Dynamics of Dealmaking: Critical Factors Shaping M&A

Regulators, attorneys, buyers, sellers. Beyond the fine print and due diligence, dealmaking is about people. This roundtable session focuses on how buyers and sellers view pricing factors in today’s deals, the board’s responsibilities during the negotiation stage, and whether sellers have an affinity for cash or stock. Deborah Scally, editor of Bank Director, served as moderator.

Bank Director: Let’s start by discussing some of the pricing factors in deals today. What are the key factors and how have they affected negotiations on both sides of the table?

Jean-Luc Servat: Pricing for attractive properties is the strongest it’s been since 1998. Interestingly, the market is one of “haves and have-nots.” If you are in an urban area with the right demographics, you’ve got an extremely competitive advantage. If you are 60 miles away from an urban area, you may be lucky to get one bid.

Dory Wiley: I would echo that. The big anomaly is that transactions are down and people are hurting for business and deals, but at the same time, we’re as busy as we’ve ever been. Looking at the relative value of exchange ratios in 1998, one could argue that it’s even stronger now. It’s a supply-and-demand issue, and there’s very little supply in the high-growth markets. Rural market demand, our area, is also strong, just at below book prices.

Ron Janis: I think it is the result of purchase accounting. People are reluctant to do big deals relative to their size, so there’s less competition in those deals. In the smaller deals—such as those for insurance brokers, investment bankers, and investment bank broker/dealers—there’s a lot going on. Once you’ve booked these deals, since there is no deduction for amortization, you’re improving your earnings from day one. So purchase accounting has had, from my view, a fairly substantial effect on what buyers are willing to do.

Steve Klein: I’ve seen a mix. Part of it is due to the region (Pacific Northwest) that we deal in. Outside of California, the West Coast has been hit harder by the economy. I agree with Jean-Luc. There are some prime acquisition targets in, say, the Portland, Vancouver, and Seattle markets, but sellers aren’t willing to sell. Also, we have more disciplined buyers, as Ron was saying. Buyers are sensitive to a number of things, including purchase accounting and asset-quality issues. Some banks have been burned, so now they have squeezed margins. Keep in mind that stock values for financial institutions, by and large, have done well, especially relative to other sectors of the economy. Interestingly, if you compare a 4X book deal done four or five years ago to a 2 - 21/2X deal today, today’s deal could be a better value for the shareholders, because they are not getting inflated currency and some excess has been filtered out. So the lack of deals we’ve seen is surprising, but we’re going through a cycle, and I think within the next year we’ll see another change.

Servat: I agree. I’ll confess that we initially looked at the change from pooling to purchase accounting as a nonevent, but now that we’ve let it work through, it has turned out to be a major event. At first, everybody tried to reason to themselves that it shouldn’t have a meaningful impact. Well, now look at it. Our firm probably had three deals this year that did not go through, because when we did a detailed purchase accounting adjustment, the parties suddenly started getting this uncomfortable feeling in the pit of their stomachs.

Wiley: We don’t have that many large banks in Texas. Large-bank acquirers that come in can pay high multiples that disappear somewhere on their balance sheets. But if you are a $1 billion to $5 billion bank and you are looking at a 4X or 5X book deal, there’s only so much you can handle before the tangible capital requirements start hitting you. Other industries don’t have that requirement, so I agree, it hit banking hard.

Servat: But at the end of the day, if it’s a relatively big deal with a smaller return on equity to show for it, you can’t just use the old measure of equity, you’ve got to use some other measurement. I think people are trying to deal with those different measures and decide whether they are realistic or not.

The other thing that happened this year, and often we were surprised by it, was the interest rate environment’s impact on securities portfolios. I know of one particular transaction where we and the other investment bank neglected to get a very fine analysis of the securities portfolios because we made some simplifying assumptions. When we actually went through it step by step again, it was horrifying, because of what was happening in the runoffs and the impact of mark-to-market. We’d not run into detailed mark-to-market impact for almost 10 years.

Wiley: I’ve seen buyers analyze a deal and if it has a low loan/deposit ratio, 50% or something like that, and you mark the portfolio to market from 4% to 2%, the bank is not making money. How do you make that deal work? In the current rate environment, this is a big problem.

Klein: Two issues we probably should address now that pooling is gone are the combination stock/cash deal and the use of trust preferred, which allows companies to raise the necessary capital to do a cash deal and support their capital, without having to go into the equity markets.

Servat: Trust preferred is a fantastic vehicle and I certainly wouldn’t want to critique it, but it has its limitations. I am surprised by how many smaller institutions are so willing to take it on. I mean, it is debt, and it’s going to have to be serviced at some point.

The OCC is concerned that not a lot of new capital is coming into the industry through the pools, because many banks are buying some of the pieces. It’s similar to the debate over subordinated debt in the late 1980s.

Klein: You’re right. I had a recent call from a client who was forming a holding company and looking at raising capital versus trust preferred. The subject bank is only five years old, and it still hasn’t made back its original losses because it hit a couple of bumps in the road. I talked to the chairman of the board and pointed out that trust preferred is still debt. There was a standard at one point that to do trust preferred, you had to be five years old and have a certain amount of earnings. That’s become diluted, and while I wouldn’t compare it to junk bonds, it certainly is a red flag in the industry. Things tend to go in cycles, and I think some people shouldn’t be raising trust preferred at all.

Bank Director: How do the regulators view it?

Janis: The Fed has been working on a revised program that would limit trust preferred to 15% (as opposed to 25%), but it is struggling with it because it knows that it’s like closing the barn door once the horses are out.

Wiley: The regulators have a dilemma. First, most banks have access to trust preferred with the smaller banks going through pools. About $8 billion plus has been issued in pools since this product came out. We’ve done $1.5 billion ourselves. How do you criticize bringing more capital into the industry? The Feds love more capital.

Klein: It’s kind of a shame, because given how well bank stocks have done relative to other industries, had we not had this plethora of trust preferred, there could have been more emphasis on raising equity in the market.

Wiley: I think it depends on the bank. Some people are abusing it and the bottom line is, you’ve got to have the debt coverage. But other than that, it’s a heck of a product that allows you to leverage the institution and maximize your cost-to-capital structure. When you are looking at an after-tax cost of 3% or less, that sure beats a 15%–20% return on equity requirement from common stockholders, as long as you don’t do it in excess.

Klein: And as long as you don’t hit the wall with asset quality.

Wiley: But the interesting thing is, a lot of people are using it to pump up their capital ratios to guard against deteriorating asset quality.

Servat: It will be interesting to see whether Wall Street pushes this product over the edge—because it seems inevitable. When you look at the pools going out, some of the things we’re talking about—fees being waived, pricing getting increasingly tight—are starting to change very rapidly. We also hear that funding the equity for these pools is getting more difficult.

Wiley: For some of the pools, it’s getting more difficult because the way they are structuring the coverage makes it riskier. In other cases, we’ve not had problems with our pools, but my fear is that if one of the pool makers ruins it for one, it ruins it for us all.

Servat: Hopefully, the product won’t disappear. The Street has a propensity to take something that works and push it until it breaks.

Wiley: If you structure it right, it’s a great product. Banks under a couple of hundred million in asset size have less than a 1% default rate—that’s a pretty good risk. People like that. And if you can take that kind of default rate into a trust-preferred pool, then you are doing OK.

Janis: All this has accelerated due to the end of pooling and the beginning of purchase accounting, because you get into part-cash/part-stock deals. Then the question is, how do I fund my part-cash? Basically you have from the time you sign to the close to do the trust preferred.

Wiley: Right, and think about it: If you’ve got a 3% after-tax requirement for the return versus a 15% ROE, suddenly the numbers begin to work.

Klein: A lot of banks also are using this for stock buybacks. When their stock is undervalued, they go out and use the trust preferred to get the cash. Actually, a more effective way to do it is not through the market, but to do an issuer repurchase offer. Banks use the proceeds from trust preferred and go back to their shareholders in an issue repurchase —it’s a relatively cheap cost of funds and it’s improving return-on-equity ratios and providing liquidity.

Bank Director: What other critical factors are cropping up at the deal table?

Wiley: One is asset quality. Once you could assume that what you were looking at on the surface was a clean bank, but you can’t do that now. Seemingly one- and two-rated banks suddenly have hair on this loan or that loan. Then it becomes a question of whether it is a systemic problem or one that you can isolate.

The second issue is the exchange ratio. The relative values of deals are fantastic nowadays, if you are in the right area and in the right market—perhaps even better than in 1998. For example, we sold a bank last year at 23/4X book and 20X earnings, and we received a 13 P/E and a 4% dividend yield. That’s a heck of an exchange ratio!

The third thing is interest rate risk. With 13 rate cuts, you’ve got a lot of banks that are asset sensitive. If a bank has a low loan/deposit ratio and the purchaser has to mark the portfolio for purchase accounting, moving from a 4% to 2% yield, it’s a very difficult thing to make work. So buyers have to be careful on evaluating interest rate risk. Some banks are going to see compressing margins and want to sell. If they’ve got a systemic problem manifested in their net-interest margins that’s going to evolve over the next year or so if we don’t come out of this rate environment; it could possibly mean a lower price.

Klein: Another factor is due diligence. During the 1990s, we saw “fly-by” due diligence. It’s very important that buyers have a careful due diligence process, particularly on the asset-quality side. The other thing to look at is core earnings. Interest rates will not go down forever, and it is important to determine how much in sustainable earnings you have outside of the mortgage and refinancing area. The worst thing you can do, in my experience, is to buy a bank, think you’ve got a good bank, and then have asset problems. The costs of time, legal counsel, loan losses, and market credibility are overwhelming.

Janis: Banks are universally in better shape than they were in 1989-1990 and the regulators are better at what they do. But what I’m concerned about is that in the fourth quarter, a lot of banks—at least in the Northeast—were beginning to have problems with margin compression that they hadn’t had before. It’s because the deposits are priced so low that they can’t go any lower.

Klein: Right—you can’t go below zero!

Janis: And they are making money on refinancing, but that’s pulling money from other areas. From what I’ve heard, the same problem is expected to occur in the first quarter, at least, and you will see earnings hurt.

As for problems other than pricing and due diligence, once you get into the deal terms, the breakup fees have been a real issue. A Genesis Healthcare ruling that came out a couple of weeks ago in Delaware is going to attract more attention to the fact that you must have a “fiduciary out.” You want a breakup fee, but the problem is to determine when the breakup fee should be paid. Some aggressive, less bank-oriented lawyers want it paid once the deal is terminated, as opposed to when you get a new deal closed.

Bank Director: Tell us more about the impact of this case.

Janis: Genesis Healthcare involved a combination of factors. The target couldn’t get out of the deal except with an adverse stockholders’ vote but there was a stockholders’ agreement to vote in favor of the deal, so it meant there was really no way of getting out of the deal. The lower court held that such a combination was acceptable, but the Supreme Court of Delaware issued an order undoing the deal. However, an opinion has not been issued yet.

The problem is that the more the acquirer gets to where it has to let the market play it out, the more the acquirer wants a significant payment. The issue is both “When do I get paid?” and “How much do I get paid?” The percentages vary between 2% and 7%.

Klein: So there is no breakup fee if someone makes a superior offer?

Janis: It depends. You fight a lot about the reasons that the break-up fee gets paid. For instance, if the shareholders vote against it, are you entitled to a breakup fee immediately, never, or only if the target does another deal in the next 12 to 18 months? It’s a hard thing to negotiate. Lockup options were much easier.

Servat: Another issue that we’ve seen come up is the fear over the economic environment. We saw it last fall in a couple of the deals where people really were unwilling to stretch because of the fear of war.

The other two issues are the pricing and the human issues that keep butting up against each other. Two deals that we attempted to get done this year as mergers of equals failed miserably. In the first deal, no one could ignore the fact that they were not getting a premium on one end. In the other deal, one party said, “I’m going to pay you a premium, but I don’t want to do it as a merger of equals. I’ll give you four directors instead of six, and I don’t want to give up the chairmanship.” So I went to the other investment bankers and I said, “It’s your choice, but you can have this deal for $80 million less if you are willing to give up two directors and a co-chairmanship.” And no one could get over that. That’s happened in many other instances, but it never ceases to baffle me that we can’t get the parties to just step back and get some perspective.

Dory was talking earlier about the relative pricing, and I think that’s a great issue, because so many times we still observe that directors are being remarkably ill-informed about pricing. People often draw a line in the sand over a price parameter and we see an absolute unwillingness to move off that line, even though a rational analysis takes you to a completely different conclusion. That’s human nature; we’re not going to change that, but I don’t think we should stop pushing them to get better educated.

Another thing is this obsession with getting 100% stock. We try hard to demonstrate that shareholders don’t want 100% stock. Half of the shareholders are perfectly happy to take cash. It’s the people around the board table who want stock. And it’s hard to get directors to appreciate that fact, even though it’s in their best interest.

Bank Director: If you were a seller today, would you be more driven toward stock or cash and why?

Wiley: I would carefully evaluate the favorable exchange ratios in the stock I was acquiring because I think you could make a really good deal.

Klein: If I’m a director and want to play it safe—assuming most people are getting double what they put into it—doing a cash/stock split is not such a bad thing, because you get your cash out and then you are playing with the house’s money, so to speak. So if the stock of the acquirer doesn’t play out the way you expected, you’re playing with the premium. If it’s all stock, you could be hurt badly.

Bank Director: But the psychology and individual human dynamics have to be dealt with in each case.

Klein: Deals are always about people. That’s why I prefer to call mergers of equals “strategic alliances.” You must have a match in culture and a match in people. If you have a CEO willing to step down in the near future, then the marriage can come together. But if you have two strong CEOs in the prime of their careers, it’s only natural for friction to occur—it’s human nature. You have to have a prevailing culture, or the company won’t succeed. Lawyers and investment bankers put the deals together, but that’s just the beginning. The integration, the cultural aspects—those are very important for boards to look at.

Wiley: It may be the most important thing. I agree—there’s no such thing as an MOE. Ask [Bank One’s] CEO John McCoy about moving into the headquarters in Chicago, or Hugh McColl at Bank of America, or Sandy Weill at Citicorp. The first things you ask are, “Who’s going to be in charge?” and “What’s the board going to look like?” Price becomes a secondary issue.

Janis: Let me take you on a detour for a moment. The NACD Blue Ribbon Commission has suggested separating the chairman from the CEO position. I’m not sure I’ve ever seen that work well, but it may be the same problem we see with MOEs.

Klein: I think it’s better to have a separate chairman position, but it depends on the role the chair plays. My view of the chairman is someone who is presiding, who is more of a buffer between management and the board and not necessarily involved in day-to-day decision making. You need a clear leader. In a very successful deal of this type, someone must emerge as the leader, otherwise the company would implode. You cannot have two people fighting for power and expect an organization to prosper.

Servat: I’m probably the exception here because I do believe that in some respects, MOEs can work. I have argued this point consistently, but it still has to be clear to everybody that someone is in charge. If you can make it work and avoid burdening the beast with a premium to earn out quickly, you’ve got something that can work.

Klein: We are all motivated to some degree by ego and power; you have to take that as a given and work within those constraints. Most deals I’ve seen have not died because of price, but because of culture or personalities. The people issues must work. Even if you price it right, the people have to make it work.

Bank Director: How do investment bankers and attorneys play a role in those matters?

Wiley: They help depersonalize it. There will be baggage in every deal, and the middle man helps take that away.

Bank Director: One last discussion point. What are the board’s key responsibilities during the negotiation stage of the deal?

Klein: Boards must make sure that their shareholders receive fair value. As a seller, you have to look at the quality of the stock you are trading for. For buyers, it’s asset quality and the future earnings of the target. Shareholders do not normally cash out right away, so if the stock doesn’t perform, you haven’t done your shareholders any favors.

Janis: After Sarbanes-Oxley, one also might ask how deeply the board must get into the rationale and due diligence.

Klein: I think that ultimately the courts will hold that boards must look under the rocks to fulfill due diligence.

Janis: And even more so if it’s a first deal for a board.

Klein: Boards can get complacent. If I had to counsel a board, I’d say step back, make sure that you understand all the materials, that you feel comfortable and understand the risk and the need to protect your company and fulfill your obligations under the business judgment rule. The next couple of years is not the time to get caught short, because there will be examples made under Sarbanes-Oxley and it will be taken to the next level.

Servat: There are some absolutely chronic violations of basic duties going on, not so much in the very small institutions where the people around the table are the major shareholders, but in the $500 million asset range. Some of them have a tremendously difficult time transitioning to a larger company size, and that is where the education is lagging behind the responsibilities they are assuming.

Klein: And that’s where Sarbanes-Oxley plays a role in determining that boards need adequate outside advisers.

Wiley: We see situations all the time where a one-on-one deal is cut because of a bank executive’s personality. The traits that made him a good buyer make him a terrible seller. Millions of dollars end up being left on the table because of ego and because he thought he could negotiate his own deal just like he did numerous times before. It’s really quite simple. If you’re a buyer, keep the investment banker on the sidelines as an adviser/coach. If you’re the seller, keep the investment banker out front and let him run with it. That takes discipline, but it pays off.

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