Now’s the Time to Identify Takeover Targets

Consolidation in the banking industry has ground almost to a halt. Stock prices have been tanking and few buyers or sellers seem interested in courting in this environment. But that might actually be a mistake, explains Steven Hovde, the founder, CEO and president of The Hovde Group, which provides investment banking, capital markets and financial advisory services focused exclusively on the banking and thrift industry. He speaks with Bank Director about what factors could change the merger environment going forward, and why bankers should be thinking about deals now.

Lots of people thought there would have been more mergers and acquisitions in the banking industry by now, but there hasn’t been. Why?

The drought in M&A activity is largely due to the remaining economic uncertainty and the inability of banks to grow revenues as a result. Furthermore, we’ve seen heightened uneasiness among investors due to the U.S.’s tumultuous political climate, as witnessed by the debt ceiling drama and the Federal Reserve’s several failed attempts to spur job growth through massive rounds of government stimulus. On top of these domestic issues, the European debt crisis has further increased investor anxiety. As long as the credit environment remains uncertain, M&A isn’t going to pick up to any significant degree.

What deals are getting done and what trends do you see there?

Deals are still getting done where the bank is small enough that the buyer can understand the loan portfolio and all potential credit issues. There have been a few larger deals, but that is not the norm. Bank recapitalizations will continue, assuming investors can get comfortable with the banks’ specific credit risks. However, most recapitalizations are of banks that have no option but to raise capital or risk failure, and are being done on terms that dilute existing shareholders down to a de minimis pro forma ownership.

What factors do you think would encourage more M&A?

The housing market must bottom out, or at least stabilize, for an extended period of time for bank M&A to return substantially. Until housing prices bottom, the overall economy will be troubled and loan portfolios will be scrutinized, particularly by buyers. Furthermore, because of economic and housing market uncertainty, the buyer’s credit marks, writing down the value of assets to fair market value, generally are too deep to negotiate a mutually agreeable transaction in today’s environment. A stable housing market—and ideally one in which housing values begin to increase—will break the dam for a gigantic M&A wave. However, with so many foreclosures in the pipeline and the uncertain debt markets in the U.S. and Europe, housing is unlikely to recover in the near-term.

What will be the impact of this environment on smaller banks, say below $500 million in assets?

Heightened regulation (e.g., the Dodd-Frank Act) will negatively impact banks and translate into reduced fees, higher expenses and reduced earnings for many community banks. Smaller banks, in particular, do not have the scale to absorb higher operating expenses and cannot generate sizable revenues from fee-based businesses like their larger brethren. Furthermore, small banks’ loan market shares have dropped, their balance sheets have become more liquid and their margins are shrinking. These trends have become so pronounced that even regulators have suggested many community banks will not survive the next few years.

What should banks keep in mind before they go down the M&A path?

Banks considering a merger or sale should understand their universe of potential buyers. Today’s operating environment is having the same negative impact on all community banks. The next M&A wave will come quickly with sellers flooding the market, ultimately resulting in a buyer’s market. Knowing the buyers for a particular bank will give bankers a leg up on timing the next wave. We often prepare our clients for sale well before they go to market. Knowing the buyer universe assists in the decision-making process. As many of today’s banks would attest, there is nothing worse than missing the market.