JP Morgan Chase CEO Jamie Dimon caused a stir—and helped spur a brief sell-off in bank stocks—back in October when he warned that “When you see one cockroach, there are probably more… Everyone should be forewarned on this.” These remarks were made in the aftermath of subprime auto lender and dealer Tricolor going bankrupt in September thanks to having made risky loans and allegedly engaging in fraud. Following that, the bankruptcy of auto-parts supplier First Brands followed, revealing in the process a complex array of hidden loans to which several financial firms that had lent to the company were exposed.

The ensuing sell-off affected many small-cap banks, with the group down roughly 4-5% in a single day. Before going on to explain why we think the flurry of selling was a classic example of investors shooting first and asking later, we want to explain why we do not necessarily disagree with the “cockroach theory.” It raises legitimate concerns, matching those we have had for a while, though we see the biggest risks as not necessarily involving small-cap banks.

In fact, many of the future potential credit issues have migrated beyond the regulated banking industry into the shadow banking system of private credit. Private credit largely consists of direct loans made by non-bank entities such as private credit funds, asset managers, and hedge funds. These loans typically offer higher interest rates and are frequently used in financing leveraged buyouts, which means they allow borrowers take on much more leverage.

The private credit industry has experienced rapid growth in the last decade, averaging 14.5% while Commercial and Industrial loans made by banks have grown at 3% over the same period. And while it’s true that private credit is taking meaningful share from the banks, this advance has largely been spurred by growth in the riskiest loans. After all, it would be odd to have both higher yields—a feature and draw of private credit loans for investors—and less risk. Given the riskier nature of these loans, their rapid growth, and their lack of regulation, we see the potential for problems in private credit should the economy slow meaningfully or enter a recession (which will happen at some point).

With this context established, it’s fair to ask what connects the regulated banking industry to the riskier world of private credit? Banks do have some indirect exposure to private credit’s potential problems in the form of loans to NDFIs—non-depository financial institutions. Many NDFIs are private credit firms that do not have deposits. These firms borrow cash from banks or raise capital from equity investors and then make loans—and it’s important to note that many NDFIs are in relatively safe and traditional lending categories, such as Mortgage Intermediaries. Most NDFIs also have a diverse portfolio of companies to which they lend.

In terms of how this relates to small-cap banks, Moody’s reports that private credit comprises about $300 billion of the $1.15 trillion in NDFI loans made by banks (as of 2Q25). Importantly, the top 25 U.S. banks are responsible for $1 trillion of these NDFI loans, while the next roughly 4,000 banks are responsible for the remaining $150 billion. Thus, the relative exposure to NDFIs is significantly larger for big banks than for small banks. However, the current concern is that many smaller regional banks have exposure to private credit via loans to NDFIs.

Of course, it is impossible to know when these credit issues will begin to materially impact banks, regardless of size. But when the market begins to price in credit risk again, it is likely going to once more shoot first and ask questions later, with most, if not all, banks in the crosshairs. And despite their relative lack of exposure to NDFIs, we suspect that smaller community and regional bank stocks will be hit hard, as they were in October.

It’s also worth recalling that for a few years the market had concerns about the commercial real estate (CRE) exposures of smaller banks, particularly office CRE. Nearly three years later, however, we have yet to see meaningful credit deterioration in CRE for the community and regional banks. Quite the opposite, in fact, as the credit performance in CRE, as measured by net charge offs and delinquency rates, has been better for small banks than their larger peers since 2022. These same concerns created compelling opportunities for us across the bank landscape.

Although we do not think that current concerns surrounding NDFI loans pose a meaningful direct threat to smaller banks, we do think that this anxiety, as well as broader concerns around the overall credit cycle, could create similar opportunities. Perhaps not coincidentally, we are already finding interesting new ideas, particularly in what we see as some of the highest quality banks in the industry. Many of these higher quality banks are now trading at multiples we rarely see, and some of them at or near decade low valuations. (Due to their quality, these banks almost never trade at or below tangible book value, but that doesn’t mean they don’t represent compelling value opportunities.)

In addition to valuations, smaller banks have two other positives that should help generate attractive returns in the years ahead. First, M&A in the U.S. banking industry is heating up and is expected to accelerate. To wit: the number of deals in 3Q25 was the highest in four years, and significantly higher than in the first and second quarters of this year, which is not only creating opportunities for us to own banks that may get acquired, but also to own banks that are savvy acquirers who are likely to see their earning power improve meaningfully in the coming years thanks to M&A. We think that this renewed M&A activity is likely to support multiples for the entire group.

There is also the dramatic performance spread over the last three years between large banks (as measured by the KBW Bank Index (BKX), which tracks the performance of the leading banks and thrifts that are publicly-traded in the U.S.) and smaller banks (as measured by the KBW Regional Banking Index (KRX), which tracks the performance of U.S. regional banks or thrifts). The BKX was up 37.5% over the last three years compared to a loss of -5.0% for the KRX. As a result of this significant performance divergence, the BKX has recently traded at a 0.40x premium (on price to tangible book value) to the KRX – historically, the KRX has traded in-line at a slight premium to the BKX.

Of the banks we hold in the Fund, here are three of our highest-quality positions, each of which has minimal, if any, NDFI exposure:

Glacier Bancorp (NYSE: GBCI) is a regional bank with operations in Montana, Idaho, Utah, Washington, Wyoming, Colorado, Arizona, and, more recently, Texas. Although they have more than $29 billion in assets, they operate as a collection of small community banks in their markets. Glacier has an outstanding deposit franchise, enabled by their strong market share in smaller markets that the larger banks choose not to focus on. For example, they are the #1 bank in Montana with a more than 20% market share (which is high for a bank), while Wells Fargo, one of only two large banks with a top 10 market share in the state, is #4 at less than 9%. This strong market share gives Glacier one of the lowest cost of deposits in the banking industry.

Credit quality has historically been pristine at Glacier. While also a very high returning bank historically, Glacier’s record of robust profitability has been hit in recent years due to their liability sensitive balance sheet, meaning that their margins were hit as interest rates rose rapidly. However, that is now changing as rates have begun to come down, and net interest margin has improved for six consecutive quarters, leading to robust earnings growth, with Glacier expected to grow earnings 19% in 2025 and a whopping 55% in 2026, in part due to recent M&A, a core competency. The bank has a long track record of doing smart, value creating acquisitions, including two deals already announced and closed in 2025. Given the now vibrant M&A landscape, we believe Glacier will continue to augment their healthy organic growth engine with future activity. At roughly 13x forward earnings, the only time Glacier has been cheaper in the last 10 years was during the depths of the 2023 bank mini crisis, when it dipped to around 12.5x.

German American Bancorp (Nasdaq: GABC) is a midwestern bank headquartered in Jasper, IN with a Midwest footprint that also includes Kentucky and Ohio. In our opinion, German American is among the highest quality banks in the U.S. Their return on assets, typically in the 1.4%+ range, and returns on tangible common equity (which measures a company’s earnings relative to its tangible common equity) typically in the 15-20% range, are rare air in the industry. In addition to German American’s robust returns on capital, we love their conservative underwriting culture, which has resulted in consistently pristine credit. With only $8.4 billion in assets, German American is positioned to grow and take share for many years to come.

While the Midwest doesn’t receive the hype of markets like Texas, Florida, and other parts of the Southeast, we see ample growth in these markets, including being direct beneficiaries of onshoring and reshoring in the U.S. While not as active as Glacier on the M&A front, German American also does smart deals, and we expect that to continue, providing a lift to both earnings and returns over time. At around 10.5x forward earnings, German American is about as cheap as it’s been since 2011. (It was a hair less expensive in 2023.) With annual earnings growth expected in the 9-10% range, along with a healthy 3% dividend yield, we like the return potential even if we see no multiple expansion, though we think that’s unlikely to be the case.

TowneBank (Nasdaq: TOWN) is headquartered in Portsmouth, VA, where it has a dominant share of 36% in the Hampton Roads area. Towne also has a small but growing presence in the fast-growing N.C. market. As a traditional bank, Towne is outstanding in its own right, with a long history of pristine credit, impressive returns on assets and on tangible common equity, solid growth, and a very attractive deposit franchise.

What makes Towne unique, though, is its diverse array of earnings that are not related to generating income from taking deposits and making loans (known as net interest income), which is the primary driver of revenues for most small banks. A typical bank might generate 80-85% of its revenue from net interest income, with the balance coming from ancillary fee income. Towne, on the other hand, derives about 36% of its revenue from fee income, much of which is not related to the bank. The biggest driver of that fee income is Towne’s insurance brokerage business. There are many publicly traded insurance brokers, and most trade at healthy multiples owing to the recurring nature of their revenues, their asset light business models, and sturdy growth profiles. We believe that Towne’s insurance brokerage business alone could be worth 30-40% of the value of the company. We also think this unique collection of businesses is valuable and quite rare in the bank space.

In addition, Towne is a disciplined and proven acquirer. In fact, of the $19.7 billion in assets on their balance sheet at the end of 3Q25, $6.7 billion came from acquisitions. With a favorable M&A backdrop, we believe the bank is well positioned to continue doing deals that will create further value for shareholders. The shares have been trading at a little over 9x forward earnings, levels we have only seen a couple of times in the last 15 years. That looks very compelling for a bank that is expected to grow earnings north of 20% in 2026 and 11% in 2027.

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