The post-recession world has created a series of new challenges for community banks, including declining margins, rising loan-to-deposit ratios and loan concentration issues. The economic climate has made it nearly impossible for banks to work through these issues through traditional means such as organic growth.
And despite what most analysts say, community banks will not find earnings relief when interest rates rise. They will instead find more trouble. Different factors influence the rate of recovery after an interest rate trough, including its duration and depth. Deposit volume and rates, existing loan portfolio half-lives, and the expected economic environment and its impact on loan demand must also be weighed.
Community bank balance sheets have been poisoned by loans that were issued in the last decade, and it will take years—not quarters, as in the past—for a normalization period to change this dynamic. Community bank CEOs and boards have limited strategic options to separate themselves from the pack and maximize relative shareholder value.
Normal organic growth will not give community banks sufficient flexibility to adjust the asset portfolio, with the potential rising costs and declining availability of deposits compounding the problem.
The only way management can substantially restructure their asset and liability base is through acquisitions. However, these M&A deals have to be structured to compliment the bank’s asset and liability strengths and weaknesses, using the proper analytics to evaluate the impact on the bank’s existing capital structure. Loan mix, portfolio maturities, fixed versus floating distribution and concentrations are just some of the factors that have to be taken into consideration in valuing both acquirer and target assets.
Properly analyzed and structured M&A transactions can be a very powerful tool in helping community banks overcome their profitability issues and other limitations. But many community banks are making mistakes when it comes to M&A.
Here are six basic rules that should be followed:
- Don't pay attention to investment bankers spouting multiples-of-book suggestions for how much a bank is worth. These change based on expected market conditions, with multiples declining in strong expected operating markets and increasing in difficult pro forma market environments. Furthermore, every bank for sale has a different value proposition for each individual buyer. This value proposition is a function of how the target’s unique asset and liability mix strengthens and weakens the acquirer’s unique asset and liability mix, as well as its eventual pro forma profitability.
- Don't focus your pre-due diligence analysis on traditional financial and operating accounting statements and extrapolated financials derived from these statements. Traditional financial statements are accounting translations of raw bank data that meet certain required reporting guidelines. While they might be an excellent summary of monthly, quarterly or annual performance, they lack the critical vintage information embedded in different layers of loans that directly affect their pro forma risk, return and maturity schedules.
- Don't wait for deals to be delivered to your doorstep, generally in the form of auctions. The probability of finding the right deal and winning the auction at a reasonable price is extremely low. The time resources that are committed to these unsuccessful and questionable bids can be easily spent in more productive directions. Instead, take a proactive approach that evaluates all banks within the acquirer’s desired geographic footprint, which can be far less time-consuming and far more effective in identifying the ideal target consistent with the bank’s own operating performance and financial strength.
- Do evaluate every acquisition against the baseline of equivalent organic growth and its impact on shareholder value. Without this baseline, even a reasonably accurate estimate of impact on shareholder value is a time-wasting exercise in number crunching. Comparing the value of transactions of different sizes can only be done consistently against an equivalent organic growth baseline.
- Do compartmentalize the value proposition of a target into the value of loans, value of deposits, value of existing excess/deficit capital and so on. Some of these value propositions are directly incremental to the purchase value, such as loan portfolios with their inherent pro forma yields and maturities; others indirectly contribute to value by eliminating operating constraints such as low loan-to-deposit ratios and high commercial real estate concentrations. Categories that contribute to value by eliminating operating constraints have to be evaluated in the context of the bank’s strategic plan and its ability to capitalize on these reduced constraints.
- Do focus on regulatory capital adequacy, both pre-and post-acquisition, to ensure that there are no unpleasant surprises as the target is consolidated into the acquirer’s operations. A fairly meaningful portion of the purchase price can be affected negatively or positively by the target’s existing capitalization.