For U.S. banks, unlike common equity that derives its returns primarily through appreciation; preferred equity gives an investor a return largely in the form of a fixed dividend. Thus, when it comes to valuing a bank with preferred debt, the question comes up do you treat the capital as common or more like a debt instrument? Because the dividend is largely like a coupon on a holding company loan or other debt instrument, it seems natural to value preferred equity as debt. However, if you count it as debt, then you have a valuation problem as the preferred dividend is not tax deductible and thus treating like traditional debt will understate the cost of the preferred capital.
The cost of equity at many community banks is roughly 12%, preferred equity runs around 9% and debt cost approximately 6%. After adjusting for taxes, the cost of debt is closer to 4%. Given the difference in costs, a bank would never choose to issue preferred equity if it were not for bank regulation. Either it wants the flexibility of common equity or it wants the lower cost of capital. However, because despite like acting as debt, regulators treat preferred equity as equity for capital ratio calculation. As such, banks think of it as cheap equity.
The irony here is that normally preferred equity is associated with money-losing firms. Startups, distressed companies and high growth companies that have high infrastructure reinvestment costs are the most common users of preferred equity outside of financial firms. This makes sense because for a money losing firm there is no tax advantage of debt. Take away financial firms and money-losing firms and it rare to see a normal corporation issue preferred equity in the U.S. (it is a different case outside of the U.S.) save for some esoteric structure customized for a particular investor group.
One important lesson from the recent crisis was that banks that rushed to take advantage of relatively cheap Treasury provided financing (TARP & SBLF) in the form of preferred stock found that the implicit cost (restrictions on compensation, additional regulatory pressure, etc.) was often more expensive than common equity.
Solving The Valuation Problem
To solve the valuation problem, one solution is that if the value of the preferred equity is less than 5% of the bank’s total market capitalization, then you can ignore it and reduce the expected current/future cash flows by the cost of the dividend. While this is a simplification, it is not worth going through a separate preferred valuation for the little difference that it will make. If preferred equity makes up more than 5% of total capital, then you need to compute the preferred equity cost by taking the dividend per share and dividing it by the preferred stock price. If the preferred stock price is not observable (which is almost always the case for community banks), then bank investors must use the preferred equity at a larger bank where a price can be determined by market forces and then make adjustments to the cost for the lack of liquidity compared to the larger bank proxy. As a rule of thumb, this liquidity preference spread is generally around 15 to 65 basis points (40 basis point median) depending on size of target institution.
Preferred equity at banks creates a valuation speed bump for potential mergers and acquisition activity or for bank investors that are trying to value an illiquid community bank stock in order to arrive at a value for investment. Knowing how to understand a key component in the capital stack will help both investors and bankers make better capital decisions.
Submitted by Chris Nichols on October 22, 2015