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PlainsCapital's Buyout of First Southwest Pivots on ARS Portfolio

Almost a fourth of the value of the First Southwest Co. buyout by PlainsCapital Corp. last year hinges on the performance of a portfolio of distressed investments over the next four years, according to a filing with the Securities and Exchange Commission yesterday.

At the end of last year, First Southwest, a financial adviser and broker-dealer based in Dallas, sold itself to PlainsCapital, a bank. PlainsCapital yesterday filed for an initial public offering and described the details of the First Southwest deal in its registration document.

Under the terms of the deal, the owners of First Southwest received 1.7 million shares of PlainsCapital stock. Supported by an independent valuation service, the companies valued the buyout at $62.7 million, which represented an $11.1 million discount to First Southwest’s book value.

The key to understanding why First Southwest would sell itself for $11.1 million less than its net assets may lie in a clause in the deal’s fine print.

As part of the deal, PlainsCapital assumed First Southwest’s portfolio of auction-rate securities, now valued at $186.9 million.

ARS are bonds on which the interest rates reset regularly at an auction at a regular interval, often every two weeks.

During the opening volleys of the financial crisis in 2007, these auctions began failing.

When an auction fails, the holder is stuck with the security. The market for ARS today is comatose.

The auction-rate securities PlainsCapital acquired will be tough to sell unless a secondary market re-emerges or the issuers restructure the debt, the company said.

Aside from the shares granted in the acquisition, PlainsCapital placed 565,810 shares in escrow, tabbed for First Southwest’s former owners.

How many of those extra shares are granted to First Southwest’s former owners pivots on how much value PlainsCapital realizes on some of the ARS.

If less than 80% of par is realized — based on value or aggregate sales price — by the end of 2012, First Southwest’s former owners receive nothing. If more than 90% of face value is realized, First Southwest’s former owners receive all the shares. If it is between 80% and 90%, they will receive a portion of the shares.

The companies valued PlainsCapital’s stock at $34 per share when the deal closed in January. That means the locked-up portion of the buyout price is $19.2 million, or 23% of the maximum purchase price.

The value of the auction-rate securities at the time the deal closed was $151.6 million. The company also had to repurchase from investors $41.6 million in ARS, under a First Southwest settlement with the Financial Industry Regulatory Authority.

It is not clear how much of the portfolio is considered for the contingent portion of the buyout. The company said it depends on “certain” auction-rate securities, including ones repurchased from investors.

After absorbing the $186.9 million in ARS into a securities portfolio that a year earlier totaled $191.2 million, PlainsCapital breached regulatory limits for exposures to individual issuers.

Of the $186.9 million auction-rate securities PlainsCapital acquired along with First Southwest, $168.4 million were issued by the Indiana Secondary Market for Education Loans Inc. and Access to Loans for Learning Student Loan Corp.

To pare down exposures to these issuers, the bank transferred $22.6 million of its securities from its held-to-maturity portfolio to its for-sale portfolio, recording a $200,000 loss, the documents show.

Securities held in a for-sale portfolio have to be recorded at market value, whereas securities in a held-to-maturity portfolio are listed at what they cost to buy.

Founded in Dallas in 1946, First Southwest now represents the bulk of one of three major divisions within PlainsCapital.

PlainsCapital was founded in Lubbock, Tex., in 1987 by Alan B. White, who is still chief executive officer and owns more than 8% of the company.

With 2,400 employees and 173 branches or offices in 32 states, the company runs a bank, a mortgage lender, and an adviser. The bank subsidiary, PlainsCapital Bank, is the 10th-biggest bank in Texas, with 34 branches.

The mortgage lender, PrimeLending, issued $2.3 billion in home loans last year, about half of which were in Texas.

First Southwest constitutes most of the financial advisory segment. The firm ranks third among financial advisers to municipalities this year, advising on $15.17 billion in deals through Wednesday, according to data from Thomson Reuters.

The remainder of the segment is Hester Capital, a smaller firm PlainsCapital bought in 2003.

First Southwest’s assets represent 8.2% of the company’s assets. Hill Feinberg, chief executive officer of First Southwest since 1991 and now a member of the parent company’s board, owns 6.5% of PlainsCapital.

PlainsCapital hopes to raise $140 million in the IPO, using most of the money to buy back the $92 million in preferred shares it sold the federal government under the Troubled Asset Relief Program, and repay $20 million it borrowed from a JPMorgan affiliate under a revolving credit agreement that matures next year.

JPMorgan is underwriting the IPO, with Stephens Inc., Keefe, Bruyette & Woods, and Fox-Pitt Kelton Cochran Caronia Waller acting as co-managers.

PlainsCapital earned $24.1 million in 2008 and $28.6 million in 2007.

Most of the company’s profit has historically come from the banking subsidiary, although a rash of refinancings in early 2009 made the mortgage lender the company’s most profitable segment so far this year.

The financial advisory segment earned $3.7 million in the first six months of the year. It is not clear how much of that was from First Southwest and how much from Hester Capital.

Without First Southwest, the advisory segment in the first six months last year earned $466,000.

If the market agrees with the company’s assessment that its stock is worth $34, PlainsCapital will have to sell 4.1 million shares to raise its targeted amount.

That would represent a 28% stake in the company, and value PlainsCapital at almost $500 million.

The stock would trade under the ticker symbol “PCB.”

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