There was a general consensus among most of the investment bankers and attorneys I spoke with at our Acquire or Be Acquired conference last January that takeovers of healthy banks will accelerate this year because an increasing number of institutions will see this as their best option for growth in the face of poor loan demand from business borrowers and shrinking net interest margins. Sounds good in theory, but one of the problems with this strategy is that acquisitions don’t always achieve their primary objective, which is earnings-per-share (EPS) accretion for the buyer’s shareholders.
Indeed, there are probably many more things that can go wrong in an acquisition than go right, and this places enormous pressure on the acquirer to hit the bull’s eye on each one of its assumptions about asset quality, cost reductions and revenue enhancements. If a buyer misses any of those targets by a wide enough margin, it will essentially have overpaid—and that means it will miss the projected increase post-merger earnings per share that it used to justify the merger in the first place. Few bank chief executive officers want to risk angering their institutional investors by overpaying for a deal.
Recently I asked Stephen Figliuolo, the executive vice president and corporate risk officer at Citizens Republic Bancorp in Flint, Michigan, for a list of questions that every bank chief risk officer (CRO) should be asking in any acquisition. Figliuolo has been on both sides of an M&A deal—transactions that Citizens has done as the acquirer and, of course, the bank’s own sale last year to FirstMerit Corp. Here are his questions, which have been organized into five categories:
- Loan portfolio: “What is the credit mark on the portfolio? How much is the loan portfolio really worth? This is dependent on the quality of the loans, so you look at loan concentration levels and ask whether the various types of loans fit your strategic need? Are the loans supported with appropriate loan documentation? Is the seller’s credit rating system similar to yours or more liberal? Are there any major reporting discrepancies to impaired loans, nonperforming loan designations or charge-offs? Are they sufficiently reserved? What is the quality of the portfolio monitoring and can it detect deteriorating credits?” These are all good questions and CROs should wave a red flag if they aren’t satisfied with the answers they get back because if you miss big on your analysis of the target’s asset quality, the deal will probably be a bust. All of these categories of risk are important, but gauging the target’s asset quality correctly is probably most important.
- Balance sheet: “What are the components of the balance sheet? What is the quality and duration of the securities portfolio? What steps will you as a buyer have to take to unwind investments that don’t fit your strategy from a duration, interest rate or risk perspective? How does the target fund itself? Does it rely more on high-cost deposits including brokered versus low-cost core deposits, in which case you will need a plan to eliminate those high-cost deposits over time?”
- Regulation: “What are the regulatory risks? The hot items in banking today are anti-money laundering/Bank Secrecy Act laws, consumer add-on products, fair lending and consumer compliance. You buy those issues as they exist at the acquired bank and you will need a plan to fix them.” An example of a consumer add-on product would be a situation where an individual takes out a loan to buy, say, a boat and the bank agrees to fund the loan for 5 percent more than the purchase price. The borrower could then use this extra money for some purpose unrelated to the boat purchase itself. “The Consumer Financial Protection Agency is all over this,” he says. “They ask, ‘Does the borrower have the ability to repay that loan?’”
- Pending legal actions: “Not only do you get an idea of prospective legal costs involving the acquired institution, but an idea on how well the company is managed.”
- Strategic fit: “What exactly are you buying and why? Is it the deposit base as a source of funding, or are you buying it for market share or to acquire an annuity-like revenue stream, to name a few of the factors? And how much expense can you take out through improved efficiencies?” This might be an especially important concern if the bank is doing an acquisition because it can’t find much organic growth in its market. A bank that feels a self-imposed pressure to do a deal might not exercise as much caution as it should. “Do you understand the strategic fit?” asks Figliuolo. “Does the deal make business sense?”
CROs will normally be an important participant in the due diligence process that precedes an acquisition, but the extent of their involvement probably depends on where they rank in the institutional pecking order. “It depends on the status and experience of the CRO in the organization,” says Figliuolo. “At some banks, the CRO leads the due diligence process. At others, it might be the chief financial officer, and the CRO only contributes to those things under his purview.”
Either way, CROs have a vital role to play when their banks are vetting a possible merger—and they could be the difference between a successful deal and one that blows up?if they ask the right questions.