With loan quality generally viewed as benign while M&A activity continues into 2019, is any emphasis on credit due diligence now misplaced? The answer is no.
With efficiency driving consolidation, bank boards and management should not be tempted to take any shortcuts to save time and money by substituting credit quality through recent loan reviews and implied findings of regulatory exams.
The overarching reason is the nature of the current business and credit cycle. The economy is strong right now, and among many banks net recoveries have replaced net charge-offs.
But it is not a matter of if but when credit stress rears its head.
And time truly is money when trying to stay ahead of the turn of the credit worm. That means now is the time to highlight a few buy- or sell-side justifications for a credible M&A credit due diligence.
Some challenges always require vigilance. These include:
- Heightened correlated lending concentrations
- Superficial underwriting and/or servicing
- Acquired third-party exposures through participations or syndications
- Insider lending (albeit indirect)
- Getting upside down on commodity or collateral valuations
- Covenant-light lending
- Credit cultural incongruity
New Risks, New Assessments
The emergence of a portfolio-wide macro approach to credit risk during the past decade has ushered in a flurry of statistical disciplines, such as calculating probabilities of default, loss-given defaults, risk grade migrations, and probability modeling to project baseline and stress loss credit marks for investors and acquirers.
Credible due diligence now provides rich assessments of various pools and subsets of loans within a target’s portfolio. These quantitative measures provide a precise estimate of embedded credit losses, in parallel with the adoption of the current expected credit loss (CECL) standard, to project life of portfolio credit risk and end deficiencies in the current allowance guidance.
Good credit assessment is capped by qualitative components. There are several factors to consider in the current credit cycle.
- Vintage of loan originations: Late-cycle loans to chase growth goals or to entice investors carry higher risk profiles.
- Exotic lending: Some banks have added less conventional loan products to their offerings, which may require specialized talent.
- Leveraged financial transactions: For some banks, commercial and industrial (C&I) syndications have replaced the real estate participation of a decade ago. They have recently grown in leverage and stress, and would be susceptible to an economic downturn.
- Hyper commercial real estate valuation increases: Recent studies have shown significant increases in commercial property values, well over the pace of residential 1-4 family properties, along with the headwinds of higher interest rates and the advent of diminished real estate requisites accompanying the tech-driven virtual marketplace.
- Dependence on current circumstance as proxies for future credit quality: We must accept that we are affected by trailing, rather than by leading, credit metric indicators.
- Lending cultural protocols: Knowing the skill sets and risk appetites of prospective teammates is imperative. Some would argue that in today’s consolidation environment, cultural incongruity trumps loan quality as the biggest determinant of success.
What Should Lie Ahead
Credit due diligence should provide a key strategic forerunner to the financial and cultural integration between institutions that might have disparate lending philosophies.
It should include an in-depth quantitative dive combined with a skilled assessment of qualitative factors, both of which are critical in providing valuable insight to management and the board. Yet, to reduce costs some have difficulty swallowing any in-depth credit diligence, given the de minimis nature of recent losses and low levels of problem loans.
Many economic indicators point to tepid economic growth in 2019. At some point, the current credit cycle will turn. A lesson learned from the financial crisis has been to be proactive in risk management to stay ahead of the risk curve—and not be left to be reactive to negative effects.
During the crisis, many banks suffered greater losses due to their reluctance to initiate remediation in response to deteriorating credit. M&A credit due diligence must be treated as an anticipation of the future, not a validation of the past, and an investment in curtailing future losses.