’t want to handcuff yourself by going in with a too low amount, but you also want to have credibility and not have your number or the amount requested be too high. 

Doug (18:15):

You’ve kind of laid out what position the credit union wants to be in. You want to have no safety and soundness issues. You want to have some size and scale. You want to have access to capital. What do you need to look at as far as any of your documents as a credit union before you go into a potential merger or acquisition?

Jeff (18:35):

Yeah. On the buy-side, maybe we’re looking at your field of membership. Is it worth going in and trying to expand, depending on the market you want to enter into as part of a transaction documents. We always recommend, you know, you have to do this the way the NCUA structures the mergers; you don’t technically need a real definitive merger agreement, but we think that’s important to have that for a variety of reasons. Just again, the covenants of the parties are reflected in the agreement. Certainly, you know, it was part of the due diligence process. You’d have a selling credit union make representations about its business and it’s sort of like confirmatory due diligence because you’re obviously going to be looking at it, but it’s great to have them confirm in writing. If you’re on the bank side, you’re going to have a definitive agreement.

Jeff (19:20):

I mean, that’s going to happen. Credit union mergers, we’ve done deals where you haven’t had it. We always try to push them not to overlook it. It’s just a much better process in terms of deal execution than not having it. I’d say those are the big two. And then as you start getting into the process contracts really on the credit union side, if you’re going to keep all the executives or senior management teams, there’s going to generally need to be consistency in comp plans and arrangements. For example, Sally, the acquired credit union CEO, has an employment agreement, but the acquiring CEO does not. Well, do we want to put in employment agreements for everybody? So they’re all treated the same 457(f) plans, collateral assignments, those types of arrangements, too. So that is whether it’s a credit union deal or a bank deal. That is certainly a big part of a transaction. Those documents as well.

Doug (20:08):

Jeff, this is great information. I appreciate your time and expertise greatly. Any final thoughts for our listeners?

Jeff (20:15):

The theme of any discussion I have is if you are accredited and you want to be an acquirer, just be prepared, have an open mind and consider all your options because you never know what opportunities are out there that will be presented to you.

Doug (20:27):

Excellent. Thank you, Jeff. 

Jeff (20:29):

Thank you. Pleasure to be here.

Doug (20:31):

That’s all the insider credit union knowledge we have for this episode. Are you enjoying the conversation? Be sure to subscribe and share your thoughts with other credit union leaders by leaving us a review. See you next time on “C.U. on the Show.”

Speaker 3 (20:50):

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. Economic forecasts set forth may not develop as predicted. All performance references are historical and are no guarantee of future results. Indexes are unmanaged and cannot be invested into directly.

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