Special situation opportunity in Harvard Illinois Bancorp

Management at many small companies is often accused of being 'asleep at the switch', a figurative expression for failing to act quickly.  But it's not often that proof of a company's management physically asleep during corporate meetings appears on the internet as is the case with Harvard Illinois Bancorp (HARI).  The picture below was taken by bank activist investor Joseph Stilwell at the Harvard Illinois Bancorp annual meeting, it shows the Chairman taking a nap during a portion of their meeting.  We don't know why he's asleep so we can only speculate.  I'm guessing it's from all the wild nights at the country club after so many long days of golf..

Harvard Illinois Bancorp is a bank with $170m in assets located in Harvard, Illinois.  Harvard is a small town located a few miles from the Wisconsin border and many miles from anything else.  The bank has three branches and has been serving their local community since 1917.

Before October 1st Harvard Illinois Bancorp was a fairly standard small bank value investment.  They began as a mutual bank that converted to a public holding structure in 2010.  After the IPO the bank traded for less than book value and has earned just shy of $1m in the trailing twelve months.  Famed mutual-conversion activist investor Joseph Stilwell owns 9.87% and has been both pushing for a sale and initiating proxy fights at the bank.

This almost looks like just another sleepy bank trading at a depressed valuation waiting for a sale to occur.  The bank released news on October 1st that makes an investment much more interesting.  At the beginning of October the company noted that $18.1m in repurchase agreements sold to them by Pennant Management on loans backed by the USDA were potentially fraudulent.  The bank isn't sure what they're going to do about the loans, if they write them down completely their book value will be reduced to zero and regulators will most likely force them to raise additional capital.  If the company is able to recover some or all of the value from these loans then the company is cheap.

How did this happen?  Pennant Management is an investment advisor firm located in Milwaukee, Wisconsin that manages an $850m loan portfolio.  Purportedly a Florida businessman named Nikesh Patel had his company fabricate $170m in loans allegedly guaranteed by the USDA that they sold to Pennant Management.  Patel used the proceeds to fund a lavish lifestyle and open a restaurant business in India.  Pennant Management has sued Patel's company for selling them 25 loans, which were then placed in client portfolios or sold to clients such as Harvard Illinois Bancorp.

The case is interesting in that Pennant felt they were protected by the USDA guarantee.  Patel's company was a USDA approved lender and had supposedly been vetted rigorously.  It's unclear how much vetting Pennant did on their own, or if they just relied on the USDA stamp of approval.  Pennant only purchased guaranteed loans with the expectation that if something were wrong with the underlying credit the USDA would back the loan.  The problem is the USDA claims they have no record of any of the loans that Patel sold.  Given this evidence the USDA states that it's unlikely they will back the loans because there were no loans in the first place.

Given these facts it appears that Harvard Illinois is stuck in a bind.  They have a large amount of securities that are completely worthless.  Pennant Management has claimed that they intend to do their best to recover as much as possible for their clients.  Pennant and their parent company manage over $30b, so it might be possible for them to reimburse some of their client's loss out of their own coffers.

The investment case here rests on the expected outcome from the securities fraud.  If Harvard Illinois recovers 100% of their investment then this is a bank with a $6m market cap that has equity of $20m and earned $1m in the past year.

If the bank is required to write down the entire amount of their holdings and raise capital the value becomes unclear.  If their capital is eliminated from the write down they will be required to raise about $13m by the FDIC.  With Stilwell pushing for a sale it's likely the bank might just decide to sell rather than find capital.  But in such a situation it's unclear whether shareholders would receive anything other than a tax loss carry forward.

The opportunity lies somewhere in the middle.  Clearly the best case scenario is one where the bank recovers their entire investment, but I view that scenario as unlikely.  What will probably happen is they'll end up writing down a portion of their investment and then suing to recover the rest.  The question is how much can they recover, and how long will it take?  If more than 50% of the funds are recovered then Harvard Illinois Bancorp looks very cheap at these levels.  If less than 30% is expected to be recovered then this is fairly priced.  Anything less than a 30% recovery would probably be a total loss given the potential for a capital raise.

Disclosure: No position