Should We Sell The Bank?

(Editor’s note: Due to the popularity of this topic, we are releasing an updated version of this article, which originally appeared in the third quarter 1995 issue of Bank Director.)

A significant portion of my time is spent working individually with clients as they try to decide whether or not to sell their banks. As the CEO or major shareholder and I work through the issues, often it becomes clear that now may not be the time to sell. For example, it is not the time to sell when earnings improvements can quickly and easily be made that will significantly increase the value of the bank in a matter of months. At other times, it is clear that now is the time to sell by actively and formally pursuing competitive bids for the bank. This is especially true when earnings are “maxed out,” growth is slow, prices for similar banks are attractive but may be in danger of declining, and the CEO/major shareholder doesn’t want to entrust a significant portion of his of her higher net worth to anyone else.

Selling starts to make even more sense if no family member wants to keep the bank, and afternoons on the golf course are beginning to look a lot more attractive than afternoons spent visiting with yet another crew of young examiners who don’t understand the bank. Finally, for many owners, the increasing necessity of making sizable investments in new technology, building a sales culture, and managing organizational changes is simply not worth the effort or the risk.

Whether or not to sell the bank is a major personal and economic decision. First, selling the bank often represents capitalizing on years of hard work and successfully managing risks. For many bankers, as well as families who have owned their banks for generations, the sale of the bank is a significant life event. Second, selling the bank is not an easy decision, nor should it be. The pros and cons of selling versus keeping and building should be explored objectively.

Third, if the decision to sell the bank is made, then the main objective immediately becomes clearu00e2u20ac”to obtain the highest possible price from an acceptable purchaser. In our experience, we have found that the best approach is to use the confidential bidding process to maximize shareholder value. When properly managed, competitive bidding often leads to notably higher prices being paid.

The triple dip

Double dipping is the bank merger equivalent of the daily double at the track. The idea being that you sell out at a premium (paid in stock) to a bank that, in turn, sells out at a premium to another bank.

The rule is: Assume only one dip. But then, all things are possible. Maybe the double dip will work. Maybe the triple dip will work. Who knows? Maybe even a quadruple dip will work. Then again, maybe there will be only one dip and the ice cream will melt in the acquired bank’s hands.

Ten major considerations

The earnings outlook

Financial institution earnings are at an all-time high. The industry reported that pretax earnings have risen from $28 billion in 1991 to an estimated $128 billion in 1999, a compound annual growth rate of 21%. What caused this $100 billion, 357% increase? Did bankers suddenly get smarter, or did a number of fortuitous events converge to make this happen? Basically, interest spreads were healthy; loan loses decreased dramatically; and noninterest income increased while noninterest expenses rose only modestly. In short, everything worked in the industry’s favor.

A quick reality check requires us to ask: Will it continue forever? Probably not. I’m reminded of the story told by Warren Buffett about a duck paddling back and forth in a pond. It began to rain and the pond rose. The delighted duck believed it was all due to his own efforts.

As I visit with leading bankers across the country, I get mixed messages about their outlook for earnings over the next three years. According to their predictions, interest spreads will continue narrowing, as they have in recent months, because of competitionu00e2u20ac”unless one believes that no competitor will ever seek to gain market share through competitive pricing. Loan losses will increase during the next economic downturnu00e2u20ac”unless one believes there will never be another recession. And, of long-term importance, when online banking becomes a reality in terms of both customer acceptance and usage, a whole new competitive landscape will emergeu00e2u20ac”unless one believes the Internet will not spawn new products, new customer expectations, and new competitors.

But from the viewpoint of an individual bank, the world may seem quite promising. Effectively marketed loan and deposit products can contribute to increased interest margins. Noninterest income opportunities may abound, especially on traditional banking services. Noninterest expenses can be reengineered to provide significantly increased earningsu00e2u20ac”often by reducing salary expenses while simultaneously improving customer service through the use of technology and process reengineering. Most important, prized customers may literally be fleeing a recently merged competitor. Therefore, the earnings outlook really does depend on an individual bank’s situation.

Growth potential

The industry has been growing very slowly in terms of total assets. Deposit growth for most banks has become especially hard to achieve due to increased competition. As one banker said, “It’s much easier to get $500,000 in commercial loans than it is to get $500,000 in new consumer deposits.” The bottom line is that the industry’s total asset growth can be described as flat.

Once again, just as with the earnings outlook, realistic growth potential varies dramatically from one bank to another. The big difference today, however, is that management decisions, such as whether to aggressively focus on customer relationship management, will determine the real winnersu00e2u20ac”even in slow-growth markets.

Achievable selling prices

The selling prices of virtually all banks have increased dramatically over the past five years. Almost without exception, there have been a number of interested buyers ready to bid competitively for every bank out there. Although prices have gone up, obviously not all banks are selling for two times book. The key word here is “achievable.” Getting the best price means understanding the potential value of the bank to specific interested buyers and effectively marketing the bank to them.

Of increasing concern to potential sellers, however, is the shrinking number of large, active acquirers because they themselves are becoming acquired. The unanswered question: Will new, active acquirers with high P/E ratios and liquid markets for their stocks emerge to buy banks? And how long will these prices last? They’ll last as long as acquiring organizations can afford to pay high premiums, which relates directly to two factors: their price earnings multiples and their ability to increase the earnings of the acquired banks. A world populated with cash-only buyers would likely mean significantly lower prices unless interest rates were very low.

Management

As we look at management, there are three things that need to be considered: management’s depth, its ability to manage change effectively, and the succession potential of senior executives.

Depthu00e2u20ac”With regard to depth, it is important to look at how vulnerable the bank is to losing key officers should it remain independent. First, consider the depth of the individual bank officers in terms of their ability to lead the bank. Then look at the depth of the bench. In other words, is there available talent to grow the bank? Is the bank training and developing a team to take it into the future in terms of both the technology and marketing skills that will be required?

Ability to manage changeu00e2u20ac”The industry is undergoing enormous change that will continue even more rapidly in the next three to five years due to technology and competition. The need for new organizational skills and approaches will be required. For example, while the basics of sound credit judgment won’t change, the market will demand faster decisions and much better pricing. Customer relationship management and the Internet are reshaping the future of banking from the customer’s viewpoint. Maintaining the status quo will work for a while, but then one day it won’t work, and the core value of the banku00e2u20ac”its franchise built on its most profitable customersu00e2u20ac”may begin to disappear. The new reality is that, in many instances, customers’ expectations are changing more rapidly than banks’ are able to respond.

Succession potentialu00e2u20ac”Every CEO knows what it takes to manage and lead an institution through the pitfalls that periodically beset all banks. Whether it is a credit crisis, an organizational challenge, or taking proper care of a difficult but important customeru00e2u20ac”the CEO is often the key individual who keeps it all together. The looming question is, can the individual who would take over as successor not only manage, but lead, especially in terms of meeting new challenges or crises? Is the individual who would become CEO intellectually honest, forward-looking, inspiring, and highly competentu00e2u20ac”or merely adequate?

Future banking success will require the same unique character traits of fundamental soundness and good judgment that have always been necessary. But today’s world also requires an ability to lead organizational change, integrate technology into the fabric of the organization and its delivery systems, and, at the same time, create a powerful sales culture. A “maintainer” as opposed to a “builder” simply will not be able to enhance the value of the bank.

The impact of technology

The top consideration in the question of whether or not to sell is the ability of the bank to make the right technology decisions and investments in an increasingly competitive environment. Is technology being adequately considered in the bank’s strategic planning and thinking? And, on a more tactical level, is there adequate utilization of the technology the bank already owns? For example, how well is the entire organization being trained in the existing technology? In the future, the right technology is going to be the key enabler of growing, high-performance banks.

Conversely, selecting the wrong technology will be the financial and marketing Achilles heel of many banks. For example, vendor-driven technology solutions are often one-dimensional and sometimes inappropriate for meeting multifaceted challenges in the near future.

In the long term, electronic banking and commerce will reshape not only the delivery of financial services but, most important, who will be delivering those services.

Increasing competition

The issue is, first, how effectively is the bank meeting today’s competition; second, how will it meet stronger competition over the next three years; and thirdu00e2u20ac”the really troubling questionu00e2u20ac”who or what will the competition be in an age of electronic commerce? How will the bank deal with businesses that want to do their banking quickly, cost-effectively, and electronically? For example, how many financial institutions will an electronically driven customer want or need? What combination of funds management, lending, and related services will the customer want from the institution?

The first wave of new competitors are the brokerage firmsu00e2u20ac”the Merrill Lynches, Schwabs, Morgan Stanleys, etc. The second wave will be those banking organizations that are highly customer-focused. They will have sophisticated information management coupled with effective sales forces, selling well-researched and carefully developed products. The third wave will utilize electronic commerce and likely will revolutionize much of how the banking industry does business.

Finally, watch Wal-Mart closely as it enters the banking business. This is a company that understands the consumer, has a great brand for commodity products, and, the last time I checked, focuses on offering low prices every day.

Alternative investment opportunities

Before seriously considering selling the bank, major stockholders need to look at their alternative investment opportunities. Reality for many long-term investors is that if the bank is earning 15% or more on equity after taxes, these stockholders will often be hard-pressed to find a better alternative investment with the same level of risk. If the bank is a Sub-S, the 15% after taxes equates to 22.5% pretax, and if all the pretax earnings are distributed, the Sub-S bank can provide an exceptionally high pretax return to shareholders. The troubling issue for many individual investors is, will the bank continue to achieve those exceptional results, or will the bank’s current 15% return on equity begin to decline steadily in the new competitive environment?

Beware of seller’s remorse. Often owners will sell the bank and immediately begin looking for another investment to manage and build, where they understand the products, the staff, and the market, only to realize that they just sold an excellent one. While the bank may have faced unique problems and challenges, perhaps in hindsight, those were more easily conquered than going into a new business, or buying another bank, or starting a new bank. The key is to avoid seller’s remorse by considering what will be done with the proceeds after the sale of the bank.

Finally, remember the economic realities of a tax-free exchange: If the seller receives stock in a tax-free exchange, even though he or she has every intention of holding it, the inherent investment risk will become clearer, especially if the stock represents a large portion of the seller’s assets. Sooner or later, some or all of the stock will be sold, and significant capital gains taxes will be incurred; because often there is a very low basis in the stock. Then the former owner will have to find other investment opportunities for a significantly reduced pool of after-tax dollars.
Whether or not to sell depends upon the owner’s perception at the end of the day about the future of the institution, the relatively high premiums being paid for bank stock, and the personal desire for increased liquidity. These must be weighed against the attending capital gains taxes and the eventual necessity to search for other investments. The availability of acceptable investment alternatives depends on return expectations, which in today’s market may be unrealistically high.

Other professional career opportunities

Often, highly capable CEOs and senior management of acquired banks find themselves effectively out of a job after a merger is completed. The reality is that many CEOs do not have a substantial equity interest in the bank. An important challenge for owners of closely held banks and their boards is to get senior management’s interests directly aligned with the owners so that they are both working from the same side of the table.

Personal considerations

Personal and family considerations are sometimes the driving force in the decision to sell or not to sell the bank. These situations often present excellent opportunities for potential buyers. While such considerations may drive the sale, if properly managed, they need not negatively influence the eventual price received.

The fun factor

Don’t overlook this one. Will it be more fun to have the money or the bank?