M & A Market Overview and Outlook

This roundtable session discusses the current market conditions affecting community and regional mergers and acquisitions. The participants were Bill Boyan, managing director, investment banking, Friedman, Billings, Ramsey & Co.; Steve Klein, attorney, Graham & Dunn; Stephen Nelson, senior vice president, Hovde Financial; Jim Rockett, attorney, McCutchen, Doyle, Brown & Enersen; Wade Schuessler, managing director, financial institutions group, Morgan Keegan; and Jerri Moss, associate publisher, Bank Director, moderator.

JERRI MOSS: What’s the current market status of M&A? What are the hot-button issues?

WADE SCHUESSLER: There are a couple of interesting market conditions today that are affecting M&A. First, if we look at the overall bank stock prices, there is a difference between premium currencies and nonpremium currencies, which creates a lack of premium buyers in a high acquisition mode who are willing to risk losing their currency. We see more selective buyers, and within the smaller banks—those in the $250 million to $3 billion asset group—we see a strong decline in any type of acquisition activity. I don’t know what will prompt that to come back.

The second condition affecting the market is the overall economy itself. There’s more uncertainty about where the economy is going. Are we going into a recession? Do we have stagflation or inflation? Those kinds of issues make it difficult for bankers to get a grasp on the future. Until that uncertainty clears up, we will see a much more reserved approach to making major acquisitions.

The third condition is asset quality, which is starting to raise its ugly head again such that bankers will need to get a little more aggressive in looking at the overall quality of their portfolios. If you combine that concern with the problems many banks face with deposit growth—which is an inability to fund future growth—then things will only get worse for banks as more competitors step into the market and take away their core deposits.

JIM ROCKETT: Asset quality issues are currently the focus of bank regulators. In the past, regulators viewed issues one at a time. Now they view them in clusters; for example, poor assets means capital problems, signaling weak management, and that in turn downgrades the banks in question, the impact of which takes these banks out of play either as acquirers or sellers. These regulatory pressures are across the board from all of the federal agencies.

Thus the declining economy, combined with regulatory pressures and the current status of bank stock prices, as Wade identified, will cause a dearth of M&A activity.

BILL BOYAN: I definitely see the economy and the potential recession as an issue, but after two and a half years of watching the bank and thrift sectors get pummeled in terms of valuations, it’s nice to see a return to the thrift sector. The commercial side hasn’t had much of an impact on many of the large thrifts. We’ve seen Washington Mutual and other thrifts trade up significantly. Though they don’t trade at 20 times earnings or 15 times earnings, they may be up to 12 times earnings and that’s much better than trading at eight times earnings, as they have in the recent past.

I’m positive that we will see some of the same buyers come to the table. BB&T is still active from Maryland to Georgia. It uses its currency to play the P/E arbitrage game to some extent, and it is also paying big prices for companies that were holdouts. Wells Fargo has a strong P/E, Fifth Third bought Old Kent, and BB&T bought F&M and a few others. These banks will continue being active as they go through the integration process. But I also agree with Wade that it’s still very much a buyers’ market, and it’s good to be an investment banker in this type of market because we can see the window of opportunity opening a little. There is the possibility of greater M&A activity going forward if the banks take care of their asset quality issues. We could see a reasonable increase in valuations in 2001 and 2002.

STEVE KLEIN: History repeats itself and things move in cycles. I agree that it’s more of a buyers’ market than a sellers’ market, but I also think that deal expectations are moderating from three- and four-times book deal.

I’m not being a contrarian, but I do think it’s the best time for sellers to do deals—and not to get the country club trophy deal that they can brag about to their board member buddies on the 18th hole. That doesn’t mean anything. Typically, people don’t cash in their stock after a deal is done; only 10% to 15% do. So arguably, you’re not buying overvalued currency when you are selling your bank. There is an upside, as there is some very attractive currency to be had. I tell my clients that what they are really looking for is another company that is a good investment.

I agree with Jim that we are starting to see what I call “regulatory paranoia,” and it’s scary. There is a softening of the economy, but I don’t know how much it’s going to soften. The regulators of asset quality will cause banks to reevaluate their strategy of staying independent and that will propel deals. It’s tough to raise capital and banks need to raise capital. They also need, of course, to make management changes, which is always hard to digest. Furthermore, to deal with the regulatory environment, they need to go in a different direction. On the buyer’s side, what’s been happening over the last few years is casual due diligence, and that will have to change.

BOYAN: The mid-tier institutions, which lately had a runoff in their currency, are saying to us, “We want to get in a few transactions before June 30, just to take advantage of the P/E.” There is certainly some disparity between the large caps and the small caps, and they want to take advantage of that while it’s still available.

STEPHEN NELSON: The largest macro issue that will impact M&A in 2001 is the big “R” word—recession: Is it going to be a soft landing or a hard landing? Nobody knows for sure, and if they claim they do, who would listen to them? If it’s a soft landing and our friend Alan Greenspan does everything right, then we can devise a very bullish scenario for bank stocks with a lower interest rate environment, and the huge credit quality concerns that are plaguing the uncertainty in the marketplace right now do not materialize. A lower interest rate environment increases the certainty of higher earnings for the whole sector. But if we are in for a hard landing, which leads to a recession, then all bets are off.

Overall, one of the things that has hindered the valuations for many of the larger cap companies, and even the mid-caps and small caps, is that a few years ago everyone was talking about double-digit earnings-per-share growth, and I don’t think anyone is thinking that now. If you are hitting 7% to 8% in 2001, then you will be doing better than most. The elimination of pooling will also impact some of the deals in the short term.

KLEIN: Go back and look at deals that were done and then look at where they are today. It’s not how much multiple you get, but the inherent value of the company and the quality of the stock that matters most. It is in our own self-interest to educate our clients about market realities.

MOSS: Will cross-industry mergers change the way banking is done in this country? Will “pure banks” be more or less successful than integrated financial institutions?

ROCKETT: A number of large investment banks have been acquired by financial institutions, but there has been a lack of activity in the trenches for cross-industry consolidation. An enormous price was paid for the Glass-Steagall Act because of the significant regulatory burdens of the Gramm-Leach-Bliley Act. Yet the banks, and other industries such as insurance and securities, haven’t seen fit to pick up on it. Does anyone have a sense of whether or not convergence will ever kick in, and, if so, will we see something significant happen?

SCHUESSLER: The melding of nonbank cultures with bank

cultures has been a tremendous challenge for those industries, and there have been some deals that were not good deals. Banks need to address cultural issues more carefully.

KLEIN: One of the problems with banks buying insurance companies is that the insurance companies’ performance is at a much lower level. If you put them together, by paying a decent premium, you drag down the future earnings of the combined entity. So economic reality is hitting and while we will still see such deals, they will be more selective. There are definitely cultural issues to consider. Banks operate more traditionally, while investment banks and even insurance companies are more like mortgage banks.

ROCKETT: I’m waiting for the circumstance where you find a geographically well-positioned community bank that merges with a local insurance agency and a local securities broker to create a dominant financial presence in that area. If that happens, then I think it could be a turning point for Gramm-Leach-Bliley as it relates to smaller institutions.

BOYAN: It’s difficult for a community bank to deal with all of those pieces at once. I’ve seen many community banks buy insurance agencies, handling P&C and to a lesser extent, life insurance. But the dealers—the “moms and pops” and certainly the larger banks—see the benefit of having distribution capability. I hope they take the necessary steps to protect their human capital, which is where they will preserve the franchise.

NELSON: When it comes to the financial modernization act, I think it was “feel-good” legislation for the community banks. While community banks theoretical have the ability to acquire a P&C insurance company and other nondepository financial-oriented businesses, most will not. The organizations with the greatest capital base will be the ones most likely to succeed when all the different industries ultimately come together. This will have a financial and strategic impact on community banks, however, because they will feel the effects of these financial supermarkets. Once the large financial services companies pull together brokerage firms, insurance companies, and banks all in one place at one time, that’s going to be something to contend with. That said, a number of community banks have done a good job at picking up insurance agencies.

BOYAN: If you plan to build a financial supermarket, then you almost need to add a layer of management to operate the bank while someone else integrates the company and works to promote cross selling between various product groups. Capital is one thing, but you need to have a person with some foresight who is adept at handling human capital and making sure you get as much out of it as needed. I do think that even though there are some cross-industry transactions happening, the bulk of activity we see will be in-market and contiguous-market deposit-gathering activity.

KLEIN: In the future, we will have niche banks. The term community bank is archaic. If you look at community banks, they are all very different and they each play to different niches. Many of them are business-oriented, but they have specialties. I think these niche banks will be a wild card going forward, because they’ll be mid-size players capable of buying smaller institutions, which could shape new bank formations and, in turn, other mergers and acquisitions.

NELSON: In the past, when Hovde would talk with $25 billion or $50 billion banks about their acquisition parameters, they would consistently raise their hurdles in terms of the size of deals they wanted to pursue. In the early 1990s, it was $250 million, then $500 million, then $1 billion, and ultimately $5 billion by the late 1990s, under the theory that bigger is better. Since 1998, in the aftermath of all those large mergers of equals and other big deals, we have discovered that some did not go well. Today, we are hearing buyers say, “Our preference is still to do larger transactions; however, we have a strong interest in a niche bank in the $250 to $500 million range.”

SCHUESSLER: I truly believe that buyers today have picked all of the strategic markets they want to be in. They are not going to pay a premium price unless it’s a key fill or they want quick entry into a new market. Then they’ll pay up, and get in there and branch throughout the area.

KLEIN: What impact will the Internet have on banking and deposit funding and how will that affect M&A?

ROCKETT: Funding growth potential for banks using the Internet is very dramatic. Once they get onto the Internet, which is inexpensive to do, then that becomes a major component of funding deposit growth. Community banks are putting together bank-to-business Internet-type products that are very innovative and will help transcend standard methods of doing business. If banks can use those products to fulfill the needs of clients in their community, then the Internet will be a very powerful source.

SCHUESSLER: Internet banking will be one of many channels for distribution of products and services. One thing for certain is that the costs of deposits will continue to intensify, especially on the Internet as funding concerns become more evident.

KLEIN: There is a segmented consumer pool with three major tiers in today’s marketplace. There are the retirees, the baby boom generation, and Generations X and Y. That is another challenge facing banks—

creating different delivery systems for different types of customers.

NELSON: Ultimately, the Internet will compress margins for the whole banking sector. Regardless of whether these online-only mortgage lenders or e-banks fail, the impact of these business models and the information they give customers will put pressure on the asset and liability sides of the balance sheet. Many of the models out there might work great, but at the end of the day, they will just compress margins for the rest of the sector because customers will shop a bank’s best rates and think they can get a cheap mortgage or deposit at a 25-basis-point improvement. If they’re good customers, the community bank will have to match it.

BOYAN: The best community banks are not those relying heavily on technology to drive the business. It’s those built on good, solid relationship banking like Southwest Bank of Texas and others who have really strong relationships, particularly on the commercial side.

MOSS: How do you expect FASBs current stance on pooling to impact activity?

BOYAN: The goodwill issue is interesting. Now that goodwill is amortized against earnings, some people think this will provide a bit of relief for M&A pricing. I disagree. The smart buyers have already started to formulate their methodology of looking at transactions. They are looking at long-term growth rates and IRR (internal rate of return). They are looking at cash earnings stream and adjusting it for certain factors: whether you are overcapitalized or undercapitalized, whether or not you have a certain amount of mortgage production, growth, and earnings per share.

Historically, you’d find that most transactions did not have a high IRR because everybody was looking for pure accretions to EPS. The smart buyers—Fifth Third, Wells Fargo, Washington Mutual, and BB&T—are trying to figure out ways to drive IRR, and that will put pressure on prices. We see cash becoming a big factor in how people pay for some of these transactions.

ROCKETT: The biggest impact will be on regulatory calculation of capital. Deducting goodwill from regulatory capital will be disastrous for the smaller acquirers. However, there are strategies available to them. They could go out and issue more stock, which isn’t easy in this marketplace, or they could do trust-preferred offerings, which I think will become the vehicle for funding future purchase accounting transactions.

Also, I don’t think we know where FASB is going to come out on the issue of allocating goodwill on a unit-by-unit basis. Right now, banks have a sword of Damocles hanging over their heads—if a particular unit falls short, under the new rules banks will not only have the problem caused by whatever losses that unit may sustain, they also will have to deduct goodwill from capital or earnings. It will have a magnifying effect on the impact on capital position, and it’s going to be a very difficult thing to manage.

BOYAN: Goodwill, and the capital you must hold against that goodwill, is going to be an interesting issue, given the amount of capital you need to raise to fund your transactions.

KLEIN: There’s too much uncertainty and people are afraid to be the first ones out of the gate. Something we forget is that purchase accounting is a much more flexible vehicle. This is going to put a premium on people doing more creative structuring of deals. If the economy softens, you will see deferred payouts, combinations of cash, stock, notes, and a variety of things. Instead of doing a trust-preferred deal, in today’s environment you may want to end up in a deal with notes to all of the target shareholders, as long as the company is a solid company. So I think we’ll see deals structured differently in coming years.

SCHUESSLER: The other issue is the risk profile of banks. When you talk about raising trust-preferred offerings to do a deal and you see that banks now do more and more of their funding by federal home loan bank borrowings, the risk profile on your average community bank has changed considerably. You layer on the pooling changes and it could certainly cause some people to believe that they need to get going on acquisitions, but it will cause others to see that there’s many things they must do to monitor their risk and that could slow some people down.

KLEIN: They may want to sell because they don’t want to deal with it.

NELSON: The whole impairment approach is definitely an improvement from the earlier exposure draft, but it’s certainly a double-edged sword. There are many details that need to be worked out, but from a positive standpoint the ability to be in the market and buy back your shares is clearly attractive. However, if you don’t have the capital because you’ve taken on goodwill and the regulators say that you have to maintain a well-capitalized tier one and leverage ratios, then you are not going to be able to do so. Thus you lose one of the benefits of moving to this new approach.

ROCKETT: Does anyone here believe that the regulators may back away and allow some measure of goodwill to be counted in the circulation of regulatory capital?

SCHUESSLER: It’s really interesting how quiet they’ve been, not really saying anything about this issue, which leads me to speculate that they will err on the side of conservatism and say, “We don’t like all of this goodwill on your books.” The regulators could be the weigh in factor on which way this proposal goes.

NELSON: They could modify the regulatory capital ratios. I hope they do, as well as modify the definition of tier one capital, which could be helpful to everybody.

KLEIN: Modifying the reserve for loan loss is an issue that is still hanging out there with the SEC, but it’s a bad idea. Putting away some nuts and berries during the good times is a great idea. The concept of being conservative is inherent in accounting. If you put it to a vote, I think the shareholders would rather squirrel it away.

SCHUESSLER: Will there be many cash sellers?

BOYAN: I think we will see many cash sellers this year.

KLEIN: Only if the bank’s in trouble. The problem is that there is no upside to cash. You have immediate tax. The challenge then is you have to make a decision of what to invest in.

It also depends on your shareholder base. If you are dealing with a small community bank owned by one family or one person, then it’s a highly personalized decision. For larger, publicly traded organizations, there will be a tendency toward stock swapping.

BOYAN: 50/50 transactions.

MOSS: What impact does purchase accounting have on pricing?

KLEIN: There is no question that it’s going to drive pricing down because you are talking about raising capital. Even if you could raise capital in today’s market, you are diluting your shareholders because you are selling your stock cheap.

NELSON: We looked at purchase accounting P/Es throughout the 1990s and found deals being completed in a fairly tight range—generally 13 to 16. In 1998, the average bank was selling for 21 times, 22 times, 23 times earnings. Even the purchasing accounting deals that took place back then were at much lower multiples, predominately due to a huge increase in pooling -of-interest transactions, highly valued stoc curriences of the buyers, and strong earnings growth rates for the sector. However, the required investment returns on behalf of cash buyers and the pricing multiples generated by cash deals and other types of purchase accounting transactions have been fairly constant over the past decade.

KLEIN: That’s a 20% discount.

NELSON: Exactly. And that’s close to where we are going to be in 2001. We are dealing with many buyers right now, like Wells Fargo, who say, “We don’t care if you want stock or cash or a 50/50 combination. We are going to account for this deal as a purchase and if you want 100% stock, that’s fine. We’ll go out and purchase “x” million shares before the deal closes and give you those at the end such that the net increase, the shares outstanding to us, is zero.”

BOYAN: Buyers are going to focus on the cash-flow earnings and what that will do to the IRR. They don’t really care how they account for it.

SCHUESSLER: You’ve got to have the luxury of being able to do cash deals, and that’s not going to happen for everybody. Pricing will still be rational.

KLEIN: There are two things that are going to drive purchase accounting. One is size. Size is going to make a difference, because to the Wells Fargos of the world, it doesn’t matter. They can do these smaller deals, and it’s not going to have an effect on them. The other thing is the ability to absorb goodwill, and also the stock price. That’s why Wells Fargo is at the top of the heap now, because of its size and a strong stock price. If that tempers, then it won’t be on top, and I would assume that it would be even more disciplined or not as active a player.

SCHUESSLER: Many sellers say they need to get out now and that may push pricing down more because the buyers out there can pick and choose. They know how they want to sell, but they know there’s other people out there trying to sell in and around their same market. We’ll see candidates play off each other and push pricing down on some of these institutions.

ROCKETT: One thing I anticipated when pooling was scheduled to depart was a rush to do deals right before the deadline. It never happened.

MOSS: Is the situation any different now?

SCHUESSLER: If they were in a hurry to get it done, then they would’ve done it six or 12 months ago. They are just not in a hurry.

BOYAN: There are some buyers out there that want to do transactions, but the sellers may not be available at the right time.

NELSON: Bill made a good point about how pooling impacts sellers. It also has a huge impact on buyers. Look at a company like Firstar, which five years ago was a $5 billion organization and now is a $175 million organization in conjunction with U.S. Bancorp. That’s not going to happen in the type of environment we are moving into.

KLEIN: There’s some denial and uncertainty with these smaller boards. They don’t realize that they might wake up and see that it’s over, especially if it was a false start. People still think it’s not going away or it’s not going to be as big a deal, but they also don’t understand the consequences of regulatory capital.

SCHUESSLER: The majority of them are extremely complacent. Most community banks have been very successful. The management does well. The ownership is pleased and looks at its environment and says, “You know, it’s probably not going to change much, except we’ll need to sell more products and services. If we really don’t like what we are doing, then we’ll just become a Sub S and run the bank as a cash cow.” Never forget that bankers are extremely adaptable.

KLEIN: The big question is: What is the exit strategy and will the same exit strategies that have been available for the last five years still be available for these banks? Sub S sounds great except when you’ve got 500 shareholders, then it’s a mess. So they don’t have a vision into the future, because if they saw the economic downturn and the M&A premiums going down, they would have reconsidered taking advantage of the pooling window.

ROCKETT: Now banks have seen the downturning ratios and are being forced to think that maybe they should accept a smaller premium or a lower exchange ratio and get out before there is no end strategy. Exit may be more important than price.

NELSON: Looking back at 2000, we had a challenging environment in the first six months from a valuation standpoint because of where interest rates were. There were people who believed the market was going to come back, yet it never did to the same degree. But starting in the fourth quarter of last year, valuations did begin to rise and activity did pick up. I think 2001 will be stronger from an M&A standpoint. Not as strong as 1998, but much better than last year.

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