The Problem We All Share Part I: PenFed’s Spurious Merger Strategy

The traditional reasons for mergers of sound, well-run credit unions are the following: the credit union must get bigger quickly, to achieve scale necessary for greater efficiency, and to acquire more resources and internal capacity to improve member value.

On the surface the logic seems plausible. The challenge is that it is not self-fulfilling in practice.

Pentagon FCU (PenFed) has been the preeminent practitioner of this business approach. But a review of its results demonstrates how shallow and dubious the logic of a merger “growth strategy” can be.

PenFed’s Five-Year Merger Efforts

From September 2015 through the third quarter 2020, PenFed has implemented a very public, nation-wide effort and acquired 18 other credit unions via merger. The largest was the $420 million McGraw Hill FCU in May 2019. This followed the emergency January 2020 merger of the $320 million Progressive CU–with its open NY state charter–which enabled PenFed to serve anyone anywhere in the US.

The final stand-alone call reports from these 18 credit unions showed total assets of $2.4 billion. This total does not include the addition of the $265 million Sperry Associates FCU finalized in October, nor the proposed December merger of the $34 million Post Office CU in Madison, WI.

The Results of PenFed’s Merger Strategy-Faster Growth?

Since September 2015 the compound annual growth (CAGR) in Pen Fed’s total assets is 6.4%. Without the added mergers and $1.2 billion in additional borrowings, its organic growth rate is only 3.1%. In the five years prior with no mergers, PenFed’s annual internal growth was 5.3%.

The five-year peer growth rate for the 14 credit unions over $10 billion at September 2020 is 11.22%. None has a merger strategy similar to PenFed’s. PenFed’s 6.4% growth is only 57% of the peer’s pace and places them 13^th or at the bottom of the peer table.

Five Year Annual Asset Growth for Credit Unions over $10 Billion in assets

( data: September 2015 & September 2020 assets)

Asset Rank	State	Name	2015 assets	2020 assets	5 Year CAGR
7	TX	Security Service	$9,052,442,285	$10,081,370,509	2.18%
3	VA	Pentagon	$19,223,138,716	$26,257,438,559	6.44%
2	NC	State Employees’	$31,162,020,508	$45,851,733,095	8.03%
8	IL	Alliant	$8,463,784,328	$13,027,161,832	9.01%
13	MA	Digital	$6,519,513,295	$10,469,689,635	9.94%
6	CA	Golden 1	$9,508,199,852	$15,567,120,747	10.36%
9	CA	First Tech	$8,335,581,297	$14,404,660,260	11.56%
12	FL	Suncoast	$6,627,125,361	$12,026,016,187	12.66%
1	VA	Navy	$71,967,667,797	$131,620,239,595	12.83%
4	WA	BECU	$13,878,323,252	$25,637,148,406	13.06%
11	TX	Randolph-Brooks	$6,665,438,060	$12,550,850,662	13.49%
10	UT	America First	$7,002,583,992	$13,795,623,334	14.52%
5	CA	SchoolsFirst	$11,438,769,717	$22,597,939,638	14.59%
14	UT	Mountain America	$4,823,680,120	$11,404,026,075	18.78%
	PG	Credit Unions Over $10B	$15,333,447,756	$26,092,215,610	11.22%

If the comparison is expanded to all 49 credit unions over $5 billion, PenFed’s growth is still much slower than this peer group’s 10.8%.

But what if a new strategy takes time? The September 2020 annual numbers show an even greater fall off from the peers’ results compared to the five-year trends:

September 2020

Annual Growth	PenFed	Peers
Share growth	5.9%	21.9%
Loans	5.3%	7.6%
Assets	6.0%	17.4%
Capital	6.0%	13.0%
Members	13.2%	8.2%
Operating Expense	18.9%	12.6%

Greater Efficiency?

The second reason for a merger strategy is that growth brings greater efficiency. PenFed is already the third largest credit union in America. So it should be at a high level of efficiency already. However, when comparing different measures of operational efficiency before and after these eighteen acquisitions, the operating results show a dramatic decrease in efficiency even as Pentagon has increased assets over $7 billion.

PenFed Efficiency Trends as of Sept 2015 and 2020

Ratio	September 2015	September 2020
Efficiency Ratio	62.6%	80.8%
Op Exp/Avg Assets	1.35%	2.33%
Assets/FTE	$12.5 mn	$9.9 mn
Avg Acct Relationship	$23,734 k	$19,094 k
Loan/Share	118.6%	108.5%
Net Worth	10.06%	10.7%
Delinquency	0.26%	1.07%

The ratios show a dramatic deterioration in efficiency and productivity. With the same balance sheet structure and net worth as five years earlier, PenFed has higher costs, members have smaller average relationships, and the expense ratio increased 73%. Delinquency is four times higher.

Greater Member Value?

PenFed’s product driven focus may provide competitive choices for members in specific circumstances. Their credit card and first mortgages can be excellent value in some markets. Building member relationships is not the focus of its strategy, however.

Several numbers illustrate this product versus member-centric focus. The share draft penetration, ( a primary financial institution indicator) is 14.1% versus the peers’ 67.4%. The average member relationship has declined from $23.7K to $19.1K over the five years. The number of share accounts per member at 1.41 trails the peer’s of 2.03.

Rather than building member relationships, the credit union’s approach is akin to commercial financial firms that move in and out of markets pursuing different product priorities as suggested by circumstances.

Investments to Enhance Competitive Capabilities?

A final rationale for mergers is that more assets provide more capacity to underwrite greater investments in technology, staff and other fixed assets to maintain or enhance competitive position. The single largest investment by PenFed was in 2016 when it purchased a new head office in McLean VA. (https://patch.com/virginia/mclean/penfed-purchases-new-corporate-hq-tysons-0

PenFed CEO James Schenck explained the reasons for the purchase, which has resulted in a 580% increase in building and fixed assets in just four years:

“In order to attract the best and brightest employees, a firm needs to not only pay a competitive salary with benefits, but needs to offer a best-in-class work environment with a meaningful mission.

“PenFed has an insatiable appetite for talented, educated professionals to provide perfect service to our members. Locating our corporate headquarters in Tysons will continue to enhance our operational efficiency and it will be conducive to sustaining growth of the intellectual capital required to keep pace with our members’ needs and deliver exceptional value and superior service.”

Before the merger strategy, PenFed reported total building and fixed assets investments of $91 million (4.8% of net worth). Five years later the $530.5 million total equals 19.4% of net worth. In this same period, the number of fulltime equivalent employees has increased just 73% from 1,539 to 2,662.

The average salary and benefits per employee of the current staff is $101,969, a 5.1% annual growth from the $79,616 five years earlier.

In addition to this growth in average salary, the credit union has increased its balance sheet assets funding employee benefit and deferred compensation plans with investments not authorized under Part 703 of NCUA Rules. This five-fold increase over five years, from $126 million to $732.2 million, includes $130.1 million in Charitable Donation Accounts.

The Strategic Mirage

PenFed’s “growth via mergers” has resulted in slowing rates of both internal and total asset growth, increased expenses, reduced average member relationships and a dramatic increase in fixed investments with uncertain return. Instead of an example of improved performance from growth, the results are at the bottom of its peer group.

PenFed’s floundering performance is being propped up by taking in as other operating income (negative good will) the equity from other strong, long-serving credit unions. As described in the analysis of the Sperry Associates FCU merger:

For over five years “$0 cost acquisitions” have been a critical contributor to PenFed’s bottom line and balance sheet size. In 2019, it booked a total equity increase of $92.4 from mergers. “Bargain gains from mergers” (negative good will) totaled $74.2 million and $18.2 million was added equity value. Of the credit union’s $151 million 2019 net income, over half is from transferring the accumulated surplus from other well-capitalized, merged credit unions which PenFed recognized as “other operating income.”

This 2019 one-time income boost came from three mergers. . . PenFed’s reported asset growth was only $300 million. But without these three mergers it would show a balance sheet decline of $500 million.

Credit unions’ advantage is their relationship with members. PenFed’s mergers help disguise the pitfalls of its open field of membership. For it has no market focus, no niche, and nowhere to effectively mine for organic growth. Its minimal performance outcomes are a veneer. They can be sustained only by finding more sound, established and well-capitalized credit unions willing to become further victims of this Ponzi-like business model.

And that raises the second, and more consequential issue. That is the irreversible shutdowns of strong, well-run, long-serving, locally focused credit unions built on generations of member loyalty.

I will address this challenge in Part II: Mergers’ Impact on the Cooperative System