James Williams, Hedgeweek

FJ Capital offers investors opportunity to leverage M&A activity in US small-cap financials

“By investing in the potential sellers and proven buyers, the Fund is uniquely positioned to fully take advantage of the bank merger trend in the US,” wrote FJ Capital Management LLC in its May 2014 investor newsletter.

Regulation in the US is propelling M&A activity in the small-cap bank sector and represents a good opportunity for investors wishing to diversify their long/short equity allocation. And as Martin Friedman, co-founder (along with Andrew Jose) of FJ Capital Management tells Hedgeweek:
 
“There are 7,000 banks in the US, most of which are very small in size (under USD1bn in assets). Consolidation has been an ongoing process since I started working in the business in 1987, at which time there were 17,000 banks.
 
“Due to the intense nature of the regulatory environment with the introduction of the Dodd-Frank Act a few years back, it is making it more difficult for smaller banks to earn their cost of capital. If you don’t have scale in the business you are more likely to want to find a partner through consolidation. That’s a big theme playing out in the US financial sector right now.”
 
The FJ Capital Long/Short Equity Fund, which Friedman says is a ‘bank opportunity’ fund, launched in January 2008. A Cayman offshore feeder fund was launched July 2013. The fund targets annual IRRs of 20 per cent plus and specialises in identifying small banks that could engage in consolidation – either as a buyer or as a seller. Banks are being squeezed both on the expenses side and the revenue side. Overlay that with a Federal Reserve that has been manipulating interest rates for a number of years through QE and it becomes clear why banks have suffered depressed earnings.
 
This is pushing management teams and boards of directors to look for consolidation opportunities to reduce the cost burden. Right now, this is probably one of the most propitious periods for M&A activity in the US small cap financials space. There have already been approximately 30 public transactions this year, of which the fund has participated in 12: four of these were sellers.
 
“We hold around 90 banks across the US in the portfolio and I would say over the next few years or so the entire portfolio will become buyers or sellers. Everyone is positioning themselves, in our opinion, to be on either side of the M&A equation,” says Friedman.
 
Another dynamic that is likely to favour the US small-cap bank space is the spectre of rising interest rates. Once the Fed starts to manipulate the interest rate curve, yields on the loans that banks make will start to improve while the deposits that they pay out on will lag, helping to widen margins.
 
“That’s important for earnings increases in the future. If it doesn’t happen as expected in the mid-2015 timeframe then I think it will drive even more consolidation than we are already seeing because without that pick-up in margin the banks just won’t be earning the cost of capital,” comments Friedman.
 
Both factors then – M&A activity and rising interest rates – are playing into the hands of the fund strategy, which holds between 80 and 90 positions.
 
There is certainly no shortage of opportunities for Friedman and his team to consider. Right now, the small-cap banking sector remains at historically low valuations. At their peak multiple back in 1998, they were trading at 2.4x book value; now they are trading on average at 98.6 per cent to tangible book value.
 
“Right now you have historically low valuations and multiple catalysts either through earnings improvements (when interest rates start to increase) or M&A activity,” says Friedman.
 
According to the firm’s May investor newsletter, the fund returned +27.93 per cent net while it has returned 4.89 per cent net year to date (through May). One important trade this year has been the doubling of a position in New Jersey-based Investors Bancorp Inc. (ISBC), after it initiated a secondary offering leading them to raise USD2.2bn of new capital.   
 
“We started that trade back in 2012. ISBC released the remaining shares that were held in what is called a mutual holding company structure. They are only at 108 per cent of tangible book value. It’s a low number considering its peers are trading at around 180 to 190 per cent of tangible book value,” explains Friedman.
 
Tangible book value represents the true figure that shareholders would expect to get back once any good will (intangible assets) on the balance sheet has been subtracted out.
 
FJ Capital looks at a universe of 1,100 publicly traded small banks, all of which are listed on the NASDAQ Bank Index.
 
Another profitable trade this year has been in SP Bancorp Inc. (SPBC), one of the four sellers referred to earlier. Early on, the FJ Capital team identified the Texas bank as a potential consolidation target. A position was taken in the bank at USD12/share. Following the announcement of the cash acquisition (which is expected to be completed by end-2014) its share price leapt to USD30/share.
 
“This is not uncommon because of the low valuations I referred to earlier. Acquisitions are happening at 1.5 to 2x book value,” adds Friedman.
 
Although a long/short fund, the main opportunities in this space are on the long side. The portfolio typically only holds between 10 and 15 short positions, which are never taken in small-cap financials but rather mid-cap names “that we think have large valuation discrepancies; they could be trading at 2 to 2.5x book value, 15 to 20x earnings, and in that group we can find interesting short opportunities”, says Friedman.
 
Another characteristic of the fund is the limited leverage it employs. Typically, the fund is only ever 60 to 110 per cent net long. Whilst there is still plenty of capacity from an AuM perspective – Friedman estimates that the fund could accommodate USD1-1.5bn – the number of positions in the portfolio would not likely go beyond 100. 
 
“We want to pick the best 10 per cent of that growing universe of 1,100 listed banks. The beta in our portfolio is quite low: about 0.50 of the market. So we don’t need to have a lot of short positions to hedge against the broader market. In terms of capacity, we could easily assign USD500mn of new capital today to the positions we hold,” confirms Friedman.
 
Whilst the mainstream media may not write many headlines, the fact is there is a strong consolidation story within the US bank space.
 
“We have a good team in place to uncover those opportunities. There’s no index to buy into community banks. We offer investors a way to express that,” concludes Friedman. 

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