Ready, Set, Go

Bank Director
An Information Resource for Bank Boards

A panel of 10 banking industry experts was interviewed at Bank Director’s 2012 Acquire or Be Acquired conference in January. The interviews were conducted in two separate sessions, and what follows is an edited synopsis of each participant’s observations about the bank M&A market.

State of the Banking Industry Today

The industry is stuck in neutral with one foot on the brake so the car doesn’t start rolling back down the hill. I don’t see things getting easier, at least in the short term. You’ve got tepid economic recovery. Consumers continue to de-leverage. Real estate is showing no signs of recovery, at least on the residential side. And then you layer on top of that an almost hostile regulatory environment in Washington. The [bank equity] market has been a little better lately but I’m not sure with a whole lot of conviction, and I think that could be reversed completely if things get worse. Clearly, we’re not out of the woods yet. It continues to be a very challenging environment for banks to grow earnings and resolve asset quality issues so that banks that need capital will be able to access the market.

How Uncertainty Impacts M&A Pricing

From the board room to the investor base, there is uncertainty on a variety of issues. What are the credit marks on loans? What is the ability to raise capital? What’s the profitability model of the industry when you have this regulatory onslaught? Investors are not certain where the [industry’s] capital levels are going to end up, and they’re not at all certain what the profitability model looks like for many of these institutions in terms of return on equity or return on assets. So if you’re not confident about what [a proposed merger] looks like on a pro forma basis in two or three or five years, how do you know what kind of discount rate to put on that future value? And when you have that kind of uncertainty, you end up with a very high discount rate.

What a Normalized M&A Market Would Look Like

I don’t think anybody knows. Once we’ve worked through the industry’s asset quality issues, and in some regions you’ve got more clarity on that than in others, we think it’s going to operate at a lower level of profitability than it did back in the 90s. The securitization market is unlikely to look like it did back then. Consumer regulatory issues are going to be a depressant in terms of fee income. Capital ratios are clearly going to be higher so a high-performing bank will probably have a return on assets in the neighborhood of 1 percent-and to get there you will probably need some help from the [net interest] margin because margins have been going the wrong way and look like they’re going to continue going the wrong way this year and maybe beyond. With the capital levels regulators are talking about-probably a [tangible] common [equity] ratio in the 8 percent range-it’s hard to imagine banks having a return on equity higher than 12 to 13 percent anytime in the near future. And that’s assuming they don’t have to take major loan provisions to address asset quality issues. That might lead to a scenario where bank stocks are trading at [one and a half times their] book value if they have a 12 percent return on equity. In terms of pricing on M&A deals, because we no longer have pooling accounting like we did back in the 90s [and intangible assets like goodwill are now treated more punitively under purchase accounting], some acquirers are going to have to go out and raise new capital for the pro forma company to be capital compliant. So I think the game that a lot of institutions played in the 80s or 90s either through pooling accounting or by carrying less capital-because the capital ratios clearly declined between the mid-90s and the middle of the last decade-that game is not going to be played again. So I don’t think you’re going to see the kind of premiums that we saw in either the 90s or part of the last decade.

Outlook for FDIC-Assisted Deals

There are still 813-odd banks on the FDIC problem list-that’s over 10 percent of the industry. There are 411 banks that have a Texas ratio over 100 percent-not an insignificant percentage. And while these deals are a lot of work, they do two things for the acquirer. In most cases they generate capital, which is a very precious commodity. And they generate earning assets, which is a really precious commodity. Now it may be a crummy asset, but you get to take the credit mark and you get to take the [current] interest rate on it and you’ve got an asset that is on the books and that is what most banks out there are complaining about. The banks that have been active in this arena, frankly, have been some of the better performing banks over the past two or three years. These are still attractive deals because not everybody can do them. And for the people that can do them, it’s one of the reasons why traditional M&A is going to be slow to recover because they’re not done doing FDIC deals.

Vice Chairman, Keefe Bruyette & Woods Inc.

“The level of M&A activity will be influenced by valuations in the marketplace, which I think are going to depend to some extent on the economic recovery and maybe in the short term by what happens in Europe.”

Outlook for Bank M&A

A number of my clients are small community banks that are looking to acquire other banks. Their strategy is to target “clean” banks with an asset size of around $200 million or less. As a result, we are seeing an uptick in M&A activity. I think some of it is due to the fact that acquirers are feeling that non-performing assets have been identified and the portfolios have stabilized. They don’t feel like there are surprises in the condition of the loan portfolio. Still, the deals aren’t going to happen just yet due to the unrealistic expectations on price. Overall, the activity around M&A is increasing, and demand in the market is there, but in order to move these deals to close, we need to find a way to close the gap with buyers and sellers on price.

How Credit Marks Impact M&A Activity

As the asset quality of banks continues to improve, the economic environment remains uncertain. While the challenges exist, we do see clients also looking to acquire banks with credit issues. In these cases, credit marks are still fairly steep. Buyers are taking a hard look at the credits and being heavy handed on certain types of loans, for example, commercial real estate. Under the accounting rules, when you have an acquisition, all of the purchased assets are marked to their fair value. None of the failed bank’s allowance for loan and lease losses is carried over to the acquirer in purchase accounting. Each acquired loan is recorded at its fair value and consequently, there is no initial loss allowance for acquired loans. So if the initial fair value of the loan exceeds the loan balance less credit marks, you could conceivably have a day one gain on the transaction. The regulators look at those types of transactions very carefully and review the valuation reports closely. The complexity of the accounting rules can make the process for a field examiner quite difficult. The examiners have a problem grasping that there is no loss allowance for acquired loans under these accounting rules and that loans that were on non-accrual are now still delinquent but accruing. Getting back to the question of credit marks, I have found that the majority of the banks that I have worked with that are in the position of needing to raise capital are not prepared for what the investment bankers are telling them-that any investor would mark the bank’s portfolio significantly more than what the board is currently thinking. These directors are not prepared to accept the dilution-or in the case of selling, the discount-to their current book value. As I said earlier, getting together on price is still a big disconnect.

What Motivates Sellers and Acquirers

The general theme I am seeing in the market is that the sellers are tired. They may be in the position where they have owned the bank forever and the book value has shown a steady increase over the years. It has run its course though, and they are looking for an exit plan because they no longer want to deal with the increased cost of regulations, which in turn lowers the return on their investment. On the buy side, these guys are newer to the market, five years or so to the bank, and they have a more aggressive outlook for their exit strategy and say: “I’m going to do all these acquisitions and then I’m going to sell and that’s how I’m going to make my money.” In these cases, we are seeing largely private equity investors being brought in. In Texas, where I am from, a lot of these groups have raised a war chest or have access to capital and they’re out there actively looking for deals with the support of an internal acquisition team.

Outlook for FDIC-Assisted Deals

I think you will still see a large number of failed bank transactions. I have a client who recently acquired a failed bank in Texas and it was a great deal for them. There are still great deals to be had. You should note, however, that the FDIC is trying to encourage buyers to do whole bank transactions without loss sharing. I do a lot of work in this space and if a bank is the winning bidder with loss sharing, the FDIC will call you and say: “If we throw in this much, or if we increase your negative bid by this much, will you take the whole transaction without loss share?” They are trying to get banks to take these deals without loss share. If you do the transaction without loss sharing, obviously, you need to make sure that you have the credit marks right!

Bank Regulatory National Advisory Partner, Grant Thornton LLP

“I have found that the majority of the banks that I have worked with, that are in the position of needing to raise capital, are not prepared for what the investment bankers are telling them-that any investor would mark the bank’s portfolio significantly more than what the board is currently thinking.”

Outlook for Bank M&A

If we look at 2012 and beyond, the concept of relative valuation needs to be embraced by banks both large and small. When you still have the stock of the largest banks in the country trading at multiples that they’re not excited about, those banks are not enthralled about issuing their stock at these levels nor can they pay the prices that a lot of the sellers are looking for. I don’t know whether sellers’ expectations are where they need to be yet. I think they have come a long way, but at the same time, buyers are a heck of a lot more selective and they’re only going to do deals that are going to create value on their end. So I think it’s going to be tough sledding for 2012 yet again.

Expectations for M&A Valuations in 2012

We need to focus on buyers’ capacities rather than on sellers’ expectations because I think that’s really what’s going to dictate valuations. Buyers today are more disciplined than I think they’ve ever been because the investment community is more focused on the pro forma financial metrics of transactions. Tell me where buyers’ paper is going to trade and I’ll tell you exactly where multiples are going to be in 2012 because buyers aren’t going to take too much tangible book value dilution. They’re only going to do deals that accrue to the benefit of their shareholders first. A well-priced deal benefits sellers and buyers, given the fact that after the deal, the acquirer’s equity should trade appropriately in the marketplace.

Community Banking’s Image Problem

What’s disgraceful, quite frankly, is that very little has been done by the industry trade associations to tell the story of community banking so that some of the politicians can better understand what a community bank does. It makes loans in its neighborhood. It supports local businesses. It supports local charities. And it has nothing to do with systemic risk. But you don’t read that story, and I think it’s really been a big miss by the trade associations. They haven’t done enough in Washington to promote what community banks are doing well.

Principal and Co-Head of Investment Banking, Sandler O’neill + Partners L.P.

“Tell me where buyers’ paper is going to trade and I’ll tell you exactly where multiples are going to be in 2012 because buyers aren’t going to take too much tangible book value dilution.”

Outlook for Bank M&A

I think to rebuild M&A activity among banks, and we are in a rebuild process, there are probably four elements. The first one, I think, we have already solved, which is trying to get everyone’s pricing expectations more in line. Actually in the last year, there’s been a lot of progress in terms of sellers understanding the new paradigm and buyers understanding what’s affordable. It’s not across the board, although there has been a lot of progress. But I think there are three other things that we still need to work on, beginning with the credit mark challenge, which still exists. In some pockets of the country, asset quality isn’t a big problem, but in others, it is. So much of the deal arithmetic now is determined by the credit mark [on bad loans]. When you go to the Northeast you can see credit marks of 2 percent, while almost any deal you see in the Southwest or Southeast, you’re in the 8 to 10 percent range if you’re lucky. That translates into book deals where the credit marks are still high, while in places like the Northeast or maybe Texas, you can see deals for two times book. The challenge of getting regulatory approval remains. And then finally I think there’s CEO confidence, which is a function of the macroeconomic environment. If Europe, which is a major trading partner, starts to shrink in terms of demand from the U.S., it will slow our economy and that would affect community banks as well.

The Importance of Capital in M&A Transactions

To be an effective acquirer, you have to have access to capital because acquisitions today are very capital consumptive, both from the way the accounting works and because of regulatory requirements. I think there are the haves and have-nots in terms of people having access to the capital markets. One of the frustrating things in this business is when a $500-million [asset] bank wants to buy a $200-million bank and needs capital to do that. It is difficult to find capital for those very small transactions. We may be very effective in getting expectations right and resolving the social issues, but for small banks it’s still going to be difficult to access capital.

The Need for Faster Regulatory Approval

The thing that puzzles me is how much uncertainty there is in the approval process for acquirers. That makes everyone worry a lot more about the pre-announcement process with regulators. For the life of me, I don’t know why the regulators aren’t being clearer about what banks need to do to expedite the M&A process. I think it would be good for the industry to have a streamlined process to facilitate consolidation. It would help from a public policy standpoint and decrease some of the regulatory supervisory challenges, and frankly, let the markets work. Right now, I believe [regulators] interfere with the markets working in the M&A context for small banks.

Outlook for Raising Capital

The public equity market right now-and this could change on a dime-is pretty healthy. The flow of funds from financial services-oriented investors right now is strong because they need to put their money to work. If we have a very harsh presidential election campaign-and I’m sure by the time this is printed it will be very harsh-we could have the same thing as the budget standoff and the country could shut down this summer. So we’re telling companies that when the flow of funds is there and you’re big enough to have liquidity and you’ve got a good story, whether you have an acquisition or not, that’s the time to raise capital so you have some dry powder.

Executive Vice President, Stifel Nicolaus Weisel

“For the life of me, I don’t know why the regulators aren’t being clearer about what banks need to do to expedite the M&A process.”

Outlook for the Bank M&A Market

Until bank stock prices come back a bit, and until asset quality in certain markets has stabilized so that people feel secure with their own loan portfolios, I think it’s going to be a slow return to M&A. At some point, there will be a cascade of deals just because there’s pent up demand on the buy side. There are many banks that [would like to sell] because they realize that it’s going to be very competitive and very difficult to make money going forward. The larger banks have not been able to grow organically, but still are looking to grow their franchises. If you track M&A through the years, the premiums that are paid and the activity that occurs tracks stock prices-it’s pretty simple.

Impact of the Regulators on M&A Activity

My sense is there is no appetite for the smaller banks. I think there will be subtle pressure on small banks to sell. On the other hand, the regulators don’t want their fingerprints on any mergers that may not work out well. So they’re extremely conservative and they may require additional capital. So we’ve got these tensions where even if you want to do a deal, if you don’t prescreen a merger with your regulator before you sign it, you’re taking a big risk.

Sellers’ Pricing Expectations

Although I’ve seen some softening [in sellers’ pricing expectations], this isn’t a very complicated process. You have to take a look at what your projected earnings stream is going to be and the value you can add to your shareholders on a stand-alone basis and then compare that to the alternatives. If these alternatives are far superior, your decision has been made for you. I don’t think most banks should be embarrassed to sell at 1.5 times book. That’s a pretty healthy premium. Over time, we may see premiums move up, but I don’t think in my lifetime we’ll ever see three times book deals again. It’s easy for someone to pay you two to three times book when their stock is trading at two to three book. But when their stock is trading at 1.4 times book, how can they pay you that? It’s impossible. And if they do, you probably don’t want to take their stock.

Partner, Graham & Dunn PC

“It’s easy for someone to pay you two to three times book when their stock is trading at two to three times book. But when their stock is trading at 1.4 times book, how can they pay you that? It’s impossible. And if they do, you probably don’t want to take their stock.”

The Banking Industry’s Recovery

I thought that we would have seen some improvement in 2011, and much more improvement in 2012. But that’s not what I’m seeing. The volatility and the European Union’s [economic] problems last summer caused a lot of difficulties for people in the U.S., and the [U.S.] economy has not come back. Community banks have a lot of commercial real estate and at least in the Northeast, commercial real estate customers have continued to face a lot of difficulties. I’ve seen some banks clear out some commercial real estate either through sales or foreclosures and then sales, but we keep seeing new commercial real estate loans go on non-accrual status and that, I think, presents an issue with a degree of equipoise. You see the non-performing loans continue to rise-they’re not rising at some sort of terrific rate but they’re continuing to rise in the Northeast. And certainly everybody who’s in the banking business has problems with the net interest margin because of the low level of interest you can get on investment securities. I see the industry as being still under duress, and if the volatility in the stock market comes back, I think banks are going to continue to be under some substantial duress.

Why Boards Finally Sell the Bank

Sometimes when we see boards [decide to sell] it’s because they have no choices left. I think BankAtlantic is a good example. [Editor’s note: BankAtlantic Bancorp Inc. agreed to be acquired by BB&T Corp. in November 2011, although the deal has been challenged in court and is still pending.] In the deal they did [with BB&T], it was after they couldn’t raise any more capital than they had already raised. It was a difficult deal to accept but they had to accept what they could get. Where there’s movement, often it’s because the board has come to grips the fact that it has a choice: It can let the bank go into receivership or accept the dilution [of a below book value deal]. But where boards don’t see that choice as clearly, they’re not moving and sometimes that’s a mistake.

Why Many Boards Fail to Act

There’s a book called “Thinking, Fast and Slow” by Daniel Kahneman, a psychologist who won the Nobel Prize in economics for showing that humans don’t always make rational economic decisions. One of the most important things he showed was that people have twice the aversion to losses, compared to their attachment to gains. So if someone sees a potential loss, they’re going to put much more emphasis on that than the potential for gain. Bank directors know that three or four years ago, their stock was trading at [much higher levels]. They know if they sell today, they can sell for a gain over what their stock is trading at now-but they’re looking at what it used to trade at and what they could have gotten-and they consider that to be a loss. And that loss is way more important to them than [a smaller gain today]. But I think over time that people in the boardroom will change their view of whether it’s really a loss, because their stock won’t have traded at those higher levels for such a long time that eventually they’ll be able to accept what’s going on and will see it differently.

Partner, Day Pitney LLP

“I see the industry as being still under duress, and if the volatility in the stock market comes back, I think banks are going to continue to be under some substantial duress.”

Outlook for Bank M&A

Most banks have been through two or three regulatory exams since the downturn and you’re starting to distinguish the winners from the losers. The $2-billion [asset] banks that are healthy want to buy the $500-million banks, and the $500-million banks want to buy the $100-million banks. All the healthy banks think they’re the buyers and they’re the survivors so there’s a lot of talking going on but not a lot of activity because I still think there’s a big spread between buyers and sellers. [From a financial perspective], there should be a lot of M&A going on, but people are-at least in Texas, where I work- forgetting the social side of it a lot of times. There are a lot of managers who are making good salaries and are also significant shareholders and if they sell, they can’t replace their salary, and the price they’re going to get [for their stock], they can’t retire on. So even though financially it makes a ton of sense to sell, you have management teams that are locked in and need to get that big multiple or else they can’t retire, and they surely can’t get a job to replace that salary in this economic environment.

Seller Psychology

When I talk to boards the common word I hear is uncertainty. They just can’t get a handle on what the future holds. When their borrowers aren’t even trying to get more money to grow their businesses, how can they make a decision on buying a bank? Until we know what the future holds and can look out 24 months, it’s hard for boards to make strategic decisions on M&A, either buying or selling. There are also a lot of boards that think a change of administrations in Washington will solve all their problems, and I think that’s nau00efve. [A Republican administration] would be more pro-business, but things aren’t going to change overnight.

Market Pricing

Everyone’s talking about market-to-book multiples. I worked eight years at Compass Bank and helped buy a ton of banks there, and we never looked at book multiples. It was all about earnings. If I was trading at 15 times earnings, I could buy you at 18 and get cost savings and it would be accretive. At some point we’re going to get back to earnings multiples. Some publicly traded bank will come into Texas and start paying 15 times earnings, 16 times earnings, and that may be 2.1 times book value and then everyone will be happy because they got over two times book and that’s always been the level they wanted to sell at. At some point, everyone will focus on earnings and there will be a lot of acquisitions based on that.

Managing Director, FBR Capital Markets Corp.

“Until we know what the future holds and can look out 24 months, it’s hard for boards to make strategic decisions on M&A, either buying or selling.”

Outlook for Bank M&A

Banking historically has been the sector that leads the nation out of a recession. It tends to be the first to go down during a recession. To the extent that those macroeconomic factors like the crisis in Europe impact the U.S. economy, it’s going to retard the ability of the bank stock valuations to move up. When buyers’ equity is trading at historically low valuations, it’s unlikely there is going to be any significant premiums paid for the banks they acquire. I’ll also say that I’m not sure we’ll ever get to a period where we can say that sellers’ expectations are reasonable. Back when banks were paying three times book for acquisitions, those buyers were trading at two and a half to three times book as well. I do think that the expectations are coming more into line in terms of the strategic types of transactions that people consider. But I’m not sure we ever had a period where sellers were happy about what they were getting.

An Interim Strategy for M&A

The issues that are affecting M&A now have more to do with concerns on the part of shareholders of buyers, and I think what we’ll see a little bit more of this year is what I’ll call an interim strategic step. This is an exchange of shares between companies not necessarily for any significant premium, but where companies can combine forces. This isn’t an end-game strategy; it’s an interim strategy where companies can combine forces and rationalize expense bases, create more critical mass and compete more effectively in their markets.

Valuation Issues for Share Exchange Deals

When we talk about these interim strategic steps where companies are combining and exchanging shares, the multiples of book earnings are less relevant than the ownership percentage of the combined company. I think the thing that is the most important to focus on is whether you’re a buyer or a seller in that transaction. The expectation is that over time, as the health of the industry improves, valuations will rise and that benefit will inure to you if you have the appropriate ownership [position] in that equity. So as long as what you’re contributing to this combination is equal to, plus or minus, what you’re getting out of it, I think as values rise, you’ll get that value. I guess a lot depends upon your outlook. If you’re a director or a management team and your outlook is that we’re headed into three to five years of very poor economic conditions-if that’s your outlook-we hear people talking more about [selling for] cash. But I think for a large majority of people, they just want to have their capital and their ownership live on in some other company. That’s where these exchanges of shares come in. This is a strategy for two middle of the road banks to combine forces at no premium to create a better franchise, a more dominant bank in that market, which also makes them more attractive as a takeover candidate to a larger bank down the road. It’s a way for a bank to strengthen itself.

Raising Capital

The public equity markets for banks work best when they are raising equity in connection with some event. Raising capital to bolster your capital ratios even though you don’t have any organic growth opportunities or any immediate use for the proceeds, particularly at illiquid companies, is difficult. Valuations are very low, and in that sense, there is some attraction on the part of investors. The hesitancy really comes on the part of the issuers, who are reluctant to raise capital at these prices. But if it’s done in connection with a smart M&A transaction, I think there is very strong demand from that kind of opportunity.

Managing Director, Raymond James & Associates Inc.

“The public equity markets for banks work best when they are raising equity in connection with some event.”

Outlook for Bank M&A

I expect 2012 to be slightly better than 2011, presuming that the economy doesn’t get worse. If the economy double dips back down, if Europe falls apart, then I think you could see [deal activity] as low as we had last year or potentially worse. I think the preponderance of transactions are going to be at the small end, a couple hundred million dollar banks getting together with other couple of hundred million dollar banks in no premium deals, not dissimilar to that deal we did in California for California United. [Editor’s note: In December 2011 California United Bank announced a deal to acquire Premier Commercial Bancorp. Hovde advised California United.] It was effectively a book-for-book type swap with the whole logic being that they would ring out cost saves and build a better franchise. I would say we’ll see a number of those types of transactions this year, but I don’t think you’re going to see the high priced deals.

Deal Pricing

You can’t sell a healthy bank now for anything more than book because there’s still a plethora of banks that are going to fail and the active buyers in large part, certainly in Chicago where we’re located, are going to chase the failed banks and maybe get an FDIC-assisted deal with a loss share agreement before going out and paying a premium for someone. In Chicago alone, there are 13 banks with Texas ratios over 200, and another 30 with Texas ratios over 100. Buyers have a big supply of potential assisted deals to go after and as long as that exists, they’re not willing to pay [a premium] for anybody. Deal pricing is also a function of where bank stocks are trading, because where stocks trade determines where multiples go. If we ever get an uptick in stock prices we’ll get back to book and a half or two times book potential.

Regulatory Impact on the Pace of M&A Activity

On the one hand, regulators encourage consolidation. At the Western Independent Bankers Conference last year, one of them actually said that if you are less than $500 million in size and don’t have strong capital, don’t have a niche and don’t have strong earnings-you probably won’t belong in this business in two to three years. So they make a statement like that and yet-unless you are a [CAMELS] 1 or 2 rated bank-they put up so many impediments to actually approving an M&A transaction. [Editor’s note: CAMELS is a system that regulators use to rate banks for safety and soundness, with 1 being the highest rating and 5 the lowest.] If one of the banks is rated a 3 or 4, the regulators are never going to approve a deal because they don’t want the healthy bank partner to get dragged down by the 3 or 4 rated bank. And yet probably 40 to 50 percent of the banks in the country right now are rated a 3 or 4.

Reasons to Sell Out at 1.5 Times Book

People are tired. If you think about it, we go in cycles and we always have. We came out of a low cycle in the late 80s early 90s. Pricing built up as stock prices went up in ’94 and peaked out at ’98. We went back down in the early part of 2000, 2002, and then we built back up again. So the last time people wanted to sell was 2005, 2006, 2007 and they decided not to and now here we are five years later and bankers are getting older and their boards are getting older. So it’s just a wear and tear factor. [Sellers’] expectations are coming down, and more importantly, their willingness to just get out is much stronger now than it was back when they were five, six or seven years younger. The regulatory burden is worse and that’s what I think is probably going to be the biggest wave here, because you’ve just got so many bankers who are so tired, so sick of this business, and sick of the regulators that they are willing to take what is now the new reasonable. [A lot of the deals are] going to be exchanges of stock, of saying, “Hey, let’s change shares and see what the combined company looks like two or three years from now hoping that at that point in time the economy has improved, bank stocks are up and we can sell this company for better multiples than we can now.”

President & CEO, The Hovde Group

“If the economy double dips back down, if Europe falls apart, then I think you could see [deal activity] as low as we had last year or potentially worse.”

Outlook for Bank M&A

Well, it’ll be more than last year, but that’s not saying much. You know, it’s been dry for the last several years, but it is steadily increasing. We’ve already announced three deals for this year and have more in the pipeline. Our pipeline is healthier this year than it’s been in six years. So I definitely think there will be more deals in 2012, and several things are driving this. One is confidence. One reason for a lack of M&A deals is a lack of confidence on the buy side. The other thing is more realistic expectations on both the buy and the sell side, as far as what pricing is. And then I would say the third thing is you can make money doing this right now. With decreasing loan demand, increased regulatory costs, tired boards, tired management teams, a sale and 30 percent cost saves can be a money maker for people with the pricing that can be done over the next 12 to 18 months.

Buyers Are More Confident

I think confidence is probably the most misunderstood thing in M&A, and it manifests itself in pricing. A lot of people have been complaining the last couple of years about the unrealistic price expectations of the sellers. I didn’t always see that. What I saw was unrealistic price expectations and a lack of confidence from buyers. Buyers wanted to buy things at book value or below-clean banks, with no problems, that didn’t pose a risk to their institution. Now I’m starting to see people have confidence that, “Hey, I know how to look at loan portfolios. I don’t think the world’s going to come to an end. It’s OK to pay a premium for a bank even if it has a few problems.” You know, the first example would be Sterling Bank down in Houston. You saw Comerica pay 2.3 times book, and Sterling had problems, but Comerica had some confidence that it could work those problems out and they got an institution that over the past 20 years would have cost at least 3 times book-if not 4 times-to acquire. [Editor’s note: Comerica Inc. acquired Sterling Bancshares in January 2011.]

Defining Franchise Value

I don’t think the definition of franchise value has changed over time: Good core deposit franchise, diverse loan and deposit mix, good fee income, good growth, good markets, good people, good management, and so on. The thing that’s changed almost overnight is that core deposits are really liabilities instead of assets, and loans have become liabilities instead of assets, if that makes sense. The question you’re getting now is: “Hey, where are we going to get loan demand? Do we have a franchise that can produce assets? Do we have a place to put money?” You’re seeing people sell core deposit branches at really low premiums. The problem, especially up in the Midwest, is they don’t have anywhere to put the money. In this ultra-low rate environment, it does change the definition of how a franchise works. But long-term, I don’t see how that definition changes. People will always need core deposits and a low cost funding base because that’s where you drive the spread. And when you get into pricing trouble and competition on the asset side, it’s because you don’t have the power on the liability or the funding side to price and structure accordingly.

Why Three Times Book Isn’t a Thing of the Past

I’m going to give a little different answer than what I hear from other guys. I think the pat answer is, “Oh no, we’ll never get it up there again, those days are gone.” I don’t agree with that. You’ve got 20 banks out there trading on a tangible book basis at two to four times book. So what does that tell you? That tells you that there’s an appetite from investors and buyers for good quality banks that can grow and do things. Is that happening? Yes. Two, that tells me that buyers are going to be willing to pay up for good franchises. And three, consolidation is going to continue because of a variety of external pressures, including the fact that you’re going to have to be a bigger bank because of higher regulatory costs, less loan demand, those kind of things. It’s naturally going to cause some competition in buying banks. Any time you get into bidding situations, as those start to pan out, prices start to go up. So will that happen tomorrow? No. But I’ll tell you this-it’s happening faster than I thought it would. We’re on a track to a recovery in bank pricing for M&A, on a faster track than, I think, anybody really thinks. What is it? I don’t know. But it’s faster than what we think, and it’s certainly faster than never.

President & CEO, Commerce Street Capital LLC

“Now I’m starting to see people have confidence that “Hey, I know how to look at loan portfolios. I don’t think the world’s going to come to an end. It’s OK to pay a premium for a bank even if it has a few problems.”


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