Even Good Deals Have Baggage: Lessons from PacWest's Energy Woes

When a bank has the word 'Pacific' embedded in its name, you don't expect it to have issues with loans in the Gulf of Mexico.

But that is part of the new reality for PacWest Bancorp in Los Angeles, which recently bought a national lending platform.

The $16.6 billion-asset company reported earlier this week that more than 26% of its $264.4 million in energy-related loans had nonaccrual status at March 31, compared to just 2% three months earlier.

PacWest inherited the loans from CapitalSource, a national specialty lender it bought last year.

In announcing the deal, PacWest had seemingly found a solution to 2013's difficult lending environment.

With limited local options for loan growth, several banks went on the hunt for ways to increase assets and profit. Many addressed the issue by buying nearby competitors, while others looked to national businesses for a leg up.

PacWest's recent energy problems are relatively small — the portfolio only makes up 2.2% of total loans — but they serve as a reminder that all deals, regardless of the benefits of size, scale or diversity, come with some added risk.

"When you buy an asset, you're buying it with all the spider webs," said Lawrence Kaplan, a partner with Paul Hastings, without specifically addressing PacWest. "As long as the spiders don't hatch, you're fine. But if they do hatch — if issues do arise — they are yours to handle."

Even small exposures can serve as an unexpected distraction for management, Kaplan added.

Despite the current energy issue, analysts say the CapitalSource deal was a smart move for PacWest.

"When you're faced with a difficult operating environment you look for ways to protect and grow your business by exploring new avenues and new sources of revenue," said Aaron James Deer, an analyst at Sandler O'Neill. "I wouldn't fault someone for doing that."

So far, the deal's overall benefits outweigh the pain PacWest might be enduring from the energy portfolio, Deer said.

"Just because you happen to have some credit issues with it, doesn't make it a bad deal," Deer said. "They took this large provision and still beat my estimate for the quarter. … I'm not saying I'm not concerned, it is not of substantive size to warrant an outsized reaction."

Similarly, Terry Turner, chief executive of Pinnacle Financial Partners in Nashville, Tenn., recently defended deals his company made in 2006 and 2007 that eventually led to losses during the financial crisis.

"Our firm has been criticized for having made flawed acquisitions," Turner said. "My belief is those acquisitions were good acquisitions. … You would be, I think, blown away by the value of what was created."

PacWest doesn't hold quarterly conference calls and Matt Wagner, the company's chief executive, didn't return a call for comment. Still, analysts like Deer and Juliana Balicka at Keefe, Bruyette & Woods said that, based on their conversations with management, PacWest has been prudent to make sure it understands the risk in the energy book.

"They haven't been shy about discussing it," Deer said.

Deer wrote in a research note to clients Thursday that the six loans make up the $69 million in nonaccruals, including a $40 million loan — one of PacWest's biggest credits — to a marine services company in the Gulf of Mexico.

PacWest's first-quarter earnings rose 3% from a quarter earlier, to $73.1 million, despite adding $16.4 million to its loan-loss allowance. The company said its energy exposure was primarily to servicers in the energy industry. Recently, several Texas banks have referenced their lack of loans to servicers, noting that such clients are often the first ones to show stress in an energy cycle.

"Those involved in exploration cut back on their business with support service providers," PacWest said in its earnings press release. "Since almost all of our energy-related credits are in support services, several of our outstanding credits weakened during the quarter."