The Market for M&A in 2009: What Happens Next?

David Payne has been eager to expand his banking franchise with a deal for a while now. The chairman and CEO of Westamerica Bancorp in San Rafael, California, just north of San Francisco, built his $4.1 billion company through a series of acquisitions in the 1990s. His last deal was in 2004. Since then, Payne has kept tabs on a list of 25 community banks, communicating regularly with many of them. While some have occasionally expressed interest in partnering up, the asking prices have always been a little too dear for his taste.

The credit crisis has changed that, and then some. California has been hit harder than most markets by the historic drop in housing prices. Banks everywhere-even those that weren’t mortgage lenders-are struggling as troubles reverberate through the economy. Some face bleak short-term prospects, and could fail. Tales abound of tired, stressed-out directors who want out.

All of that has more bankers reaching out to Westamerica, a commercial lender that has remained profitable through the crisis. And they’re no longer seeking outrageous premiums for their franchises. “We have a considerable number of active conversations going on right now, and the negotiations over pricing have seemed fairly reasonable,” Payne says. “Sellers’ expectations have come in substantially.”

Payne says he’s happy to finally see “some potential opportunities to build the franchise.” Even so, he isn’t promising to do any deals just yet. Prices drop for a reason, and in the chaotic world of banking, circa 2009, asset quality and capital woes, not to mention the prospect of a long recession, are the stuff of high anxiety. For sure, there are bargains to be found, but also some ticking time bombs. Acquiring in this environment is tricky business. Do it right, and the bank could be poised for future growth when the economy rebounds. Do it wrong, and the board and management could be haunted for years to come.

And so Westamerica’s board is moving with extreme caution, conducting ultra-intense due diligence, and not being shy about walking away -or at least waiting a bit longer to see how things play out -if it concludes that balance sheets don’t measure up. “Especially in this environment, it all has to make sense economically,” Payne says. “Nobody wants to buy someone else’s problems.”

Variations of Westamerica’s story are being told with greater frequency around the country. For years, the lament of wannabe acquirers was that sellers’ asking prices were too high. That’s not always the case anymore. Bank stocks are battered-the KBW Bank Index recently traded at 70% off its early-2007 highs-and a sense of morbid reality about the short-term future has taken hold.

Whether or not it will have a significant impact on M&A volumes in 2009 remains to be seen. There’s too much uncertainty-about the economy, asset quality, housing prices, capital availability and more-for anyone to make anything more than an educated guess. What is sure is that the present environment has made this gut-check time for boards on both sides of the M&A equation.

Directors of some banks in relatively strong positions are being presented with once-in-a-lifetime chances to leapfrog several stages of development and potentially emerge from the mess bigger and stronger than when it began. The question is, how much additional risk are they willing to take on to claim that reward, and will the ability to buy something on the cheap pay off over the long haul?

Board members of potential sellers, meanwhile, are faced with some painful decisions. Many have messy balance sheets and are running low on capital. Even if they’re not in immediate peril, the future might look shaky. Those directors must check their emotions at the door, dig hard into their own numbers, and make an honest assessment of whether or not there’s a strategy in place to fight through the mess that makes sense for shareholders. If not, then the task of finding a buyer and winding things down might be next on the agenda.

“They might look at each other around the table and say, ‘Look, this was a great ride, but we’re in for a very challenging two or three years. We’ll be working harder than ever over that time, and when it’s done, we might not have anything to show for it,’” says Stephen Nelson, a principal with Hovde Financial LLC in Inverness, Illinois. “‘Given all that, we might be better off just selling now.’”

The credit crunch that got its start with subprime mortgages and has since spread throughout the entire system has decimated banks large and small. Prices for real estate, still the collateral of choice for most loans, have fallen sharply in many markets. In the third quarter, 24.1% of all banks and thrifts lost money-the highest percentage in nearly 19 years, according to the Federal Deposit Insurance Corp.-and a potentially jolting recession appears to be picking up steam. Comparisons to the Great Depression, which once sounded like hype, now feel uncomfortably close to the mark.

“In all honesty, it really doesn’t get any tougher than this,” says Rick Maples, co-head of investment banking and head of the financial institutions group for Stifel, Nicolaus & Co. in St. Louis. “We’re in new territory here. No one alive today has seen anything like this.”

The distress is driving an almost-surreal pace of change in the industry, some of which is reflected in the M&A figures. Uncertainty made 2008 a dud of a year in terms of deal volume-through November, just 153 deals were announced, compared to 317 in a 2007, according to SNL Financial in Charlottesville, Virginia-but it wasn’t lacking for fireworks. More than 10,000 branches were sold, nearly three times as many as in 2007. And while deal values slumped to half of what they were-$37 billion, versus $74 billion in 2007-a whopping $1.3 trillion in assets and $1.2 trillion in deposits changed hands (compared to $379 billion and $253 billion respectively a year earlier).

In other words, while the ratio of deposits to deal price was less than 4:1 in 2007, it was 35:1 a year later. The median price/earnings multiple ballooned to nearly 37, (a smaller earnings denominator was to blame), but price-to-book ratios slumped to 170-its lowest level in years.

To be sure, some banks have survived, even thrived, amid the chaos. Institutions in the northeast, Texas, and parts of the Midwest-areas that didn’t experience a big housing boom-have yet to be as bothered by asset-quality troubles. “You’re not seeing a whole lot of distress in the New York metropolitan area, and there isn’t much for sale,” says Ron Hermance, Jr., chairman and CEO of Hudson City Bancorp, a $50 billion thrift in Paramus, New Jersey, that turned in record profits in 2008.

But the overall numbers illustrate both the desperation being felt by battered sellers and the willingness of government regulators to step in and initiate transactions to stabilize the system. Since spring turned into summer, we’ve seen forced sales or FDIC-assisted transactions involving such once-iconic names as Wachovia Corp., Washington Mutual, National City Corp., Merrill Lynch & Co., and Lehman Brothers.

A new breed of megabanks that has emerged from the crisis-JPMorgan Chase & Co., Bank of America Corp., and Wells Fargo & Co.-promises to ratchet up pressure on community banks with their national branch and ATM networks and top-to-bottom product menus. Wall Street is a shell of its former self, and the only two big investment banks left standing-Goldman Sachs and Morgan Stanley-have morphed into bank holding companies, pledging to compete aggressively for deposits with their newfound kin.

The government’s involvement in the industry has grown to unprecedented levels. It has taken over the two mortgage giants-Fannie Mae and Freddie Mac-at the heart of the mortgage crisis that sparked a worldwide contagion. The Treasury Department has come up with various plans to use at least $700 billion taxpayer money (many predict it could eventually exceed $1 trillion) to revive the industry. In a nod to just how tough things are, most of the nation’s largest banking companies now count the government as a major owner. Disagreements linger over how that capital should be used, but M&A is clearly an option.

It’s going to take a while to assimilate these and other changes and find a new equilibrium. Don’t forget, there are still billions-perhaps hundreds of billions-in losses from bad mortgage loans to absorb, and potentially big problems in areas such as commercial real estate and credit cards that have yet to be fully recognized.

The FDIC seized 25 banks and thrifts in 2008, and some analysts expect the tally to rise into the hundreds before we’re done. (At the end of the third quarter, the agency listed 171 “problem” banks, with $116 billion in assets-the highest level since 1994.) About the only sure thing is that when we pop out on the other side of this mess, the industry’s rules and competitive dynamics will be far different from what they were just a year ago.

What this all means for bank M&A activity in the coming year is unclear. Common sense says that the industry is due for an active round of consolidation. There are simply too many struggling institutions-too wide of a gulf between the industry’s haves and have-nots-for banking to continue plodding on in its present form.

Greater regulation is a given, which should make compliance even pricier-a potentially big incentive for smaller banks to get out. Capital requirements will likely be stiffer, too, while raising money, at least in the short-term, promises to be more difficult. Competing with the big guys’ products and technology is another perpetual challenge.

The psychological toll on directors has been severe. Stories abound of board members working overtime to keep their institutions afloat. Jeffery Smith, a banking partner with Columbus, Ohio, law firm Bricker & Eckler, says many of his client boards are increasingly “tired and frustrated” with the environment. “They’ve gone from focusing on growth and the business of banking to putting all of their energies into compliance and regulatory issues, struggling to survive,” he explains. “For many of them, it’s not as enjoyable as it used to be.” Adds Stifel’s Maples: “A lot of board members are tired of fighting the fight. They’re looking for an exit.”

With the supply of potential sellers greater than those looking to buy, and a widening gap between the currencies of strong and weak institutions expected to emerge, the makings of a buyers’ market are in place. Pricing expectations, at least in some markets, are down. “A lot of banks just don’t have the strength to get through the rest of this cycle,” says Ray Davis, CEO of $8 billion Umpqua Holdings Corp. in Portland, Oregon, who goes on to say he is “seeing some movement” on pricing.

Throw in the recent gift from the Internal Revenue Service, which permits acquirers to use losses on a target’s books as a shelter for their own operating income, along with some anticipated tweaks in mark-to-market accounting rules, and there could be enough incentive to inspire opportunistic buyers with the requisite capital, management, and intestinal fortitude to make a move.

Just how many buyers will step forward is an open question. To be sure, there are companies willing to make purchases. Berkshire Hills Bancorp, a $2.6 billion company based in Pittsfield, Massachusetts that reported record earnings in each of the first three quarters of 2008, recently raised $36 million in a common stock offering. “This isn’t defensive capital, it’s offensive,” says CEO Mike Daly. He expects to see more banks in the company’s markets, including Vermont and northern New York, struggling due to “economic pressures,” and plans on deploying at least some of that capital on deals that afford the right “strategic and cultural fit. … We’re prepared to grow, and feel like these challenging times can be opportunistic ones for us.”

In November, Umpqua received $214 million from the government’s Troubled Asset Relief Program, or TARP. Davis says he, too, is looking to strike a deal under the right conditions. “We’re going to remain optimistic, and if something comes along that fits into our strategy, we’re going to consider it.”

Nonbank companies also have shown-or at least talked about-a willingness to enter the fray. Several insurers have recently acquired banks or thrifts, for instance, in a bid to get some regulatory cover and access to wholesale funding. Private equity funds run by successful retired bankers-former North ForkBancorpCEO John Kanas, Sovereign Bancorp’s ex-CEO Jay Sidhu, and others-are circling for fix-it-uppers.

Goldman and Morgan Stanley have become bank holding companies, and are eager to bulk up their funding bases with deposits. “They have two choices: totally blow out their online and mobile banking channels, or find some good banks to buy,” says Bob Meara, an analyst with Boston-based Celent. He expects at least one of the investment banks to buy a large regional bank or two. Foreign banks have issues of their own, but still could view the weakness as a chance to position themselves for future U.S. growth.

All that argues for more activity. Even so, cynics say there are more than enough headwinds to keep overall deal volumes low. Bank stocks have never been more out of favor, leaving some would-be buyers with weakened currencies. And while some seller boards are getting religion about the pricing, others remain stuck in the past. “A lot of boards saw their stock at $40, and thought they could get a $50 deal. Now it’s trading at $20, but they still think they can get $50,” Hudson City’s Hermance says. “Reality isn’t entering into the equation as much as you’d like it to.”

Credit quality concerns-particularly surrounding housing-are being exacerbated by what’s shaping up to be a long, nasty recession, giving buyers pause. “It’s difficult to get a grasp on bank valuations until we find a bottom for housing and make some reasonable assumptions about the future,” Hovde’s Nelson says.

Beyond such external factors, most buyer boards and managements are so preoccupied with their own problems that the idea of acquiring someone else’s troubles sounds silly. “Even good banks are being very prudent right now,” Nelson explains. “They are hunkered down, dealing with their own concerns. The attitude is, ‘How can we talk about acquiring XYZ Bank when we have so many [internal] issues on our plate?’”

In short, there’s no big apparent rush to do deals -at least not yet. Nor, Maples argues, should there be. During the S&L crisis of the 1990s, banks that bought early got stung, while those that waited for the turmoil to play out were rewarded. This time around, some investors that bought early in the crisis have been penalized severely: Witness the private equity players that pumped capital into WaMu and National City and lost it all. “People have been rewarded for waiting to this point,” Maples says. “There’s not a real sense of urgency on the part of buyers.”

How things play out is anybody’s guess, but most are predicting a year that evolves in fits and starts-one with depressed pricing and waves of intense deal making interspersed with lulls, but that ultimately winds up more active than 2008. Volumes are expected to be higher in distressed geographies with good long-term growth prospects, including Florida, California, and Arizona. While a handful of regional banks could fall before the year is out, most of the activity is expected to center on troubled community banks that have simply run out of steam.

The first surge, already in play, centers on troubled banks that have failed to land needed capital from the Treasury’s TARP program. Cleveland-based National City was among the first to fall, forced, after being denied TARP money, to accept a hurried low-ball offer of $2.25 per share from erstwhile rival PNC Financial Services Group, a TARP recipient. Analysts expect to see many other banks that were denied money pushed into fire-sale scenarios.

More FDIC-assisted deals for failed institutions are expected, and for the right buyer those can present an attractive alternative to traditional acquisitions as a way to pick up branches and deposits while being shielded from toxic assets. The process typically involves a blind bid that must be submitted to the FDIC within weeks of being notified. Winners are given exclusive option periods to purchase both branches and loans priced at par.

In November, Houston-based Prosperity Bancshares Inc. paid $60 million (or a mere 1.7% deposit premium) for 46 branches and $3.7 billion of deposits when crosstown rival Franklin Bank Corp. collapsed. In Las Vegas, $4.5 billion Nevada State Bank, a subsidiary of Zions Bancorp., bought $1.7 billion in FDIC-insured deposits formerly held by failed Silver State Bank at a premium of just 1.3%. Silver State was a big construction lender in Las Vegas, which has seen housing prices drop more than 30% over the past year.

“All we bought were the deposits and five branches, but we also got 11,000 clients,” says Nevada State CEO Dallas Haun, who is eyeing the chaos as a chance to strike more deals. “We have an opportunity in the next 18 months to become a dominant bank in this market.”

A second, more significant bump in activity could come after the industry’s recovery begins-initiated by exhausted bank boards ready to cash it in after two years of turmoil and completed by buyers who begin to see glimmers of balance-sheet clarity. “We’re going to see [sellers] that say, ‘OK, enough. Our share price was down 60%, and now we’re only down 20%. We’ve had enough; let’s get out of here,’” predicts Jim McCormick, president of First Manhattan Consulting Group in New York. “And the buyers could get some very attractive deals.”

Troubled banks that burn through government capital, but don’t solve their credit problems, could fuel the selling fire. Some regional banks in hard-hit markets, including the likes of Ohio’s KeyCorp, Huntington Bancshares, and Fifth Third Bancorp, are thought likely by investment bankers to pursue a sale. “We’ll eventually begin to see more opportunistic deals, as more sellers realize they don’t quite have the wherewithal to get all the way through this difficult time,” predicts Bill Hickey, co-head of investment banking for Sandler O’Neill & Partners in New York.

For all that, the best guess is that a true M&A recovery won’t emerge until late 2009 at the earliest, and more likely in 2010, when (hopefully) more uncertainty about asset quality has been cleared away. “There’s a lot of pent-up deal-making desires out there, among both sellers and buyers, but people won’t really get serious about M&A until they understand that there’s light at the end of the tunnel,” says Andrew Senchak, vice chairman of investment bank Keefe, Bruyette & Woods in New York. “The recession doesn’t have to be over, but we need a collective opinion about when nonperformings in these portfolios are going to peak, and at what levels.”

Any way it’s sliced, the current environment presents untold challenges for boards. For potential buyers with enough capital and the interest, Maples suggests that a board honestly assess its own balance sheet issues, management team’s skills, and bench strength and any potential risks that could come from a deal. “I’m going to be focused first on my own management and the quality of our due diligence,” he says. “Does my management team have the horsepower to analyze the assets and deal with any problems we might inherit?”

Cast the net wide, and explore all possibilities. Just because a bank you’ve coveted for a long time has suddenly become available doesn’t mean it’s necessarily the best option. “I’m going to want to challenge management to identify and prioritize the top five candidates in a way we can easily understand,” Hickey says.

The assessment should include traditional strategic considerations, such as geography, dilution, potential cost saves, ease of integration and culture, as well as balance sheet risks and pricing. Also look hard at whether any additional business lines-areas that might not fit with your own core competencies-are part of the package. “If you are going to buy someone, you need a full understanding of the risks,” Hickey says.

This can be easier said than done. Many of the basic metrics traditionally used to assess deals-price/earnings or price-to-book multiples, for instance-might not present an accurate picture of an institution’s worth in such trying times. And with more trouble to come, who’s to say what happens next?

Hovde’s Nelson recommends looking closely at deposit premiums, which have declined from a high of 20% in the glory days to an average of around 10%, as a gauge. He offers the example of a community bank with $100 million in deposits and tangible capital of $8 million. A fair ballpark price might be $18 million-the capital plus 10% of deposits. “It’s a better indicator in this environment, easier to understand,” Nelson explains.

Some buyers are sticking more with the tried and true. Mick Blodnick, chairman and CEO of $5.2 billion Glacier Bancorp in Kalispell, Montana, recently closed on a $23 million deal for Bank of the San Juans in Durango, Colorado. The deal for the $145 million operation was valued at 189.6% of book and 12.4 times trailing earnings-a good, “strategic” purchase in a market Glacier has long coveted.

“We’ve stayed with the old metrics. The fact that some of them look depressed right now, who’s to say that isn’t a new paradigm?” Blodnick explains. “Two years from now, we might be right back at 2006 levels, or maybe not. It could be worse and sellers will be wishing they had taken advantage of today’s prices.”

Smart buyers are, by necessity, digging into targets’ asset quality. Boards are ordering exhaustive due diligence, and aren’t afraid to walk away if they don’t like what they find. San Juans, for instance, decided to sell after it recently lost out on a couple of large loans because it didn’t have enough capital. While no big credit problems were immediately apparent, Glacier’s team spent two weeks on the ground going over the loan portfolio in detail. “We looked at almost all of the loans. We viewed projects, we talked with customers,” Blodnick says. “These are things we never used to do, but it’s a different time and you have adjust.”

At Westamerica, Payne’s team recently examined “95% of the loans” in one potential target’s portfolio before deciding to hold, at least for now. “Ten years ago, that would have been seen as substantial overkill,” Payne says. “Today, you don’t just stress-test a sample. You look at everything. The board insists on it. Directors are saying, ‘We won’t buy anything we don’t know absolutely everything about. We don’t want to make a mistake.’”

Equally important in these funding-challenged times is liquidity. In an era of higher-rate deposits, customer loyalty is no longer what it was. Westamerica is “looking at deposit-product types, the duration of those products, the rates and terms,” Payne says. “You need to understand the stability of deposits before you pay for them.”

After it gains a good grasp of the loan and deposit mix, Westamerica’s board has management “completely rebuild” the target’s balance sheet to determine its real value. “We’ll say, ‘We won’t match rates on their high-rate CDs, so we’ll have substantial runoff in the deposit base. And we’ll wind up writing off these loans or selling them to another institution,’” Payne explains. “We’re trying to get to the balance sheet we think will be there when things settle down-not the one they’re showing us-and from there we’ll figure out the earnings stream it can generate.

“That’s how we work out the pricing,” he adds. “It’s not book-driven or EPS-driven. It’s ‘what is the real earnings potential of what you’re thinking about acquiring on an incremental basis?’”

And if, after going through that type of exercise, you’re not happy with the condition or price of the target, then walk away. Maples says he’s seen many boards performing due diligence “and then either wanting a price adjustment because things are worse then they thought, or simply deciding not to move forward.

“In a normal environment we see very little of that,” Maples adds. “But this isn’t a normal environment.”

Boards of potential sellers have a different set of mandates in front of them. Much as with potential buyers, they should start with a good self-assessment that considers all of the options available. In addition to the balance sheet, weigh such factors as local economic conditions, the institution’s future strategy, projected regulatory and technology costs, the mood of shareholders (many are surprisingly understanding about the present situation), and management’s ability to confront whatever troubles might lie ahead.

“You need to know your company exceedingly well-better than you ever have,” Maples says. “What additional provision expenses will be required? Do you need capital? Do you need funding? And if so, how quickly?”

If directors reach consensus that the bank’s share price is too low and believe management can fight through the present downturn, then it might be smart to hold tight. Industry valuations are bound to rise sooner or later, analysts say, and if key rivals also are stressed, there could even be an opportunity to grow at their expense.

Boards that maintain stiff backbones under such conditions could benefit their stakeholders. In the mid-1990s, Senchak advised the board of the old Michigan National Corp. when it fell upon hard times. “The CEO wanted to sell, but the directors said, ‘No. You fix this sucker first, then you can sell it,” he recalls. Two years later, in 1995, the company was sold to National Australia Bank for a much higher price. “You don’t want to leave value on the table if you can avoid it,” Senchak says.

Even so, after doing their assessments, many boards are reluctantly concluding they have no choice but to sell. Some are following the time-honored tradition of hiring investment bankers to shop their companies in a limited auction process and try to inspire some competitive bidding. Others are approaching managements of neighboring banks informally to gauge interest, in some cases offering would-be buyers exclusive negotiating windows that permit both sides some time to delve into the issues with less pressure.

At a time like this, Sandler’s Hickey says, sellers often “need to take the first step” and initiate conversations-and be realistic about prices-because buyers’ currencies are weakened. Premiums of three times book value or more, common just two years ago, likely won’t fly. “Historic premiums are not relevant today,” agrees Senchak.

As for currency, some experts argue for seeking the safety of cash as a shield against today’s uncertainty. Others say that accepting beaten-up shares of a well-run company could provide plenty of upside when the industry recovers. Already, more boards are treating sales as “investment decisions,” weighing suitors’ asset quality, track record, and long-term business strategies to determine which stock offers shareholders the hope of future gains.

“Do your due diligence on the buyer,” Maples advises. “If you can take a low-premium deal with the stock of a bank that’s been beaten down some, but has a good strategy and management that you can ride on the rebound, your shareholders will benefit.”

Regardless of which side of a transaction you might find yourself on, make sure, above all, that your decisions are based on facts, not emotion. Each prospective deal is different. Yet at its core, a sale is a financial transaction where you’re seeking the best result for shareholders, so don’t panic or make it anything more-or less-than that. “As a director, the best thing you can do is to be informed and realistic about your options,” Maples says. That will be truer than ever in the year to come.