Opportunities Abound: The Buyside Outlook

Buyers are evaluating a wealth of opportunities available in the market today. Our panel of experts say capital markets are favorable, supplies are ample, and many regions offer strong possibilities for growth and expansion.

BANK DIRECTOR: What are the major economic and market factors affecting M&A activity in 2006?

Steve Hovde: One of the big things affecting M&A is margin compression, along with a flat interest rate environment. A lot of earnings releases reflect this margin compression as well as stiff competition on assets and deposits. So one of the issues from a buyer's standpoint is, how do you overcome that? Is an acquisition one way to do so?

John Duffy: I agree, the competition for both deposits and loans is probably as fierce as we've seen it, driven by the shape of the yield curve and margin compression, although ultimately, I think it will lead to more deals. Last year we had a depressed level of activity–there were certainly no large deals.The small caps are still trading at higher prices than the larger caps. At some point, we’ll see the valuations on some of the small caps that have earnings challenges come down, and the bigger banks that have challenges in terms of growing their earnings may stretch a bit to get a deal done. Although those two lines are far apart today, perhaps they’ll eventually converge, leading to more deals. But that may take several quarters.

Mike McClintock: I’m surprised how many deals were done last year. A year ago, we thought it would be much worse. In fact, there were a fair number of deals in the last year, and the multiples were actually pretty high.You could even argue the cyclical peak we saw in 2004 really didn’t decline much at all in 2005, although there weren’t any great big bank deals.

BANK DIRECTOR: What do you attribute that to?

McClintock: I think it’s the flat yield curve and Sarbanes- Oxley–though I would say Sarbanes-Oxley is the biggest factor, at least according to the people I talk to. CEOs who felt they were always in charge of the company now have outside board members–who previously had not shown either interest or knowledge of the banking industry–having a lot more to say about it, and this is a little frustrating for them.

BANK DIRECTOR: A year ago, Bill, you mentioned we might expect more going-private transactions. Has that played out?

Bill Hickey: We’ve not seen a tremendous amount of going-private transactions, but there have been a few, primarily driven by the regulatory burden.That’s a trend we’ll continue to see, although it’s difficult for a company to go private and still be meaningful, going forward.You severely limit your access to capital when you go private, so then how do you grow? If you’re in a good market, great–you can fund your growth through internal generation of capital. But if you’re in a nongrowth market and you go private, there are fewer options.

Duffy: You certainly can’t have any buying aspirations.

Hickey: Right. One could argue if an individual owned a bank and was satisfied with an 8% to 12% annual return on investment, he or she could achieve that, depending on the demographics of the market. Once you go private, however, it’s very difficult to continue to grow and to be an acquisitive company. It’s a short-term stop before sale.

Duffy: One of the other factors affecting M&A activity is the capital markets.The market basically went sideways last year, and while the multiples are still respectable, there’s plenty of capital out there in the system as a whole and within the sector. So, generally, if people need to do deals or if they find deals to do at the right price, getting the capital to finance the transaction is not a problem today, whether it be equity or debt. Certainly debt is still very, very cheap by any historic measure, despite the fact that the short end of the curve has come up.The markets are attractive at very favorable rates right now.

Hovde: If you had to pick one thing that’s driven pricing more than anything lately, it’s probably the availability of trust-preferred securities (TPS) at ever-cheaper levels. Even though interest rates have risen 300 basis points, the spread over LIBOR has continued to narrow. So, being able to finance deals with regulatory capital at a 6% to 6.5% pretax cost is what’s driving a lot of available capital to complete accretive transactions. If this cheap TPS wasn’t here, and banks had to rely on secondary offerings and equity capital, I think we’d see fewer deals.

Duffy: Plus, you’d have lower prices.

Hickey: That’s right. In fact, if you look at nationwide multiples for 2005, they were higher than they were in 1998, which we generally thought was the high-water mark, right? In 1998, the vast majority of deals were all-stock deals. It was still the era of pooling-of interest accounting. Now, with the availability of financing, we’ve got incredibly high multiples with big cash components, so it’s the perfect time to be a seller. I don’t think it’s going to last a lot longer, though, because valuations, as John pointed out, are likely going to come down, particularly for the smaller-cap companies.

Duffy: I see a bifurcation in the market.There are some pockets of the market where things are very strong, such as Texas or Florida or most areas of California, where the multiples continue to surprise us. But there are other geographic regions where the situation is a lot different.You’ve got no-growth franchises and constrained buyers, and it can be a lot more challenging if you’re selling a franchise in Podunk and there’s not an aggressive acquirer.

McClintock: They still want the big multiples in Podunk, though!

Duffy: Yes, but after you have a failed auction, sooner or later expectations begin to drop. However, often this takes a lot longer than we assume–people can be in denial for a long time.They’ll blame their lack of ability to get a big price on other issues.

BANK DIRECTOR: But, overall, the scale is tilted toward buyers right now in terms of supply, right?

Hickey: My fear in 2006 is that we’ll have excess capacity in the number of sellers and not enough buyers. But this is a healthy position for the market to be in, because it will ultimately drive some valuations down, which will help activity in the long run.

BANK DIRECTOR: You’ve mentioned Florida and other Sun Belt areas. Is there anyplace else that’s emerging as a growth area that may spark additional activity?

Hovde: Just look at the growth MSAs. Nashville,Tennessee is one, and I’d also say the Mid-Atlantic region and certainly Florida and Texas.There’s not enough independent banks left in the Southwest right now, but it’s still a growth market. Las Vegas is clearly a growth MSA, and a couple deals were done there recently. From a buyer’s standpoint, how else can you pay these prices unless you assume there’s going to be growth in the market?

Hickey: And in some cases it’s all relative, particularly from a buyer’s perspective. If you’re in an average 2% growth market and there’s a market adjacent to you that’s a 6% growth market, it’s a lot better than 2%. So everything’s relative. Some banks in poor markets will find incrementally better markets, because what else are they going to do? We’re consistently asked the question from companies in lowergrowth markets up North, “Should we buy something down in Florida or in Texas?” It is a very difficult strategy to employ, but if you’re in it for the long term, perhaps it makes sense.

Hovde: Another issue coming to the forefront is that some buyers are focused only on de novo branching, others are focusing on a combination of acquisitions and de novo branching, while still others are interested in pure acquisitions. I believe the whole de novo branching strategy may be overplayed now in certain markets. Look at Chicago, for instance.There have been 500 new branches in two years, and every bank in Chicago is suffering margin compression. Chicago is a prime example of too much capacity from the de novo branching standpoint. Houston has seen it, and Washington D.C. is also going through de novo branching craziness. Likewise, Atlanta went through it.

Duffy: This has occurred even in Manhattan. I’ve been a Chase customer since 1972, and I think they’ve opened more branches in Manhattan in the last year than they opened in the last 25!

Hovde: Many have seen it as a cheaper route to go than acquiring institutions, but once everybody else is done de novo branching, you have to wonder–it just can’t work for everyone. Everybody’s de novo branch can’t be successful.

BANK DIRECTOR: Let’s talk about how buyers identify the best strategic fit. How can a bank know whether a different geographic area that’s been generally targeted as a growth opportunity might make sense strategically?

Hickey: It’s certainly not about the immediate short-term economics or metrics of the transaction.The acquiring institution has to have the vision that it can pay up to get into a better market and make it work in the long term. How does it do that? By identifying not so much the right market, but, equally as important, the right people who are going to run that business, because you can’t run a business from a couple thousand miles away.There’s no doubt you’re going to face dilution. But the question is, how long is it going to take to earn out of that dilution and then have that deal become the driver of the organization going forward? It’s tough. It’s not easy to stand up in front of your shareholders say, “This deal is dilutive, but don't worry, we’re going to execute it." Shareholders tend not to be that patient.

Duffy: You’ve got two issues. One is you’re paying a higher because you’re going into a growth market, and two, the execution risk goes up exponentially with geographic distance. And Bill's right.The key is having confidence that you have the management team to run it, because presumably, it’s a market you don’t know very well, or at least the people in the market don’t know you. You've got to acquire a management team you know you can have confidence in.

McClintock: Even if you’re buying somewhere far away from where you’re based, it’s important to make sure you tie up the people you’re buying either with stock plans or employment contracts if they’re critical to running that franchise. Otherwise there’s really no point if they can all walk out and start another bank after they sold one to you.

Hovde: One of the biggest changes from the 1990s is that back then, buyers didn’t focus too noncompete and nonsolicitation agreements.The result was, too many acquirers watched the companies they bought open up banks next door six months later with the same management team and the same customers. Today, good buyers clearly understand the need to tie up people under noncompetes, nonsolicitations, ongoing employment agreements. Otherwise, if they don’t keep the producers, they’re not going to keep the business.

Duffy: We probably would all agree that overpaying and the inability to retain key people are the principal reasons why people don’t have accretive acquisitions. Yet, some of that is hubris on the latter point–they may lock up a couple of the execs, but those guys are the ones that have made the decision to sell, so they’re almost, by definition, going into semiretirement.You’ve really got to keep the guy who’s got the day-to-day relationships. In a lot of organizations, that’s not going to be the CEO or the CFO or the president–it’s the guy who’s out calling on customers. If those guys don’t get enough of a retention package, many times they’re gone six months later either to a competitor or they’re out raising $15 million from their buddies and starting a new bank down the block-taking some percentage of the business with them.

BANK DIRECTOR: Let’s talk about business line expansion.We had two interesting deals last year that crossed banking and credit card business lines: Capital One/Hibernia and BofA/MBNA. Could you comment on these or any other business areas that you see as being opportunistic for bank buyers this year?

Hovde: Expanding successfully in this way is a function of the makeup of the buyer. For instance, we see some buyers that are great deposit gatherers and not great lenders, so to make their organization more profitable they need to acquire a niche lender. Conversely, others are good lenders and need deposit sources.

McClintock: I was thinking more of asset management or insurance. Everyone loves to buy asset management.Walt Pressey, the president of Boston Private, has done a lot of these deals, and it’s all about getting to know the people over a long period of time. Boston Private’s deal with Gibraltar Savings is the perfect example. Boston Private called on Gibraltar four or five years before the deal finally happened. At the end of the day, that shows the long lead time it takes in a fee-oriented business to get a deal closed.

Duffy: A lot of people love asset management but very few have been able to execute like Boston Private. In fact more of them have been selling. What I have been seeing is more interest in acquiring some type of lending operation–commercial finance, asset-based lending–things that historically, bankers have considered the next rung down on the ladder, but they look more attractive today because of the spreads that are in those businesses. In terms of generating a respectable margin in this type of yield curve environment, you’ve got to have a fairly high loan-to-deposit ratio.

Hovde: I agree. It comes down to niches–whatever the buyer is lacking is what they need to pursue.

Hickey: Companies buy lines of business in which they think they can do well. And directors constantly ask, “Should we be in the insurance business? Should we be in the asset management business?” And the answer is yes–if you can make money doing it.That sounds pretty simple, but a lot of people buy companies who don’t necessarily know how to run them. It relates to the same points we discussed earlier–you have to have the right people running those businesses because you have to protect against your downside. It’s the people who are going to drive that business for the buyer.

Hovde: This comes back to a great point about culture.You’ve got to align yourself with the right people with the right cultures who believe in each other’s philosophy and strategy.

Duffy: In terms of avoiding acquisition failure, you need to know your own strategy.There are some banks out there trying to do acquisitions that are trying to figure out their strategy. Sometimes they’re facing their own challenges, and sometimes they’re grasping at straws.

BANK DIRECTOR: In terms of defining a strategy, what are some of the questions board members should be asking themselves?

Duffy: What are their goals? Sometimes the goal of the CEO is to remain independent and he feels that by being bigger, he’s got a better chance of staying independent.That can be the wrong strategy completely. In fact, if you don’t execute correctly, you’re more likely to make yourself a target. Sometimes the board may have a lack of clarity in understanding the strategy, and sometimes the CEO may have an idea what the strategy is but the board may not be completely aware of the CEO’s intent, or maybe it has a different view. That’s where conflict ultimately will arise.

McClintock: A lot of it comes back to the bank honestly assessing its own strengths and weaknesses. Some banks will look at acquisitions as a solution to some of their weaknesses, and if they choose the right partner, those can be good ultimate decisions. But if they don’t understand their own weaknesses and strengths, it’s going to be hard for them to be successful buyers.

BANK DIRECTOR: Changing the discussion a bit, it’s always interesting to talk about a successful deal that happened in the last year to help us understand the reasons why it worked.

Hickey: One of the unique deals we did this year was representing Central Coast Bancorp in its sale to Rabobank International. First, it was a negotiated transaction–Rabobank, the buyer, paid cash at a full price. So from a valuation perspective, the shareholders of Central Coast seemed satisfied with the transaction.The more unique aspect of the deal with Rabobank was the cultural fit of Central Coast Bank, a small institution in Salinas, California, an agricultural community, and Rabobank, a worldwide agricultural bank. Interestingly, once these companies got to know each other through the transaction, it really turned into a wonderful economic and cultural deal for the folks at Central Coast. You don’t generally find that in a cash deal where a large company buys a small company, and this one was as good a fit as I’ve seen in a long time. It will also help Rabobank going with its acquisition strategy, because now it has done a couple of deals in California and will continue to grow.The word will get out that it knows how to execute.

Hovde: One I liked this year was Pinnacle Financial Partners and Calvary Bancorp coming together in the greater Nashville market in an all-stock transaction. Pinnacle has always been a dynamic company, but it’s going to create an even more dynamic company in the greater Nashville MSA.The strengths and weaknesses of Pinnacle and Calvary complement each other. Pinnacle is a strong lender with a great lending team. Calvary is a strong deposit gatherer, but not as strong a lender as Pinnacle. Pinnacle was looking for certain markets south of Nashville and Calvary fit the bill. Calvary also has a top-class insurance brokerage operation, a business that Pinnacle wanted to enter.This deal is going to create significant growth in the Nashville market for the combined company.

Duffy: I’ll pick a deal we worked on, Chicago’s First Midwest purchase of Bank Calumet.The reason we liked it was because it was an all-cash deal for First Midwest, which really gives it an opportunity to manage the balance sheet. Steve started this discussion off by talking about today’s yield curve being a challenge in the interest rate environment. One of the critical things in this environment is managing your balance sheet such that you’ve got the optimal mix of loans to assets or loans to deposits so you can generate a respectable margin. And one of the ways of doing that is by putting your capital to use and by buying other franchises. The franchise didn’t necessarily come cheap–it was an auction– but First Midwest was pretty aggressive in terms of the price it ultimately got to because it looked at how it was going to construct the balance sheet in presumably a flat yield-curve environment. So the deal was more valuable in this environment than it might have been at some other point in time. It was a smart deal from that perspective.

McClintock: I thought the two most interesting deals were BofA/MBNA and HSBC’s purchase of Metris Cos.The consolidation of the card business is picking up–Wachovia said it’s going to get into the business itself and start issuing again.

Duffy: I agree.The MBNA deal was one I was thinking of mentioning since we were involved in it.You know, when BofA was presented with that opportunity, our advice was, how could you afford to pass on a franchise like that? And again, BofA didn’t get it cheap, and people knew the bankruptcy issue was coming down the pike and would cause higher chargeoffs in ‘05, but in terms of a strategic acquisition, the MBNA asset is very, very valuable. Another smart deal, and markets embraced it ultimately, was the Zions Bancorp/Amegy deal because it got Zions into a great market. It was a big deal for Zions, and there was some market skepticism in terms of whether Zions could handle it, but its stock has eventually done pretty well. And strategically, getting a large franchise in Texas is something a lot of people would love to have, so to Zions’ credit–it pulled it off. Now, if it doesn’t execute, it’ll get taken out to the woodshed, but so far, so good.

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