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The following segment was excerpted from this fund letter.
During the quarter, I built a position in United Bancorporation of Alabama (OTCQX:UBAB). This is my jockey in the Emergency Capital Investment Program (“ECIP”) trade. For those of you who are unfamiliar with it, the ECIP was established in 2021 to encourage lending into disadvantaged communities. Organizations certified as Community Development Financial Institutions or Minority Depository Institutions were eligible to receive funding in the form of nonvoting, perpetual preferred equity. The cost of the preferred equity is zero for the first two years and will thereafter range between 0.5% and 2.0%. While the goal of the program is to increase lending, receiving institutions can effectively use the capital how they please (there are some limitations around capital distributions that exceed net income).
Assuming the most conservative action, a receiving institution can park the ECIP money into treasuries and net the spread between say 3.5% and the maximum funding cost of 2.0%. And given the size of the ECIP capital relative to their market cap, this could be meaningful. For instance, UBAB received $124mm of ECIP capital vs its current market cap of $130mm. A 1.5% spread on the new $124m equates to an additional $1.5mm of essentially risk-free net income (i.e., earnings yield increases by 1 percentage point annually).
Taken to the other extreme, a bank could use the ECIP capital to support more deposits and lending activity. At 8x assets/equity the new capital would allow UBAB to write another $1.0bn of loans. Assuming a 3.5% spread (in-line with historical levels) and a 50% efficiency ratio on the incremental capital, this would imply $13.5mm of additional net income (i.e., earnings yield off the ECIP money alone would provide a 10% annual return to shareholders).
UBAB has historically grown its deposits in the mid-single digits, experienced low loan losses, and operated with an attractive efficiency ratio in the mid 40% range. With regard to their efficiency ratio, the company benefits from owning all of its real estate and has had a focus on cost control. Additionally, they have been active in other stimulus programs geared to CDFIs like New Markets Tax Credits. This is a capital efficient earnings stream whereby UBAB sells tax credits to a larger lender to fund a development project.
As you may imagine, these are desirable assets, and it was difficult for UBAB to break-in (the government does not want to allocate tax credits to an institution that cannot find attractive projects). While UBAB applied and lost for several years, they eventually got their foot in the door and have been active ever since. This past November, they received an additional $45mm allocation.
Last year, UBAB initiated a repurchase program for 5% of the outstanding shares and quickly acted upon it. Going forward I anticipate they will continue repurchasing shares (within the ECIP limitations), execute on acquisitions (they completed one small acquisition in 2021 but are actively looking), and grow organically. The company ended the year at $35 or 7.7x earnings / 1.7x book value. Of note, UBAB has already marked down its available for sale securities portfolio by $46mm or 16% given the mark-to-market moves in fixed income; importantly, they have not shifted any of their designated AFS securities into held to maturity to avoid these mark-to-market losses. If they were to adjust the designation (given that these securities are typically held to maturity), I would imagine the losses would be reversed.
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General Disclaimer This material does not constitute an offer or the solicitation of an offer to purchase an interest in Merion Road Small Cap Fund, LP (the “Fund”), which such offer will only be made via a confidential private placement memorandum (the “Memorandum”). An investment in the Fund is speculative and is subject to a risk of loss, including a risk of loss of principal. There is no secondary market for interests in the Fund and none is expected to develop. No assurance can be given that the Fund will achieve its objective or that an investor will receive a return of all or part of its investment. All statements herein are qualified in their entirety by reference to the Memorandum, and to the extent that this document contradicts the Memorandum, the Memorandum shall govern in all respects. This material is confidential and may not be distributed or reproduced in whole or in part without the express written consent of Merion Road Capital Management, LLC (the “Investment Manager”). The information and opinions contained in this document are for background purposes only and do not purport to be full or complete. Unless otherwise stated, the information in this document is not personalized investment advice or an investment recommendation on the part of the Investment Manager. The performance data discussed herein do not represent the performance of the Fund, but rather, represent the unaudited performance of a basket of separately managed accounts managed by the Investment Manager pursuant to the same strategy expected to be implemented for the Fund. Results generated in the Fund once outside capital is admitted could be materially different than those results shown. The results shown reflect the deduction of: (i) an annual asset management fee of 1.5%, charged quarterly; (ii) a performance allocation of 15%, taken annually, subject to a “high water mark;” and (iii) transaction fees and other expenses actually incurred. The management fee and performance allocation were applied retroactively and do not reflect actual fees charged. None of the results shown reflect the deduction of certain organizational and operating expenses common to investment funds, which would serve to decrease profits or otherwise increase losses. Results were achieved using the investment strategies described in the Memorandum. Results are compared to the performance of the Russell 2000 Index, the Russell Micro-cap Index, and the Barclay HF Index (collectively, the “Comparative Indexes”) for informational purposes only. The Fund’s investment program does not mirror any of the Comparative Indexes and the volatility of the Fund’s investment program may be materially different from the volatility of the Comparative Indexes. The securities included in the Comparative Indexes are not necessarily included in the Fund’s investment program and criteria for inclusion in the Comparative Indexes are different than criteria for investment by the Fund. The performance of the Comparative Indexes reflects the reinvestment of dividends, as appropriate. This material contains certain forward-looking statements and projections regarding market trends, investment strategy, and the future asset allocation of the Fund, including indicative guidelines regarding position limits, exposures, position sizing, diversification, and other indications regarding the Fund’s strategy. These projections and guidelines are included for illustrative purposes only, are inherently predictive, speculative, and involve risk and uncertainty because they relate to events and depend on circumstances that will occur in the future. The guidelines included herein do not reflect strict rules or limitations on the Fund’s investment program and the Fund may deviate from the guidelines described herein. There are a number of factors that could cause actual events and developments to differ materially from those expressed or implied by these forward-looking statements, projections, and guidelines, and no assurances can be given that the forward-looking statements in this document will be realized or followed, as described. These forward-looking statements will not necessarily be updated in the future. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. |
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