How High Interest Rates Changed Bank M&A

The few banks that are doing deals are increasingly focusing on an important financial metric: the fair value discount.

The mechanics of bank M&A, which includes assigning values to the seller’s assets, have made it harder for buyers and sellers to agree on a price in this new rate environment. But the fair value discount can boost the earnings power of the combined institution due to how the income is recorded in earnings.

“If you think about M&A, it’s like a balloon: I can push it one way and it’s going to come out somewhere else,” says Rick Childs, a partner at the public accounting, consulting and technology firm Crowe LLP. “The first thing I push is that I’m creating a lot of goodwill and dilution with today’s [deal price]. I will, however, get a number tomorrow that’s going to be beneficial to me — it’s just going to be slower [than the Day 1 dilution]. And depending on how [big] the discount is, you might get a nice bump.”

As part of due diligence, bank buyers revalue all a seller’s loans and securities for their credit quality and market value and incorporate those valuations into the purchase accounting adjustment that makes part of the deal price. Figuring out the fair value of interest-bearing assets and adjusting the yields often means assigning discounts to assets that carry interest rates below current market rates. 

This purchase adjustment, driven by fair value discounts, can be a lucrative benefit to a buyer if the asset pays off as expected — such as a bond that’s lost value as rates have gone up. A bank records the difference between an asset’s market value and its par value as accretion income in its earnings — a benefit that comes at the cost of more goodwill and dilution recorded on Day 1 of the acquisition.

In a recent deal that illustrates this, Boston-based Eastern Bankshares announced in September it would acquire Cambridge, Massachusetts-based Cambridge Bancorp, which had $5.5 billion in assets in the third quarter. The fair value marks in the $528 million deal totaled $585 million pre-tax, which the pro-forma bank will recognize over seven years. Eastern, which had $21 billion in assets in the third quarter, expects fair value accretion income to be $63 million in 2024, according to the deal presentation. 

The accretion income helps the Boston-based earn back its 7.5% tangible book value dilution over a period of 2.75 years. It also expects 2024 earnings per share to grow by 20% or more. Eastern Bankshares Chief Financial Officer James Fitzgerald called the dilution created by the rate marks “temporary” during the bank’s investor call, since “it will be accreted back into net interest income over the life of the assets.”

“The lower asset yields that Cambridge is living with today will be gone at closing and there will be an immediate, sustainable increase in net interest income that will benefit” the pro-forma bank, he said. 

Shares of buyer Eastern Bankshares were up 3.5% the day after the deal was announced; shares of Cambridge were up 6% the day after announcement. 

Investors know discounted asset values can lower the overall value of a selling bank, widening an already-sizable chasm when it comes to price expectations between buyers and sellers. A buyer may hesitate to pay a premium for a seller’s assets that they have to discount, since that can lead to larger dilution. Plus, the boards of banks selling their institutions may be miffed at the idea of accepting a lower price. 

Valuations on some of the largest deals in 2023 have already begun sinking below medians recorded in recent years, according to a Nov. 14 article from S&P Global Market Intelligence. The median deal value to tangible common equity was 122.6% for 2023 announced deals; it was 153.9% in 2022 and 161.3% on the 53 deals in the fourth quarter of 2019. The deal for Cambridge Bancorp valued the bank at 114.5% of tangible common equity. There have also been transactions with deal values that were priced below the seller’s TCE and book values. 

One was the October announced acquisition of $1.1 billion Community West Bancshares by Fresno, California-based Central Valley Community Bancorp for $99.4 million, which was 88% of the seller’s tangible common equity. The all-stock deal carries a tangible book value dilution of 18.7%, which the $2.4 billion bank expects to earn back in 2.4 years, according to the deal presentation. The purchase price includes a 7.8% interest rate mark on Goleta, California-based Community West’s loans, which will contribute to the 42.5% EPS accretion in 2025. 

Community West shares fell 2.9% on the first trading day after the announcement of the low-priced deal. But Piper Sandler & Co.’s Managing Director Andrew Liesch says that management was prepared for the initial reaction and stressed the earnings power that would come from combining the two banks. The transaction will boost the pro forma bank’s return on assets by about 50 basis points to 1.6% and return on tangible common equity by 600 basis points, according to the deal presentation. 

“It was a pretty big negative reaction right away. But Central Valley investors looked the next day at the earnings accretion that’s going to come through — for their shareholders, this should be good,” he said. “And in theory, Community West’s shares should now trade in lockstep with Central Valley’s.”

Indeed, shares of Community West were up 13% in late November.

Timothy Coffey, managing director and associate director of depository research at Janney Montgomery Scott, wrote in an Oct. 11 report about the deal that, “In our opinion, both deal pricing and the impact of fair value marks reflect the cost of doing M&A in the current interest-rate environment. It also requires, in this case, that investors put their thinking-hats on to recognize the potential benefits of the pro forma [b]ank.” 

That kind of thinking in board rooms and among investors — and a willingness to make trade-offs — may be necessary for more deals to get off the ground.