KBRA Comments on Old Second Bancorp, Inc.'s Proposed Acquisition of Bancorp Financial, Inc.

On February 25, 2025, Old Second Bancorp, Inc. (NASDAQ:OSBC) ("Old Second" or "the company") (KBRA senior unsecured debt rating: BBB / Stable Outlook), the parent company of Old Second National Bank, announced a definitive merger agreement with privately-owned Bancorp Financial, Inc., the parent company of Evergreen Bank Group ("Evergreen"). Under the agreement, Bancorp Financial, Inc. would merge with and into OSBC in a stock-and-cash transaction (75% stock / 25% cash) valued at ~$200 million or 1.3x P/TBV at deal announcement (based on OSBC's closing stock price on February 24, 2025). The acquisition is expected to close in 3Q25, subject to customary regulatory approvals, with minimal changes to the pro forma Board of Directors (BOD) and the management team. However, Evergreen will add two members to the BOD, including Darin Campbell, who will lead OSBC's Consumer Lending Division, leveraging his extensive experience in Evergreen's powersports consumer lending vertical. Overall, the transaction aligns well with Old Second's business model, in our view, enhancing asset generation while leveraging its high-quality, low-cost core deposit base. Additionally, it diversifies the franchise by expanding consumer lending, a segment that has demonstrated favorable risk-adjusted returns across various interest rate and credit cycles. The acquisition also strengthens Old Second's market position in the greater Chicago metro area, particularly in the western suburbs. With pro forma assets of $7.1 billion, Old Second would become the second-largest bank in the Chicago MSA among institutions with less than $10 billion in assets.

From a balance sheet perspective, given the relative size of the deal (26% of total assets) and Evergreen's significant concentration in consumer lending—particularly indirect lending through its powersports divisions (FreedomRoad Financial and Performance Finance), which accounted for 67% of total loans as of 4Q24—the pro forma balance sheet is expected to change significantly. Evergreen's loan book is primarily funded by market-rate deposits, with certificates of deposit (CDs) comprising 64% of total deposits. Post-merger, the combined entity would have a more diversified loan portfolio, with commercial lending representing the largest segment. CRE exposure would remain at a comfortable level and is projected to be below the peer group average at 208% of total risk-based capital. However, consumer lending would become a more significant component, increasing to 21% of total loans. Management expects this level to be maintained despite potential growth opportunities. Additionally, Old Second's deposit mix is expected to deteriorate slightly, with non-interest-bearing (NIB) deposits declining from 37% to 31% on a pro forma basis, while higher-cost time deposits will increase from 16% to 26% of total deposits. Following the closing of the transaction, management plans to proactively reposition the balance sheet by selling Evergreen's entire AFS securities portfolio ($123 million) and purchased solar loan portfolio ($62 million). Proceeds from these sales may be used to de-leverage wholesale borrowings, as Evergreen reported ~$183 million in brokered deposits and FHLB borrowings as of YE24, thereby enhancing the funding mix. Importantly, the liquidity and capital profile is expected to remain strong, with a loan-to-deposit ratio of 86%, $1.4 billion in cash and securities (20% of assets), and pro forma TCE and CET1 ratios of 9.6% and 11.7%, respectively. The maintenance of solid capital levels is supported, in part, by minimal interest rate marks ($13 million markdown on loans), given Evergreen's shorter duration and higher-yielding loan portfolio.

With respect to financial performance, a key benefit of the proposed transaction is the anticipated reduction in Old Second's asset sensitivity, better positioning the company for a declining interest rate environment. Evergreen's primary lending segment, powersports loans, is generally structured with five-year terms, resulting in a shorter duration than most community banks. However, its higher-beta deposit base—primarily CDs—provides pricing relief in the event of lower interest rates. Assuming no further rate movements before the expected closing, OSBC's NIM of 4.68% during 4Q24 is projected to remain largely unchanged, despite the notable anticipated increase in total deposit costs (1.54% based on 4Q24 financials). Nevertheless, OSBC is expected to maintain one of the strongest core deposit bases in the KBRA-rated bank universe, in terms of mix and cost. The resilience of the pro forma NIM is primarily driven by the strong loan yields from Evergreen's powersports segment, which recorded an average rate of 9.48% on 4Q24 originations, contributing to an above-average loan yield of 8.35% for the target bank during the quarter. Given the maintenance of a healthy NIM on a pro forma basis, and projected cost savings of 30% on Evergreen's noninterest expense base, which is expected to be fully phased in by 2026, the combined entity's earnings power is projected to improve, with ROA around 1.5%, positioning it in the top quartile of its rating category. However, reliance on spread revenues is expected to increase, given Evergreen's limited fee income, which accounted for only 5% of total revenues in 2024.

Lastly, credit quality metrics are expected to modestly deteriorate due to the higher-risk nature of consumer lending, with Evergreen reporting an NCO ratio of nearly 1.0% in 2024. However, management remains confident in the leadership and expertise of the team, supported by a proven track record, including an NCO ratio that has remained at or below 1.5% since 2010. This stability reflects conservative underwriting, as a majority of these loans are backed by strong borrower credit profiles, with a weighted average FICO score of 717, and 56% of loans having a FICO score of 757 or higher. As such, credit losses are expected to rise, though they are offset by favorable risk-adjusted yields, which have averaged approximately 8.5% (powersports yields net of charge-offs) in recent quarters. Moreover, this portfolio has historically outperformed all other consumer lending categories (excluding credit cards) within the banking industry over the long term. Additionally, we believe that OSBC's management team conducted a thorough due diligence process and is expected to record a conservative credit mark on the Evergreen loan portfolio, projected at $28 million, or 2.3% of total loans at closing.

Overall, we view integration risks as comparatively minimal for this in-market transaction, particularly given the similar cultures and long-standing familiarity between management teams. Additionally, KBRA takes comfort in OSBC's established track record of successful M&A execution throughout its operating history. Assuming effective integration of the target bank, we consider the proposed transaction neutral to OSBC's ratings in the intermediate term, while acknowledging the longer-term strategic benefits to the institution.

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