Last week Pacific Enterprise (PEBN) announced it was selling to Bay Commercial (BCML). Pacific Enterprise is a $650 million, 1-branch bank in Irvine, CA with 1/3 of loans in PPP, typically earning 7% ROE at 65% efficiency.

Normally PEBN holders would read the merger release and do mental math on their gains, except in this case the transaction was a “take-under”.

This post is therefore a debrief of “The PEBN disaster” and a reminder to invest in differentiated, fee-income generating banks.

Pacific Enterprise’s Merger Discount:

What happened: Not only did the transaction come under market value; it came under tangible book value, as PEBN currently trades 98% of tbv.

In other words, the Pacific Enterprise franchise – deposits, cost saves, scale and all, is worth less than accounting liquidation, even after the typical 20-25% control premium.

Also, the public markets were tricked into over-valuing the private value of the franchise, and things were challenging enough that management and the board gave up their compensation streams, option packages, community standing etc in order to partner at below liquidation value.

What are the lessons here:

• The private market is doing a better job looking through to 2022 earnings. Pacific Enterprise had a heavy reliance on PPP loans. Today’s 12% ROE becomes tomorrow’s 8% ROE if those loans are not backfilled. This also goes for negative or zero provisions we see at PEBN and most other banks, in addition to heavy reliance on mortgage – next year’s bank earnings report simply won’t be as lively as this year’s at most banks.

• What can you do with one branch? A one-branch bank is heavily reliant on local staff. If not managed properly, this one-branch, $650 million asset operation can quickly become a $300 million asset piece of half-empty real estate. We can sense this from BayCom CEO Guarini’s message to his prospective employees:

• Deposits are not necessary. Our central bank has flooded the market with liquidity. Deposits may be more valuable next year but right now most banks have more than they need.

• Fee income is valuable. Inefficiently-source spread income is not. Pacific Enterprise has among the lowest fee income contributions to total revenue of any public bank, at 1-2%.

• Is the spread income good? At first glance, Pacific Enterprise’s nearly 4% margin and clean credit suggests the bank worked with quality borrowers, but the bank has material reliance on SBA and other government-guaranteed programs. If not well administered, these increasingly may be funneled into fintech verticals in the years ahead. Loan portfolio value is in flexible but thoughtful commercial underwriting.

A banker familiar with Pacific Enterprise shared with me that even with well above-average cost saves, he was not close to Bay Commercial’s price and believes he protected shareholders by passing on the transaction.

To line up with bank acquirers, a portfolio will need to invest in fee income, distinct businesses, and quality spread clients.