Driving Forces: Trends in Bank M&A

Today’s M&A market is heating up and conditions are prime for successful deals. This roundtable session focuses on the issues that are shaping today’s M&A arena–the increased expectations on boards, and costs, brought about by stricter corporate governance standards, profitability trends, and the risk tolerance level of boards. Deborah Scally, editor of Bank Director, served as moderator.

BANK DIRECTOR: Has the increased scrutiny on corporate governance played a part in the minds of board members who are considering mergers and acquisitions this year?

Ben Plotkin: I think it has made a difference in the M&A process, but it probably hasn’t fundamentally changed an acquirer’s risk appetite. Like everything else regarding today’s public corporations, things have gotten less efficient and more bureaucratic, and there’s more involvement by the audit committees. On the sellers’ side, I think it is considered overregulation, which could, at the margin, trigger some incremental consolidation.

James Rockett: There is a series of unintended consequences associated with the Sarbanes-Oxley Act, which is the latest in a string of bad laws, including USA PATRIOT and Gramm-Leach-Bliley, to which banks have been subjected over the last five years. But by definition, bankers are risk takers. Understanding risk (and reward) is a critical part of the banking industry—it just has to be anticipated and controlled. If a board of directors does its job in the course of due diligence, if it has undertaken thorough negotiations, if it has excellent documentation and good disclosures in its shareholder documentation, I don’t think Sarbanes-Oxley should have any significant or lasting impact on the M&A culture.

Jean-Luc Servat: I don’t think it has any impact. This industry is so regulated that the additional burden of Sarbanes-Oxley does not materially change anything related to M&A. Clearly there are a few people who moan and groan and may use it as another excuse to go to their boards and say, “We need to sell.” The reality is, however, that the cost is higher to stay in business.

Raymond Gustini: We’re finding that it has increased the cost for our clients significantly, at least while the law is in its infancy. I think banks find it more than a little unsettling, such that they want to make sure that they are in full compliance before they go too far down the road with anything new. I tend to agree that the impact will be on the sell side more than on the buy side. Banks are highly regulated institutions. You can really learn a lot about a bank just by reading its examination and audit reports. These show that banks have been tested not only by independent accountants, but also by very independent, and sometimes very aggressive, regulators.

Art Loomis: I concur. It is a nonevent for buyers, but sellers are using it as an excuse. In connection with that, we’ve quantified the cost of Sarbanes-Oxley as being in the magnitude of $100,000 to $250,000 a year. That’s the ROA for a year in smaller organizations! Consequently, if you are subject to Sarbanes-Oxley, you may legitimately have a reason to sell.

Plotkin: It kicks up the efficiency ratio a bit, so it makes the sale argument that much more compelling at a certain point. I also think one of the impacts on community banks is the loss of a relationship with the accounting firms. In many cases, the accounting firm was also a business adviser, which now is not allowed under Sarbanes-Oxley. So that’s one more negative.

Rockett: Our firm just compiled a 38-page outline of the requirements under the new Sarbanes-Oxley/SEC/NASDAQ rules and regulations that a CFO must confront this year. How the smaller institutions are going to deal with all of these changes and still be able to keep their eye on the ball and keep their momentum going is hard to see.

Gustini: It has always been very costly and inefficient for smaller companies to go public and carry the costs of public reporting. We’re seeing more banks considering deregistrations.

Plotkin: Do you believe there is a risk of the banking regulators extending Sarbanes-Oxley to nonpublic companies?

Gustini: The FDIC issued a comment [in late 2003], before it got reined in, saying that institutions of at least $150 million in assets ought to be doing what everybody else is doing [regarding corporate governance practices]. That changed a bit after some further thought, but even so, we have some nonpublic companies that are trying to follow Sarbanes-Oxley—adopting codes of ethics, doing the right things with the audit committee, and so on. They feel the pressure, even if it’s not official.

Rockett: It’s not just the examiners, though; it’s the shareholders who are starting to have expectations in terms of good governance. I also think one thing we’re not focusing on is the fact that we are probably going to see a lot more hostile activity as the SEC expands shareholder rights and gives activists the right to access proxy statements. We also may start to see splintered boards of directors in situations where shareholders are permitted to elect board members by direct election if the SEC extends that process. And I’m not sure any of this is good, ultimately, for corporate governance or for the well-being of the companies and banks and the execution of their ultimate objectives.

BANK DIRECTOR: Let’s talk about profitability trends, specifically, noninterest income sources. What developments in this area are enhancing shareholder value?

Loomis: The major trend we’re seeing is a heavy focus on gathering deposits—whether it’s organic or through external branch acquisitions or whole-bank acquisitions. As for noninterest income, banks are still looking at insurance, whether it’s property and casualty or life, as well as asset management and trust. Everyone understands why these noninterest income sources work, but what is not generally articulated is that they provide longer client relationships. These “elevator asset” businesses typically promote more lasting client relationships than a traditional commercial bank or thrift has within its client base. I’ve seen statistics that suggest eight years is the average life for a traditional commercial bank relationship, but with trust and insurance asset management, the average life is 17 to 29 years, depending on the product. So they extend the life cycle of the typical customer.

Plotkin: For the most part, community bank executives have had little trouble avoiding nonbank acquisitions that could be truly problematic. For those community banks that get it—that are able to buy wealth management or insurance agency companies and run them successfully—you have a leadership culture that can deal with elevator assets. I think most community bankers have an appreciation for the complexities of running that kind of business.

Gustini: Wouldn’t you agree that, with the exception of a couple of big money-center banks, the changes brought about by the Glass-Steagall Act really have not done much to lure the top-tier companies in terms of restructuring their businesses? I haven’t seen many insurance companies rushing out to acquire banks. Obviously, there have been a few banks that have bought insurance companies, but the “one-stop shopping” concept that we all thought would be the wave of the future really hasn’t materialized. Instead, one-stop shopping has been very specific to a couple of products: wealth management, insurance, and the like.

Rockett: I agree. The Gramm-Leach-Bliley Act has been stuck in first gear since it became law in 1999 and now, five years later, there really have been no new powers granted by the Federal Reserve. We had one breakthrough where the OCC permitted ownership of technology companies to perform third-party data processing work—that’s certainly not unique. Before Gramm-Leach-Bliley, banks could do commercial insurance, and they were already doing investment management. For the most part, what we’re seeing are very cautious steps taken by bankers, with very little breakthrough progress being made.

The lesson bankers have learned is that they must have really good management lockups and earnouts in these transactions. Cross selling becomes a key to profitability. There may be a lack of understanding and vision regarding what the target industries are doing, and therefore the banks have been somewhat unsuccessful in integrating new businesses into full-service products within their own culture. So it is going to take a lot more time, and, it seems to me, we need a bit more progress from the Fed in terms of giving a broader palette of opportunities to banks. For the last four or five years, for example, the Fed has been trying to decide if real estate brokerage is a financial services product. To me, that’s just a no-brainer.

Servat: I’m fairly negative on the whole topic. If we look at what happened between the time Gramm-Leach-Bliley was passed and the end of the 1990s, we saw a flurry of overpriced transactions—overpriced in terms of elevator assets, as everybody likes to call them. But if we are honest about this, there are few success stories. It seems that those banks that stuck to things relatively close to lending, such as factoring, came out on top. But even then, if they did more than just put their toe in the water, they typically ended up overpaying, acquiring staff they didn’t know how to manage, and not planning for the transition of the management into a new team or the cost of the retention packages.

Loomis: I agree with your general comments, Jean-Luc, but I think, as Ben said, the key is really with the quality of management of the buying organization. How flexible is management in terms of understanding how involved it should be, versus just becoming a monitoring organization? For example, when Oneida Savings Bank in Oneida, New York, was a $300 million mutual holding company, it bought an insurance agency platform that has subsequently purchased four additional area agencies, and its revenues have taken-off. That insurance income is now 62% of companywide noninterest income and 21% of total revenues.

BANK DIRECTOR: What do you attribute those success stories to?

Loomis: Bank management was smart enough to figure out that it had entrepreneurs who were focused, who were driven, and who really wanted to perform, and it was enough for the bank just to be a shareholder, in effect. An appropriate analogy might be that the entrepreneurs should remain the pilots of the plane, the bank should be just a passenger.

Servat: I agree, and in the case of Greater Bay Bancorp and ABD Insurance and Financial Services, that was the very reason the deal worked. Greater Bay’s chairman and the two principals at ABD were very close; thus management left them alone. It was good timing, as insurance rates were hardening.

Rockett: What this says to me is that these success stories are few in number, so there must be significant lessons to be learned. We can also learn a lot from the failures—notably the failure to understand the culture of the target. Bankers have a limited vision, which is actually good. As Ben said earlier, we like banks to focus on limited things, but that sometimes causes them to not understand other cultures. For instance, they often don’t accept the compensation process in other industries because bankers are used to having a very limited, lockstep compensation process, and the companies they are acquiring are the opposite.

Loomis: But the insightful ones, I think, do understand that.

Rockett: Yes, but again, there aren’t that many successes. The unsuccessful acquirers don’t understand the motivating factors of the companies they are acquiring. They have a tendency to bureaucratize the companies they acquire and try to fit them into the bureaucracy of the banking environment.

Gustini: My experience is a little different. With the insurance agency acquisitions I’ve seen, management starts by locating a high-profile peer in the same community or market area and uses that person and program as a model around which to build later acquisitions. Maybe he or she is even given overall supervisory management responsibilities over the next platform that is created as the bank continues to acquire agencies. But it seems to me that these banks encourage autonomous operations for the most part. The first big acquisition becomes the paradigm.

Servat: I am a big fan of pure plays, and as you look at growth and what the Asian banks are doing right now, for instance, you find organizations that have tremendous P/Es because their basic business is good and they are not trying to become diversified. What I worry about is when banks get really excited about something a little sexy because they have gotten bored doing the basics. These forays into diversification end up like broken toys—two or three years later, they are buried or the investment banker comes back and says it’s time to resell.

Plotkin: There are a lot of viable businesses that community banks can start de novo without using too much of their capital. For the most part, community banks have been disciplined and haven’t abused the opportunities, although they probably haven’t fully evaluated the threats, either.

Rockett: I’m not sure they haven’t addressed the threats, but the fact is, the community banks have had to compete against the Bank of Americas and the Wells Fargos, and they’ve done a darn good job of that. I’m not sure that the introduction of banking products through Wal-Mart or Merrill Lynch has really impacted community banks or their ability to prosper.

Plotkin: Yet, deposit market share has been shrinking for the community banking industry as a total of U.S. financial assets.

Rockett: But total deposits are up.

Plotkin: True, but you have to look at it as a pie.

BANK DIRECTOR: The last issue I want to address is your general consensus on the M&A market. What are the most critical issues today for bank directors who are discussing their future growth strategy?

Servat: I think it was [Sovereign Bank Chairman] Jay Sidhu who said, “If you’re not a buyer, if you’re not a seller, you’re a fool.” I think he’s right, even though that’s a harsh statement. People are in an environment they won’t see again for another five or six years. Stocks are at an all-time high, and trends are very positive. Credit costs are minimal and investors love banks—people are buying bank stocks. I think banks ought to take advantage of that.

Rockett: I’ll speak a little contrary to that. I think some of the biggest successes in banking have been in internal growth. As long as the board is patient, as long as it is delivering reasonable results to shareholders, and as long as it understands that the internal investment in growth will affect profitability and it is willing to accept that impact, I think you can have a very successful community bank that looks to the long term and benefits from rising stock prices. If you have a good, focused strategy that creates growth, I don’t think you have to go out and buy instant gratification. One good example is [Merced, California-based] Capital Corp of the West.

Servat: I would in no way try to undermine anyone who is committed to internal growth. So I wouldn’t want my argument to be construed as saying, “Buy anything you can find.” But I think there are so few times when you have the convergence of these current events that you have to think very hard about it and not simply be asleep at the switch.

Plotkin: It’s a matter of risk tolerance. Banks that want to grow are going to have to take some risks. If they are less risk tolerant, organic growth may work better for them. But one of the things that is becoming clearer to community bankers has to do with the cycles of opportunistic selling. The fact is, you don’t just decide one year you want to have an M&A strategy. It really follows from the cycles—from the relationship between market premiums and growth rates. Jean-Luc is right. This is a time when there are a lot of opportunistic sellers. Community bankers are smart—I give them a lot of credit. And the buyers understand that as well. There’s a time when the sellers come out, when the buyers have the currencies, and that’s when the prices get paid and the deals get done.

Gustini: I agree—it is a very good time. But bankers also need to decide on a Plan B if an acquisition doesn’t happen. Will it be internal growth or a branching strategy? They also should be mindful that rates are going to change. Looking at the majority of balance sheets and income statements, we have had banks growing deposits over the last three years by 10% to 12% per year, while their interest expense on those deposits was declining by 7% annually. How often can that phenomenon be replicated?

Loomis: You raise some good points. It is a heated market. In some cases, if a buyer has the capacity to expand, it is foolish not to step up to the plate. The corollary to that is “How many times can you sell your bank?” Usually, it’s just once. Currencies are stratospheric right now. The exchange ratios are coming down. So while you do have considerable nominal price benefits as a seller, the real price benefit may be illusory if it’s a stock deal. Studies have demonstrated that the best time to sell for stock is when deal prices generate higher relative exchange ratios, which is not now. However, if it’s a cash deal, now is the time.

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