A Market Rebound In Slow Motion

A group of experienced merger advisors shared their perspectives on the bank M&A market in separate roundtable discussions at Bank Director’s 2013 Acquired or Be Acquired conference in late January, or in interviews shortly thereafter. The participants’ comments were recorded and edited for brevity. The roundtable discussions were sponsored by Grant Thornton LLP.


Outlook for Bank M&A Market
I think many people have been waiting for the next M&A wave and it’s been probably slower to come than most people either thought or hoped for. Clearly consolidation is going to happen. I guess that the pace is going to pick up somewhat in 2013. I think conditions are a little bit more conducive for more deals, but I’m not sure things have changed dramatically really over the last year or two where activity has been at what I would probably refer to as a subdued pace. The economy is growing, but slowly. I think acquirers generally are still being somewhat patient and disciplined in terms of their approach to deals. I think the supply/demand equation is still greatly in their favor. There are many more potential sellers than potential acquirers. The environment is a little bit better because stock prices have done surprisingly well thus far in 2012, probably stronger than many of us would have imagined given the financial and economic conditions. So I think the pace will pick up, but I am not sure it will be a dramatic change. The acquirers are out looking, but you’ve got to make the numbers work. People aren’t overpaying. And investors are still pretty tough on the acquirers that do overpay.

Emerging Consensus on Deal Pricing
As earnings start to normalize, and as credit issues become a little bit less of a factor in the earnings picture, and you take a look at where the acquirers are trading in terms of multiples and assume most of the deals are either going to have a heavy stock component or be all stock, you can kind of triangulate to say that the healthy banks are probably going to sell somewhere in the book-and-a-half range. In some faster growing markets like Texas, you’ll see prices above that. And in areas where there are still asset quality issues or no growth, prices are probably going to be below the median or the average. So I think we’re someplace close to one-and-a-half tangible book value for healthy franchises.


Outlook for Bank M&A Market
There’s still a lot of stress out there with some of the banks, and for some of them selling is the only way out. If you look at the industry’s nonperforming asset ratio, the four worst states are in the southeast: Florida, Georgia, South Carolina, North Carolina, in that order. So you’ve got banks that are stressed and, frankly, management teams and boards that are just fatigued. I’ve got a friend that sold his bank about six months ago and he said, “I’m just tired. I’m tired, my board’s tired and we just don’t see it getting much better. We got what we think is a fair price.” It was not quite book value, just under it. And I think that’s driving a lot of the sellers, just fatigue.

Outlook for the Operating Environment for Banks
I think it’s still going to be challenging. The economy is growing, but it’s still sluggish. Revenue growth is going to be tough to come by. The industry’s asset quality problems have improved, but the nonperforming asset levels for any bank are not where they were prior to 2007, so we’re still dealing a little bit with that. Margins continue to fall and I think will continue to fall in 2013 and early 2014. In fact, most of the banks that have announced earnings already, if they gave any guidance they guided for lower margins in 2013. If you’re in a growth market you probably can get some loan growth. If you’re in a rural market or in a no-growth market, loan expansion is going to be really, really hard to come by.

Why Some Banks are Reluctant to Sell Out
I think in a lot of cases their strategy is hope, which is not a very good strategy. They’re just unwilling to accept reality, and they just believe if they hang on, you know, they’re going to get back to where they were pre-2008, I guess. And it’s just not going to happen. It’s easy to calculate your loss when you sell your bank for less than book value. It’s harder to calculate how much you gave up by resisting. For example, I know a couple of banks where the boards have rejected an offer as insufficient just to watch the bidder’s stock continue to climb and theirs continue to fall. So what was their loss? It hasn’t been realized yet, but it’s going to be even worse.


Outlook for the Operating Environment for Banks
The environment in the broader sense is generally favorable. The industry is clearly past the worst of its credit quality issues, which were probably the most significant we’ve seen in a long time, but peaked in 2010 or 2011. The most significant issue facing the banks today is persistently low interest rates. And this is not a small thing. We don’t typically think of excess liquidity in the industry as being a problem, and it’s not a problem per se, but it has caused significant margin compression and has made it somewhat more difficult for banks to increase their earnings, particularly at a time when loan growth has been modest primarily because of a weak economic environment. But the industry is profitable. Asset quality has improved, and the industry probably has more capital than it’s ever had, at least in the last few decades. So I would say, overall, the outlook is favorable.

Outlook for Bank M&A Market
Generally, it is a buyer’s market. There are a good number of small- to medium-sized banks that would have interest in combining with a larger partner, most likely in a stock transaction. But for those larger partners, there are impediments. That is a smaller group to begin with. And there’s still a fair amount of regulatory uncertainty with respect to future capital requirements. [Editor’s note: As this issue went to press in April, the federal regulators had yet to issue final regulations for the proposed Basel III capital requirements.] You also have the consideration of goodwill and how that impacts future capital. So the buyers have to be careful. The other issue is that for the buyers, their stock valuations, while they improved last year, are still significantly below where they were several years ago. So spending capital at these valuations can also get very expensive, which tends to limit what buyers are willing to pay.

Are Regulators Taking Too Long to Approve Deals?
I don’t think the regulators per se are slow in transactions. I think in general the regulators expect for there to be more consolidation, and as the industry gets consolidated into the stronger and better-managed banks, that’s a favorable thing for the regulatory environment. I think it has more to do with pro forma capital in a proposed deal. You could see an announced deal that gets slowed down for regulatory approvals, but that may well have to do with the regulators’ concerns about whether the proposed deal will have adequate pro forma capital. Again, that’s where the lack of clarity comes in. I think it’s more that the regulations haven’t been finalized, and I think once they’re finalized, it’ll be a little bit easier to plan and model for that.

[Editor’s note: Michael Mayes did not participate in the roundtable discussions at the Acquire or Be Acquired conference, but was interviewed later.]


Outlook for the Operating Environment for Banks
Industry margins are down by 20 percent. Efficiency ratios are up by 15 percent to 20 percent because of regulation. And capital ratios are now 15 percent or 20 percent higher because of regulation. That all leads to a lower return on assets and a significantly lower return on equity now that you’ve got a bigger denominator and a smaller numerator, which if you flip it you’re just saying, okay, then what will the price-to-book-value be for a bank? It’s coming down because the return on equity of a typical bank has gone from lower double digits to high single digits at best.

When Selling for Less than Book Value Makes Sense
The M&T Bank Corp./Hudson City Bancorp deal was a great example. Hudson City’s business model was very broken and very flawed going forward. They made the decision to sell to M&T at a discount to tangible book. A lot of people would have said “I could never do that. That would just be an admission of defeat.” The guys at Hudson City acknowledged that M&T stock has been a wonderful currency to own for many, many years. They got it at a reasonable 10 to 15 percent premium, and M&T stock is now up 25 percent since that deal was announced. There are precedents out there that will allow smarter boards to see that you can do that.

How Capital Issues Will Drive M&A
The capital markets are fatigued. We’ve been through a couple rounds now of private equity money and institutional money where investors have lost a significant amount of their principal, and so they’re being far more judicious about the kind of turnarounds and the recaps they’re putting money into. If that dries up, or some of these troubled institutions aren’t able to raise capital, the only alternative is M&A.


Outlook for the Operating Environment for Banks
I am a pessimist. I look at the low interest rate environment that we have now because of the Federal Reserve’s monetary policy: Deposit rates have been driven as low as most banks can drive them. There is insufficient organic loan growth for the vast majority of banks. As a result, you have Peter robbing Paul with large banks coming downstream to go after smaller customers, and good credit quality loans being re-priced downward. As a result, what we’re seeing is contracting margins quarter after quarter. And I’ve actually had a discussion with a firm that does a lot of profit modeling for a number of community banks, and their view is if this interest rate environment continues with this intense loan competition and with no economic growth of any note, a whole lot of banks by the second half of 2014 are going to see inadequate net interest income to be profitable.

Outlook for Bank M&A Market
I see a significant pickup in the number of deals but not a significant pickup in the pricing of transactions, and if my pessimistic view of the world plays out you could actually see a continued reduction in price. My big concern from a pricing standpoint is whether 2013 is going to be better than 2014. Are sellers better off waiting? My concern is the longer you wait, we could very well reach a time when the supply magnifies as sellers finally come to the realization that, “Darn, I thought it would get better, but it’s not getting better.” And if net interest margins stay under pressure, by 2014 you could have a whole lot of banks finally saying, “That’s it, I’m packing it in.” And then you go back to the basic economics 101 of supply and demand. And when you have too big a supply coming with limited buyer demand, the buyers are going to cherry pick and pricing is going to come down. That doesn’t mean, though, that the number of deals will come down. It simply may mean we have a large number of low priced deals. So be the early mover if you’re going to sell. Have a buyer universe that hopefully is larger, and control your own destiny rather than being forced into it.

How Industry Fatigue Could Drive Deals
A lot of M&A comes about because of the age of many boards and management teams. And if you think about it, the last good time we had in this industry was up until the summer of 2007. And now we’re approaching the summer of 2013, and six years is a long time for guys that are now six years older. For boards it hasn’t been a fun six years and at some point in time you simply get frustrated and worn out and you begin to think, “Let’s get out of this rather than wait and see if we can get back to 2.5 to 3 times book,” because the guy who was 56, 57 is now 64, 65. Reality hits. And I hate to say it, but as you get older your temperament and willingness to just continue to hold out, hold out, hold out starts to disappear.


Outlook for Bank M&A Market
I believe that it will remain pretty much the same as it was in 2012. Last year at this time people had an expectation that there would be an improvement in the economy and maybe an improvement in margins more quickly than there was. And now there is the view that margin compression is going to continue for some time and we don’t know exactly when that’s going to end. So you’re looking at a situation where if you’re a buyer, you’re going to be reluctant to pay a lot of money for a bank, and I think that’s going to slow things down because the sellers-who would certainly accept the lower prices that are almost inevitable if they were completely rational-are human beings who have different emotions than economists would predict. So I think it’ll bounce along about the same as it did last year.

How Regulators Impact M&A
I had a recent experience where a well-run bank had a substandard compliance rating, and they went to their prudential regulator and the regulator said, “We’re fine with approving an acquisition.” Then the well-run bank went to the Federal Reserve for a waiver for approval, and the Fed said “We’re not fine with that.” And it’s really the Fed more than anybody else, especially for the smaller banks, that has caused a lot of difficulty. I think part of it is the Fed is more reluctant than the other regulators to approve mergers if there’s a compliance issue. The Fed’s safety and soundness examiners say they can’t argue or challenge the Fed’s compliance division. In essence the Fed application group and safety and soundness examiners say about the compliance team, “We don’t have any control over them. So if you have a compliance issue, that’s your problem and we’re not going to be able to say yes.” Now, the New York Fed might have slightly more ability to run the offense for you, but at other Fed regional banks it seems like the compliance people are controlling the outcome. It’s not going to stop every deal, but it has caused backups in some deals, and it’s caused other deals to never get off the ground.

Outlook for the Operating Environment for Banks
I think the operating environment is sort of camouflaged a little bit because we see some banks with loan growth and some banks with no loan growth. One question is how were they growing? A lot of it is taking market share from other people. Some people are getting it from residential mortgages where they might be taking an interest rate risk that could be quite substantial. And if they’re taking loans away from other banks, you just aren’t going to know for another two years whether that was a good risk or a bad risk. I think that’s hard when you look at the banks that are growing, especially if you’re a seller and you’re going to take the stock of an acquirer. I’m not so sure how good that stock is going to be. It’s one thing if you’re getting cash. It’s another thing if you’re going to take their stock and you expect to hold onto it.


Outlook for Bank M&A Market
I think consolidation is inevitable. It’s going to happen. It already has happened. We did about 160 deals in this industry last year, up from around 100 the year before. So that was a big increase. It wasn’t 200 or 300 that we all would have liked, and they weren’t big, but it has already been happening. It’s inevitable and it’s essential. This industry needs to consolidate. I’m not an economist, but the economy is creeping along in the right direction. Stock prices have increased for the buyers pretty dramatically from their low point, which gives them the ability to do deals. So I think we’re going to continue to see slow but steady improvement on the lower end of the scale.

Are There More Buyers Now?
I would say there’s more people looking at doing transactions. Whether they’re really buyers or not, I’m not so sure. They are feeling better about themselves. Their balance sheets have gotten better. But the essential part of it is they need to grow their balance sheets and they can’t grow them organically. So we’re seeing a lot more people looking at deals on the sell side, and also buy-side clients saying to us, “Run these numbers, we’re taking a look at some new markets.” But I think that’s just the beginning of real buyers in the market.

Outlook for the Operating Environment for Banks
If banks are a play on the economy, and the economy is not going to grow any better than 2 percent to 2.5 percent for the foreseeable future, and we’re going to have continued 7-plus percent unemployment, you’ve got to take market share from somebody else. It’s going to be a slog. We’re in a sale process now with a community bank, and they just revised their forecast for us because a big regional bank in their market has blanketed the market with unbelievable pricing. They just know they’re going to have to reduce their yield on their assets or give the loans away. So there is some irrationality in this market.


Outlook for the Operating Environment for Banks
I think the biggest challenge for the community banks is growing and growing profitably. That will propel M&A activity on the seller side. And from the buyer side, there’s the same issue. The only way they can really grow effectively and grow earnings is to buy someone and achieve efficiency. And I think that’s going to propel consolidation in the industry when people realize they can’t grow earnings and the value of their franchise may not increase in the next couple of years.

How Regulation Impacts M&A
What people don’t realize about Dodd-Frank is they think you have to have $10 billion or more in assets to be impacted. No. Those rules are going to trickle down and affect everybody. And what’s happening in the regulatory environment as the economy strengthens and there are fewer bank failures, the next hot button will be compliance. As we move away from commercial real estate, it’s going to be compliance. That raises the cost of running a small bank and I think that’s going to drive consolidation as well, because if your margins shrink and you can’t grow your loans and you have increased costs on the regulatory front, it’s going to make it hard to maintain your earnings. And I think boards and management teams get frustrated. I think that will be a big driver in people accepting less. That will change the bogey for what people will accept in mergers because they figure, “We’ll take stock from someone else, they’ll get efficiencies we could never realize and we’ll ride their stock up in value.” I really think that’s what’s going to happen.

Knowing When It’s Time to Sell
The little banks have to make a decision about what direction they’re headed. The real reason to do a deal now versus sometime down the road is because if you’re partnering with the right party and you get all or a chunk of stock, presumably that stock will be worth more in the future. So why not get out now and ride that stock up at a time when a lot of the stocks have not yet peaked? I also think that takeover premiums for a decent bank will range from 1 to 1.5 times tangible book value, depending on the bank. And the thing that people often lose sight of is this: Buyers think in terms of multiples of earnings while sellers think in terms of multiples of book value. If you have too much capital and you’re trying to sell, you’re not going to get paid for it. Buyers are not going to pay you a book-and-a-half premium on 12 percent capital. They can’t afford to. And I think people forget that. So if you’re going to position your bank for sale, I’d have a plan over the next year or two to leverage its capital in a variety of ways. Maybe you pay a special dividend. Maybe you do a buy back. Try to leverage that capital a bit within regulatory tolerance. You will get a better return on the remaining capital because the acquirer is buying earnings; it’s not buying your capital.


Outlook for the Operating Environment for Banks
The challenges facing banks are significant and shouldn’t be discounted, but we remain an industry that’s built on real estate and some of the metrics that we saw in the broader real estate market in the fourth quarter suggested that the industry was stabilizing and beginning to improve, and as that happens it’s going to increase opportunities for community banks. The challenges are real, but so are the opportunities. We continue to be in an industry where they’re not printing a lot of new charters, so the opportunity to be a bank and to make loans and take federally insured deposits gives us a significant leg up on other financial players. And certainly, the cost of funds being so low provides a lot of opportunity. Banks that have access to capital and whose management teams have a plan for dealing with the economy that we’re living in today will prosper and survive. Those that don’t will have to find partners in order to survive. That doesn’t suggest to me an industry that’s in the doldrums or isn’t dynamic, but it suggests that we have to adapt to the new realities, and there will be winners and losers in that.

Keys to Success in a Challenging Environment
Some of it is genetics. Banks that are in high growth areas of the country relative to the broader marketplace will have a certain built in advantage just because they’re in a place where there’s a lot of loan demand and a certain economic dynamism at play. Diversification is also something to consider because there are higher margin businesses outside the real estate market: commercial loans and certain other fee-based lines of business, for example, where banks can serve markets that have a need and at the same time diversify the revenue stream away from traditional low-yielding real estate products. You can acquire the diversification through acquisitions or you can lift out teams, but it requires a certain vision at the board and management level, and it requires access to capital to be able to afford the human resources and the platforms that you’ll need in order to succeed in those businesses. Banks that are able to grow their asset size, whether through organic growth or acquisition, and spread their costs across a wider asset base, will be the survivors in this new economy that we’re dealing with.


Sellers’ Expectations About Price
I don’t believe anybody is out there thinking they’ll get 2.5 times tangible book value anymore. But in our markets you’re starting to see some community banks sell for 140, 150, even 160 percent of tangible book. So some folks are raising their hand and saying, “Hey, do you think we could be in that range? Do you think we could get there?” And my answer is always not today, but maybe someday if industry multiples continue to improve and your bank continues to generate a 1 percent or 1.10 percent return on assets when the rest of the market is doing 70 basis points. Maybe you can get there in two or three years. But if you’re thinking, “Well, I’ve got $20 million of tangible common equity in my bank and I was really hoping to sell my bank for $40 million someday,” you can probably sell for $40 million once you build your bank to $30 million of tangible equity and then sell for 1.33 percent of tangible book-which gets you a $40 million price. But to do that you’ve got three or four years of operating risk. So what’s your discount rate? What are you willing to take today to avoid all of the industry headwinds that you’ll have to contend with? The execution risk is huge, and we’ve seen some boards say that the next three or four years are going to be tough, and even though they had it in their heads to get 170 or 180 percent of tangible book, maybe accepting a 130 price today and taking three years of execution risk off the table isn’t a bad thing.

Outlook for the Operating Environment for Banks
On the visits we have with CEOs, I usually end every meeting by asking what can we do to help, and the number one answer right now is, “Find me quality earning assets and a decent spread.” There’s this trickle-down effect of where the big banks are competing for loans in the super-regionals’ space, the super-regionals have moved into where true regionals were playing and the regionals are playing in the community banks’ space.


Jack Milligan


Jack Milligan is editor-at-large of Bank Director magazine, a position to which he brings over 40 years of experience in financial journalism organizations. Mr. Milligan directs Bank Director’s editorial coverage and leads its director training efforts. He has a master’s degree in Journalism from The Ohio State University.

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