2014 Bank M&A Survey

Brian Vance, president and chief executive officer of Olympia, Washington-based Heritage Financial Corp., a bank holding company with $1.7 billion in assets, is seeing more deal activity in his part of the country, the Pacific Northwest. He says part of that stems from banks seeking to grow to create some efficiencies within their own institutions, but he also sees a bit more confidence in the economy. “The Pacific Northwest has one of the more vibrant economies in the U.S. right now,” says Vance. “CEOs are looking at expansion with more confidence than they have in the last five years.”

Indeed, it would seem that the banking industry is clamoring for deals after several years in which transaction volume has been relatively low. Seventy-six percent of those responding to Bank Director’s 2014 Bank M&A Survey, sponsored by Crowe Horwath LLP, expect to see deal activity pick up this year. However, expectations don’t always live up to reality. While more than half of respondents say that their bank plans to purchase a healthy bank this year, just five percent say they’re willing to sell.

Looking back at what respondents planned to purchase versus what respondents say their banks actually bought in 2013, many institutions were unsuccessful in making a deal. Forty-six percent of respondents to the 2013 Bank M&A Survey revealed plans to purchase a healthy bank, yet less than one quarter of respondents to this year’s survey say that they purchased one or more healthy institutions. Plans to complete a government-assisted deal with the Federal Deposit Insurance Corp. also did not meet expectations, with just 8 percent buying a failed bank compared to the 17 percent that revealed plans to do so in 2013.

“Those planning to do a transaction don’t always reach the finish line,” says Chad Kellar, senior manager at Crowe Horwath. “When it comes to whole bank or FDIC-assisted transactions and even branches, the appetite is there, but getting it done is just not happening.” And for banks to get the deal done, it boils down to price.

The board and management at Effingham, Illinois-based Midland States Bancorp Inc., a bank holding company with $1.7 billion in assets, consider themselves to be veterans at the bank M&A game. Chief Financial Officer Jeff Ludwig, as well as Leon Holschbach, the president and CEO, shifted the bank’s strategy in 2007, when the company had only $380 million in assets, to a strong M&A focus culminating in eight acquisitions so far.

Midland States looks at a lot of deals, benefitting from a market full of community banks under $1 billion in assets in Illinois and the surrounding region. The bank is a known buyer at this point, with investment bankers and potential sellers knocking on Midland’s door. If the target bank fits into Midland’s footprint at the right price, then the two parties just might be able to make a deal. But price is a deal-breaker. Price comes up early at Midland States’ negotiating table, and if the two parties can’t agree, then the bank simply moves on to the next seller.

“We’re still not seeing sellers willing to sell for just any price, or for any structure that’s out there,” says Crowe Horwath Director Rick Childs. Thirty-five percent of respondents say that coming to agreement on the right price with the other bank is the greatest challenge their board faces when considering an acquisition or merger. When asked about barriers to making a deal, 63 percent of potential buyers say that the pricing expectations of potential targets are too high. Forty-two percent of potential sellers claim that current pricing is too low.

Lynn Fuller, president and CEO of Heartland Financial USA Inc., a $5.7-billion asset financial services company based in Dubuque, Iowa, says that the only deals he’s been turned away from have been due to price. Heartland’s recent purchase of Merriam, Kansas-based Morrill Bancshares Inc., for 1.25 times tangible book value at $55.4 million, was completed for $16.6 million in cash and $38.8 million in stock. Fuller finds that many sellers like to take stock, and should find comfort that as shareholders they will benefit from the combined banks’ continued growth. “Isn’t that a better deal than what you currently have?” he asks. “If the seller is thinking about the value to the shareholder, it’s an easy sell.”

Both buyers, at 56 percent, and sellers, at 40 percent, favor a transaction of both cash and stock. Childs says that few are interested in all stock or all cash deals, and as stock prices rise and banks seek to preserve capital, he’s seeing a growing interest in a combination of the two. “It will manage dilution but also [allow banks] to raise capital for the transaction,” says Childs.

In addition to price, asset quality remains a concern for bankers-though just 5 percent of potential sellers say that their banks’ asset quality is subpar. Forty percent of buyers cite the asset quality of potential targets as a barrier to making a deal. However, concerns about asset quality have dropped by 19 percentage points since the 2013 survey. “There is a negative view in terms of asset quality still from the buyer’s perspective,” says Kellar. He finds that acquiring banks are often pleasantly surprised once the credit review is done. “Those that are actually stepping through the transactions in real time are finding things are better from a credit perspective.”

Ludwig says that asset quality will always be a concern. “We believe we’re fairly conservative in the way we lend, and we got through the storm pretty well,” he says. He sees asset quality improving among target banks, which will improve the chances of closing the deal and of seller banks getting a high price. “But we still spend a lot of time and effort looking at their loan portfolio, and we will always do that,” he says.

Half of respondents say one of the top reasons to seek an acquisition or merger of equals is to increase earnings per share. Forty-four percent aim to further expand geographically, and 42 percent say they want to supplement or replace organic growth.

Geography and business focus are central to Heartland Financial’s M&A strategy. “We like metro centers that are rich with [commercial loan] business,” says Fuller. And while just 16 percent of respondents say that picking up key personnel is a good reason to make an acquisition, it certainly can help close the deal and strengthen the acquiring bank’s team.

Heartland Financial looks for banks based on the market they’re in and the quality of that bank’s staff, and Fuller says that it was important to the Saylor family, former majority owners of Morrill Bancshares and now Heartland Financial’s second largest shareholder, that key employees could stay on board. “There are a number of their staff that are going to be very additive for Heartland,” says Fuller, specifically citing staff in treasury management and commercial banking. “It really was a nice match-up, because we can use some of the expertise that they have that we didn’t necessarily have.”

Twenty-three percent cite cultural fit, a variable that’s difficult to quantify, as the greatest challenge their boards face when considering an acquisition. “It’s one of those things that can effectively submarine the deal,” says Childs.

Heritage Financial announced in October 2013 plans to merge with $1.6-billion asset Washington Banking Co., based in Oak Harbor, Washington, in the first half of 2014. Vance thinks the two bank holding companies are well-aligned culturally. Heritage Financial has taken a steady yet disciplined approach to M&A, looking for institutions not only with strong credit quality and a good geographic fit but that also align culturally with their own. “That discipline has caused our growth to be slower,” he says, but “when you do the integration and find banks that are similar in market areas where you do business, I think you find that the synergies beyond the transaction close are a lot stronger and drive future performance.”

While less than one quarter of respondents overall report buying a bank in the last year, 54 percent of those from banks with between $1 billion and $5 billion in assets report the purchase of a healthy bank. Overall 8 percent report making a FDIC-assisted deal, compared to one quarter of respondents from banks between $1 billion and $5 billion in assets.

Childs sees significant activity at banks of that size. “They’re the ones that are the right size to do deals,” says Childs. “They’ve got capital behind them, either in the form of private equity money that was invested or money that they’ve raised themselves, and they’re beginning to have stock prices that are favorable compared to the prices they are paying, and they don’t seem to have the competition they used to have” for deals. The average size of the seller is also smaller. Ten percent of respondents from banks with less than $500 million in assets intend to sell the bank in 2014, compared to five percent of respondents overall. No respondent from a bank with more than $1 billion in assets indicates plans to sell their institution.

Many banks hesitate to make further acquisitions as they reach $10 billion in assets due to the additional regulatory burden imposed on banks of that size. Childs says he’s seeing banks at this size making the deals they can, then stopping to reorganize the acquired assets that don’t make strategic sense. Those banks should “take a breath and find out what’s going on from a regulatory standpoint and from an industry standpoint before [they] willingly jump over the $10 billion threshold,” he says.

When asked for reasons to sell, 45 percent of bank executives and directors responding to the survey say they simply won’t. Forty-six percent of respondents say they would consider a deal if the bank received an attractive offer. “An attractive price, which is a combination of considering not only the absolute dollar amount of it but also how it’s being paid to you, whether it’s all up front, whether there’s any being held back, the probability of it not occurring, whether I’m getting stock that’s so illiquid that it’s really not any better off than holding my own stock, all those things go into an attractive price, says Childs. “[Boards] recognize that if they got the right price, they really have to consider selling because that’s their fiduciary responsibility.”

Twenty-three percent of respondents cite limited growth opportunities as a reason to sell, and Jim Brownson, chairman of $2.5-billion asset QCR Holdings Inc., a multi-bank holding company headquartered in Moline, Illinois, says that QCR’s recent purchase of Community National Bancorp., based in Waterloo, Iowa, with $279 million in assets, was driven by growth concerns on the part of the seller. “I think that they were wondering where their future was-were they going to continue to grow themselves, or were they going to try to hitch their wagon to another company,” he says. The bank’s focus on small business and commercial & industrial lending was a good strategic fit for QCR.

The Saylor family wasn’t actively looking to sell Morrill Bancshares when Heartland Financial was calling on banks in the Kansas City area to seek a deal, but had an interest as long as the bank-the oldest state-chartered institution in Kansas-could keep its charter. The opportunity to buy came by chance. “It was very fortunate that we had a chance to talk to the Saylor family, because they, like ourselves, run a very high quality institution, very clean, very profitable,” says Fuller.

Ten percent of respondents cite CEO succession as a reason to sell, and almost 20 percent say they’ll sell if the management and board of the bank no longer find the experience to be rewarding. At small community banks, particularly those that are family-owned, succession may be an issue. “We had no new generations of the family coming in,” Kurt Saylor, former chairman and CEO of Morrill Bancshares, told the Kansas City Business Journal in June 2013. In his early 60s, Saylor is now a member of the Heartland Financial board, and the oldest institution in Kansas will keep its charter.

Survey respondents are split over whether their bank would consider a merger of equals, or what some in the industry call a strategic partnership. Thirty-five percent would consider this type of deal as a way to gain scale and spread the bank’s operating and regulatory costs over a wider base. Twenty-one percent say they would consider a merger of equals if it was the only way to consummate a deal with an attractive merger partner. However, 39 percent of respondents don’t believe that there can ever truly be such a thing as a merger of equals, as one of the banks always comes out ahead.

The union between Heritage Financial and Washington Banking Co. is being termed a strategic partnership, and the two parties expect to see many benefits from the deal. The merged company will double in size, to $3.3 billion in assets, and Vance sees a real benefit from the increased footprint that will take the combined bank from Portland, Oregon, to the Canadian border, making what Vance says will be the largest community bank network in western Washington. “From a strategic point of view, it was a very compelling marriage or merger of two very equal companies, and I think [that] makes a very strong franchise,” he says. “I think that everybody from day one saw the value of putting the organizations together.”

Whether it’s a strategic partnership or a straight-forward acquisition, each deal has its difficulties. Fifty-three percent of respondents say that assessing credit quality was the toughest part of their most recent acquisition. Post-merger integration is cited by 45 percent, and cultural compatibility by 43 percent, as the most difficult aspects of the acquisition. Childs says that banks focus a lot of time on credit quality, but should not overlook full due diligence. “Due diligence is more than credit, and really is the whole process of understanding the bank very well,” he says. “You can learn a lot through the due diligence process beyond what the findings are. You learn a lot about the cultural fit and management of the organization.”

Many in the industry have been shouting that the regulatory environment hinders M&A, but anecdotal evidence is slim, and survey respondents are mixed. Almost sixty percent of the directors and officers responding to the 2014 Bank M&A Survey believe that it is more difficult to get regulatory approval to make an acquisition than it was five years ago. However, 20 percent of respondents say that they just don’t know if regulators are really any harder on M&A deals, and when asked about roadblocks to M&A, regulations barely warrant a whisper, with just 11 percent citing the ability to gain regulatory approval as a potential barrier when seeking a deal.

Big-name deals like the stalled merger between M&T Bank Corp. and Hudson City Bancorp, in limbo due to concerns from the Federal Reserve Board about M&T’s compliance with anti-money laundering regulations under the Bank Secrecy Act, get a lot of mileage in the press, but Childs says that deals are achieving regulatory approval with some speed for community-based banks. “At the same time, from a smaller bank perspective there is still a fear of what’s going on from a regulatory standpoint,” he says. Serial acquirers are meeting with their regulators regularly, and the transparency is improving the process.

The management and board of Midland States meets with their regulator, the Federal Reserve Bank of St. Louis, regularly throughout the year, and the bank has yet to lose a deal due to regulatory barriers. The bank has seen their deals approved relatively quickly. “We meet with [regulators] on a regular basis, whether we have a deal on the table or we don’t, and not just at exam time,” says Ludwig. “We’ll tell them what we’re doing, [so] they clearly understand our strategy and what we’re trying to do; [we’re] very open with them.” Midland States has made a significant investment in risk management “so the regulators can see that we’re building the infrastructure ahead of our growth,” he says.

However, even seasoned acquirers hit the occasional bump in the road. Midland States is currently facing pushback from a local Missouri group lobbying against the bank’s acquisition of Heartland Bank, a $794-million asset bank headquartered in St. Louis, due to concerns about the acquisition’s impact on minority lending in the St. Louis market. The group cites the low percentage of loans that Midland States has made to African Americans. The Heartland Bank acquisition will greatly expand Midland States’ presence in the St. Louis market, to 16th in deposits.

One way in which increased regulation might be having an impact on M&A is in driving some banks-particularly those with less than $500 million in assets-to sell. When asked about reasons to sell their institution, 25 percent of respondents cited the high cost of regulation.

Will Basel III be the earthquake that shakes out even more deals, finally driving more consolidation in the marketplace? Forty-one percent of respondents believe that Basel III will cause an increase in M&A, while one-third don’t expect Basel III to have an impact at all. When asked about M&A strategy at their own institutions, more than half expect little impact from Basel III.

Childs thinks that Basel III is more likely to impede deals for buyers than to compel banks to sell. “Basel III has made it more difficult for [banks] to buy, because [they] have to have tangible common equity, says Childs. “[They] really have to limit the amount of non-common capital floating around in the deal.” Banks need a capital buffer on top of all that, “and we all know that the regulator is going to operate with a buffer on top of the buffer,” he adds.

About the Survey Respondents

In September 2013, over 200 bank executives and directors responded to the 2014 Bank M&A Survey, which was conducted by email. Independent board members account for 46 percent of the responses, and 38 percent of participants serve as the chief executive officer of the bank. Response from publicly traded and privately held banks was almost evenly split. Thirteen percent of the respondents were from banks with $5 billion or more in assets, 24 percent from banks between $1 billion and $5 billion in assets, 18 percent from banks between $500 million and $1 billion in assets, 23 percent from banks between $250 million and $500 million in assets and 22 percent with less than $250 million in assets. The largest number of respondents, at 31 percent, came from banks in the Midwest. Just over one quarter represent banks in western states, while 23 percent represent the Southeast and 20 percent the Northeast. Full summary results of the survey are available in the research section at BankDirector.com.