Evaluating Strategic Opportunities

Deposit growth is the name of the game, and banks of all stripes are canvassing markets to find pockets of opportunities to buy or build additional market share.

ARTHUR L. LOOMIS II
President, Northeast Capital & Advisory

JAMES M. ROCKETT
Partner, Bingham McCutchen LLP

JEAN-LUC SERVAT
Managing Director, RBC Capital Markets

DORY A.WILEY
Managing Director, Samco Capital Markets

What considerations should come into play when a potential buyer is evaluating a market or region?

James Rockett: Regardless of the objective in entering a new market, the most important thing is finding the right people. If you don’t have the right people in that marketplace, then other objectives are meaningless. So that should be the primary focus.

Jean-Luc Servat: I would agree, but I also think that looking for growth is an important element. You need to look for a good market that is of a size that the opportunities are not going to dilute the acquirer’s growth potential.

Rockett: But even in a slowgrowth market, if you have the right people, you can outperform the market.

Servat: Absolutely, as you say, it’s essential. If you don’t have the right people, it doesn’t matter where you are.

Arthur Loomis: Banking is a people business—that is the key ingredient for success. People are in charge of the execution—not machines.

Dory Wiley: We’ve all seen instances where you question whether or not a bank ought to put in a branch, because of the market, or the location, etc., but if they have the right people, they can still make it work. If that’s 90% of the equation, the other 10% definitely needs a hard look. What are the demographics? What’s the branch penetration per population? Who are the competitors? How do they price their products? How does that fit in with what you’re doing? All those things are really key, but in the end, I agree, 90% of it is who you hire.

Servat: I come back to this notion of growth because investors today are relatively skeptical about people who are launching new initiatives.There have been plenty of times where people launched into markets that simply haven’t been that great.You must ask yourself what you bring to a new market other than just being a new entrant. Does your approach work? Those things are critical.

Loomis: First Manhattan Consulting Group has done many studies on new branch initiatives to determine what’s been successful versus unsuccessful. Researchers there looked at demographics as a factor to determine whether it was the dispositive element, and they concluded that what really made the difference was prior success with de novo initiatives. If you have a footprint that works, you can use it again and again and again.

Servat: That’s a very good point, particularly because we think of expansion mostly in terms of acquisitions, but the ability to execute expansion well on a de novo basis and be able to transfer your model is essential to real value building.

Rockett: Whether it’s a growth market or a slow market, location becomes very important. Consider a good market such as California–more specifically, the dynamic Sacramento market.Those banks are doing well because they’re in the right place, and other banks aren’t doing well, even though it’s a great market, because they’re in the wrong location. As an acquirer examines a target for its ability to contribute to the bottom line, evaluating the location and existing market penetration is very important.

Wiley: And that location has to say “convenience.” Otherwise, how are you going to get customers in there? You’ve got to drive branch traffic.

We keep hearing that deposit generation is the real key. How do you evaluate a market for potential deposit generation?

Loomis: The way we do it is to zero-in on the most valuable types of deposits as opposed to just deposits as a broad category. Traditionally, the most valuable deposit category is non-interestbearing or DDA accounts, which provide returns approximately eight times the magnitude of CDs or even traditional savings accounts.We’ve found that small-business banking on the commercial lending side can drive a fair amount of deposits if the lenders are astute and ask for the deposit relationship, which in turn will self-fund all the bank’s lending activity.That becomes the niche.

The other factor we’ve looked at is the fact that the best deposit customers in thrifts are growing older. If you look at an age profile of the largest deposit accounts in thrifts compared to commercial banks, 50% to 80% of the total deposits in the bank will likely be gone within the next 10 to 20 years. So there’s a real threat with respect to losing deposits, which argues for having or creating an asset management or wealth management function in order to grow or retain deposits.

Does anyone else have a different take on that?

Wiley: Deposit generation is the name of the game.We’ve seen deposit growth slow in the last couple of years; it’s down from 2004, when it was at a high of 8.2%. Now it’s 4.3%. When you look at multiples over the last five years, the price-to-book ratio has gone up 36% on average, but the P/E has gone up 44%.That’s 30% more earnings in the industry. If you add that in, prices are up 57%! So they’re paying a lot.

When you look at multiples on deposits, it’s even more evident, because core deposits are decreasing. Finding those core deposits is key, and obtaining them starts with the non-interest-bearing accounts. Banks with key strategies that focus on that aspect are going to do better than others over the long run.

Loomis: But admittedly, in the spirit of Woody Hayes, it’s “three yards and a cloud of dust” to get those deposit relationships.There’s no magic bullet.

Wiley: It’s service, just service.

Loomis: Picking up on another comment of Jim’s when he was talking about location, the other thing that affects considerations on market expansion is the scarcity of properties to buy, which may be influencing some of the statistics Dory mentioned. It’s unclear whether or not we’re going to see prices start to fall, because most of the really valuable properties have been acquired. But anytime you’re looking into a new market, the question you have to ask is, who is the premier provider in that marketplace? Can you purchase that organization? If not, is there anyone else in that market that holds allure to you?

Rockett: I want to point out that banks have to consider the fact that non-interest-bearing deposits may be short-lived, because the Fed could very easily revise its current regulations and permit interest-bearing corporate accounts.That issue has been examined for some time, so now is the time for banks to think strategically about how to develop alternatives to reliance on noninterest-bearing deposits.

Servat: You’ve got to look long term, because the classic business funding model, where business customers provide 30% to 40% of their own loans to the bank, will come to an end at some point. We’ve talked for some time about the demise of cash management systems, and I think that is starting to occur now, with the environment in which we’re operating. Look at what’s happened on the Internet with regard to deposit generation—whether it’s ING or Citibank or others.They can generate a substantial amount of deposits, albeit at fairly healthy costs, but because of that, many independent banks are at a significant disadvantage in that world.

Wiley: That’s a very good point. It’s getting tougher and tougher to build commercial bank deposit franchises. But the question becomes, how valuable are those in a sale? Because if a large bank buys them, it’s going to look at how many products it can drive through the system, so a larger bank’s perspective tends to be more consumer-oriented.The question then becomes, how do you drive low-cost consumer deposits? You’re going to have to get creative by using tiered systems that are timed to certain objectives. Some banks have been very successful; others are just pure storefront ideas. Umpqua Bank, for instance, showed “March of the Penguins” in the bank on family movie night. The Wall Street Journal ran an article recently describing how Washington Mutual offers a play area for children.The article said Wamu gained 900,000 (net) new checking accounts in 2005 that the bank attributed just to the children’s area!

Servat: But those are fairly large banks with recognizable names.The problem for a lot of banks is they don’t have that type of brand appeal, so finding a retail strategy that works is a real challenge.

Wiley: But larger banks have a lot of those same challenges. They’re finally starting to realize they can’t just buy a small-business bank and make it work by setting up a young loan officer with a laptop.They need a senior person with a handle on those business relationships—that’s what small businesses want. Otherwise, they end up not retaining the business.

Rockett: Among community banks focused on small businesses, there’s a gradual evolution occurring concerning the manner in which they accommodate customers’ needs—especially on the relationship side. As these community banks, which stress hands-on contact with their customers, grow and merge into larger institutions, gradually they take on the characteristics of larger institutions. Eventually they become a supercommunity bank, and that type of institution becomes very attractive as a target for a larger institution.

Servat: The tough part is that many community banks have relied on the mistakes of larger players to get ahead. Increasingly, though, they’re faced with large players that really know what they’re doing. So it’s become more difficult to build their businesses that way.

Rockett: Having worked inside an organization like First Interstate, I can say that no matter how carefully larger companies attempt to assimilate the businesses they acquire, when integrating a community bank in the $1 billion to $10 billion range, they face some real challenges.The people who have cemented business relationships inside the community banks generally drift away and don’t want to be part of the large acquirer. So I think there will always be a healthy competitive opportunity for community banks. And, as I say, I view this as kind of an evolutionary process for community banks, in which they can combine with each other and still retain much of their competitive nature.

What other challenges are community banks facing that might affect M&A this year?

Wiley: Over the next 12 to 24 months, along with figuring out how to bring in consumer deposits, community banks will need to look for commercial loans to increase the value of their franchises. It’s going to take more than crayons and lattés to pull customers in the door in the face of a declining rate environment.The Fed finally paused in August 2006 after approving 17 rate hikes. So all signs tell us that rates are coming down—we just don’t know when. When that happens, deposit competition is going to get even tougher. Consumers will start looking for higher yields and before you know it, you’ve taken an already difficult deposit competition situation and lit a fire to it.That, along with the excess capital in the system and the fact that investors aren’t going to get the returns they want, is going to put a lot of pressure on boards to sell.

Loomis: There’s a confluence of challenges with respect to deposits and decisions about what kinds of business lines make sense and how to deal with margin compression.

Staff expertise is another challenge. Can banks offer an appropriate level of compensation to get the employee sophistication they need to advise customers who are gravitating away from DDA accounts and toward interestbearing accounts?

I’ve always felt that community banks have the trust of the customer, so if they know what to recommend and how to advise the depositor, they will retain those customers. And customer retention brings greater opportunity for profitability in the organization, whether it’s from noninterest income or just business retention, and it’s certainly better than watching customers flock to the larger money-center banks or superregionals.

Wiley: You have a great point. It just boils down to pure capitalism—supply and demand. If I’m a small-business owner, can I get the service, rates, and everything I need from a large bank? If not, then I’ve got to go somewhere else to get it.

This sometimes creates opportunities for small banks. Just look at all the de novos that are going up. Part of the reason we’ve seen so many de novos is not just because investors are throwing money at them, but also because there’s a lot of good management and talent out there that knows how to build solid, serviceable relationships with customers.

Which is where Jim started our discussion—having great banking talent is absolutely critical.

Wiley: Right.

Rockett: I’d also like to add that one of the most significant influences on selling right now is fatigue. It’s fighting the competition, fighting the economy, and having aging boards with directors who don’t want to go through another down cycle and who also have no succession plan for management. All these things lead to overwhelming fatigue that causes some bankers to say, “The time is right to exit the business.”

Given the challenges you just presented and the fact that it’s a very tough environment right now, with margin compression what it is, how do you counsel boards to help them find opportunities with particular business lines or fee income?

Servat: There are a limited number of options for banks right now. Insurance still works for those that know how to target it properly, because it is a natural extension of the banking business. A good commercial insurance agency in some markets can really bring strong business and good fee income. Factoring has worked for some. I believe that staying with businesses that are natural extensions of banking makes the most sense.

Loomis: SBA lending has been very successful, as has mortgage banking.

Servat: However, with the mortgage business, I think the long-term viability is debatable. For independent banks, there are not a lot of great options out there.

Loomis: Do you all believe that the model that works best is to buy a platform organization in whatever field of endeavor for noninterest income you are interested in, and then leave it alone?

Rockett: The best model is as you just described it. Find a target that really has its arms around a particular strategy, and try to leave it alone. But the buyer must demonstrate an ability to monitor the new business sufficiently and intelligently and to make sure it’s going to perform in the expected manner. A lot of banks have stubbed their toes because they haven’t been able to accomplish the second part of the equation.

Loomis: Sometimes when they buy that platform, they think they’re buying a complete platform, but it doesn’t have the professional management team built in.That’s a risk.

Wiley: Consider it this way: If you’re building franchise value and you’re trying to enhance revenue by driving products to your customers, shouldn’t the eventual acquirer of the franchise look at it the same way? But in some cases it seems it can almost detract from franchise value versus adding to it, because sometimes the prospect of being able to drive products is more valuable than actually doing so. That’s one observation I have.

Furthermore, I agree with everyone on the risks of these noninterest businesses—all of them tend to be cyclical, especially the mortgage business. It’s really tough. How can anybody be more cost efficient than Wells Fargo? For community banks, that is just not going to happen.

There are many situations where selling may be the most viable option. So when boards are ready to make a deal, what advice can you offer on how to present the business case for shareholders so it makes sense?

Rockett: Frequently, too much emphasis is spent on getting the deal negotiated and announced, with very little emphasis on how to present it to shareholders and prospective investors. My view is that you need to state the business case simply and intelligently. Also, don’t build in any unrealistic assumptions, because investors hate unrealistic assumptions.

Finally, it seems to me that often there is almost no effort spent on showing the upside of a transaction. Bank of New York and Mellon did an extraordinary job of selling this point to investors [in their Dec. 2006 deal], which makes it a great case study in proper investor relations.

Servat: One important thing is to act as an investor yourself. If you take that view from the start and then stick with it, you should be able to convey your reasons for selling to the marketplace.

Wiley: And you not only have to think like an investor, but regardless of the deal, you have to actually do the research and say, “What is the market perception of my bank right now?”You have to know that, because there is always a little market buzz going around—like “good management,” “good job,” “great business model,” etc. So you have to know what the market’s perception is. Or the buzz can sometimes be negative: “They screwed up that last deal,” “They don’t have any credibility,” and so on.You’ve got to know what that buzz is and you have to address that buzz in your deal and turn it into a positive. Your response could be a statement like,“Well, when we did a deal four years ago, we made some mistakes and here’s the reason why, and this is why it won’t apply this time”–that type of thing.The market loves honesty, and that’s how you build credibility.

Loomis: Another thing you can do with respect to getting the public to reward the vision of the acquisition is to discuss how the target fits into the strategic plan—its strengths and weaknesses—and how it rose in priority among all targets, and why.That helps to focus things on the positive as well. It’s a technique that helps describe the transaction in a way that highlights what will be magnificent about it.

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