U.S. credit unions are building a war chest for more M&A in what is already shaping up to be a banner year for deal-making.

Total outstanding uninsured secondary capital for U.S. credit unions surged roughly 69% in the second quarter to $533.8 million, up from $315.7 million in the year-ago period. Secondary capital consists of uninsured loans — from banks, other credit unions or socially conscious investment pools including foundations and endowments — that credit unions can assume and classify as net worth on their balance sheets with regulatory approval.

Credit unions, which have limited capital-raising tools because they cannot issue stock, historically have used secondary capital for organic growth or to offset loan losses. But now, amid a wave of deals that brought five credit union acquisitions of banks in 15 days, advisers say more credit unions are looking to raise funds.

Michael Macchiarola, CEO of the advisory firm Olden Lane, said he has seen an influx of interest in funding secondary capital for M&A in the last six months.

North Liberty, Iowa-based GreenState CU, which acquired Fort Dodge, Iowa-based First American Bank in 2020 and recently announced pending acquisitions of Omaha, Neb.-based Premier Bank and Oak Brook, Ill.-based Oxford Bank & Trust, reported $20 million in outstanding secondary capital in the second quarter and will likely fund more in the near future, CFO Todd Fanning said in an interview.

Secondary capital will boost the credit union's capital ratio after it spent cash on back-to-back bank deals, and will allow GreenState CU to look for more acquisitions, Fanning said.

"If an opportunity presented itself in the future, we'd be better able to handle it when it comes up, rather than try to go out and get more capital to see what happens," he said. "It just strengthens us all the way around for what might happen."

Similarly, Alabama CU recently funded $30 million in secondary capital in anticipation of more M&A, its chief executive said. The Tuscaloosa, Ala.-based credit union kicked off a string of deals by disclosing Aug. 5 that it plans to acquire Security Federal Savings Bank.

A range of uses

A growing number of credit unions are issuing debt as a shot in the arm for various types of growth, not necessarily through acquisitions, advisers said.

"A lot of secondary capital raises are related to organic growth [like] originating more loans, supporting or adding to the branch network," Peter Duffy, a managing director at Piper Sandler, said in an interview. "Perhaps it's being invested into technology. So, aside from M&A, it supports a lot of organic growth initiatives."

Macchiarola said the operating environment over the last year, in which deposits surged and loan demand waned, contributed to the increase in debt issuance. Credit unions' large holdings of cash have pushed net worth ratios down, but adding secondary capital, which can be classified as net worth, has helped raise them back up to historical norms, he said.

Some credit unions also see secondary capital as a way to better withstand loan losses, Macchiarola said, pointing to one client that funded secondary capital in anticipation of impending losses related to a taxi medallion portfolio.

"Secondary capital allowed them to actually accelerate that scenario and put the taxi medallion losses that were essentially inevitable behind them faster, because it allowed them to grow in their other loan verticals," he said.

Expanding the pool

While the amount of outstanding secondary capital is increasing, the number of participants is still limited.

Under current National Credit Union Administration rules, only low-income designated credit unions — in which a majority of members meet certain low-income thresholds — can access secondary capital. Only 20 credit unions reported outstanding secondary capital on their second-quarter call reports, out of a total of 2,657 institutions that had the designation at June 30.

The number of credit unions that can access secondary capital is set to increase on Jan. 1, 2022, following a final rule from the NCUA that will expand access to include any credit union with more than $500 million in total assets. With the final rule, 312 more credit unions will have access to secondary capital based on second-quarter call report data.

Still, advisers are unsure if the new rule will lead to a surge in credit unions taking advantage of secondary capital, because the newly included non-low-income designated credit unions will not be allowed to include it in their net worth ratios.

For large institutions seeking to support their capital ratios, "the issuance of sub debt or secondary capital is not going to fulfill that goal for you," Duffy said. "But the funds can be used to support your growth."