Pursuing Growth in a Tumultuous Year

Roundtable participants

Steve Klein, attorney, Graham & Dunn

Michael Mayes, managing director, Raymond James & Associates

Ben Plotkin, executive vice president, Stifel, Nicolaus & Co.

Jean-Luc Servat, managing director, RBC Capital Markets

With 140 bank failures in 2009, there’s little doubt the landscape for banking changed drastically during the last 12 months. Yet many banks are seizing opportunities to acquire market share with increasing numbers of government-assisted deals. Let’s talk for a moment about the dynamics of this market and what challenges and opportunities such transactions present.

Ben Plotkin: FDIC-assisted transactions have developed into hot M&A opportunities over the past few months. However, there exists big differences among various regions of the country as it relates to these opportunities. There are lots of companies that have over 100% Texas ratios in certain markets-the Southwest, the Southeast, Midwest-but when you get to the Northeast there are relatively few of those opportunities. So I think we’ll see pursuit of FDIC-assisted deals in those markets I just mentioned over the course of 2010 due, in large part, to the capital-accretive nature of those transactions. But in markets where there are fewer opportunities for FDIC-assisted deals, we will see some conventional M&A return due to a number of factors, including higher capital requirements.

Michael Mayes: I agree, the straight-up transactions are few and far between. What’s become active are the FDIC-assisted transactions. If you view yourself as a buyer, and you want to become active in that business, it makes sense to get involved in the process on a few transactions even before you’re ready to bid on something. The due diligence periods are very short, and the deal timeframes are very short, so it makes a lot of sense to cut your teeth on a few transactions before you actually do your first one.

Jean-Luc Servat: Echoing the same comments, I think this is probably the biggest gold rush we’ll see in a long time, and there is plenty more to come. So there is going to be plenty of wood to chop for a while. But I don’t know how many buyers there are, actually, to accommodate all the sales. And buyers are going to have to be awfully creative to be able to absorb the problems they’re facing. Because although these deals have been attractive, they seem to be a bit of a moving target. What I mean is that everybody is focused on the accounting as a great solution to all the capital problems. But now we’re starting to see regulators telling people not to rely on accounting, excessively, if that’s what’s bringing your capital in. We’ve seen that in a couple of deals. So this environment is a moving target. And while we haven’t had a lot of non-assisted deals, I’d be willing to bet that by the end of the year, we’re going to see another wave of consolidation in this business, the likes of which we haven’t seen in a long time.

Steve Klein: Today there’s a fairly limited group of eligible buyers who perceive that FDIC-assisted transactions are potentially more accretive opportunities, so they’re putting their priorities there. But the other thing that’s driving deals is capital. There’s only so much capital available, and people are using that capital judiciously and so capital preservation is a big issue. The third wildcard in the whole equation is regulatory approval. Regulatory approval of healthy bank deals probably is harder than with assisted deals because you’re not bailing the government out. Frankly, if the regulators feel the buyer is being stretched, they’re probably not going to approve it. So there’s an interrelated group of complex problems. Going forward, I think we’ll see some more whole-bank deals toward the end of this year, and more in 2011. The bottom line is, until real estate values in the troubled areas bottom out, we’re going to continue to see the flow of blood with FDIC-assisted transactions.

Mayes: I agree. While there may be hundreds of institutions over the coming years that may fail, there are not going to be the same number of buyers. There’s going to be, perhaps, dozens of buyers.

Also, I have mixed feelings about how many institutions will ultimately fail. A lot of that will depend upon the economy this year and next year. We had 140 failures last year, and conventional wisdom seems to indicate there will be more this year than last year. And while we’ve all looked at the number of problem banks in terms of the ratios, I would be surprised if we got up to 1,000 in total.

Plotkin: I hope that’s the case. I believe one thing that will happen is we’ll see more cross-regional activity, because there’s a shortage of acquirers in the markets that have the most companies with over a 100% Texas ratio. We’re already seeing companies go into different regions than they might have planned to-and it’s not just for the capital-accretive nature of the deals. There are acquirers that are recognizing we are in the middle of a prolonged recession and, as such, are focused on acquiring government-guaranteed assets with attractive yields. It is worthy to note that assisted deals not only have the bargain purchase element, but they have the ability to place on the left side of your balance sheet some low-risk assets, which is important for a lot of institutions. So there are a lot of elements involved with FDIC deals. There is a need to focus on the accounting treatment, the discount related to the assets, and the retention of deposits, among other things. In any event, FDIC activity will fuel some cross-regional activity and that in turn may be the trigger for follow-on conventional M&A.

Let’s talk a little bit about the due diligence process on FDIC-assisted transactions.

Mayes: Going through the process a few times, even if you haven’t bid, helps you be prepared. But also, to a degree, the level of due diligence isn’t as critical because of the nature of the way certain assets are covered by a loss-share agreement.

Klein: But you only get three days.

Mayes: Yes, but that’s why you want to go through it a few times to get your knowledge level up to speed. But to a degree, the risks are lower, because you are going to get a loss-share agreement and you’re going to cherrypick some loans.

Servat: One issue people tend to minimize is how to manage these assets going forward. It is a time-consuming process that requires resources. For a lot of smaller banks, that’s a big challenge. Everyone is interested in these transactions until they realize they’ve got to dedicate 30 or 40 people to handle these assets, because the FDIC expects you to try to recover those losses.

Klein: Also you’ve got to keep separate books and records. The human cost of doing assisted transactions is very high. And while people say the deals done 20 years ago eventually panned out, today the jury is out. We are in a different environment compared to the thrift crisis, when you had healthy commercial banks buying thrifts. This is totally different. This is a national recession-not just one part of the industry.

Servat: You can go back to the Texas banking crisis, which basically took 10 years to resolve and that was an economic catastrophe for the state involving a commodity issue and a real estate issue all combined into one. But at the time, you still had a healthy part of the industry that could bail out Texas. Today there’s no part of the world that is not affected.

Plotkin: For the typical, healthy community bank, this is a once-in-a-corporate lifetime opportunity to attain risk-averse growth in the middle of a recession.

Servat: I think we will start having an emergence of two distinct segments of this business. To me, people have begun to focus on the return on their money, and that is the rub, particularly for companies that are looking for opportunities to invest, as the returns may be awfully paltry. Look at some recaps. If you’re going to save somebody from the brink and if it all works out you’re going to get 5% or 10% IRR, and we all know where that will lead. So now as we look at deals we’ve done over the last 18 months, where the first wave was exciting, now people are starting to sharpen their pencils and step back and realize they’re putting all their capital in the organization.

So is this a rational buying market?

Mayes: It’s becoming more rational. As Ben and Jean-Luc have both said, we’ve had a massive wave of both public and private equity come into the industry when valuations were at historically low levels. We’re in a little bit of a lull now because year-end numbers are getting filed and finalized, and once all the 10Ks are filed we’ll likely see another wave. But I believe in that wave there’ll be more differentiation in terms of where people will be investing.

The other thing I would say, at the risk of stating the obvious, is there is a big difference now as compared to a few years ago with regard to capital raises for banks. Today the prevalence of banks issuing capital off of an active shelf has become extraordinarily common. Active shelf registrations have become very important to issuers. Capital raises are now done in literally either days or hours, and so you’ve dramatically reduced your exposure to market risk in a process that used to take maybe 30 to 60 days for drafting, filing, and marketing. The vast majority of the capital that’s been raised publicly has been off the shelf.

Servat: One of the things that surprised us is just how much focus has been on the public market, in the sense that there’s probably a lot of transactions that would have been better handled had they gone to the private market first and resurfaced somehow as a public deal on the back end.

Plotkin: Well, let’s face it: Financing for community banks is more complex these days. What has become paramount is to get a measure of price discovery before commencing a public process. It is an investment banker’s job to suggest a methodology to accomplish that. But to the core question-will capital raising continue in 2010 for those with good pre-provision cash flows? I think the answer is yes.

What valuation trends do you see over the next 12 months, while many of these assisted deals make their way through the pipeline?

Klein: If a large number of buyers see opportunities in assisted deals and are throwing their resources in that direction, it’s going to put the demand for other banks down and then keep the prices where they are currently, at very low multiples. So until there’s an absorption factor of the FDIC-assisted transactions, I don’t think you’ll see multiples or activity return to normal-or even close to normalcy.

Plotkin: It’s hard to overstate the impact of fair value accounting, FAS 141-R, on valuations. I just don’t think we will really see significant premiums to book multiples occur again until such time as you don’t have to take serious marks in the loan portfolio. It’s as simple as that.

Can you give us a brief explanation of 141-R?

Plotkin: It’s where you have to mark-to-market the loan portfolio in the most simple terms when you acquire it. Today, a community bank doesn’t have to mark to market its loan portfolio, but if tomorrow it sells itself, it will have to mark to market and so that creates potential goodwill for the acquirer. So in my view, until the marks become less severe and you can bear the capital depletion associated with fair value accounting, we can’t really get back to premiums in the marketplace.

Mayes: I agree that the accounting has become a major issue in all these transactions. Not only the accounting itself, but the timing of the accounting, too. For example, you sign an agreement and then four or five months later, you close. Actually, the accounting marks get done when you close. So you have potentially significant exposure between a signing and a closing.

Klein: And the real impact is that the increased goodwill goes against your regulatory capital, so there’s a huge cost.

Plotkin: And it affects your tangible book value.

Mayes: Right, so tangible common equity is an issue, tangible book value is an issue, valuation is an issue, regulatory capital is an issue. And, of course, this is in an environment where regulatory capital ratios are clearly being moved up, whether officially or unofficially.

The other aspect that complicates so-called straight-up transactions is the regulatory due diligence component. If you’re a seller, and you’re going to be acquired by what looks to be a strong bank, the combination can create some issues for the buyer in the eyes of the regulators. As we said earlier, regulators are not too keen on weakening what they believe is a stronger bank with an acquisition that has some potential problems. So if you’re a seller, there needs to be a fair amount of regulatory due diligence to get a sense of what the execution risk will be to get approval.

Klein: And as a seller, there are a couple of things to point out. One, the regulatory risk puts you at jeopardy because if the deal falls apart, you’re probably going to be the one blamed, no matter what. People are going to perceive there was something wrong with you, rather than the buyer. The other thing is, would you want stock or cash? When you sell your bank for cash you’re selling your bank. When you sell it for stock you’re making another investment. But to me, you’ve got to be really cautious about taking someone else’s stock, even if it’s at an all-time low multiple of book value, because how can you ever get comfortable with a larger acquirer’s portfolio? You’ll never get due diligence to where you’re really comfortable. So there is a psychological barrier on the seller’s side as well, not just the buyer’s side.

For banks that may find themselves in the catbird seat this year with a great FDIC-assisted opportunity, can you talk more about how to move quickly through that process? What are your key recommendations?

Klein: It’s all about asset quality. And the reason these assisted deals have attraction is not only the low cost, but because of the government guarantee on the loss side.

Plotkin: My practical advice to a potential acquirer is to understand your own capabilities in terms of loan review. Some companies understand their limitations and they team up with someone that can really help them get a handle on asset quality. Others have built that capacity in-house. But frankly, if a bank wants to become acquisitive, whether it involves FDIC deals or a book-value deal for a company down the road, they’re going to have to be able to figure out what their fair-value mark is and they’ll have to figure out who they can rely on for that.

Mayes: Today, it probably means you’re going to end up getting your accountants involved earlier in the process than you might have in the past, because you’re going to need your accountants to tell you they feel comfortable with what those adjustments are. In the end, they’re the ones who are going to sign off on the accounting. And I also come back to the issue of the regulatory due diligence for yourself as a buyer or for yourself as a seller. You want to get those issues front and center pretty quickly.

Servat: On the selling side, to me, one of the issues that may be overlooked in haste is the “doability” of a transaction and the qualifications of the buyer. Because particularly in an age where you’ve got a lot of new investors in this industry that come into play, you’ve got a lot more deals that are failing in the regulatory approval process than we’ve seen in a long time. So spending a lot of difficult moments getting properly advised on the chances of that deal going forward, even though it may look like a lifeline or at least a temporary lifeline, is important.

Mayes: And this is where the knowledge and experience of a trusted adviser-whether it’s your banker or your lawyer or both-can give you some serious guidance and help make boards aware of the potential risks going forward.

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