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Trust Preferred Securities: Are they always your optimal source of capital?
by Philip K. Smith
The use of trust preferred securities as an alternative funding vehicle continues to be a priority for many institutions. The use of that structure, which provides a capital-raising tool with both debt and equity elements, is certainly beneficial in many situations. However, far too often, community banks in particular may be tempted to simply “jump on the bandwagon” without considering other alternatives that might be more appropriate for their particular situations.
Trust preferred securities are frequently marketed as a means of raising tier 1 capital, while avoiding shareholder dilution and gaining the benefit of a tax deduction. That is, these securities are considered as equity from a regulatory perspective and as debt for taxation purposes. Under a typical trust preferred structure, a financial institution would issue junior subordinated debentures to a special purpose subsidiary, or business trust. In turn, that subsidiary would issue trust preferred securities and pass the proceeds back to the financial institution. The trust preferred market has been further expanded by the proliferation of pooling structures that have enabled community institutions to gain access to this form of capital in a manner that is more efficient than via a stand-alone offering.
When considering the various alternatives for acquiring new capital, it is typically true that “debt is cheaper than equity.” This means that, for most community financial institutions, the time, cost, dilution to existing stockholders, and other problems that arise through a new stock offering or equity issuance far outweigh the benefits to be received. Thus, for most institutions, the alternative is some type of debt financing through borrowings from a correspondent bank, trust preferred securities, or some other mechanism. However, the popularity of trust preferred funding does not necessarily imply that it is the best way for your particular institution to raise capital.
In spite of the tax and non-dilutive benefits of trust preferred securities, there are some downsides. As a source of funding or capital, trust preferred securities are long-term instruments (i.e., 30-year maturities) that do not allow the borrower to prepay without substantial penalty in the five years immediately following issuance. Additionally, while the cost of issuing trust preferred securities has come down substantially since their inception, there is still time and cost involved in establishing the business trust, utilizing one of the larger regional institutions to pool the various participants for funding. On the other hand, a simple advance line from the Seattle Bank can be executed quickly and inexpensively.
Perhaps the primary decision-making factor, though, for whether trust preferred is more beneficial than wholesale debt financing is simply in the amount of funding needed. A feature of trust preferred is that there is no incremental cost associated with its issuance. Whether you need to borrow $1 million or $10 million, the time and cost involved in obtaining the funds is the same. Therefore, trust preferred funding may be preferable where larger sources of funds are needed (to the extent the institution can qualify). On the other hand, if you need $1 million to finance a stock repurchase transaction, additional funding for an acquisition, or short-term funding to shore up your tier 1 capital, you might be better served by tapping into your more readily accessible sources of wholesale funding. Generally speaking, if you only need $1 million to $2 million, a Seattle Bank advance can usually fill the bill. If, however, more substantial funds are needed, trust preferred could be appropriate.
In looking at the trust preferred market, carefully weigh the advantages and disadvantages and choose the funding solution that is right for your own institution. Think like a wise, old centenarian, and you’ll never need to worry about peer group pressure!
Philip K. Smith is a principal in Gerrish McCreary Smith Consultants, L.L.C. and a member of the Board of Directors of the Memphis-based law firm of Gerrish McCreary Smith, P.C., Attorneys. Mr. Smith's legal and consulting practice places special emphasis on bank holding company formations and use, community bank mergers and acquisitions, financial analysis, acquisition and ownership planning for boards of directors, strategic planning for boards of directors, regulatory matters, securities law concerns, and other matters of importance to community banks. He is a frequent speaker to boards of directors and a presenter at banking seminars. Gerrish McCreary Smith Consultants LLC and Gerrish McCreary Smith, PC, Attorneys offer consulting, investment banking and legal services to community banks nationwide.
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