2023-09-27 08:49:02 ET
Summary
- Heritage Nola Bancorp, a small Louisiana bank, is being taken over by a local competitor in a merger deal.
- The estimated transaction value is $19.00 per share, while the current share price is $18.25, indicating a potential arbitrage opportunity.
- There are risks involved, including regulatory delays and uncertainties in calculating the consideration based on book value adjustments.
Heritage Nola Bancorp ( OTCPK:HRGG ) is a small Louisiana bank getting taken over by a local competitor. The bank was a mutual conversion, which is always an interesting place to look for bargains since generally speaking the cash from selling the shares to the public ends up on the balance sheet of the bank (and thus owned by the people who bought those shares). Since Heritage Nola is quite small, they don't really have the scale to be a standalone operation, but their couple of branches and loan/deposit book is reasonably attractive to other local players looking to grow.
I had written them up as a long on the Microcap Review almost exactly 6 years ago when they traded at $11.80, when I had this to say:
. ..suggests banks in that profitability band have sold for an average of 133% of book value, which suggests a long term price target of $20 per share.
They've recently announced they're selling for a $6.5 MM premium (~31%) to book value at close, with an estimated range of $19.50- $20.50. So my long term sale estimate was quite close. Anyway, the history is somewhat interesting but not too critical, and at this point I'm buying/holding this as a merger arbitrage position.
The big reason the backstory is important here is that I think the downside is relatively limited at the current share price of $18.25. There would almost certainly be other bidders at a price not that different to the current purchase price, and management has now indicated a willingness to sell the firm. That's a big potential risk with undervalued small banks - that management can just run them for salaries for years. Since they've decided to sell, that eliminates a significant risk.
Book value at their last report was $20.7 MM, and then we get to $27.2 MM with the $6.5 MM premium. There are also 145k in-the-money options that will presumably be exercised before close, which would get book value up to $29.0 MM. With 1.384 MM shares outstanding (including the options) that suggests recent book value is $20.95.
The release notes that HRGG's transaction costs, losses on securities, and termination payments will all be deducted from the book value, which is how they got to their $19.50-$20.50 range. I'll make my own estimate.
Figuring 5% for transaction costs is $1.45 MM, and based on past experience I think that's reasonable. The fact the target is paying their own transaction costs probably makes management more likely to try and keep them reigned in (incentives matter!).
Next, in their most recent financials (linked above) they had $8.358 MM of held-to-maturity securities, I'll assume a 10% loss on those which is another $0.83 MM. Finally, on their final proxy prior to going dark, the CEO/CFO had a combined base salary of $283k. I'll assume they keep everyone else and spend 1.5X that figure on severance, COBRA, etc., which pulls off another $0.42 MM. That gets me to an estimated value of $19.00 per share, compared to a current share price of $18.25, which is a 4.1% spread.
I did write this up as an arbitrage for my Investing Group subscribers in August at $17.83, and at that time I estimated a close of December 1, 2023. The press release for the deal indicated a Q4 close, so I think that the closing date is still reasonable as an estimate. The quick close makes quite a big difference to the expected IRR, which pushes a 4% spread to a 20%+ IRR, although obviously only for a few months. See the table below for the worked-through calculations.
Risks
Of course, generally speaking, every type of investment comes with some kind of risk. And this is a merger arbitrage investment in a microcap bank deal, so there are a number of different risks.
On the regulatory side, there could be some sort of hiccup. The combined business won't have any antitrust concerns, and I think the FDIC is more likely to approve mergers quickly after the events in banking earlier this year. Still, bank deals can be delayed for regulatory reasons, which would reduce the IRR.
The other big risk here is that the consideration isn't fixed, but is rather based on the book value at close and a specified set of adjustments. That makes it harder to calculate and also subject to potential reductions for unforeseeable reasons. In particular, the losses on their securities' portfolio are not easy to predict and could be larger than what I've estimated here, especially as long term interest rates have continued to increase. That lowers the present value of mortgage backed securities, increasing the potential for losses on their portfolio. As an offset, they will get credit for any increase in book value from their earnings during the time it takes the deal to close. I think the risk of expenses/offsets coming in higher than anticipated is probably the biggest risk here. It's also likely the reason for a larger-than-normal spread - because the exact consideration is difficult to calculate, arbitrage investors are likely demanding a larger-than-normal margin of safety. Many bank arbitrage deals trade at much lower estimated IRRs than what I've estimated here, so in my opinion, the extra risk of the uncertain consideration is compensated by the extra return.
Finally, it's reasonable to mention that this trades OTC and doesn't file with the SEC. They do have publicly available Call Reports and file summary financials with the OTC markets every quarter, so they aren't dark, but shares might be difficult for some to buy.
Conclusion
Heritage Nola is a sleepy little bank in the New Orleans area. It has converted from a mutual institution and is now getting sold as part of ongoing consolidation in the sector. The exact consideration is somewhat hard to calculate, and I believe that (along with it generally being an under-the-radar name) has caused a higher-than-normal merger arbitrage spread.
For further details see:
Heritage Nola Bancorp Is An Attractive Merger Arbitrage