With the credit crisis wounds still raw for many banks, management and directors have become more risk-averse. Organic growth has stalled at most banks, forcing bankers to seek alternative avenues to return shareholder value. Furthermore, today’s low bank valuations have precluded many institutions from exploring a sale, piquing interest in strategic mergers (i.e., stock-for-stock exchanges). These transactions can enhance shareholder value at both institutions, while creating a more saleable franchise. That said, strategic mergers are not without complications and must be structured properly with a complementary partner in order to enhance shareholder value.
What is a Strategic Merger?
Strategic mergers sometimes are labeled mergers-of-equals, although this is usually a misnomer. Rarely, if ever, do two banks merge on completely equal terms. And thinking in terms of “equality” in mergers can be counterproductive. The more appropriate question is whether shareholders would be better off on a standalone basis or with a share of a combined entity. Often strategic mergers involve institutions of differing sizes and strengths, and while the two merging banks may end up with different ownership percentages, shareholder value can still be enhanced by improving the competitive position in a market, leveraging economies of scale, increasing pro forma earnings per share (EPS) and creating a stronger combined management team. In other words, a strategic merger is a marriage in which shareholders of both banks are better off on a combined basis than by remaining independent.
Rationale for Strategic Mergers
Strategic mergers tend to work best between two healthy banks struggling with growth in the present environment. Many banks have cleaned up their balance sheets and are beginning to think about future growth prospects and exit strategies. The trouble is that today’s historically low interest rate environment, anemic loan demand, and escalating operating costs due to new regulations have made it extremely difficult for many banks to grow earnings organically. And with bank valuations in the doldrums, boards are reluctant to sell. Given these realities, the key to maximizing value three to five years down the road will be building a franchise with critical mass and a substantial and consistent earnings stream. Combining two like-minded institutions with similar goals today can create a franchise better positioned to command a more significant premium in a sale down the road.
Generally, strategic mergers occur between two banks within the same market, which allows for greater economies of scale and higher efficiency. Often banks with differing operating strengths will combine in strategic mergers to create a more diversified and valuable franchise. For instance, a terrific loan generator with a high loan-to-deposit ratio might combine with a bank that has a deep core deposit franchise and low cost of funds. The combined institution could realize greater spread income than either bank could achieve on its own.
Whether shareholders of an individual bank will be better off in a combined entity depends on the exchange ratio of shares that is negotiated. Many factors determine the proper exchange ratio, including EPS, tangible book value (TBV) per share, franchise and asset quality, etc.
In addition to the simple economics that make strategic mergers so attractive, they are one of the only ways in today’s environment to amass scale and improve franchise value. Generally speaking, larger institutions command higher valuations. In fact, according to SNL Financial, banks with more than $1 billion in assets sold for, on average, 251.6 percent of TBV over a 10-year period compared to 179.1 percent for banks less than $1 billion. Clearly, not all banks must reach $1 billion in assets to maximize value, but larger franchises tend to attract more interested bidders and drive up valuations.
Challenges of Strategic Mergers
Strategic mergers can be difficult to structure and both banks need to acknowledge they are entering a partnership in which goals must be aligned. Besides the exchange ratio, which can be daunting to establish, other structural challenges remain in strategic mergers, including: which bank becomes the surviving legal entity, which bank becomes the surviving brand, how many board seats each bank retains and how management is restructured. These “social” issues can derail a deal no matter how compelling the economics might be. It’s critical to discuss all these factors before walking too far down the aisle. Otherwise, that strategic partner that made so much economic sense could leave one standing alone at the altar.
For a more in-depth analysis of strategic mergers detailed in a recent Hovde Group publication, please click here.