Strategies for Deal Negotiation

Maintaining good chemistry among the directors, the management, the investors, and the professionals is the key to good communication and a smooth deal process.

DAVID BURNS
Partner, Northeast Region Financial Institutions Practice Leader,
Grant Thornton LLP, sponsor

RONALD H. JANIS
Partner, Day Pitney LLP

MICHAEL T. MAYES
Managing Director, Raymond James & Associates

BEN A. PLOTKIN
Chairman & CEO, Ryan Beck & Co.

Based on current stock valuations, is consideration in cash, stock, or a combination of both more advantageous in today’s market?

Ben Plotkin: If you look at the environment today, earnings growth is challenging for most community banks.This means, in many respects, stocks are at relatively high valuations. If a buyer examines its tangible capital and can afford to do a deal with cash, cash consideration is looking very attractive to many sellers. In contrast, if a buyer’s stock is attractively valued, a seller should seize that opportunity. However, I do caution that many stocks are a little ahead of themselves today relative to the earnings growth rate of the acquiring company. One other consideration is longterm capital-gains rates, which, at 15%, look pretty good given there’s consensus that they may be going up again in the future, which would also favor cash consideration at present.

Michael Mayes: I agree, but I’ll add one point. It’s true the earnings outlook for this year and next year is weak, which means both P/Es and valuations have come up. On the other hand, there are situations involving some very attractive companies—with good managements and good fundamentals—whose stocks are considerably off their 52-week highs. I tend to like consideration mixtures, which have become very attractive in this environment. Taking some stock and participating in the growth of the new company going forward is a nice thing.

How should a buyer reasonably look at a seller’s long-term earnings and come up with an appropriate pricing scenario? Take us through the thought processes the board should be going through.

Plotkin: First, it’s important to understand why a seller is selling. If a seller is selling because the board foresees hitting an earnings wall, that is, if the company’s historical earnings trends and asset-quality trends have been much better than what the board sees going forward, then, “Buyer beware.” In that situation, a buyer should model the selling bank, assuming a continued inverted yield curve, and project out the ongoing weakness in the margin and also try to figure out where the asset-quality concerns exist. Valuation of the seller should be established by the buyer using this earnings scenario.

On the other hand, if a bank is selling because of other organizational reasons, such as board fatigue, lack of CEO succession, or to be strategically opportunistic, that’s a much better situation for a buyer.These reasons don’t, in and of themselves, call into question the historical earnings trends.These reasons contrast with the situation where the seller is selling because the board simply sees earnings growth going to nil from a historical 5% to 7%.

Mayes: In my opinion, buyers are doing, and need to do, a lot more homework today than they did a few years ago.The motivation behind why somebody might decide to sell is important. When we’re assisting buyers in their due diligence, we spend a lot of time focusing on the quality of the balance sheet and looking very carefully at asset quality. If a seller has any significant operating history with asset quality, we want to see its performance in different economic cycles. And maybe the most important thing is the quality of management and management succession and looking at how long the current management has been in place. So all these things go into assessing future earnings potential.

I would also say, in today’s environment, buyers are much more focused on budgets, monthly results, and staying on track. During the approvals process, which can take anywhere from four months to a year, you can monitor and track very carefully how your target is performing month to month. I see much greater focus on that in deals going forward.The days when buyers were less concerned about future earnings are long gone. In fact, buyers are almost singularly focused on the earnings capacity over the next three years of the bank they’re buying.

David Burns: Do you see buyers today more anxious to find that next acquisition because they have taken all their gains from their investment portfolios as well as disposed of unprofitable branches, and thus they need new earnings in the future?

Plotkin: Yes, but the question is, earnings at what price? Earnings opportunities exist at every potential seller’s company, and there are also potential cost savings, though those are often a one-time event.The question is, who gets the benefit of these earnings opportunities–the buyer’s or the seller’s shareholders? This is determined by valuation. A bigger issue is, what is the impact on the buyer’s growth rate going forward? Ultimately, that’s how the market is going to price the buyer’s stock. So if a company has an internal growth rate of 5% to 7%, and it’s buying a company that shows a 1% or 2% long-term growth rate, that’s not a very good deal, unless it’s been priced right.

Mayes: There is a very strong focus on growth. It’s true that if you’re growing your earnings at a certain rate, the market looks for you to acquire something that will accelerate that growth in the future, and if you can do better on your own without the acquisition, or if you just get that first-year benefit from cost savings, that’s not going to be viewed long term as an attractive acquisition. It is also true that in various regions of the country, there’s more deal activity. Currently there’s a lot of deal activity in the Southeast and the Southwest, and less in the Northeast and the Midwest. A lot of that has to do with growth rates and prospective growth rates.

Plotkin: There are big differences in regional valuations right now. Look at deal activity in Florida over the last two months versus valuations anywhere else.

In terms of regulatory and accounting considerations, what’s coming down the pike in 2007 that may change the landscape for potential buyers and sellers?

Burns: Well, from a regulatory perspective, one of the biggest issues for the industry today is credit quality. Banking has experienced a long period where credit quality has been good.The economy is now at a point where the loan-loss ratios of many institutions are low. So if there’s a hiccup at an institution, the impact that it has on core earnings is much greater today than it was in the past. In general, the allowance to nonperforming loans is down across the board. Not to generalize, but regulators are seeing in many cases that banks are doing whatever it takes to get the deals done.They are softening their credit underwriting standards to get them done.This is unfortunate, but as a result, regulators are putting more focus on credit quality in their examinations.

Also, because of the flattened yield curve, institutions are going into other service lines, such as wealth management, broker/dealer arrangements, or are getting into a business line that has not been a traditional interest-earning activity for them. As banks venture into these new businesses, the regulators are focusing more of their examinations on compliance and on the establishment of proper policies and procedures, so the regulatory burden is increasing.

Mayes: Given what they’re going through now with respect to credit quality, a lot of banks are saying that their inability to establish appropriate loan-loss reserves in the last few years is contributing to the problem. What is the accounting profession’s position on reserve adequacy? Given that we have business cycles, and these things come around from time to time, is it better for banks to be a little more prepared? Or is it better to take the charges as they occur?

Burns: That’s a great question, because the accounting world and the regulators have been discussing this issue.The basic accounting literature guiding the maintenance of the allowance for loan losses has been established for some time now.The FFIEC issued a Q&A in December 2006 to guide institutions in the proper development of their allowance. So, the days of putting reserves away for a rainy day are gone. Doing so simply is not a GAAP-approved practice, because it involves the recognition of losses in earnings before they actually happen. From one perspective, the banks are not building reserves because they don’t have the excess earnings to do that anymore. But that creates a problem, because as loan balances have grown and, arguably, so has risk, we have observed reserves on average going down. One could conclude that banks are utilizing their “unallocated reserves” provided in the past and allocating them today.That puts a large burden on the accountants to consider whether current reserves are reasonable and adequate and whether the allowance methodology is being applied consistently.

From a regulator’s perspective, asset quality and safety and soundness are very important. Some say regulators would like to see more reserves. So today, documentation has become a key internal control for institutions as they determine the adequacy of their allowances.The institution needs to justify its allowances based upon a number of factors spelled out in the current literature, such as evaluating the appropriate peer information as well as looking at other factors such as the economy and specific lending risks.

Ron Janis: In the late 1980s and early 1990s, banks put a lot of reserves away because they were doing well.The SEC at that time was not so harsh on the issue of whether banks were doing so just to try to manage their earnings. Today, that’s changed, which hasn’t been helpful from the perspective of safety and soundness. So we are in a more difficult position. Some banks are OK with regard to their loan-loss reserves because they have made very conservative decisions about lending, but you also have banks that have lent too much in terms of commercial real estate, and now they are having difficulty. Overall, the larger banks don’t seem to be having that much difficulty. It’s mostly the small and mid-cap banks that are having trouble, both with the regulators and with their accountants, on the loan-loss reserve issue.

Do you feel the due diligence process has been helped by some of the recent regulatory and accounting changes?

Plotkin: In my view, the recent regulatory accounting changes have helped M&A activity. Although it’s been hard for many community banks, there’s more consistency in how loan-loss reserves are treated and much better documentation surrounding everything from tax provisions to internal controls. So from a buyer’s perspective, some level of diligence risk has decreased, because the documentation is all there. So I believe it’s actually taken some of the risk out of these transactions.

We are now entering a new phase over the next few months with enhanced compensation disclosure. Often, our biggest M&A challenge has been figuring out which parachutes and change-of-control contracts are in place. But now we can see all that in the proxy.

Burns: So you’re saying Sarbanes-Oxley is good for M&A activity?

Plotkin: Well, the question with Sarbanes-Oxley has always been not so much whether it’s good, but at what cost—is the cost disproportionate to the benefit? It’s undeniable that there are benefits. It has been disproportionate from a cost and burden perspective. But in terms of feeling better about the documentation and information quality, the financial and internal controls, and the ability to assess those, I believe it’s better.

Burns: I would agree, documentation is better today. And it has reduced uncertainty in target banks.

Janis: Yes, but there’s still risk. I don’t know how much of the risk actually has been taken out, but people think it has been taken out. They think that all the processes people have gone through have somehow eliminated the risk, but I’m not so sure that’s the case.

Plotkin: Actually, I disagree. If a buyer wants to spend the time to look through the documentation, he or she can make a more informed judgment as to the risk, with better information.

Mayes: It is easier today to do a higher quality due diligence than, say, two or three years ago, just because the quality of the reporting is better.The reports have become more reliable and also more compatible from bank to bank.

Burns: Yes, but the one possible flaw I see as we discuss better documentation is that the small public banks are still exempt from the reporting requirements under Section 404. My sense is that many institutions have been waiting and hoping that Section 404 would be repealed and never apply to them.Time is running out for these institutions. And beginning at the end of 2007, they will at least begin to document their assessment, followed by an audit of this assessment in 2008. But this could all change in May 2007, when more guidance on Section 404 is anticipated. Therefore, one could conclude that at some of the smaller-cap banks, documentation may not be at the level of the current accelerated filers. So we will need to be more cautious when we do due diligence at these institutions.

Let’s change the topic to deal negotiations. When a bank is in the exploratory stages of seeking an M&A partner, when do you advise it to pursue an auction?

Mayes: As a practical matter, Ben earlier touched on some of the reasons why banks might consider selling. When you have board fatigue, or you have a company hitting a revenue wall, or you’re faced with enormous upcoming investments in technology or because of regulatory issues, typically boards turn to an investment banker and ask, “If we were to sell, what would we be worth?” At that point, the bank may consider an auction.

Of course, there are different kinds of auctions. In some cases, we’ve seen people put a book together and send it to 100 banks! But that’s not the type of auction I recommend. It’s better to have a more targeted, quiet, behind-thescenes approach. One of the challenges with having a very broad auction is, it’s not going to be too long before everyone knows–which creates a whole host ofdifficult issues for the bank.

At the other end of the spectrum, sometimes banks have relationships with other banks and they’ve gotten to a point where they think a combination would make sense. In that kind of scenario, when you’re bringing companies together to create a new company, there is less of a reason for an auction.

And sometimes you have a third scenario, which is where a large bank approaches a smaller bank and makes a very attractive offer, such that the seller is very interested and excited about it.

There’s a tendency sometimes to take that number, try to improve it, and sell the bank.Typically I would advise a board in that situation that if you’re going to sell the company for a large premium outright, it would behoove you to at least do a market check.

Plotkin: This is where an experienced, well-networked investment banker can help, because often boards ask for a screen of all the potential buyers and then say, “Oh, that’s 15 companies that would consider buying us.” But because the investment banker knows those banks, he or she will likely know that 10 of them, for various reasons, aren’t going to consider a particular acquisition. And maybe there’s only one that would. So the answer to the question of whether you do a limited auction, a broad auction, or negotiate a transaction is fact-specific.The best possible thing is for a board to narrow the universe without ever having talked to a number of those banks.

The second consideration I’d like to bring to the table is that banking is becoming much more like a professional service organization, so it is people-dependent. And the competition for talent is heating up.Therefore, the potential risk of shopping your company too broadly is increased, because there are banks out there literally waiting for your bank to sell so they can lift out your talent. It’s an important consideration. Many boards do not focus enough on it, yet it should be part of every planning process and should be part of the decision about how to market the bank.

Janis: There are clearly two significant downsides to undergoing an auction. Ben has mentioned one, which is what happens when people in the institution know that the bank is going to be sold. Once the word is out about a potential sale, employees become less focused on what they’re supposed to be doing, which causes a problem in trying to drive the institution forward.The second problem may not exist in some regions where there’s a very active market for acquisitions, but in others, like the Northeast, you risk a failed auction, even if it’s only to three or four banks.You may end up without satisfactory bids, or, in some cases, no bids at all.

What are the other risks you face during this phase, and how do you protect against them?

Mayes: There are considerable risks to your customers, your employees, and your share price. But if a bank has good counsel and a good investment banker—people who are very experienced in these matters—they’re going to substantially minimize those risks. Also, because we [investment bankers] are active in this business, we have a good sense of who’s doing what, who’s interested in what, who wants to be where, and who likes this kind of a deal or that kind of a deal. A few years ago I worked on a deal where we were selling a bank that was very clean and had a small loan portfolio, huge deposits, a big investment portfolio—clean as a whistle.Two banks looked at it. The first bank said, “I hate it. It has no loans.”The second bank said, “I love it. It has no loans.” In other words, the investment banker develops a sense of what people are looking for, and that knowledge benefits banks on both sides.

The bottom line is, once you start this process, you may develop customer issues and employee issues. So knowledge and preparation and speed become very, very important. When you try to ensure a smooth negotiation process, what is the number one challenge banks face?

Plotkin: In my experience, the number one issue is that the board, in its preparation for the M&A process, hasn’t reached a consensus in terms of what’s most important. Is it purely a financially driven deal? Are the so-called social issues important only to a few directors or to the entire board? It’s a problem if they haven’t committed to that wish list as a board and don’t have a thorough understanding of the trade-offs in terms of how some of these nonfinancial issues affect shareholder valuation.

To be proactive in an effort to avoid problems, it often comes down to the need for the board to role-play some hypotheticals. For instance, at the end of the day, if the CEO doesn’t have a job at the acquirer but it offers a great valuation, would the board be willing to do the deal? Without candid discussion—and many bank boards unfortunately don’t have candid discussion in the boardroom— the board is going to face some crucial discussions in what may potentially be a time-critical situation.While not insurmountable at that time, it is preferable to work out the tough social issues well before the 11th hour.

Mayes: Preparation is key, and there’s nothing wrong with taking a little more time before you start, including doing housekeeping and looking at things like severance policies, employment contracts, and so on.With respect to negotiation and how things can sometimes break down or get off track, I would say the single biggest problem is when banks don’t speak with one voice.You might have the board or a committee of the board giving instructions to the investment banker as to what is important, for instance, but then you may have a director, or someone in management, having disparate conversations about other issues. So the buyer gets mixed messages, and that’s typically where negotiations come off the rails a bit. And that may happen because the board isn’t fully prepared and hasn’t made decisions about which issues are most important.You’ve got to speak with one voice, and the instruction you give to the buyer needs to be clear and unequivocal, and everyone needs to line up behind it. My experience has been if you have that, you can maximize not only price issues but social issues as well.

Janis: In my experience, the most serious hitch is when the board and the investment banker don’t trust each other.This happens in situations in which the whole process gets started because the investment banker brings in an idea, and the idea turns out not to be based on reality and not well thought out, which can cause enormous problems.There are situations where the investment banker is a good salesman and pushes his idea, but the board doesn’t have any experience with that banker, and doesn’t know whether the idea is credible. More often than not, this leads down dead ends, which is not helpful to anybody.

Mayes: For banks that decide they want to sell, it’s in their best interest to already have a good, close relationship with an investment banker, because trust becomes so important.There are moments during negotiations when you’re talking to a board and if the directors don’t have confidence in what you’re saying, it’s not going to work. In that respect, it’s a very intimate business.The discussions are very sensitive, and there needs to be a good level of trust.

Plotkin: Plus, for most community bankers, their bank is not just a financial investment—there’s an emotional attachment. Face it: If they wanted to be bank stock investors, they’d be bank stock investors, but many of them have worked closely with the customers and with the key executives for years and years.Too often, investment bankers don’t recognize that side of it (present company excluded!) and they come to it purely as a financial transaction. That’s often where the issues arise regarding lack of trust, because they are not looking at the whole relationship involving the individuals in this corporate entity. And it really is a relationship. It’s deep, and it’s wrapped up in their identity in the local community.

Burns: This gets back to the initial point of speaking with one voice. Although relationships may have been developed between the investment banker and the CEO or between the investment banker and the chairman, these two individuals may have different thoughts on the right direction for the institution. And often the entrepreneurial board members may have different interests—that’s the biggest challenge.

Mayes: Right. When the chemistry is good between the professionals, the management, and the board, you generally have the best outcome.

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