Since the financial crisis, investors have looked at falling stock prices following a merger and not been pleased.
While the mixed results of M&A transactions in general have long fueled investor skepticism, banks have fared worse than buyers in other industries since the financial crises.
There are many reasons for the negative reactions that we have seen. For instance, investors remain focused on tangible book value and have imposed harsh penalties on those acquirers that cannot illustrate the ability to rapidly earn back dilution. In general, investors have a low level of confidence in the earnings power of the industry and thus have a low tolerance for acquisition-related risks.
The current operating environment, characterized by declining net interest margins and increasing operating expenses, is causing bank boards and bank stock investors to re-evaluate M&A for a number of reasons:
- Cost savings from merger transactions are one of the few ways to grow earnings in the current rate environment.
- Credit related purchase accounting adjustments are gradually decreasing.
- The rally in bank stocks since post-crises lows has made stock buybacks less attractive versus reasonably priced M&A.
- Earnings per share accretion can help to maintain dividend levels.
- The demise of the serial acquirer has reduced seller options.
While circumstances are right for investors to view bank M&A in an improved light, we do not expect to see widespread investor acceptance of high market premiums. As a result, boards need to study the potential benefits of stock-for-stock mergers that are reasonably priced and often include various nonfinancial aspects.
Banks should not use the “merger of equals” or “strategic merger” labels. The MOE label has been used to describe transactions with a wide variety of financial and governance characteristics causing much confusion in the market. Using the MOE label will make it more difficult to explain a transaction to the market. Similarly, we think using the word “strategic” can imply that the financial merits of the transaction are lacking and can create ammunition for investor criticism.
By their nature, stock-for-stock mergers are based on the potential long-term value created by the combined company and do not constitute a change of control as defined by relevant case law. As long as a board has gone through an appropriate process to evaluate the benefits of a merger transaction versus other options there is no need to further define the transaction as anything other than a merger to shareholders.
Boards should study past merger deals (no matter what they were called) to gain an understanding of the many ways to balance financial and governance considerations. However, the presentation of the deal to the public must be sensitive to investor expectations that are shaped by the current operating environment and not just what has worked in the past.
The following suggestions can assist the board in structuring a merger that will win over shareholders:
- The exchange ratio must produce financial benefits to both sides.
- Cost savings estimates should be simple to explain and understand. An acceptable estimate of merger-related savings will be in a range of 5 percent to 15 percent of combined expenses.
- Be prepared to explain why the merger is better financially than simply buying back stock or increasing the dividend.
- Proactively explain the impact of purchase accounting adjustments on pro forma financial estimates.
- Evaluate the risk of the transaction being “jumped” by an interloper when negotiating the financial and governance deal terms. Investors will be more demanding regarding the financial benefits if they perceive that a materially higher initial premium is available.
- The exchange ratio may in fact result in a market premium to one side. However, the perceived buyer cannot be seen as paying a full premium while also granting significant governance concessions and the perceived seller can’t be seen as accepting a lower price in order to save management jobs.
- Governance issues such as board splits, CEO succession and senior management roster must be conducive to a smooth integration. Investors will criticize complicated power-sharing arrangements that can hinder post-transaction performance.
- Minimize the jargon around the strategic benefit.
- Keep in mind that many of the best banks in the country based on long-term shareholder returns have gone through at least one significant and successful merger in their history.
- Be careful not to create a written record that can be used against the bank. Avoid exchanging term sheets as a means of negotiating.
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