Does PacWest + Banc of California + Warburg Pincus = Value?

September 18, 2023 | Premium Service | Back in July, when Banc of California (BANC) agreed to acquire the battered remnant of PacWest Financial (PACW), we saw perhaps hope for value recovery. The idea of ~ $10 billion asset BANC inhaling the $40 billion PACW was stunning and a bit intriguing, especially with Warburg Pincus (WP) and Centerbridge Partners in the mix. The two PE firms are providing $400 million in new capital, but they better hurry. The chart below comes from the 2021 PACW 10-K.

When we read the presser that the “Combination will create California’s premier relationship-focused business bank,” however, we nearly tossed the milk and cheerios. PACW was a mediocre commercial lender living on the fringe with an originate-to-sell private label loan business that nearly killed the bank. Back in the 2021 annual report, after the part about “premier relationship-focused business bank.” PACW described itself accordingly:

Sound a lot like the bank f/k/a First Republic? Yeah. It’s fair to say that a good bit of this business description is now discussed in the past tense, particularly after the forced sale of the PACW asset-based loan portfolio to Ares Management (ARES). At the end of Q2 2023, more than half of PACW's assets were supported with wholesale funding vs 14% for Peer Group 1. Net losses equaled 6% of assets in Q2 and given the other operating metrics, the bank may be out of capital if not cash by the end of Q3 2023.

When the ~ $11 billion asset BANC is merged into the ~ $40 billion asset PACW, the result after further asset sales will be a bank with $36 billion in assets and a far cleaner, more liquid balance sheet. Yet then comes the tough question: What sort of commercial bank will the post-close BANC really be and how will it differ from today’s business at BANC?

Source: Google Finance

Like PACW, BANC is a pedestrian peer performer that has been trading below book value since the end of 2022. In Q2, income for BANC, literally the smallest bank in Peer Group 1 at $11 billion in assets, was in the bottom quartile of the group. BANC is so small, in fact, that it is still compared with Peer Group 2 because it only just went above $10 billion in assets. One wonders why the FDIC supports this transaction. Maybe they've got no alternatives.

Operating efficiency for BANC is dead on peer, the funding at BANC is weak (30% of assets supported with non-core funding) and the rest of the story is unremarkable. Real estate loans are the largest and indeed predominant exposure on the pre-close balance sheet at BANC.

There is a fair amount of idiosyncratic wobble in the BANC financial metrics published by the FFIEC, which is part of being a small bank but something to keep in mind nonetheless. Credit loss rates have been below peer for BANC some years, but now are above peer. Looking at the latest financials, there really nothing notable about BANC other than its consistent mediocrity.

Given BANC’s history, what is the plan? The presser states: "The merger will create the premier California business banking franchise, which will be well-positioned to capitalize on market opportunities and broaden the channels and customers it serves through increased scale and expanded product offerings." The proceeds of asset sales will be used to pay-down $30 billion in wholesale funding, leaving the bank in theory able to pursue opportunities with less market volatility in the stock.

Jared Wolff, President and Chief Executive Officer of Banc of California, will retain the same roles at the combined company. John Eggemeyer, who currently serves as the independent Lead Director on the board of PacWest, will become the Chairman of the board of the combined company. The board of directors will consist of 12 directors: eight from the existing Banc of California board, three from the existing PacWest board and one from the "Warburg Investors."

Now normally we’d tell you that the involvement of WP makes the likelihood of success higher than in your typical bank recap transaction, but BANC + PACW may not be such a case. WP has more than $67 billion in private equity assets under management and an active portfolio of more than 215 companies, but not every investment has been a winner.

We view all investments in assets related to non-agency residential mortgages with great skepticism. And given the mixed pedigree of BANC’s residential mortgage business to date, BANC + PACW looks like more of the same, only bigger with the timely capital infusion by WP and Centerbridge Partners.

Just as PACW was banking the world of fringe mortgage products and business purpose loans, so too BANC was also involved in similar products. It might surprise some of our readers that BANC is the loan servicer for Sprout Mortgage, a non-QM loan originator that was subject to an involuntary bankruptcy petition earlier this year (8:23-bk-72433) brought by units of Ellington Management and other investors. BANC is a party to the bankruptcy.

Sprout was a non-agency, non-QM mortgage lender that was funding its operations via a $250 million warehouse line with Family First Funding, a subsidiary of First American Financial Corporation (FAF), and also lines with PNC Bank (PNC) and First of Indiana. FAF has sued Sprout in federal court (1:22-CV-04406). The former CEO of Sprout, Michael Strauss, had his license pulled last year, according to Inside Mortgage Finance, and has been embroiled in litigation with former employees (See: Agudelo v. Recovco Mortgage Management).

So are the folks at WP really credulous enough to get involved with a recapitalization of two second-tier, non-QM mortgage lenders? Apparently so. Readers of The Institutional Risk Analyst may recall that WP had acquired control of another non-QM lender, Newfi, which is described as a “a technology driven multi-channel mortgage lender.”

The experience with Newfi was said to be less than WP hoped, leading to the 2021 sale of Newfi to Apollo Global Management (APO) portfolio company, Athene (ATH). WP closed that transaction just in time to avoid the collapse of the non-QM market. APO sold its AmeriHome unit to Western Alliance (WAL) at the top of the market in 2021. Watch what the great managers do, not what they say.

With the increase in interest rates over the past 18 months, the demand for non-QM loans and related assets in the world of business purpose loans (BPLs) has fallen dramatically. The entire residential mortgage market led by the likes of Rithm Capital (RITM) is migrating to a multi-asset orientation, but the folks at WP see value in giving these two proven losers in non-QM lending more capital.

If the combined BANC+PACW entity looks and behaves anything like BANC has in recent years, then we’d be inclined to avoid the name. Moreover, we worry that the FDIC may have pushed to approve this recapitalization by two apparently credible PE firms for want of other practical alternatives. The Q2 2023 disclosure for PACW suggests an institution that is bleeding cash and operating in extremis, making us wonder if this transaction is not already receiving support from the Fed's discount window.

But even if this transaction eventually closes, this is precisely the sort of CA mortgage focused institution that will extend itself in the market for non-QM loans as and when the FOMC drops interest rates. When the sun is shining and interest rates are falling, non-QM loans seem attractive, even compelling. Baring a miraculous change in strategy, the enlarged BANC will be perfectly situated to get clobbered as and when the residential housing market experiences a maxi price reset around the end of the decade.

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