In today's episode, we (Joe Fenech & Kevin Swanson) discuss
Summary:
- Webster’s sale to Santander: what the latest large regional bank deal tells us about regulatory openness, scarcity among the 25 scaled regionals, and why consolidation continues to unfold.
- Regional banks as the scarcity play: how takeout multiples reset valuation floors across the peer group – even for banks that haven’t yet transacted.
- Private credit back in focus: applying a historical credit-cycle lens to recent structural concerns – and assessing the potential implications for banks.
- The current backdrop: broadly strong fundamentals despite emerging pockets of credit scrutiny.
This session is also available on Spotify or Youtube
Transcript
Spotify Intro
Alright, let’s jump in. Three things today: First, another major regional bank deal and what it tells us about where we are in this cycle. Second, private credit. It’s back in the headlines, and I want to walk through how we’re thinking about it as bank investors. And then we’ll wrap up with a quick update on fundamentals as we move through the first quarter.
Disclosure:
Quick disclosure: Joe Fenech and Kevin Swanson are employees of GenOpp Capital Management, an investment advisor that maintains exempt reporting status in the state of Indiana. This podcast represents the views, beliefs, and opinions of GenOpp members and does not assert to be complete. The information presented in this podcast is provided to you as the dates indicated and opinions presented may change. You should not rely on this podcast as a basis upon which to make an investment decision. This podcast is not intended to provide and should not be relied upon for tax, legal, accounting, or investment advice. GenOpp’s clients or its members may hold or recommend to GenOpp’s private fund clients the purchase or sale of securities of companies discussed in episodes of this podcast.
M&A:
Ok, let’s start with M&A. Since our last episode, another large regional bank M&A announcement. Webster has agreed to be acquired by Santander. Full disclosure – we owned Webster, and takeout potential was an important component of our thesis. The buyer may have surprised some people, it surprised us. The fact that Webster was in play did not. And more importantly, this deal is confirmation that the regional bank M&A thesis is playing out. We’ve been very specific about this cohort.
There are only 25 banks in the country over $50 bil. in assets. That’s a very small universe. For most of the past nearly 20 years, that group was effectively frozen out of transformational M&A. The regulatory environment simply wasn’t supportive of large regional combinations. That’s changed. For the first time in a long time, regulators are open to these transactions. And so when you combine that regulatory unlock with the fact that there are only 25 scaled institutions to begin with – and generally cleaner deal math at that size – you get scarcity.
Now layer in Webster specifically. Webster had scarcity value nationally as one of those 25. But it also had scarcity value regionally. In the Northeast, which is not the fastest growing part of the country, there were only about five scaled banks left in that size range. Now there are four. So even in a less demographically attractive market, scale becomes strategic becomes there simply aren’t many platforms left to acquire. That’s a microcosm of why we’ve referred to regional banks more broadly as the scarcity play of this cycle. We’ve framed the group as hunters and hunted, and each of these regionals is in either one bucket or the other. And this dynamic continues to unfold. 7 of these larger regionals, roughly a quarter of the total, have now participated in transformational M&A in this cycle.
Now, here’s the part that often gets overlooked. M&A doesn’t just affect the bank that gets bought. When Comerica sells initially at 1.7x tangible book, and Webster sells closer to 2x, the market starts asking a very simple question:
If that bank is worth 2x book, what is the next one worth? It’s not complicated. Investors look across the remaining independent regionals and start to benchmark them against takeout values. And over time, that tends to pull valuations higher for the entire peer group – even for banks that aren’t transacting. That’s sort of the gravity effect of M&A.
Now, alongside all of this, there’s been a narrative forming that activists are driving consolidation in regional banks. But if you look at the facts so far this cycle – roughly seven large regional banks have participated in transformational deals, and only one of them had an activist investor involved. The most recent one, Webster, did not. To us, that reinforces the point we’ve been making all along: Activists are along for the ride. They are not driving outcomes.
This wave is being driven by structural considerations – regulatory openness, scarcity, strategic necessity. And that distinction matters. B/c if consolidation is structurally driven, it has durability. If it were activist-driven, it would be more episodic. Now, having said that, no investment theme should ever be treated as a bet the ranch assumption. If your mandate is more M&A centric – and you’re concentrated in underperforming institutions on the premise that you can influence a sale – your risk profile looks different. In a benign environment, that can work. But in a downturn scenario, underperformers tend to underperform for a reason. And if the M&A window narrows – temporarily or otherwise – flexibility matters. That’s not our base case. If it were, we wouldn’t have owned names like Comerica or Webster. Bu as investors, we believe you want to participate in the structural M&A tailwind while still maintaining that balance in case the macro environment shifts.
And that brings us to the next topic, private credit, which is something we are watching closely, not because we think it derails the M&A cycle, but because it informs overall risk.
Private Credit:
Let’s shift to private credit. There are really two conversations happening right now. One is around direct exposure – particularly to software businesses and potential AI-related disruption. That’s real. But what has raised our antenna more recently goes beyond sector exposure.
Last fall, when Tricolor and First Brands ran into trouble, and several banks had exposure, we said at the time that those situations didn’t appear to represent broader, pervasive credit issues for banks. And we also said that the sell-off in bank stocks through the early fall was driven just as much by funding market stress behind the scenes as by those apparent one-off credit events.
So what’s changed now is we have some additional information – this situation involving MFS, Market Financial Solutions in London, where public reporting has raised questions about collateral structure, including potential double pledging of assets, which has been reported to involve questions around collateral structure similar to what we saw last fall. So again, could be another one-off. But when you see multiple instances over time where the discussion centers not just on credit losses, but on collateral transparency and layered financing structures, it’s reasonable to step back and ask whether there are common structural features that are worth taking a closer look at, and it highlights something that we’ve been watching closely for awhile now.
So let’s take a step back for a minute and put this into context. So banks historically did a lot of this type of lending. After 2008, Dodd Frank and other regulations tightened the screws on banks, and pushed a lot of this type of lending outside of the regulated banking system. And a lot of this stuff found a home in private credit and private equity structures. And we’ve seen this migration dynamic before, where this type of lending morphs into something else after it gets into trouble, but it’s essentially the same thing.
In the 80’s, it was leveraged buyouts financed by junk bonds, and that all ended with the Drexel Burnham collapse, then in the early 2000’s it was subprime mortgage lending. And then it shifted again after the 2008 collapse, this time into private credit. And for more than a decade through a period of explosive growth, the backdrop was extremely supportive.
Very low rates, stimulus like we’ve never seen before, after ’08 and especially after the pandemic. Easy access to capital. Limited regulatory oversight compared to banks. In that environment, almost any credit model can look pretty good. And the pitch was simple and pretty effective – we can move faster than the banks, we can be more flexible, customize structure to the customer, charge a higher rate, lock up capital long-term. No bank regulatory exams, you mark your own portfolio, fees based on reported NAV, and in some cases, banks will lend against those NAV’s. When asset values are stable or going higher and the system is awash in liquidity, that structure functions pretty well. But things can change, and they have changed. When public reporting begins to raise questions about collateral layering or when publicly traded vehicles trade at persistent discounts to reported NAV, it suggests that market confidence in valuation marks could be shifting. That doesn’t automatically mean the marks are wrong, but it does mean perception of risk is changing.
And that brings me to a quick anecdote, from over 20 years, 2005 to be specific. I was a sell-side analyst covering banks, and I brought a group of investors in to meet with Bob Wilmers at M&T. M&T was the first larger-sized regional bank stock I was assigned to cover. And of course, Wilmers was a legend in banking, probably the most well-respected banker of his generation.
Someone asked him what kept him up at night. And he said without any explanation: negative amortization lending. This was 2005. Housing data looked fine, credit looked fine, home prices were going up and up. No obvious cracks yet. Someone asked him why that worried him. He didn’t make a prediction, he didn’t talk about what could happen in recession scenarios. He just said it doesn’t make sense. And if you think about the structure, the structure allowed borrowers to make monthly payments that didn’t even meet the monthly interest that was due on the mortgage. So your loan balance would grow over time, and the theory that it rested on, which seems ridiculous today, is that home prices would rise at a faster rate than the mortgage debt would, so if there was a problem ever for the borrower, they could just sell their home and easily satisfy the debt. His point wasn’t about timing. It was about structure.
He thought the design itself created a vulnerability under stress, even if there was no data really at all to back him up on that at that time when he made the comment. And I never forgot that, especially after what happened three years later. And so when I look at certain segments of private credit today, what gives us pause isn’t one particular industry exposure. It’s sort of the overall structure. That doesn’t mean there is an imminent event. Or if there is ever a material event. But when similar structural questions arise more than once, and you start to think about the broader macro backdrop and how it’s changed and how those macro conditions fueled the growth of that asset class, you start to wonder how those structures would behave during a real downturn, which we are obviously not in today.
Impact to Banks:
So what does this mean for banks? First, any stress that might develop here did not originate within the regulated banking system. Banks have ceded quite a bit of market share in many of these lending categories over the past 10-15 years. So if you were to have a major problem here within private credit, private equity, banks aren’t going to be at the epicenter in the way they were in 2008. And I think that distinction matters.
However, that’s not to say that banks are completely insulated, not by any stretch. Banks lend to these institutions. They provide lines of credit to funds. In some cases, they provide financing secured by fund assets or reported NAV. We’ve heard management teams talk about how their exposure to these areas historically experienced very minimal losses. All true. But long periods without losses also go hand in hand with tighter spreads.
And banks are obviously credit-sensitive. So no matter where within or outside the system you see credit stress, the reaction with respect to the stocks is to shoot first and ask questions later. You will definitely see spillover through relationships, from the fact that banks are also risk assets, and it’s not going to matter especially early on if the bank sector isn’t the source of the stress. So that’s the framework we’re using as we think about risk. We talk to a lot of banks, all the time. And we are not hearing talk about credit stress on bank balance sheets, we just aren’t. And if it does turn out to be a major problem emanating from some other segment of the market, like private credit, it’s going to be painful for banks in the short-run, but it’s also going to represent a tremendous longer-term opportunity, as banks would presumably have an opportunity to reclaim some of this lost market share over the past decade. So we zoomed in on this topic, now let’s zoom out to close.
If you look strictly at bank fundamentals right now, they are very very solid. Earnings have been very strong, funding markets are functioning well now relative to last fall, QT has flipped to this form of QE light, which is a big big deal. Capital levels are very strong. The operating backdrop for this sector right now is pretty compelling. So we have two realities at once: Strong fundamentals and attractive valuations, and then a segment of the broader credit market that bears closer scrutiny. Our base case remains bullish for the banking sector as a whole. And we will continue to monitor these issues as things develop. And with that, thanks for listening today, we will talk to you again soon.
Disclosures:
Of the individual stocks mentioned, our investment fund currently has a position in Webster Financial Corp (WBS).
The information in this newsletter does not constitute an offer to sell or a solicitation of an offer to buy any security. This information does not purport to be complete, is subject to change, and is qualified in its entirety by the definitive offering documents related to any private fund managed by GenOpp Capital Management LP. All time-sensitive references are made as of the date set forth above, unless otherwise expressly indicated, and there is no obligation to update any such reference. The delivery of this information does not imply that the information is correct and no representation or warranty is made as to the accuracy of any information contained herein. This information is not a recommendation to buy any security and does not constitute any form of legal, tax, investment, or other advice.
