Strategic Considerations for Sellers in 2006

Banks evaluating the window of opportunity for a strategic sale need to consider several factors to maximize the probability of a successful deal. Along with ensuring the financial equation makes sense, regulatory due diligence is critical, as is a thorough review of employment agreements, severance programs, and long-term vendor contracts.

BANK DIRECTOR: What's the picture look like for sellers this year, and what steps should the board be taking to prepare for a sale?

James Rockett: First, if a bank is planning on a sale in 2006, the board should have already done many things in 2003, 2004, and 2005 to prepare. In terms of what a board can do to prepare, there are really more “don'ts” than “dos.” For example, you don't want to give away value by putting rich severance payments in place.That can strip value out of the company and away from your shareholders. The bank should have a wellbalanced severance program that takes into account 280G issues so it will avoid the severe tax penalties arising from excessive golden parachute payments. And community banks especially should avoid gross-up payments for taxes because that money comes right out of the shareholders' pockets. You should also take a look at the management of IT and DP contracts because those have long-term impact, and termination can be very expensive.This should regularly be done when these contracts are being renewed or when the bank is entering into new contracts. Make sure these contracts don't have long tail periods that strip value out of the company. And, finally, in my view, you don't want to try for short-term gains by putting out new products the bank doesn't understand or by engaging in high-risk lending that could backfire and create credit risk.

Ben Plotkin: In this challenging environment, a key for many boards and managements is to try to maximize their probability of success.There have been a lot of failed transactions recently because sellers' valuation expectations were much higher than buyers. Most of that depends on having a realistic assessment of the sellers' earnings power, given the yield-curve environment that is currently slowing deposit growth. So the number-one thing we're focusing on today is making sure potential sellers understand their value and its relationship to their current earning stream and growth rate.We don't want to encourage companies to enter the M&A market without a high probability of success.

Michael Mayes: I think Jim's point about reviewing data processing contracts is important. A lot of contracts are long term, and you want to be sensitive to the costs you might have a buyer incur if you extend those contracts too long. But I'll take issue with one thing Jim said about severance contracts.We often tell boards that any issues they have with senior management that relate to employment contracts, grants of stock, or stock options should be gotten out of the way early. As long as they're reasonable and customary–in line with industry standards–it's important to do them before you begin the deal process rather than during the process.The other important area is having an attractive employee severance policy in place, because clearly, there will be some job losses. Last, it's a smart thing for boards to establish a special committee–often called an M&A committee or a strategic options committee–to receive regular updates about their market value. This can include information such as what the conditions are like, who the buyers are and what they are paying, what potential acquisitions are out there, who their favored partners are, and their capacity to do transactions at a certain level. Often, when you get started in this process, the one or two potential partners you had in mind get acquired themselves. So it's good to be knowledgeable, both with counsel and with your investment banker, about what's happening in your market.

Jean-Luc Servat: One of the most important things is valuation.The valuations being paid for performance in the current operating environment look fantastic, yet they may disappear at any moment.There are a few potential buyers that haven't done a deal in a long time and are panting to get one done. Furthermore, in the last 12 months, people have been willing to do deals that are not accretive for the first year and they are adding synergies to their numbers to make the numbers look better. So broadly speaking, if you're really thinking of selling and are not doing it now, I'm not quite sure you should be in the business at all.

To Ben's point, however, the most important thing we do ahead of time is educate boards about valuation.We've got an absolutely phenomenal environment today, yet at the same time, boards need to hold their expectations within a realistic price range.The industry is reaching its limit with purchase accounting–we are truly at the edge. So whether you are speaking of intangible equity ratios or the amount of intangibles you're booking, it can be scary. Sensitizing everybody to the nuances of valuation is critical.

The second point I will make is the importance of having a clear idea to whom you're going to sell. If you're launching into the process and you haven't identified a potential buyer, you've probably either got the wrong investment banker or you've got the wrong product to sell. Focusing on your three best prospects, is the most important thing to ensure success.

David Burns: As banks prepare themselves for sale, we have seen some of them moving away from their core banking strategy. For example, suddenly they believe that in order to make themselves a more attractive target, they need higher levels of noninterest income. In turn they begin to explore ownership in other operations outside of traditional banking, such as trust operations or perhaps even a wealth management or title company. Although a bank's level of noninterest income is important, it may not have been the principal business that built its franchise in the communities it is servicing.

Mayes: Obviously you want to have your financial house in order before you embark on this process. I would say the most important thing is to make sure you're comfortable with your loan quality. I think the most difficult issue a buyer faces involves acquiring serious loan portfolio problems. If you decide to embark on a sale process, there are a lot of things that are important to do in advance in a relatively short period of time. When a bank comes to us and says it would like to partner with somebody, it doesn't take years or even months of planning to get things in order to do that. Sometimes the time is just right–and if you work with capable and experienced people, it doesn't have to be a long, involved process.

BANK DIRECTOR: What has been the regulatory environment's impact on M&A this year? Have things quieted down at all?

Rockett: Not at all.The Bank Secrecy Act (BSA), including anti-money-laundering compliance, continues to intrude on M&A transactions. As a result, many would-be acquirers are forced to sit out, and those doing deals are very conscious of how BSA may affect them after they integrate the target. In other words, if a target's customer base has serious BSA implications, that will reduce its value. Also, community groups are monitoring and protesting much smaller mergers today because, with the HMDA (Home Mortgage Disclosure Act) data being reported, they have great tools enabling them to basically halt a transaction by raising fair-lending questions. Plotkin: The ratcheting up of regulatory issues continues, as it has every year for the last five to seven years.Today, sellers must not only be able to show that their last BSA exam report is clean, or that their last management letter from their accounting firm is clean, but in addition, buyers are looking more closely at the process to see if there is a good compliance and financial process in place at the bank to preempt future problems. What buyers are most concerned about is not what has shown up already-but rather what happens after they own the bank and during their first exam, once they have already become responsible for BSA compliance. So buyers are concerned about the “tone at the top” and the compliance culture at the bank, and sellers need to prove they have that type of compliance culture in place. Beyond that, there are always new hurdles.The SEC recently came out with a new compensation disclosure proposal that's going to affect a lot of companies over the next 12 months.That may be another issue that becomes a “tipping point” for some banks, to the point that a potential sale of the bank becomes more likely.

Mayes: The real question, though, is do these regulatory issues impede transactions or fuel transactions? Clearly, there are transactions that get gummed up because a target has regulatory issues and the buyer doesn't want to inherit those issues. On the other hand, for every one of those, there are probably three or four where these burdens are what push banks to look at a merger partner.

Plotkin: Especially in small-cap companies.

Mayes: Right. Companies where market caps are, say, below $100 million. So it pushes boards and managements to combine with larger companies that have the resources, expertise, capital, and earnings necessary to rationalize these costs.

Servat: However, I would say the main impact has been on the large acquirers. I won't deny it's a big issue for all the small and mid-cap players, but I think the major issue has been that the larger players are unwilling to step into what could be considered a quagmire, because they will be held accountable and told to clean it up. I'm surprised, actually, how little impact it seems to have on the willingness of mid-size or small-size buyers to make acquisitions despite the daunting challenges it presents.

Burns: We have seen a continued movement on the part of regulators toward more regulatorycompliance-focused examinations. Not to say that safety and soundness is not important, it just appears to be secondary to compliance today.The regulators have the impression that banks have their financial houses in order, so it gets back to the point made earlier that compliance issues are a big concern today. For example, information technology is a large concern for regulators, and quite frankly, an even-larger concern for many banks. Banks have been scrambling around hiring outside consultants to help them with their IT concern, whether it's with HMDA or BSA or system integrity. Basically, a bank does not want to end up with a bad IT examination, particularly if it's looking to sell the franchise in the near future.

Plotkin: This all puts a lot of pressure on the diligence process. In other words, how does an acquirer look at a potential seller and figure out if its processes are good, beyond just looking at the exam reports? Today, we're in a transition period as companies figure out how to do a better job of measuring the risk of assuming someone else's regulatory problems. I see banks taking a lot of different approaches to it–some are better than others in assessing it. But for potential sellers, whenever regulatory hurdles grow, the underlying pressure for consolidation is incremental, and it clearly tips some banks to look at consolidation.

Rockett: Furthermore, there is a dearth of skilled compliance people able to advise on these issues, because those who have the experience are either in institutions where trouble exists and are working to clean it up or they are being hired away by larger institutions.This has left very few skilled people for smaller institutions. When a bank faces these daunting challenges without a skilled compliance officer, often its board will consider teaming up with someone else that does.This scarcity of compliance personnel may very well fuel some smaller players to move toward consolidation.

BANK DIRECTOR: Do any of you believe all this emphasis on compliance has created a red herring in terms of the regulators not paying attention to the very safety and soundness fundamentals that made the banking industry so strong in the last 15 years?

Plotkin: There's always that danger, but my view is that most bankers and regulators have not been distracted from safety and soundness fundamentals. Compliance is not a red herring: you take these compliance issues very, very seriously because if you don't, they can knock you out of the game. At the same time, bankers recognize they're in an environment where credit has been pristine for years, and eventually credit erosion is going to rear its ugly head. Some of the midwestern banks are starting to see more charge-off activity and an increase in loan-loss provisions, for instance. So we're going to return to a position that's more normal from a historical sense. On the asset/liability front, I think banks have done a good job dealing with what has been a difficult interest rate environment, even in the face of all the regulatory issues.

Mayes: At the risk of stating the obvious, a lot of these new regulations have been extremely beneficial to the banks. As Ben said, from the regulators' point of view, we've enjoyed a period of pristine asset quality and, in effect, I think regulators are using this time to force banks to develop procedures and processes and a culture that is consistent with maintaining high asset quality and high operational standards. Today, this means managements and boards are devoting a disproportionate amount of time to dealing with these issues. But many aspects of these regulations have created better institutions, better processes, and better board oversight than we had, say, five or seven years ago.

Burns: I agree with Ben and Mike. Today, bank capital is at a very high level and loan losses have been at very low levels, so a greater focus on compliance makes sense. On the compliance front, one of the newest regulators for small public banks is the PCAOB. Many smaller public banks are spending an enormous amount of time and money on their anticipated compliance with Section 404 on internal controls.This layers on top of all the other compliance issues faced by banks.With the Section 404 deadline approaching for smaller institutions, something will have to give. In fact, the SEC established an Advisory Committee on Small Public Companies to assess the current regulatory system for smaller companies and on December 14, 2005, this committee heard recommendations from various subcommittees, including the internal control subcommittee.The internal control subcommittee's objective was to provide recommendations related to the regulations on internal controls to enhance compliance and reduce costs.With a long comment period expected, these banks will need to continue their efforts on their anticipated compliance with Section 404.

BANK DIRECTOR: Let's talk about an issue for smaller, closely held institutions today. Is this a good time for an S corporation to consider selling, and can you also explain what specific considerations buyers might have in considering these companies?

Mayes: With respect to selling, whether you're an S corp or a C corp, you want to pick a time that's right–and coincidentally, now is a good time.Valuations remain high and there are still a lot of active buyers in the marketplace. At the same time, we're seeing the number of experienced, active, and aggressive buyers beginning to decline. Part of this has to do with the limitations of purchase accounting that Jean-Luc referred to earlier.Therefore, experienced, active buyers are becoming more discriminating.While there are certain accounting issues that relate to the shareholders of S corps, what's paramount is that you choose a time when you maximize shareholder value.We probably just passed a peak in M&A valuations during the third quarter of last year, but the current levels remain relatively high by historical standards.

Plotkin: I agree.The analysis with an S corp is not any different from a strategic standpoint from any other institution, although the tax and accounting implications of having passed a 10-year S corp anniversary are there and can make a transaction even more rewarding. However, I think the culture at many S corps is different, in that they are smaller companies. By their nature, they haven't been in the public company 404 environment. As such, more preparation may be needed for an S corp to consider a sale when it is compared to a private, conventional, larger public company.

Rockett: The real issue right now is there are a lot of smaller banks with relatively small shareholder bases that might contemplate converting to S corp status. What they sometimes fail to realize is that this will impair their ability to sell over a period of time because the built-in gains tax can, during the first 10 years following conversion, basically hold them hostage to remaining in business as an S corp.

Servat: I'm curious to hear whether you all think there are times an S corp is a little too much of a mystery for buyers. I've found that any time you've have an S corp for sale, there's a bit of a stigma attached to it because the question becomes, why did it convert to an S corp in the first place if ultimately it was going to sell? As far as the general issues go, the timing is no different from any other organization, but you have to be more careful because there will be more explaining to do, and this complexity creates a level of uncertainty that may be a slight deterrent.

Mayes: I think that's a fair point. I don't think the mystery is insurmountable. But when it's time to sell, it's preferable to do whatever you can to make the process as simple and as uneventful as possible. I would say if a company was considering a sale somewhere down the road, it wouldn't make sense to be thinking about changing to an S corp.

John Ziegelbauer: All the points made are quite interesting. According to FDIC call report data, S corporations actually make up over 25% of existing banks– there are over 2,200 S corporation banks right now. Almost 100 of these banks have more than $500 million in assets so their controls should be in line with regulatory standards.They shouldn't be such a mystery during an acquisition. If a bank had been a C corporation prior to becoming an S corporation, the real question is “If the bank is subject to the built-in gains tax, how big is the premium right now compared to what it was at the conversion date?” If there's been significant appreciation since the conversion date, there's a real opportunity there. If an S corporation that was previously a C corporation is going to sell in 2006, there's going to be some uncertainty associated with structuring the transaction in a favorable way. It will be important for everyone to understand the tax consequences. For tax purposes, when you have a normal C corporation deal, that premium is locked up as a nondeductible asset on the balance sheet. If you buy an S corporation and structure it as a deemed purchase of assets, you get to write off that premium over time.That is significant.There are situations where people thought the benefit was just getting a single layer of tax, but as it turns out, it's also just a single layer of tax applied to the appreciation and value that has built up over time.

Servat: I don't think anyone would challenge that.Yet if we were to sell a publicly traded C corp that has a high volume of trading–all things being equal–that's going to be a lot easier than selling an S corp with the same performance. Of course, undiscovered gems make that process easier. But a lot of the organizations that have gone to S corp status have done it deliberately to remove themselves from public view, so that creates a stigma.Obviously it's not the rule–there's are also some fantastic private companies with C corp status.

Plotkin: I think our job as investment bankers is to take things that are a bit out of the ordinary and turn them into valuation opportunities. What's happening is that the 10-year anniversary is coming up in 2007 for a large bunch of S corp companies–about 500. A good M&A professional is going to understand this and present it properly.

Ziegelbauer: The question was also whether 2006 is a good time for an S corporation to sell.The fact is, we're looking at banks that made the S corporation election in 1997 so they are hitting the 10-year mark. In 2006, if they are now thinking about selling, they need to decide whether to wait it out six months, nine months, or just wait until that 10th anniversary to get the more-favorable tax treatment. Mike made the point earlier that valuations are still relatively high. So it's like comparing one in the hand versus two in the bush. Potential sellers need to consider these factors in any decisionmaking process.

BANK DIRECTOR: But don't they also have to begin making themselves more visible? Deal making involves personal relationships as well as numbers.

Plotkin: That's true, and an S corp that thinks it may want to sell a year from now, or two or three years from now probably needs to become more visible in the banking community because of that interpersonal relationship between CEOs of potential buyers and sellers. It is important.That's how trust gets built. And for S corps, it's probably even more important for the CEO to have familiarity with other CEOs of potential buyers and the investment banking community.

BANK DIRECTOR: Are there any other major considerations for sellers in 2006?

Plotkin: We didn't discuss deal structure. As Michael mentioned, valuations are still relatively high and just as important, long-term borrowing costs are still relatively low, even though short-term rates have risen. So the fact is, potential sellers should realize that the window is still open to get high valuations with cash as a form of consideration since the long-term cost of cash is still relatively low. Today, that's a wonderful thing for sellers since there is no better price protection than having a considerable portion of consideration in cash.

Rockett: Also, with valuations where they are right now and cash being readily available, I think banks that have any inclination to sell should seize this moment, because this window may be relatively short. Board members may find their bank standing on the sidelines if they don't get into the proper mode to commence a process where they carefully evaluate and act on their options.

© Board Member Inc. All Rights Reserved