Eat or Be Eaten

The board of directors at Evansville, Indiana-based Old National Bancorp had long chafed at a prohibition against in-state mergers, so when banks there were finally given the go-ahead to gobble each other up it didn’t wait long to bite. “I don’t think the ink was dry on the law when we announced our first purchase,” recalls Larry Dunigan, Old National’s non-executive chairman and a director since 1982. “We had a deal in our pocket, ready to go as soon as it was passed.”

Old National bought some two dozen banks over the ensuing decadeu2013essentially turning mergers and acquisitions into a line of businessu2013before it hit a patch of rough credit in the early 2000s and had to pull back. In 2004, the board hired Robert Jones, a former KeyCorp executive, as its chief executive officer. And in 2006, after Jones had engineered a quick turn around, Old National paid $77 million, or 2.3 times book value, for $490-million-asset St. Joseph Capital Corp. of Mishawaka, Indiana.

Old National looked poised to resume its acquiring ways, but then the financial crisis arrived, and like most every other bank it hunkered down instead. Even so, the $8 billion-asset company’s board never really stopped looking for takeover candidates. Its balance sheet was stronger than most, thanks largely to sound lending disciplines embraced earlier in the decade. An ad hoc M&A committee reviewed potential opportunities, and even signed off on a few unsuccessful low-ball bids on failed banks.

Then late last summer, $850-million-asset Monroe Bancorp, the largest player in Bloomington, home of Indiana University, found itself in a capital bind and was willing to talk about a deal. Old National’s directors had some concerns about Monroe’s balance sheet, but the opportunity to acquire such a coveted franchise was too great to resist.

“We’d had our eyes on that bank for many yearsu2013two, maybe three, managements agou2013but they were never interested,” says Dunigan, 67, who is also CEO of Holiday Management Co., an Evansville healthcare services firm. “It’s right in the middle of our footprint and the financial pillar of a Big Ten university town.”

Monroe got into trouble by stretching for growth during the boom times of the mid-2000s. It moved into new markets, most notably Indianapolis, and loosened its underwriting standards. Now, loan losses were mounting and it was operating under a memorandum of understanding with both federal and state regulators.

Monroe’s board oversaw a cost-cutting push, slashed management salaries and cut the dividend to a penny, but the moves weren’t enough to counteract the effects of soaring loan losses. Needing more capital, directors conducted a “present-value analysis of how shareholders would benefit under … various options,” says Monroe CEO Mark Bradford.
Directors considered raising more equity, but after seeing share prices fall 70 percent-from near $19 per share to below $5u2013in three years, “we could not overcome the dilutive impact that issuing additional stock [at such low prices] would have on our existing shareholders,” Bradford says.

Reluctantly, Monroe’s board concluded that investors would be better off riding the stock of a stronger company. It considered several bids, and in October settled on an $81.3 million offer from Old National that valued Monroe shares at about $13 per shareu2013roughly triple the stock’s value at its low point, and 146 percent of the bank’s book value.

Bradford is not happy that he had to surrender to a stronger suitor, but at least he salvaged something for shareholders and was able to control his own fate. Jones, on the other hand, is giddy about his opportunistic buy. Striking a similar deal with Monroe would have cost nearly three times as much three years ago, he says. Bloomington “is the second-best market in Indiana [behind Indianapolis], and I get dominant market share,” he says. “What’s not to like?”

Indeed, for healthy and acquisition minded institutions like Old National, there is a great deal to like about the current banking environment. Although the U.S. economy seems pointed towards a modest recovery, a large number of banks are still weighed down by sluggish loan demand, razor thin net interest rate margins and lingering asset quality problemsu2013all of which have put downward pressure on earnings.

These are just the kind of conditions that have sparked consolidation booms in the past: Banks strong- and smart-enough to keep their heads above water during the bad times emerge to devour their weaker brethren, in the process sucking out the system’s excess capacity and aiding the industry’s recovery. There’s no reason to think things will be much different this time around.

The winners in this next wave of deal making will be those institutions with the capital, credit quality, and compliance and risk-management expertise to thrive in this new operating environment. The losers will be banks that lack those things and conclude, as Monroe did, that a sale is the bestu2013if not the onlyu2013way to salvage something for their shareholders.

“There are haves and have-nots,” says Jimmy Dunne, senior managing principal at Sandler O’Neill + Partners in New York. “If you have capital, you’ll be challenged to make it work, but you’ll also have opportunities to use it effectively. [If you don’t], you need to think very carefully about your optionsu2013what your earnings and franchise value might be over the next few years, versus what turning your stock into someone else’s [stock] might yield.”

Most securities analysts and investment bankers project that the 7,700-plus banks we have today could be whittled down to between 4,000 and 5,000 over the next five years or so, with the pace of consolidation picking up this year.

Some of that activity will come from liquidations of failed banks by the Federal Deposit Insurance Corp. The Washington-based agency has already shuttered more than 300 banks during the crisis, and listed 860 institutions on its “problem bank” list at the end of Septemberu2013the most since 1993.

“Somewhere between one-quarter and one-half of those will fail over the next few years,” predicts Joe Stangl, a principal who specializes in FDIC-assisted deals at Sandler O’Neill.

Acquiring failed banks from the FDIC accounted for much of the deal activity in 2010, and that will continue this year. Many also expect an increase in old-style marriages of healthy institutionsu2013the kind that feature market premiums, not loss-share agreementsu2013and involve sellers that might be able to survive indefinitely on their own but understand the cost and revenue advantages of size, and see a brighter future paired with a larger bank.

“As the world of banking evolves, it’s clear there will be significant strategic advantages to being bigger,” says John Koelmel, chairman and CEO of First Niagara Financial Group in Buffalo, New York. “M&A is the best way to achieve that scale.”

In August, $21-billion-asset First Niagara agreed to pay $1.5 billion for NewAlliance Bancshares Inc., a New Haven, Connecticut-based thrift. The pricing represented roughly a 170 percent premium to the NewAlliance’s market capitalization the day before the merger was announced, and 146 percent of its book value. But what really caught people’s attention was that, like First Niagara, $8.7-billion-asset NewAlliance has remained profitable throughout the crisis.

“This was not about any red flags. It was about accelerating the strategic plan of the bank and totally wearing my shareholder hat,” says NewAlliance chairman and CEO Peyton Patterson, who estimates the combination will generate per share earnings this year that her board hadn’t anticipated until 2015.

While we’ll likely see more deals of that type over the next few years, the bulk of the activity is expected to look more like the Old National-Monroe transaction, where an opportunistic buyer in relatively good shape capitalizes on a seller’s weakness to gain scale and market share.

The backdrop for this anticipated surge in activity is an economic and regulatory environment that’s much harsher than in years past. Revenue growth promises to be pinched by pallid loan growth, margin compression and the Dodd-Frank Wall Street Reform and Consumer Protection Act, which caps fee revenues in such key areas as overdraft protection and debit-card interchange.

Costs are expected to rise for everything from compliance and risk management to deposit insurance, putting additional pressure on the bottom line, while higher regulatory capital requirements promise to make it even harder to earn decent returns.

“It has become so challenging to grow the top line, and the costs of doing business are so much higher,” says Aaron Deer, a securities analyst with New York-based Keefe Bruyette & Woods Inc. “The best way to deal with it is to gain more operating leverage through a merger.”

For many stronger banks, the best growth strategy might be an in-market acquisition with the potential for significant post-merger cost savings.

Many sick banks, meanwhile, confront difficult operating conditions and asset quality problems. They also face the problem of raising capital from skeptical investors to solidify balance sheets. If they can’t do that, selling to a stronger competitor might be the best option.

Signs of greater activity already are evident. One hundred eighty-five transactions had been announced through November 30 of last year, according to SNL Financial in Charlottesville, Virginia. That put 2010 on pace to exceed the 120 announced in 2009 with room to spare.

Rick Maples, head of investment banking for Stifel Nicolaus & Co. in St. Louis, thinks we could see at least a 50 percent volume increase over those 2010 levels this year, and perhaps double the number of deals in 2012.

“We’re starting to see more traditional activity. People are starting to get more proactive, saying, ‘If I really want something, I need to find a way to get it done,’” Maples says. “I tend to think that 2011 should be the beginning of a robust period for bank M&A.”

Analysts single out PNC Financial Services Group in Pittsburgh and Minneapolis-based U.S. Bancorpu2013the two top-10 banks best positioned to weather the stormu2013as the most likely large bank buyers. However, two giant banks with a long history of doing acquisitionsu2013Bank of America Corp. in Charlotte and San Francisco-based Wells Fargo & Co.u2013may have to sit this round of consolidation out. No bank is allowed to have more than 10 percent of the nation’s total deposits, which effectively bars Bank of America and Wells from acquiring additional depository institutions-at least without a divestiture attached.

Stronger regionals, ranging from $157-billion-asset BB&T Corp. in Winston-Salem, North Carolina to $8.6-billion-asset Hancock Holdings Corp. in Gulfport, Mississippi have openly professed their desires to cut deals. Well-capitalized smaller banks want a piece of the action, too.

“We’re not an acquiring bank, but the economics are strong enough that we’ll be looking [to buy] once there’s a bit more clarity,” says Stephen Buster, CEO of $2.9-billion-asset Mechanics Bank in Richmond, California.
The buying won’t be limited to banks. Many of the biggest serial acquirers of the past decadeu2013former CEOs John Kanas of North Fork Bancorp, Ken Thompson of Wachovia Corp. and Jay Sidhu of Sovereign Bancorp among themu2013are heading up private-equity plays.

“Our investors believe the banking business can still create great value for customers and a decent return for shareholders,” says Paul Murphy, CEO of Houston-based Community Bancorp LLC, which has $1 billion in private equity money to spend. Murphy’s board includes former JPMorgan Chase CEO William Harrison and Bob Steele, ex-undersecretary of the Treasury and a former Wachovia CEO.

The prime targets will be banks with attractive deposit franchises and geographies that have stubbed their toes on credit and now lack the capital, operational tools or business models needed to compete in what some call the “new normal.”
The list of potential sellers includes such big names as $133.5-billion-asset Regions Financial Corp. in Birmingham, Alabama, and Milwaukee’s M&I Bancorp, with $51.9 billion in assets. Both institutions continue to struggle with losses and relatively high levels of non-performing loans, and both must repay large investments from the federal government’s Troubled Asset Relief Program (TARP) that could make it difficult to raise capital on attractive terms.

“Some of these boards will need to evaluate whether it makes more sense to raise capital to repay TARP, which will hurt earnings per share, or to take someone else’s currency at a premium,” Dunne says.

The bulk of the activity, however, is expected to come in the small-bank space, where credit problems persist, capital terms are prohibitive and some business models look outdated. The average asset size of an acquired bank in 2010 was about $800 million.

The earliest signs of increased activity already are appearing in the Northeast, where the crisis’ effects were felt the least. In one three-week period at the end of October, three separate deals were announced, including $2.7-billion-asset Brookline Bancorp Inc.’s $19.7 million cash purchase of First Ipswich Bancorp, a $262-million-asset company. The deal between the two Massachusetts banks was priced at 145 percent of First Ipswich’s book value.

Parts of the Midwest and Texas also have seen increases in deal volume, but the bigger spike could occur in markets hit hardest by the collapse in housing prices.

Until recently, for instance, California’s consolidation has been defined by failed-bank deals. But according to Buster, who also is chairman-elect of the California Bankers Association, that state’s market is poised to “shift from government-assisted acquisitions to 50 percent stock-50 percent cash willing-party transactions.” He predicts that California could see more than 20 “live-bank” deals in 2011.

An awakening of the market for “live” transactions would be welcome news for an industry that considers mergers part of normal day-to-day life. The past several years have seen such activity squelched by the reluctance of both buyers and sellers and the smothering effect of FDIC-assisted deals. That, too, is taking a turn.

In the early days of the crisis, large buyers like New York-based JPMorgan Chase & Co., U.S. Bancorp and PNC availed themselves of FDIC assistance, fattening their deposit rolls or filling in geographic holes with sweetheart loss-share agreements.

Some substantial regional players, including BB&T, Iberiabank Corp. in Lafayette, Louisiana, Huntington Bancshares in Columbus, Ohio and M&T Bancorp in Buffalo, New York, also cut deals with the FDIC, as did a handful of big foreign banks, including Spain’s Banco Bilbao Vizcaya Argentaria, which bought Guaranty Bank of Texas from the FDIC in 2009.

Back then, the agency would simply cover 80 percent of the losses on an acquired portfolio to a certain threshold, and 95 percent of losses beyond that level. The bidding was confined to what that threshold would be, and how much the agency would pay the acquirer to take on the mess.

The process indirectly encouraged prospective buyers to wait for targets to fail, hoping their patience would be rewarded with fire sale pricing and loss protection.

Competition has heated up significantly since then. Capital-rich private equity firms have become more aggressive, and a growing number of banks are confident enough in their own prospects to make more-aggressive bids.

Last April, for example, Toronto-based TD Bank Financial Group bid a 0 percent deposit premium, a 0 percent asset discount and just 50 percent loss-sharing up to $449 million to win a heated contest for the remains of $3.5-billion-asset Riverside National Bank of Florida in Fort Pierce. “The geography made it a highly sought-after target,” Stangl explains.
Over time, the FDIC has ratcheted up the complexity of the bidding process to create more competition, while lowering the deposit insurance fund’s exposure.

In the latest iteration, the agency typically splits a failed bank’s future loan losses into two categoriesu2013residential real estate and commercialu2013with three tranches each. The FDIC sets the loss-share coverage for the middle tranches, while bidders propose their own figures for the first and third in each category.

For a failed bank with $300 million of loans, the first tranche might include all losses up to $12 million for single-family loans, and up to $15 million on the commercial side. The second would stipulate coverage up to, say, $40 million for single-family and $50 million for commercial. The third tranche would include all losses above those figures.

Potential buyers place four separate loss-share bidsu2013for each of the first and third tranchesu2013and the package that comes in at the lowest cost to the deposit insurance fund wins. The idea is to give buyers a stronger incentive to keep loan losses downu2013something that hasn’t always been the case in the past.

Some banks also have included so-called “value-appreciation instruments” in their bids. In December 2009, New York Community Bancorp in Westbury, New York paid nothing for Cleveland’s AmTrust Bank, and got the FDIC to share losses on the first $6 billion in losses on the $9 billion of loans it took on.

In return, it offered the agency a chance to participate in the short-term upside in New York Community’s stock, similar to an option. “The stock [price] went up, and the FDIC made more than $12 million,” Stangl says.

But nothing is set in stone. The FDIC is bound by statute to take the deal that represents the lowest losses to the fund. When $337-million-asset Sonoma (California) Valley Bank failed in August of last year, 10 banks pursued the franchise. Westamerica Bancorp of San Rafael won with a bid that featured a modest 2 percent deposit premium, a $43 million asset discount and no loss-share at all.

“The FDIC basically wrote us a check, and it brought closure for them to a potentially messy clean-up. Now they’re off the hook,” says David Payne, chairman and CEO at $5-billion-asset Westamerica. “We liked it because we don’t have the additional oversight” that comes with loss-share agreements.

The upshot is that FDIC-assisted deals are no longer the bonanza they once were. And the process carries significant disadvantages for the buyer, most notably the inability to conduct thorough due diligence. This is pushing more banks to act preemptively, seeking to cut deals before the agency seizes an institution.

“More boards are saying they don’t need the FDIC’s involvement,” says Randolph Moore III, a financial services partner with the law firm Alston & Bird in Atlanta. “They’re willing to take on more risk in exchange for getting the chance to control the process and do as much due diligence as they want.”

Directors at selling institutions see some advantages, as well. They don’t have to carry the stigma of serving on the board of a failed bank, and can garner something for shareholders. They also don’t have to worry about the FDIC taking them to court. The agency has launched criminal investigations into some 50 failures, and recently began filing civil suits against the directors of some failed banks.

“You don’t get sued by the FDIC for a live-bank transaction,” Moore says. “You might not get a high share price, and investors might be unhappy. But as long as you’re informed, seek the guidance of outside experts and act reasonably, you should be protected.”

Buyer willingness to leapfrog the FDIC-assisted market is a key force behind a potential rebound in live-bank deals. For sellers, broken business models can be almost as big of a motivator.

Many community banks, for instance, were able to capitalize on a vibrant market for residential or commercial real estate. “Now that the boom is gone, how will those banks grow?” asks Sung Won Sohn, an economics and finance professor at California State University and a director at $6.2 billion-asset Western Alliance Bancorp in Phoenix.

“A lot of these institutions need to remake themselves and find new niches-whether it’s ethnic banking or wealth management or small business,” adds Sohn, former chief economist for Wells Fargo. “If they aren’t capable of that, then they’ll need to merge.”

Banks that rely on consumer fees for an outsized portion of their revenues also are in trouble, due to new laws and rules that limit fees. “If you can’t compensate for that [loss of fee income], what are you going to do?” Westamerica’s Payne asks. “Your only alternative might be a sale.”

Layered on top of all this is director fatigue. The job, once fun and profitable, is now filled with long hours, headaches and uncomfortable scrutiny. Many boards have been dealing with credit problems, and things aren’t improving as quickly as management promised.

“Directors are psychologically and emotionally exhausted,” says Murphy, who estimates he’s talked with about 50 bank boards in the past year. “They’re trying to do the right things for employees, customers and shareholders at a time of extraordinary economic stress. It’s a very difficult situation.”

In many cases, regulators are pressing boards to raise capital levels, something that’s easier said than done. New federal restrictions on the use of trust preferred securities at banks with assets of more than $500 million will deny most institutions of a popular capital instrument. Of course, there doesn’t seem to be much investor appetite for new bank equity issuance, particularly by smaller institutions that are still trying to recover from their asset quality problems. The Keefe Bruyette & Woods Bank Index, which includes the stocks of 25 large banks, remains off 60 percent from its 2007 highs.

“There’s not a lot of demand for the [stocks] of financial services companies,” Koelmel says. “We’re in the crosshairs as the bad guys for causing the crisis, and we’re not generating the kind of returnsu2013or valuationsu2013that we did four years ago.”

Another factor that could help drive further industry consolidation is growing concern about director liability. Financial services companies were targets in 30 percent of all class-action suits filed in the first half of 2010, according to the Stanford Law School Securities Class Action Clearinghouse. And a decision by the FDIC to aggressively sue directors at failed banks would only add to the liability concerns.

“Board members are worried,” Moore, the attorney, says. “I’m getting a lot of questions about, ‘What is my personal liability here?’ and ‘What do I need to be doing to protect myself?’”

After years of fighting the good fight, a growing number of boards are taking “a more jaded view of what they’re being told by management,” Moore adds. “There’s a realization that it’s going to be a longer haul to return to profitability than they’ve been told. … Frankly, a lot [of directors] are approaching the point of capitulation.”

One possible impediment to a resurgence in M&A activity is the unrealistic expectation of many potential sellers that their banks will still fetch the high multiples of five years ago. Healthy banks must conclude that a saleu2013even at today’s depressed pricesu2013is better for shareholders (and directors themselves) than going it alone.

John Eggemeyer, managing principal of Castle Creek Capital, a private-equity-backed holding company in Rancho Santa Fe, California, that invests in banks, says many boards of troubled banks remain fixated on repairing their institution’s problems first to regain past valuations-or at least something close to them.

“That might work,” Eggemeyer says. “But if the acquirer’s stock goes up in the meantimeu2013and it goes up more, because they don’t have as many things to fixu2013then you’re actually losing.”

Dunne says boards should conduct regular and thorough analyses of what the bank’s future holds as a standalone operation, and then compare it to a sale. “Prices might not be as high, but you could be better off getting into a stronger bank’s currency that isn’t valued as highly either,” he says.

Communities are more possessive of headquarters jobs, and investors are on the warpath. NewAlliance shareholders, for instance, challenged the First Niagara deal in court, calling the price “inadequate and unfair,” while Connecticut Attorney General (and Governor-elect) Richard Blumenthal launched a probe of the merger, which includes a potential $24 million severance deal for Patterson.

“The proposed merger raises significant and far-reaching legal and public policy issues, including its effect on Connecticut jobs and our economy,” Blumenthal told reporters.

The agencies also are paying more attention to the system risks of potential deals, and the parties’ compliance history. In November, $8.1-billion-asset Northwest Bancshares Inc. in Warren, Pennsylvania, was forced to terminate a proposed acquisition of NextTier Inc. in nearby Butler because Northwest hadn’t complied with new consumer protection rules.

On the buyers’ side, the issues center mostly on uncertainty. Koelmel says a lot of the “courage and conviction” of acquirers in normal times has been replaced by fear of “catching a falling knife.” While valuations looks historically attractiveu2013the average bank sale in 2010 was priced just above book valueu2013boards must also be confident that they have the management and capital wherewithal to turn around a struggling bank’s fortunes.

“The biggest difference [between the past and] today is the risk that comes with an acquisition,” Maples says. “You need to be a little better with your execution and due diligence than you were three years ago.”

Most deals today are drawn-out affairs, with jittery buyers poring over every nook and cranny of a potential target. Community Bancorp spent more than two months examining the loan book of $1.9-billion-asset Cadence Financial Corp. before bidding $67.8 million for the troubled Starkville, Mississippi-based company last October.

“We looked at 73 percent of the loans, a very deep sample,” says Community CEO Paul Murphy. “In this environment, you’ve got to turn a lot of files and make sure you really understand what you’re getting into. The risks are so high, there’s no room for speculation or dabbling.”

Directors of prospective buyers are asking many of the same questions they proffered during the good times, but with a sharper edge. “What’s the strategic rationale? Will it help us grow? How will it enhance the company’s value?” Maples explains.

To satisfy himself on the wisdom of Old National’s purchase, Dunigan had a face-to-face meeting with Bradford, Monroe’s CEO, probing for insights: “How was employee morale? What kept him awake at night? Was he resistant [to a merger]?” Dunigan recalls asking.

Above all, Dunigan wanted to better understand Monroe’s credit problems. “We had our own due diligence team up there, but this is a risky time to be buying something,” he explains. “I like to look a guy in the eye and chat with him about what precipitated the decision, and what the future might look like if we did or didn’t do it. … I was trying to build a rapport and see what was inside of him.”

Dunigan learned that Monroe’s board “felt some remorse” about its predicament, but also “had talked long and hard and decided that a sale was in their best interest.”

To protect itself further, Old National built a “ratchet provision” into the purchase agreement, allowing it to terminate the deal if Monroe’s loan losses or capital levels move too far in the wrong direction before closing. It also included a separate clause that permits a price adjustment if Monroe’s charge-offs or non-accruals exceed specified levels.

“Four years ago, you didn’t see many of those types of provisions,” says James Ryan, Old National’s director of corporate strategy and development. “Now, we feel they’re necessary.”

But if committed acquirers like Old National are proceeding cautiously given the heightened risk of doing a bad deal, they are still intent on pressing their advantages at this particular point in time. Throughout the history of bank consolidation in the United States, strong banks have always used acquisitions during turbulent economic times to build out their franchises and gain a competitive advantage over smaller, weaker rivals.

In the fight for survival, it’s always better to eat than be eaten.

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