The irresistible pull of the US marketplace on Canada's giant banks has opened another channel of fresh capital for stateside lenders seeking to rid themselves of underwater assets.

KeyCorp's sale of a 14.9% stake to Bank of Nova Scotia for $2.8 billion is, by a wide margin, the largest private placement by a US bank since 2020, according to data from S&P Global Market Intelligence. KeyCorp plans to use about half the capital generated in the transaction to absorb losses on bonds that have plummeted in value since the Federal Reserve started raising interest rates in early 2022.

Banks such as Truist Financial Corp. and Trustmark Corp. have taken advantage of high prices for their insurance brokerages in sales that allowed them to offset the capital hits from similar restructurings. US banks have also turned to capital offerings to support bank acquisitions where underwater assets are an issue.

The KeyCorp stake sale secured a stock price premium from Scotiabank, which wants to build its presence in the US. The move was surprising since KeyCorp had an independent path out of margin-crimping balance sheet positions, Piper Sandler analyst R. Scott Siefers said in an Aug. 12 note. But the deal "solves a number of investor concerns," including rapidly lifting the bank's key regulatory capital ratio from near the bottom to close to the top of its peer group.

Scotiabank's purchase was met with some trepidation about its ability to transform a minority stake into a successful full-scale strategic expansion.

"The track record of Canadian banks entering the US has been mixed at best. The allure is understandable, a market that is 10x Canadian GDP offers significant growth runway," BofA Global Research analyst Ebrahim Poonawala said in an Aug. 13 note. "The downside is acceptance of a lower [return on equity (ROE)] given what is a much tougher US banking market."

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KeyCorp breakthrough

Scotiabank is paying $17.17 per KeyCorp share, a 17.5% premium to the latter's closing price Aug. 11, the day before the minority stake sale's announcement. By close Aug. 20, KeyCorp shares were up 14.3% to $16.70.

KeyCorp estimated that the capital raise, including an offset from the restructuring, would lift its common equity Tier 1 (CET1) ratio by up to 210 basis points to 9.4%, including all other comprehensive income (AOCI), which includes unrealized losses on available-for-sale bonds. The bank also estimated that the move would be accretive to its EPS in 2025, with dilution from the shares issued to Scotiabank outweighed by a pull-forward of $400 million of net interest income annually from the restructuring.

Jefferies analyst Ken Usdin called KeyCorp's modeling relatively conservative since it does not presume incremental loan growth.

"The commercial capital raising engine at [KeyCorp] has been largely turned off for the past year or so as [KeyCorp] has guarded capital intently," he said in an Aug. 19 note. KeyCorp slashed its risk-weighted assets last year as a part of an effort "to preserve capital given its lower CET1 inclusive of AOCI position relative to peers."

Friendly border

The transaction extends a long string of acquisitions by Canadian banks that have given them a large position in the US. Top-tier US bank subsidiaries of Canadian banks together hold more than $1 trillion of assets, led by Toronto-Dominion Bank's TD Group US Holdings LLC with $523.65 billion.

Market participants have noted that foreign banks sometimes proceed with acquisitions in steps, potentially providing a precedent for a full takeover of KeyCorp by Scotiabank. For example, TD bought 51% of Banknorth Group Inc. in a deal designed to support acquisitions by Banknorth before acquiring the rest of the company. TD terminated its deal for First Horizon Corp. in 2023 over regulatory obstacles.

Scotiabank will have the right to designate two members of KeyCorp's board, but will not be able to raise its stake in KeyCorp above 19.9% for five years.

Addressing speculation about a full takeover in a Aug. 12 note, Jefferies analyst John Aiken said that "what will be critical for investors will be to see whether the proposed strategic benefits can accrue to both parties, or if this is simply an investment."

BofA Global Research's Ebrahim Poonawala said he was "closer to neutral" on the deal from Scotiabank's perspective.

It is a "low execution risk, opportunistic and capital efficient way to add US earnings," he said, and should allow the bank "to familiarize itself with US regulatory agencies while using limited management bandwidth."