The Changing Landscape: Mapping a Strategic Path in Opportune Times

From stock valuations to sweeping regulatory changes, the M&A arena is in constant flux. This roundtable session focuses on this year’s dealmaking environment, how branch deals differ from whole-bank deals, and the importance of strategic planning in transactions. Deborah Scally, editor of Bank Director, served as moderator.

BANK DIRECTOR: What are some of the factors that have created a challenging environment for dealmaking this year?

Dory Wiley: We’ve definitely got to watch the stock market. There’s been a lot of rotation from other sectors into the financial sector because of a perceived security in financials after the downturn a couple of years ago. If money starts to rotate out of the sector because of overvaluation, or if there is growing confidence in other sectors, that could definitely have an effect on bank M&A activity. Right now, I think there’s a general sense in the investment community that bank stocks are pretty highly valued.

Michael Mayes: I agree with Dory. Bank stock valuations will be a big challenge. The recent rise in share valuations has allowed buyers to meet the expectations of sellers. Put another way, expectations have not come down, but higher-valued currency has enabled buyers to offer more without having to use more stock. Another big challenge, particularly for community banks, is that the pickup in M&A activity is also impacting their likely buyers. It is not unusual for a community bank’s best buyer to be acquired, thus reducing the number of purchasing competitors for small to mid-sized banks.

Robert Rogowski: With the Federal Reserve’s current bias to raise rates, it will be interesting to see how the market reacts to changing bank and thrift earnings if higher rates return in the second half of 2004. If banks continue to be asset sensitive, in terms of repricing their assets quicker than deposits, then their earnings and stock prices will stay strong. On the other hand, with the refis going away, a number of thrifts are facing decreased mortgage origination volume as well as shrinkage of their net-interest margins.

Wiley: That’s a good point because historically, when rates go up, the stock analysts love to ding the bank stocks, and yet they usually do OK. Take 1994, for example. There was a 350-basis-points rise in the one-year Treasury and the worst bond market in history, yet it was a record earnings year in banking.

Looking forward, what’s interesting dynamically is while most of the banks are asset sensitive, a lot of the loans are at floors. So for the first 100 basis points, a rise in rates is actually bad because of pressure from the liability side. It’s going to take a big movement in rates for banks to be OK. I don’t expect a lot of problems with that. I think there is more danger from what stock analysts are going to do because traditionally, when rates go up—boom—bank stocks fall off. So it will be interesting to see what happens.

Rogowski: Let me counter that. With economic conditions improving, you are going to see more new loans. In the Northwest, it’s been pretty soft for the last two or three years, but we are starting to see nascent loan growth in a number of sectors—commercial real estate being the exception. But I believe you’ll see loan yields go up because they’ll be adding on new loans at higher yields, and those higher yields should translate into better net-interest margins.

Moving to the deposit side, for several years banks had enjoyed the runoff from the stock market because the stock market had been in negative territory. However, last year and this year it was just the opposite. So the question is, how much of the money will go back into the stock market, if you will, to create another bubble? Not into bank stocks, but into the overall market, which would then force banks to go into the market for purchased funds versus getting them from depositors. Will it be tougher to get core deposits the second half of the year? I think it will.

Stephen Klein: It’s an interesting by-play. I think funding is going to be an issue, especially as loan demand increases. Historically, like Dory said, when interest rates go up, bank stocks go down. Also, as other sectors of the economy improve, there will be more upside in those stocks and you’ll find movement to those sectors. What does that mean for bank M&A? We may have had a short-lived renaissance. Because stock prices for banks have gone up so much, deals have become more plentiful and values have headed into the astronomical range, though not quite where they were in the late 1990s. But I think they’ve come up too quickly—sellers now have unreasonable expectations. That has always been the biggest problem with deals: the unreasonable expectations of sellers. What you are finding now are more disciplined buyers—buyers who realize what happened in the 1990s, when companies got burned in the market for overpaying or ended up having to sell.

Mayes: Steve makes a good point about unreasonable expectations, which has slowed activity until this year. One of the things that is different now, though, is that sellers are experiencing margin compression like never before. Loan growth is modest in many regions. I also agree with Bob’s comment about funding. Core deposit growth will likely be modest in 2004 as funds return, albeit slowly, to the stock market and to alternative investments.

BANK DIRECTOR: How does all this affect deal funding and financing?

Klein: If you look at a lot of the deals post-pooling, there are very few that are straight stock deals. Most of them are a combination of cash and stock, and many have been funded in a relatively soft stock market by trust-preferred securities. If the trust-preferred vehicle goes away amid regulatory changes, that’s going to impact the M&A arena as well.

Rogowski: I agree that a number of transactions, if not most, during the last couple of years have had a cash component, and in part that’s been driven by low interest rates as well as by access to capital from trust preferreds. Going forward, I think you’ll see more all-stock deals if the stock market stays at high levels; cash will be more costly given the rise in rates. Having said that, some of the active acquirers have either been on the sidelines or have amassed cash war chests, which will allow them to pay cash for several more years. Echoing Steve’s comments about buyers’ and sellers’ expectations, I believe it’s unique to the growth characteristics of the companies involved and that as regional economies become stronger, you’ll see increasing ability to pay higher prices. Now whether they’re “reasonable” or not is in the eye of the beholder.

Wiley: I agree. Cash deals will stay around longer thanks to trust preferred, because a number of companies have been piling on a lot of cash, and they’ve got to do something with it. Furthermore, I believe trust preferred has helped fuel a lot of M&A activity over the last year—almost balancing out the detrimental effect of the elimination of pooling. Most small-bank acquisitions are done by other small banks under $500 million, and they have a problem choking down goodwill. Goodwill is a big issue, and even though there’s a temporary mindset of, “Hey, I don’t have to write off this goodwill, so I’m OK because it doesn’t affect earnings,” it just postpones the problem of what to do for tangible capital. Well, trust preferred has helped fight that for now. Today, the Fed has a real dilemma about trust preferred. The Fed likes capital, but with all that pressure, I think it’s very likely that relatively soon it will move Tier 1 capital qualifications from 25% to 15%.

Mayes: Trust-preferred financing has been something of a boon for banks. My sense is that, as an industry, we’re approaching peak levels, and regulators will begin to cut back that portion of regulatory capital that consists of trust-preferred capital. And that’s probably a good thing. Deals will likely have a larger stock component, given current valuations. The goodwill issue has caused buyers to be more disciplined and more selective, which is also a good thing.

Klein: Trust preferred has been a relatively cheap and nondilutive way of raising capital. However, that’s really unfortunate, because in the last few years if you were going to do an offering, bank stocks—especially community banks or regional banks—would be the ones that would sell well. They haven’t lately because capital dilutes earnings per share.

Wiley: Your point about IPOs is absolutely true. Trust preferreds have helped keep banks from going to the IPO market. However, those that have gone the IPO route, two in Texas specifically—Texas Capital Bank and Franklin Bank—have been very, very successful. I think it’s a great time for banks to go public. If they don’t do it now, they are going to miss the boat.

Mayes: Public equity for community banks has been very strong. Our pipeline for secondary offerings is strong. Valuations have held up well. For example, last year we raised $10 million for a newer bank, Bank of Florida, which has operations on both coasts in south Florida. The company went public at $10 per share and now, 14 months later, is trading in the $16 range. Many investors, both retail and institutional, are finding this segment to have very strong fundamentals, less price volatility than larger-cap names, and a fair amount of takeover speculation as well.

Klein: We’ve done a number of community bank offerings, and they sell out well within the subscription period. Even the few new banks that have formed have been able to raise substantial amounts of capital. With rare exception, it’s not a question of whether a community bank will succeed; it’s how successful it will be. The track record for community banks has been rather impressive. People who put money in community bank stocks 20 years ago would easily be retired today, even if they made a mistake or two.

Rogowski: Regarding capital and price-to-book ratios, to coin a phrase in an election year: “It’s earnings, stupid.” Earnings drive deals—multiples, pricing, book, and tangible capital are all things that can be worked out. The question that really matters to acquirers is, “What kind of earnings stream am I getting, and how reliable and recurring is it?” Those factors are key. What you’re really talking about is the risk/reward trade-off when you acquire an institution.

I would take that a step further with regard to the merger of equals issue, because “a merger of equals” is often a euphemism for “low premium.” So with a merger of equals, you are melding two cultures—but there has to be a dominant culture. No two sides are ever equal. So those transactions are damn difficult to put together. Steve [Klein] and I were in one last year that fell apart three times. It never happened because of the price-driven friction between the two partners, as well as social issues. We thought we had all the social issues hammered out, but it turned out to be board-driven price expectations that killed the deal.

Klein: Also, in a world that now must use purchase accounting, size does make a difference because of its impact on the buyer’s ability to absorb goodwill. Small institutions don’t have that ability. It impacts their regulatory capital. So the larger a company gets, the greater the absorption factor with goodwill.

Wiley: I can think of a number of institutions that demonstrate what you are talking about. What made them what they are today was doing a merger of equals with pooling that propelled them to the next level. The perfect example is J.P. Morgan Chase. It’s much tougher to do those deals with purchase accounting, unless you can come in and do some kind of low-premium deal.

Rogowksi: You are talking about “transformational deals,” which are few and far between. With J.P. Morgan Chase, both sides recognized the juggernaut that they would create by putting the two sides together. The same thing happened with Washington Mutual in 1996 when it bought American Savings in California. In that case, the Bass brothers agreed to take the stock and basically bet on Washington Mutual as an accretive deal. The stock took off like a rocket, and the company has done very well with that currency and has now expanded to become the largest thrift.

Wiley: The J.P. Morgan/Bank One deal creates an interesting dynamic for those of us in the Southwest, particularly Texas, because there’s so many people who want to be in that market. Seven of the top 10 banks are not in Texas. You can’t get in—we have a barrier to entry because there’s nothing you can buy of size.

Klein: So how do they keep their growth rate up?

Rogowski: Take Ray Davis and Umpqua Bank in Oregon. They’ve efficiently and carefully integrated a broker/dealer into their bank holding company with the purchase of Strand, Atkinson, Williams & York. That was a very fragile deal. Just look at the wreckage on the side of the road from all of the bank holding companies that have bought broker/dealers in the last five years—US Bancorp and Piper Jaffray, BofA and Montgomery Securities, for instance. A lot of people haven’t done it very well.

Klein: But there’s one reason for that—Ray Davis can create a sales culture. That’s one of the problems with these cross-industry deals—they involve sales cultures that conflict with the more traditional banking culture.

Rogowski: It’s also a matter of understanding separation. Davis has maintained the broker/dealer with a separate identity and held onto its key people. Strand Atkinson has its own compensation structure and its employees cross-sell like crazy to the bank because they are incented to do so. That’s the right way to do it. But with a number of these other broker/dealer deals, we saw mass defections of key players who charged that the bank was changing the compensation structure, the incentive structure, the sales culture, thus the deal fell apart.

BANK DIRECTOR: How do branch deals differ from whole-bank deals?

Rogowski: Branch deals typically involve smaller deposit amounts and slower growth markets and/or forced divestitures based on antitrust rules. Divestitures tend to be packaged together, and typically the package is sold by a larger bank holding company that wants the deal to go to one player because it doesn’t want the inconvenience of converting to several different systems. It wants one conversion. So in a number of these larger, block transactions of branches, the community banks pretty much get frozen out. They can do a consortium bid, but that is often frowned upon as being second to an all-branch bid.

Klein: Some of that is because the relative size of the branches is small and the premium is small, and to a large institution, it’s not worth the pain.

Mayes: In the Northeast, branch transactions generally involve fallout from branch overlaps in large bank mergers and are generally sold off to community banks, often to different buyers and sometimes in the same market. The advantage in this case is that the seller ends up “breaking up” potential competition into smaller, presumably less-effective, buyers. I’m not sure that works in the end, but in many of these divestitures, the seller remains in the market and has an interest in the competitive landscape after the divestiture. From the buyers’ point of view, branch acquisitions are a very effective way to accomplish a market extension on a relatively low-cost basis. A lot of the baggage with whole bank deals is also not present. If you translate branch deals into whole-bank deals, you can see how financially effective they really are.

Rogowski: Getting to the pricing of deals, the thing is, if they have loans attached, they become attractive. We’ve been in several situations where the loans are attached such that whoever gets the branch basically gets the loans—so banks have priced up those types of transactions. The interesting element to this is that you are buying into smaller markets with slower growth characteristics.

Klein: But for the small to medium-size banks that don’t have the same access to mergers, branch acquisitions offer a unique opportunity for them to grow their franchises. And if they are not public companies and thus don’t have the same earnings-per-share growth pressures of a public company, it’s a luxury to be able to buy those branches.

Mayes: You’re right, Steve. It is a luxury. I often tell buyers who are nervous about paying a 10% premium in a branch deal to look at whole-bank deals on a branch-premium-equivalent basis. It’s not unusual to see whole-bank deals getting done at 20% plus deposit premiums. Granted, the transactions are not the same, but branch deals can be very effective on a unit-cost basis.

BANK DIRECTOR: Which legal precedents or regulatory changes have changed the landscape for bank mergers this year?

Wiley: I think the Sarbanes-Oxley Act has helped redefine the fiduciary duty regarding the processes a board ought to go through. So many times boards are involved in deals that are knee-jerk reactions or one-on-one situations, which are not necessarily bad, but you really should follow a process.

Klein: I agree. The Delaware courts have been very strict on boards of directors. So I think it’s really important that directors are sensitive to the need to make informed decisions in a deliberative fashion. It’s only going to take one or two bad situations to raise the bar even higher, and no board wants to be the target of a lawsuit.

Mayes: I think Sarbanes-Oxley has had more of an impact on corporate America than on the banking industry, which has been heavily regulated since 1933. In fact, it’s hard for me to imagine doing deals in an unregulated market. Sarbanes-Oxley, though, has had the unintended consequence of causing some bank boards to more actively consider a merger partner. At some smaller banks there is a certain sense of worry about certifications and liability, which has caused their boards to look for a larger partner to reduce that exposure.

BANK DIRECTOR: What do you tell your clients about Sarbanes-Oxley to help educate them about the need for oversight?

Klein: Sarbanes-Oxley didn’t change fiduciary duty rules, it just brought them to people’s attention. What Congress was asking was, “Who’s watching the store?” The other message is that the board cannot simply rubber-stamp what management suggests—whether it is regarding compensation or an acquisition. It has to do its own independent testing. Directors can rely on management and experts, but they have to question them. What you want is the protection of the business judgment rule, which presumes the board acted in good faith—if it went through the proper process. The courts would much rather not superimpose their judgment. But even so, going forward, where there have been abuses, there’s no question that people will be held accountable.

BANK DIRECTOR: Would you each give us your thoughts on the importance of strategic planning?

Mayes: Having a road map is very important. Not only a geographic map of where you want to be, but also outlining who the target companies are in each market, what they would cost, what you can afford, and who the likely competitors are for that target. Develop friendships and personal relationships with bank presidents and be willing to devote time, over a period of years, to understanding these banks and their markets. Be prepared to move quickly, should the opportunity arise. Evaluating the businesses and products you want to be in is also important and will likely change as circumstances change. For example, the residential mortgage business is very different today from even three years ago. On the expansion front, don’t be surprised if you lose out on one or two deals before you make one. The old Boy Scout motto, “Be Prepared,” is the best advice I can offer.

Klein: Whether you’re an acquirer or not, strategic planning is a key element of corporate governance. This doesn’t mean you have to have a 100-page strategic plan. It means you have to have a game plan, typically for about a three-year period. The board gives some direction to management, and management develops a strategic plan, and then the board has to agree on it. Then they hold each other accountable and revisit it at least quarterly and also at the annual retreat, perhaps with a third-party facilitator. This is a very healthy exercise. And if you are in an acquisition mode, it is absolutely essential. The ironic thing about acquisitions, though, is you can plan all you want, but opportunities present themselves when they present themselves.

Wiley: Strategic planning is really important. I think culture is probably the No.1 issue when it comes to deal success, but strategic planning brings disciplined pricing. It’s easy to get caught up and be a deal junkie and get hooked on the adrenaline. We see that all the time. Most of the active buyers are smaller institutions, and if they are under $5 billion, often the buyers are the CFO or a couple of analysts that have other jobs as well. Once when we asked a large institutional buyer at a conference how he valued a deal, he stood up and said, “Well, we found out what price it took and then we justified it.” That was his analysis!

Klein: That’s backwards.

Wiley: In another case, a bank was paying a premium for a bank about its size, which is the kind of deal that makes you nervous in the first place because of all the goodwill. They constructed a deal, signed an agreement, and the buyer called us in because it wanted us to issue some trust preferred, and guess what was missing? A pro forma! The buyer had not even made a pro forma of the deal. To me, that’s scary. That’s a plaintiff’s attorney’s fantasy camp if something goes wrong.

BANK DIRECTOR: These kinds of cases are what make director education so valuable.

Mayes: That has been one of the positives coming out of Sarbanes-Oxley. Boards have become more financially sophisticated. The old country club, social atmosphere has changed pretty dramatically, and for the better. I find boards to be much more engaged and active in the decision-making process.

Klein: Historically, we have laws—whether they are corporate or otherwise—that are developed because of the abuses of the few. There are things out there that are scary. The one thing I think everyone should remember about Sarbanes-Oxley is that good corporate governance really is the foundation of doing good transactions. We really don’t know what’s going to shake out in the next three to five years with the law. It’s not the SEC that’s going to call the shots; it’s going to be the courts, based on lawsuits, that determine whether boards have really met the standards. That means you should be very thoughtful in your process, get good advice, and not do things hurriedly. It doesn’t mean you can’t be responsive. But, if you have not gone through the proper process, you’re vulnerable.

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