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


  1. Very good analysis. I'd argue HARI has 3 avenues for recovery:

    1) The USDA guarantees the loans, ensuring 100% recovery for Pennant and thus HARI.
    2) Pennant is able to recover 50%+ of the fraud amount, seems reasonable given the fraud was recent (implying less time for value destruction of the embezzled amount.)
    3) HARI sues Pennant for negligence. Pennant should've checked the loan guarantees of each loan individually vs relying on the blanket USDA-approved lender status of First Farmers.

    Obviously, Pennant styles itself as the unwitting victim of fraud but it does seem they f*cked up by not checking each loan individually.

    1. I agree, and I think ultimately if any of these things come through shareholders prevail.

      The wildcard is the FDIC. If you take the $18m away from HARI's balance sheet they have essentially no capital. Will the FDIC be patient and let them work this out, or will they force them to raise capital or sell? The FDIC angle is what worries me.

      At the same time the fact that they're a bank gives them tremendous leverage with Pennant. I doubt that Pennant wants the publicity associated with letting a bank fail due to bad investments and poor research. If that happens assets wouldn't walk, they'd run out the door.

  2. Nate:

    An interesting situation, great research!....but I can see a few problems EVEN IF the bank somehow manages to recover on the bad loans...

    A). Assuming they will recover and continue as a going operation, the P/E will only be about 6. At the bottom of the cycle, you could buy banks for MUCH LOWER multiples than that...Of course, we aren't at the bottom of the cycle now. Now you can get banks at about 8X earnings that don't have "hair" all over them.

    B). As the photo shows, these doods aren't the sharpest cueballs. If they were foolish once, they will probably be foolish again...

    C). Management has been shown to be subpar as evidenced by ROA & ROE, even when things are going right.

    D). If they can recover AND change management, then you MIGHT have a good situation. Two very big "if's" though...

    I see the problem as this, even IF you recover you've got poor management. You aren't getting enough of a return for all the problems in my opinion.

  3. Good Article. Cool site as well, first time visitor.

    Before buying HARI please read, might save you some money. Here are my thoughts:
    1) USDA guarantee, not happening. The loans were never loans, the USDA can't guarantee something that never existed. It’d be like someone demanding that the FDIC reimburse them for every small time crook that said “We are FDIC insured” right before he robbed you.
    2) The majority of the money is gone. It looks like Nik Patel is eager to sell all of his property/cars/boats/watches to raise cash, and possible to reduce his jail time. The interesting part of this is that he only had $6.1 MM in cash at the bank (~3% of the 180). That means that everything else has been spent on something or sent somewhere else. Some will be in the hotels he’s selling but not enough to help HARI. I think he sent it to India, here is this little gem:
    3) Time to recover what is left will be a problem. HARI only represents about 10% of the entire repo line and there are much bigger players looking to get their money back. For starters here is an ESOP in Texas with $13.6 MM and IMET with $50 MM. I understand that the recovery will be pro rata but this means the little amount left to recover will be tied up in courts.



    4) Don’t look for money from Pennant or parent company. USFS, Greatbanc, Pennant = Parent company, Trust Company, RIA. None of these have substantial capital requirements. The lawsuit even shows that it took 30 mins to verify a handful via email with the USDA (showing negligence) The funny part is that the ESOP who is suing Greatbanc/Pennant/Salem even pointed this out as well. This will sink Pennant for sure and possible the parent company as well. It looks like Pennant used the First Farmers in their Mutual Fund (that means SEC will be involved):


    Check out this chart: http://www.google.com/finance?q=usldx&ei=g1BMVJi-PJKtqAGQ8oH4Aw
    tl;dr: don’t touch HARI, I’m guessing they are trying to find someone to buy them right now.

  4. These are great points, but miss what I think is the most critical point, the FDIC. Sure an ESOP lost money, but they're not federally regulated. The ESOP has no capital requirements, and they can't be seized and forced to sell. A bank can.

    On one hand you probably have HARI pushing for *something* to avoid an FDIC seizure. If they write down this entire amount they have no capital. Banks with no capital are closed on Friday and reopen on Monday with a different name.

    Is is possible that even though HARI's loss is small that they might receive something back due to the nature of their business? If Pennant wants to stay in business, and what company doesn't then putting a bank out of business isn't in their best interest.

    There's also the aspect of insurance, it's possible that Pennant has some.

    I don't own HARI, but this is interesting, a very binary situation. The wildcard to me is the FDIC, do they allow them to operate for long without this capital? There are two outcomes with the FDIC, a capital raise or a forced sale. If the FDIC doesn't act then I think there's a decent chance of recovery here.

    But as you point out with the chart clearly investors are dumping to get out. So which is it? We just have to wait and see.

    1. The ESOP was just another Pennant customer that will be put in line looking for recovery, I just used it as an example because they made it public and it adds to the wait to receive any recovery.
      I agree with you that the FDIC is the critical point. I think they'll be forced to sell and they'll be forced to mark that capital to zero like Pennant did in their USLDX fund.

      They won’t receive a dime from Pennant except what they get from the recovery. Even if they had E&O insurance it won’t cover it and if it did it wouldn’t be enough b/c it would have to be pro rata with everyone else.
      The chart was just the USLDX fund repricing the first farmers repo to zero.

  5. Thanks for pointing out USLDX. Arguably there's an opportunity there if the First Farmers is marked at zero but there's a chance of some recovery.

    I wouldn't count out the USDA stepping in here and picking up the guarantee. The FDIC analogy is excellent but USDA-approved lenders are very few and the functioning of the secondary market relies upon the USDA's next steps here.

    Assuming zero recovery there is still some book value to HARI (perhaps $2mm) - assuming a buyer was willing to pay 1x book that gives at least $2.50 and then one has to discount expected recovery on the rest.

  6. Blackhawk bank (Bhwb) also ensnared in this. Wrote down a little less than half of the amount they had with pennant.

  7. Press release today about the estimated recovery and strategic alternatives:


    1. Do I get extra points for being dumb enough to own this before they announced the fraud loss?

    2. If you doubled down when it hit the low then yes!

  8. No I was too chicken. By dumb luck I sold half my position in August at $16.70 or so, and commitment bias prevented me from dumping the other half after the fraud was announced.

    What are we at now, 60% of Bv or so?