The Growing Imperative of Scale

bank-scale-2-1-16.pngWhy are there so many people attending Bank Director’s 2016 Acquire or Be Acquired Conference this year, which at over 900 people is the largest number of attendees in the 22 years that we have been holding this event? Clearly the participants are interested in learning about the mechanics of bank M&A and the trends that are driving the market. But something seems to be different. I sense that more boards and their management teams are seriously considering M&A as a growth plan than perhaps ever before.

The heightened level of interest could certainly be explained by the continued margin pressure that banks have been operating under for the last several years. The Federal Reserve increased interest rates in December by 25 basis points–the first rate hike since 2006. But Fed Chairman Janet Yellen has said that a tightening of monetary policy will occur gradually over a protracted period of time, so any significant rate relief for the industry will be a long time in coming.

Other factors that are frequently credited with driving M&A activity include the escalation in regulatory compliance costs – which have skyrocketed since the financial crisis – and management succession issues where older bank CEOs would like to retire but have no capable successor available. But these challenges have been present for years, and there’s no logical reason why they would be more pressing in 2016 than, say, 2013.

What I think is different is a growing consensus that size and scale are becoming material differentiators between those banks that can look forward to a profitable future as an independent entity and those that will struggle to survive in an industry that continues to consolidate at a very rapid rate.

In a presentation this morning, Tom Michaud, the president and CEO at Keefe, Bruyette & Woods, showed a table that neatly framed the challenge that small banks have today in terms of their financial performance. Michaud had broken the industry into seven asset categories from largest to smallest. Banks with $500 million in assets or less had the lowest ratio of pre-tax, pre-provision revenue as a percentage of risk weighted assets – at 1.41 percent – of any category. Not only that, but the profitability of the next four asset classes grew increasingly larger, culminating in banks $5 billion to $10 billion in size, which had a ratio of 2.27 percent. Profitably then declined for banks in the $10 billion to $50 billion and $50 billion plus categories. Banks in the $5 billion to $10 billion are often described as occupying a sweet spot where they are large enough to enjoy economies of scale but still small enough that they are not regulated directly by the Consumer Financial Protection Bureau or are subject to restrictions on their card interchange fees under the Durbin Amendment.

Size allows you to spread technology and compliance costs over a wider base, which can yield valuable efficiency gains. It makes it easier for banks to raise capital, which can be used to exploit growth opportunities in existing businesses or to invest in new business lines. And larger banks also have an easier time attracting talent, which is the raw material of any successful company.

There will always be exceptions to the rule, and some smaller banks will be able to outperform their peers thanks to the blessings of a strong market and highly capable management. But I believe that many banks under $1 billion is assets are beginning to see that only by growing larger will they be able to survive in an industry becoming increasingly more concentrated every year. And for banks in slow growth markets, that will require an acquisition.

A Front Row Seat on Bank M&A

bank-manda-1-28-16.pngJanuary 30 will mark the kick off of Bank Director’s 22nd annual Acquire or Be Acquired Conference at the Arizona Biltmore resort in Phoenix. Although he is not the architect of record—that distinction belongs to the lesser known Albert Chase McArthur—the famed Frank Lloyd Wright is generally credited with designing the iconic structure, and it bears his formidable imprint. We’ve held many of our AOBA conferences at the Biltmore (and at the Phoenician resort in nearby Scottsdale), and both venues have given us a front row seat on history.

By my count, this will be the 15th AOBA event that I have attended and the architects of countless M&A deals have spoken there. Interestingly, the number of U.S. banks and the number of AOBA attendees have had a dichotomous relationship over that period of time. The conference has gotten bigger—this year we are expecting over 900 attendees, which would make it the largest ever—while the number of banks has gotten smaller. There were approximately 12,000 depository institutions in 1994—the first year of the conference—compared to just over 6,000 today. While we would love to take full credit for driving that dramatic level of consolidation, the Acquire or Be Acquired conference has at least provided tens of thousands of attendees with important information to make one of the most important decisions of their business lives.

I don’t believe that any single trend or event has had a greater impact on the industry since 1994 than the long wave of consolidation, with the possible exception of the 2007 to 2008 financial crisis. Of course, those two dynamics—consolidation and the crisis—are intertwined, as I’ll get to in a moment. Consolidation has created a bipolar industry of extremes. According to SNL Financial, the nine largest U.S. banks hold about 44 percent of the country’s banking assets, the other 6,000-plus institutions hold the balance. 

The impact of this great disparity between the biggest of the big and everyone else has been profound. It was out of a deep well of concern about the systemic risk posed by the country’s largest financial institutions (including investment banks, insurance companies and other giant non-bank financial companies) that Congress passed the Dodd-Frank Act of 2010, which greatly increased the regulatory burden for all institutions regardless of their size. Compared to the Big Five, community banks and larger regionals pose very different public policy challenges in such areas as regulation, capital adequacy and risk—although this distinction isn’t fully reflected in the reality of the laws or regulatory attitudes that impact the industry today. With the exception of Citigroup, which has never been a significant factor in the domestic M&A market other than its historic 1998 merger with the Travelers Group, four of the Big Five—JPMorgan Chase & Co., Bank of America Corp., Wells Fargo & Co. and U.S. Bancorp—are products of consolidation. You can see a personalized history of bank M&A in any of their family trees.

In recent years, the bank M&A market has settled into a steady if somewhat measured annual reduction in the number of banks. There were 225 healthy bank deals in 2013, according to SNL Financial, for an average price to tangible book value (P/TBV) of 123.3 percent. Two years ago, there were 285 deals for a P/TBV ratio of 141.1 percent. And in 2015 there were 284 deals for a P/TBV ratio of 144.9 percent, reflecting a slight increase in pricing if not in activity, according to   data from SNL. That’s a far cry from 1994 when there were a record 524 deals for an average P/TBV ratio of 171.5 percent, but there aren’t as many banks to sell today as there was 22 years ago.

Much of the M&A activity in recent years has been driven by community banks and their regional counterparts since institutions with $50 billion in assets or greater—which are considered to be in a different class by the regulators—have largely been barred from doing acquisitions. There are signs, however, that some of these players are getting back in the game, evidenced by the recent announcement that $71 billion asset Huntington Bancshares would acquire $25.5 billion asset FirstMerit Corp. for $3.4 billion.

Generally, the Acquire or Be Acquired conference is an opportunity for bank CEOs and their directors to gain knowledge about the mechanics of bank M&A. It is not a place where most people come to do deals, although I did have a CEO tell me recently that a contact he made at a past conference lead to an acquisition. So not only has AOBA been a witness to history, occasionally, it helps make it.

Issues & Ideas for M&A Related Capital Raising

During Bank Director’s 2015 Acquire or Be Acquired conference in January, this session explored alternatives for raising capital required to close a specific M&A transaction. The discussion included the pros and cons of both public and private transactions with specific examples of offerings that worked well and those that faltered. The presentation also focused on the evolving role of private equity as a source of acquisition related capital.

Presentation slides

Video length: 54 minutes

About the speakers

Todd Baker – Managing Director & Head of Americas Corporate Development at MUFG Americas Holdings / MUFG Union Bank NA
Todd Baker is managing director and head of Americas corporate development at MUFG Americas Holdings / MUFG Union Bank NA. He has had a lead role in scores of bank and financial services M&A transactions over the past 30+ years. Some of his more recent transactions in the community bank sphere include the 2012 acquisition of Pacific Capital Bancorp by MUFG Union Bank, the 2009 acquisition of The South Financial Group by TD Bank and the 2006 acquisition of Commercial Capital Bancorp by Washington Mutual.

Frank Cicero – Global Head of Financial Institutions, Managing Director Investment Banking at Jefferies LLC
Frank Cicero is the global head of financial institutions, managing director investment banking at Jefferies LLC. He specializes in M&A and capital markets transactions for depository institutions. Previously, Mr. Cicero was the head of investment banking coverage for banks at Lehman Brothers and Barclays Capital.

John Eggemeyer – Founding & Managing Principal at Castle Creek Capital LLC
John Eggemeyer is a founding and managing principal at Castle Creek® Capital LLC which has been a lead investor in community banking since 1990. The firm is currently one of the most active investors in community banking with approximately $700 million in assets under management. Prior to founding Castle Creek®, Mr. Eggemeyer spent nearly 20 years as a senior executive with some of the largest banking organizations in the U.S. with responsibilities across a broad spectrum of banking activities.

2015 L. William Seidman CEO Panel

During Bank Director’s 2015 Acquire or Be Acquired conference in January, a panel of four community bank CEOs, all of whom are publicly traded, above $5 billion in asset size and are active acquirers discuss their different strategies for the future with our president, Al Dominick. This session is named after the former FDIC Chairman and Bank Director’s Publisher, the late L. William Seidman, who was a huge advocate of a strong and healthy community bank system.

Video length: 46 minutes

About the speakers

David Brooks – Chairman & CEO at Independent Bank Group
David Brooks is chairman and CEO of McKinney-headquartered Independent Bank Group, which currently operates 35 Independent Bank locations spanning across Texas. He has been active in community banking since the early 1980s and founded this company in 1988.

Daryl Byrd – President & CEO at IBERIABANK Corporation
Daryl Byrd is president and CEO of IBERIABANK Corporation. He serves on the boards of directors for both IBERIABANK Corporation and IBERIABANK, where he joined in 1999. Headquartered in Lafayette, LA, IBERIABANK is the 126-year-old subsidiary of IBERIABANK Corporation operating 187 branch offices throughout Louisiana, Arkansas, Alabama, Florida, Texas and Tennessee. With $15.5 billion in assets (as of October 31, 2014) and over 2,700 associates, IBERIABANK Corporation is the largest and oldest bank holding company headquartered in Louisiana.

Ed Garding – President & CEO at First Interstate BancSystem, Inc.
Ed Garding is president and CEO of First Interstate BancSystem, Inc. He has been chief executive officer of First Interstate BancSystem since April 2012, chief operating officer from August 2010 and served as an executive vice president since January 2004. Mr. Garding served as First Interstate’s chief credit officer from 1999 to August 2010, senior vice president from 1996 through 2003, president of First Interstate Bank from 1998 to 2001 and president of the Sheridan branch of First Interstate Bank from 1988 to 1996. In addition, Mr. Garding has served as a director of First Interstate Bank since 1998.

Mark Grescovich – President & CEO at Banner Corporation
Mark Grescovich is president and CEO at Banner Corporation. He joined Banner in April 2010 as president and became CEO in August 2010 following an extensive banking career specializing in finance, credit administration and risk management. Under his leadership, Banner has executed an extremely successful turnaround plan involving credit stabilization, improved risk management, a secondary public offering and other capital raising activities and a return to profitability based on net interest margin improvements.

Marketing the Legacy: Challenges and Opportunities in Selling Family-Owned and Closely Held Institutions

A respected bank CEO and a veteran investment banker discuss the process and decisions that resulted in a landmark merger transaction during Bank Director’s 2014 Acquire or Be Acquired conference in January. The presenters share their thoughts on deciding to merge, selecting a partner and overcoming challenges on the path to closing the deal.

Video Length: 46 minutes

About the Speakers

C. K. Lee, Managing Director, Commerce Street Capital, LLC
C. K. Lee is a managing director in the financial institutions group of Commerce Street Capital, LLC. In that capacity, he assists clients with mergers and acquisitions, capital raising, balance sheet restructuring, business plan development and regulatory matters. Prior to joining Commerce Street in 2010, Mr. Lee was regional director for the Office of Thrift Supervision, Western region, headquartered in Dallas with offices in Seattle, San Francisco and Los Angeles.

Thomas L. Legan, Chairman – Central Oklahoma Region, Prosperity Bank
Tom Legan is chairman of the Central Oklahoma Region for Prosperity Bank. He was previously president and CEO of Coppermark Bank and Coppermark Bancshares, Inc. for over 34 years. He has over 56 years of banking and credit related experience. Mr. Legan was formerly a board member of the Oklahoma Bankers Association.

L. William Seidman CEO Panel

During Bank Director’s 2014 Acquire or Be Acquired conference in January, a panel of three community bank CEOs, all of whom have completed a recent acquisition, look at what the future holds for community banks and share their individual experiences and perspectives. This session is named after the former FDIC Chairman and Bank Director’s Publisher, the late L. William Seidman, who was a huge advocate of a strong and healthy community bank system.

Video Length: 53 minutes

About the Speakers

G. William Beale, CEO, Union First Market Bank
Billy Beale is the chief executive officer of Union First Market Bankshares, a publicly traded diversified financial services company based in Richmond, Virginia. He has held this position since the formation of the company and its predecessors in July 1993. Prior to joining Union in May 1989, Mr. Beale had spent 18 years working for 3 banks in Texas.

Richard B. Collins, President, CEO & Chairman of United Bank
Dick Collins is the president, CEO & chairman of United Bank since 2001. Prior to joining United Bank, he was president and CEO at First Massachusetts Bank in Worcester, Massachusetts. Other positions Mr. Collins has held are regional president at Bank of Boston from 1994-1995 and president and CEO at Mechanics Bank from 1983-1994.

William H. W. Crawford, IV, President & CEO of Rockville Bank and Rockville Financial, Inc.
Bill Crawford is the president and CEO of Rockville Bank and Rockville Financial, Inc. In this position, he is responsible for the build out of the company’s infrastructure including the addition of a risk department, the expansion of the mortgage banking division, the enhancement of the financial advisory services division, the introduction of the private banking division and the acquisition of a commercial lending team from a competitor bank.

E. Robinson McGraw, Chairman & CEO, Renasant Corporation
Robin McGraw is the chairman and CEO of Renasant Corporation and Renasant Bank. He has been with Renasant for 38 years and assumed his current role in 2001. Mr. McGraw is past chairman of the Mississippi Bankers Association. Also active on the national banking level, he has been a member of the American Bankers Association’s government relations council.

What’s on the Minds of Today’s Banking Leaders

While the future is starting to look brighter for the banking industry, compressed net interest margins, slow loan demand and regulatory compliance continue to plague many financial institutions. Based on the results of an audience poll conducted at Bank Director’s Acquire or Be Acquired conference in Arizona in January, Molly Curl reviews how banks are dealing with these ongoing growth challenges.

Industry Overview: Size Doesn’t Matter, but Profitability Does

2-3-Emilys-AOBA.pngBank executives, boards and industry experts have long debated—and disagreed—on exactly how big a bank needs to be to survive in today’s harsh operational and regulatory environment, with bank CEOs typically reporting that the perfect size is “a little bigger than [their bank],” quipped Curtis Carpenter, managing director at Austin, Texas-based Sheshunoff & Co. Investment Banking, during a presentation to more than 500 attendees. But William Wallace, vice president of equity research at Raymond James & Associates Inc., would argue that the size of the bank doesn’t matter.

“You don’t have to get bigger. You need to get more profitable,” said Wallace during a separate session.

The Acquire or Be Acquired Conference, held January 26-28 in Phoenix, attracts many banks seeking to make deals—many as a buyer, some as sellers. Most attendees were bank CEOs, senior executives, chairmen or directors, with an average bank size of $682 million in assets.

If size is indeed any indicator of strength, then banks with assets between roughly $1 billion and $15 billion have seen rising stock values and have the currency to make deals. John Duffy, vice chairman at Keefe, Bruyette and Woods, a Stifel Company, told the audience that banks with between $5 billion and $10 billion in assets are the most highly valued and profitable, making this size the sweet spot for investors. Many banks of this size are regional banks, whose stocks Duffy said have “exceeded our expectations both for the overall market and the banking sector.” Carpenter predicted that institutions with more than $2 billion in assets will be tempted to pursue an initial public offering (IPO) after seeing the high pricing commanded by similarly sized institutions—particularly those active in the M&A market.

The market responded more positively to deals in 2013, making both all-stock deals and strategic mergers more attractive. Carpenter noted that the response was particularly positive when those deals resulted in market expansion for the surviving bank, at a median stock price gain just shy of 6 percent 20 days after the deal was announced, versus almost 4 percent when there was a partial overlap in the market and little gains—less than 0.5 percent—when the deal was entirely in-market.

Overall, the industry could be looking at brighter days ahead as banks emerge from the dark days of the credit crisis. Margin pressure likely won’t get much better, but net interest margins have stabilized, though they remain historically low, said Duffy. And many institutions have learned to live with shrinking margins, Billy Beale, CEO of $7.1-billion asset, Richmond, Virginia-based Union First Market Bankshares Corp., said during a panel discussion. Rates are expected to rise this year, albeit gradually, and higher rates should result in greater profitability for the industry. For board members, executives and investors at small and mid-cap banks, there is much to be optimistic about: The industry saw deposit growth of 6.2 percent, despite low rates on deposits, and Duffy predicted that these banks will see better loan growth than bigger banks.

2-3-Emilys-AOBA-2.pngOverall the industry is healthier, with FDIC–assisted deals shrinking from a high of 157 in 2010 to just 24 in 2013, according to Carpenter. Credit has improved. “Asset quality issues are becoming a thing of the past,” said Duffy. And healthy sellers will command a better price in the market, though coming to terms on price will likely remain a point of contention for buyers and sellers.

“Things feel better today,” Frank Cicero, managing director at Jefferies LLC, said during a panel discussion of bank stock analysts.

However, banks with less than $1 billion in assets face challenges. According to Duffy, these small banks are less profitable, with a median return on assets of 0.47 percent, half that of mid-cap banks with between $5 billion and $10 billion in assets. The diminished importance of branch networks underlines the importance of further investments in technology. Small banks barely trade at book value, and they are less efficient. Ben Plotkin, vice chairman at Stifel Financial Corp. told attendees that banks with less than $1 billion in assets have a median efficiency ratio of more than 71 percent. In contrast, banks with between $5 billion and $15 billion in assets had a median efficiency ratio of 59.8 percent.

Given these challenges, it’s not surprising that banks with less than $1 billion in assets comprised 89 percent of total deals in 2013. Ben Plotkin expects further shrinking in the industry, predicting that there will be less than 5,000 banks in the next 5 years.

Smaller banks need to gain size and scale to absorb costs and increase profitability, or resign themselves to selling to another bank.

Dealing with M&A: What You Don’t Know Can Hurt You

Dealing with a potential sale or acquisition can be a stressful time for a bank’s board. Bank Director asked speakers at its upcoming Acquire or Be Acquired conference in Phoenix, Arizona, to describe what bank boards understand the least about M&A transactions, with an eye toward improving a board’s readiness to deal with these issues.

What aspect of M&A transactions do bank boards understand the least?

Kanaly-Mark.pngThe most misunderstood part of the M&A process, from a board perspective, is the difference between the current deal environment—where deals are priced as a function of tangible book value, and are measured by the earn-back period and the cost savings—versus deals in the ‘90s and early 2000s, which were priced based upon earnings and opportunity (growth). This leads to large disconnects on pricing, opportunity, etc.

— Mark Kanaly, partner, Alston & Bird LLP

Plotkin_Ben.jpgGenerally, boards struggle with the concepts related to relative valuation. In other words, how do you evaluate the currency you are receiving in return for the sale of the company? This involves much more than simply looking at the stock market trading values of both involved companies. In particular, the growth prospects and quality of earnings of an acquirer should be important considerations in the analysis of relative valuation.

— Ben A. Plotkin, executive vice president and KBW vice chairman, Stifel Financial Corp.

Quad-Rich.pngShareholder value in an M&A transaction is more about what happens after closing than the multiple achieved at signing. For sellers, it means acquiring an attractively priced currency with upside potential, a strong dividend and liquidity. It means finding an experienced partner to navigate the regulatory approval process, access additional capital if necessary, and treat new customers, employees, shareholders and communities like their own. For buyers, it means setting, and then exceeding, reasonable financial expectations, executing the operational integration flawlessly, blending two cultures into one, and putting customers first. Many high multiple transactions have turned out poorly for the seller and low multiple transactions have turned out poorly for the buyer because of a lack of planning and execution.

— Richard L. Quad, senior managing director & co-head, Financial Institutions Group, Griffin Financial Group LLC

Hay_Laura.pngWe often find that directors are surprised at the impact golden parachute provisions have for the bank and the executive. As boards continue to eliminate gross-up provisions, they often make decisions on how to handle change-in-control severance payments that would be subject to excise tax without any financial analysis or review of the other agreement provisions. We have found situations where the aggregate cost of all severance payments could be a barrier or that payments to certain executives are far lower than intended. Digging into the change-in-control provisions and running financial scenarios can help to avoid surprises that could derail a deal.

— Laura A. Hay, managing director, Pearl Meyer & Partners Comprehensive Compensation

Duffy-John.pngI would have to believe that the aspect of M&A transactions that is truly least understood by most directors of bank boards is the accounting. Hopefully, the financial expert and lead director on the board understand the financial and accounting issues on any merger, but I doubt that most directors really grasp the nuances of merger accounting in a mark-to-market world. The impact that certain accounting assumptions can have on the pro forma balance sheet and the forward income statement are material and it is critical that board members grasp those issues if they want to understand how their shareholder constituency will react to an announced transaction.

— John Duffy, vice chairman, Keefe, Bruyette & Woods, Stifel Financial Corp.

Dugan-John.pngSmith-Scott.pngBank boards (and management) do not always appreciate the need to brief regulators early about a potential transaction, well before an agreement is signed and the transaction is announced. Post-financial crisis, regulators are taking a much more active role in scrutinizing transactions for issues, and it is far easier than it used to be for deals to get delayed or even scuttled based on regulatory concerns. In this climate it is much better to vet transactions early so that any regulatory concerns can be identified and addressed early—or, if the regulatory obstacles are insurmountable, to learn that early, before wasting time and resources.

— John C. Dugan, partner and Scott F. Smith, partner, Covington & Burling LLP

McCollom-Mark.pngMany times, boards do not appreciate the level of capital required to make a transaction happen. In many deals, the mark-to-market adjustments and merger-related costs (including but not limited to management contracts, technology contract costs, balance sheet restructurings, severance, branch closure costs and professional fees) are too large, and a deal becomes prohibitive. Purchase price as a percentage of tangible book value (P/TBV) is sometimes misleading, as adjusted P/TBV may show a much higher net purchase price for a target.

— Mark R. McCollom, senior managing director & co-head, Financial Institutions Group, Griffin Financial Group LLC

Murphy-Jared.pngColeman-Samuel.pngM&A transactions invariably require decision making under uncertainty. The time available to buyers to evaluate target companies or lines of business is generally compressed. Sellers face analogous uncertainty as to whether markets are adequately valuing their business. A by-product, and an arguably unintended positive consequence of the current phase of regulatory scrutiny, is that banks are putting in place comprehensive, rigorous, and extensively tested and validated risk models. As these modeling regimes come on stream and become routinized, buyers and sellers alike (and their boards) will be armed with powerful new tools to make decision making far more transparent and efficient than in the past.

— Jared Murphy, managing director and Sam Coleman, managing director, BlackRock