Window of Opportunity

There couldn’t be a better time in banking to make a deal, right? Colossi of the banking industry join in combinations of breathtaking scope. Loan margins are good. Capital is high. The economy is thriving. This is the stuff banking dreams are made of.

But many directors reading this storyu00e2u20ac”whether you know it or notu00e2u20ac”may own part of a bank that is steadily losing value. So despite the fact that record-breaking deals seem to be announced every other week, is the window of opportunity beginning to close?

Several analysts and bank executives interviewed for this story repeated that warning. “For community banks,” says bank analyst Jay Tejera of Dain, Rauscher, Wessels, “it’s a ‘last man out’ phenomenon. Traditional community banks in urban areas should be thinking about their exit strategy, because their franchise value is eroding.”

The same goes for rural banks, says Don Mengedoth, incoming president of the American Bankers Association and president of Community First Bankshares in Fargo, North Dakota. “There

are some rural markets where the owners have already waited too long. If there is not any economic vitality to sustain a growing financial services business, the population is declining, and the Main Street businesses are going out of businessu00e2u20ac”you may have already seen the train leave the station.”

Banks of any size can survive, acknowledges banking analyst Jean-Luc Servat of Hoefer & Arnett. “But some are definitely experiencing a loss of franchise value,” he says. “If you are in a major market and have a combination of retail and commercial business, you are probably having a hard time…. A lot of banks are being left by the side of the road.” Many larger buyers are pursuing MacArthur’s island-hopping strategyu00e2u20ac”they just ignore targets that are not large enough. “They would, frankly, rather let them die.”

As Betsy Cohen, founder, chair, and CEO of Philadelphia-based JeffBanks explains, “It is not that 90% of the banks won’t be thereu00e2u20ac”but they will languish, which, vis-u00c3 -vis shareholder value, is not the best thing.”

These are sobering thoughts in mind at a time when many directors are considering their own banks’ strategy for mergersu00e2u20ac”and long-term survival. In general, financial institution deals are separating into two markets. Big banks look at deals with other big banks, and community banks eye other community banks, while the middle market is disappearing. “We are starting to see that long-feared barbell of really small and really big banks,” says Christopher Quackenbush, head of investment banking for Sandler O’Neill & Partners. “Most combinations are of like size. Unless a target bank is 20% or so of the acquiring bank’s assets, it’s not important enough for them to really focus on.”

After a decade of consolidation, the top 100 banks, Tejera notes, now control more than 90% of the assets in the industry, up from 70% 10 years ago. But beyond that basic, widely agreed-upon picture, there are other patterns taking shape.

“It gets down to the old buy vs. build question,” says Tejera. “For years, ‘build’ was almost always more expensive. But that is changing. Only half of bank transactions are in a bank branch now. Plus, two or three banks are almost big enough that they can justify national advertising, and a lot of banks can justify heavy regional advertising. All that is changing the equation. They can just advertise and capture customers, instead of buying them. That’s a tectonic change in the industry.”

Several experts stress that banks involved in mergers for stock should look not at the dollar price, but at the percentage of ownership they will wind up with in the merged bank. As Quackenbush puts it, “If you bring 20% of the earnings to the table, and wind up with only 15% ownership, you ought to at least understand why. Figuring the ‘has/gets’ on the back of a napkin is key, as a gut checku00e2u20ac”’What do I has, and what do I gets?’” Earnings, capital, deposits, and loans all play a part, he adds, but earnings is the most important element.

Cohen, who has been involved in a number of community bank acquisitions as head of JeffBanks, says community banks are more willing to sell now than they were a few months ago, if they think the local mission of their banks can be continued. She says directors of small banks increasingly realize that the window may be closing, and so are more realistic about the size of the multiple they expect. Over the years, Cohen asserts, premiums have consistently been about one-third of the acquirer’s book value. That is, an acquirer whose stock is trading at two times book will pay 2.3 times its book to buy a bank, and an acquirer trading at three times book will pay 3.3 times. The market is settling back to that range, she says, “so the rest of us can make more rational acquisitions now. Our bank stayed out of the market for two years, except for one deal, to let this madness pass.”

And yet, she warns selling banks to evaluate acquirers carefully. That includes not only analyzing measurements like earnings and capital, but also fully understanding the basic mission, compatibility of customer bases, where managers will wind up, and all the other human aspects of the business. “Very rarely is the price the major determinant. It’s how all the human aspects work. It’s like finding somebody with a dowryu00e2u20ac”but ultimately you have to marry them.”

Community banks will survive, and many will prosper. Those in urban markets will need to develop specialties, such as doing only small business lending, or SBA lending, or finding similar niches. Many will try retaining a degree of local autonomy while becoming part of a larger institution. Larger banks such as Regions Financial of Birmingham, Union Planters of Memphis, and Zions Bancorp of Salt Lake City have a strategy to acquire community banks, generally retaining local decision makers and using their combined size to offer extra products and effect savings in areas such as data processing and other back-office functions. The formula is the same for the bank of ABA President Mengedoth, who says the ideal target for Community First Bankshares is a $150 million bank in a community of 10,000, in an 18-state area in the Midwest or West. In fact, the bank started with 21 small community banks that were being sold off by Mengedoth’s previous employer, First Bank of Minneapolis. Community First raised money through venture capital and junk bonds in 1987. The contrarian philosophy paid off. Mengedoth says after the bank went public in 1991, the original investors gradually sold off, all getting more than a 25% compounded annual return.

Tejera predicts the 400 publicly traded larger community banks like those above will eventually buy the remaining 7,100. Part of such buyers’ strategies, he says, is to grow big enough to eventually be bought by one of the giant banks.

Nonsense, says Harris Simmons, president and CEO of Zions.

“Size is a disconnect,” he insists. “We have no particular size goal at all. We don’t think about it, we don’t talk about it. Our strategy is to create value, and you can do that as a small bank, or a shrinking bank, or by growing into a larger bank…. I liken it to the restaurant business. Think of a good Italian restaurant in your hometown. Why wouldn’t Olive Garden [a chain restaurant] be the first name? It’s because it is notoriously difficult to create high quality on a massive scale.”

Despite the optimism of buyers like Zions, and the general feeling that the community bank structure will survive national consolidation, there are critical issues on the table for directors of community banks. They must keep up with the high cost of regulatory compliance and technology. They bump up against lending limits for their best customers. And current growth rates will be hard to maintain, according to Servat of Hoefer & Arnett. “The megamergers definitely created opportunities for independent banks to move in and get seasoned business,” he says. “But you’ve got to assume, pretty soon, that’s going to stop. In California, the rallying cry has been, ‘We’re not Wells Fargo.’ That’s fine, but at some point, Wells Fargo will get its act together and stop bleeding customers.”

Another concern, according to Bill Kacel, national director of the community banking practice for Deloitte & Touche, is that the real competition is not the huge banks, but the credit unions and brokerage firms.

Add to that the large-scale worries about the economy and when banking will return to the credit cycle. As Servat says, “When a slowdown comes, independent banks are more affected. They’re like oysters in the bayu00e2u20ac”they typically get hit first when the water quality goes down.”

In short, despite the historic boom and flush times in banking, directors have plenty of reason to buckle down and give serious consideration to their long-term M&A strategy. For all but the largest companies, the window of opportunity may indeed be narrowing.