Bank M&A

Asset Quality Drives Pricing

The M&A market is showing new signs of life but there still is a huge divide between banks that sell for a premium and those that sell at a discount. Steve Hovde, the president and CEO of investment bank The Hovde Group, writes about what factors influence the seller’s value and what a board can do about it.

Name the five most important factors that influence your bank’s value in a sale.

Credit quality and properly reserved loans remain the most important factor influencing your bank’s value. Core earnings historically have been the largest driver of value, but have taken a backseat to credit quality since the Great Recession hit. Also, scarcity value is important. Banks with dominant market share in a desirable location will always command higher premiums from a larger number of suitors. Asset size is a factor as well. Recently, larger banks have been commanding higher values as buyers see volume and scale as the only way to grow earnings. Last but not least, core deposits are important, although of diminished value recently because interest rates are so low.

Can you expand on the first two?

Credit quality is always a critical element in determining a bank’s inherent value. Many of the loans predating 2008 proved to be poorly underwritten. As a result, buyers now are understandably skeptical of—in effect—buying another bank’s lending culture. While most banks that survived the past five years have worked through their problem credits, buyers will still haircut the value of loans and take additional reductions on the selling institution’s portfolio. In fact, a study we have conducted internally demonstrates that banks with non-performing assets to total assets greater than 5 percent tend to sell at a discount to tangible book value while banks with non-performing assets to total assets of less than 5 percent sell at a premium to tangible book value. The second factor—earnings—used to be the predominant driver of value in bank mergers and acquisitions. Buyers regularly would pay two to three times tangible book value if the earnings stream of a seller justified the price. Today, earnings are less important for two reasons. First, if a bank’s credit quality is not clean, earnings will erode over time. Second, banks across the country are seeing net interest margin compression, and there is very little a bank can do to reverse this trend while interest rates remain historically low. A buyer understands that a seller’s core earnings are unlikely to increase in the short-term absent synergies that may result from the acquisition, so there is no reason to pay up for earnings at this point in time.

How will this change in the future?

While I am still a firm believer that the ultimate driver of franchise value for a bank is its core deposit base, there simply is not as much value in core deposits in today’s low interest rate environment as there was when rates were higher. In fact, many bankers will put little or no premium on deposits in today’s M&A environment. In areas of the country with low loan demand, many banks are shrinking deposit portfolios because there simply is nowhere to deploy the funds. That being said, core deposits remain critical to franchise value, and once interest rates begin to rise, they will again be paramount in determining sale value.

What other factors determine a bank’s value?

In today’s mergers and acquisitions environment, it is rare to see a seller receive more than a handful of offers from potential suitors (and often it may be only one or two offers), whereas five years ago those sellers may have received a dozen or more indications of interest. Today, the law of supply and demand is even more important, and if you are a seller in an attractive region with few competitors, there will be more demand from buyers, thereby driving up the price.  Also, selling institutions in healthier regions of the country (i.e., those areas without a supply of failing banks) will command higher premiums because buyers understand there are not as many options to expand.

What can a board do to positively impact the value of its bank?

The board can only control what goes on within its own institution. By cleaning up problem loans quickly and efficiently (taking the medicine early, so to speak), boards can get their banks back on solid footing and enhance value. Many have already done so. Profitability will continue to be a concern as net interest margins compress; however, boards should do whatever they can to enhance core earnings if they are contemplating a sale. Furthermore, scale is valuable, and growing the bank through an acquisition or strategic affiliation (e.g., a stock merger) can enhance overall franchise value. Boards should be exploring these strategic options. Unfortunately, there are scarce opportunities to grow banks profitably through organic means, except in specific markets where loan demand may be exceptionally high.


Steve Hovde