Bank deal activity in 2017 is likely to be on par with 2016, as the bank executives and board members responding to Bank Director’s 2017 Bank M&A Survey reflect lower levels of optimism for the bank M&A environment. In this video, Rick Childs, a partner at survey sponsor Crowe Horwath LLP, provides his perspective on the survey results and explains why, despite a lower number of sellers, it really is a buyer’s market today.
Before a board and management of a bank pursue an acquisition, they should realistically assess their bank, the characteristics of the board and the shareholders, and the alternatives available.
The board and senior management should develop a strategic plan for the bank. The Federal Deposit Insurance Corporation has cited an increasing number of banks for lack of strategic planning in matters requiring board attention. The Office of the Comptroller of the Currency also has focused on strategic planning in the last few years.
All board members must share a commitment to the strategic plan. Divisiveness in the boardroom often jeopardizes a bank’s ability to achieve its objectives.
The board has a fiduciary duty to make fully informed business decisions as to what is in the best interests of the hypothetical shareholder who is not seeking current liquidity. Management must assume the responsibility of educating the board (or bringing in consultants to do so) regarding the bank’s strengths and weaknesses, its inherent value, and the market(s) for targets. The board and senior management should meet regularly to discuss the bank’s strategic direction.
Debate in the planning process is healthy, but once the board agrees on a course of action, the board and management should speak with a united voice.
The board and management should communicate the bank’s strategic direction to shareholders. If key shareholders disagree with the direction, the board and management should arrange for such shareholders to be bought out or be comfortable that the bank need not do so. It is difficult to achieve strategic objectives if the board and key shareholders are working at cross purposes.
Evaluate Alternatives The prospective buyer has a number of alternatives for enhancing shareholder value or multiple paths to be pursued at the same time. The board should evaluate such alternatives to identify the most attractive transaction.
Evaluate Your Prospects for Success In embarking on bank M&A in the current environment, sellers will demand assurances that buyers can close. Here are some of the factors purchasers should consider:
Community Reinvestment Act and compliance ratings: Purchasers need to understand the “hot button” issues driving regulatory reviews and stay up to date. Yesterday’s focus on asset quality, anti-money laundering and Bank Secrecy Act compliance and third-party relationships have been joined by redlining, incentive compensation, concentration risk and cybersecurity, among others.
Capital levels: Determine whether the bank’s capital is sufficient to support an acquisition. If not, where will your bank obtain the needed funding?
Management: Does the purchasing bank have sufficient senior management capacity to staff the acquired bank or will target management be needed to implement the acquisition?
Systems and facilities: The purchasing bank’s board should evaluate whether the bank has compliance management systems and an enterprise risk management program that can scale for the acquisition.
Coming up with a good strategic plan while considering the bank’s alternatives is important for the board to discuss before embarking on an acquisition.
Negotiating the Transaction There still may be a problem: What if there are very few targets that the bank has identified as “fits,” and none of them are in the market to sell?
Increasingly would-be buyers are willing to consider offering stock as part or all of the merger consideration. There are several drivers of this newfound willingness. First, buyers must meet increasingly challenging capital requirements. The exchange ratio in the merger may offer more attractive pricing to the buyer than issuing common equity to the market. Second, sellers have become more willing to accept private or illiquid stock as merger consideration. This may be a function of sellers’ understanding that economies of scale offer potential for greater returns on investment while enabling sellers to refrain from taking their “chips off the table” as would be the case in a cash sale. The recent run up in the stock market indexes has not yet translated into a general increase in M&A pricing. Third, a transaction that provides for a significant stock component allows for more one-on-one negotiations. Lastly, a strategic combination allows for mutuality of negotiation.
Just offering the selling shareholders stock may not be enough to convince a reluctant seller to consider a transaction. Would-be community bank buyers must recognize that there are social issues in any transaction (even when the merger consideration is cash). Accordingly, the buyer must evaluate in advance the roles of senior management of the seller, retention arrangements to proffer, severance to provide as well as bigger picture social issues such as board representation, combined institution name and headquarters.
A focus on the social issues and a willingness to put stock on the table may allow community bank buyers to continue to compete for acquisitions despite the rebounding stock market. Other competitors may be able to offer nominally more attractive pricing, but such an offer may not have better intrinsic value.
Not ready to file an IPO? Over-the-counter markets can be an effective solution for community banks, and offer similar benefits with less complexity and cost, explains Jason Paltrowitz of OTC Markets Group.
A deal may be great on paper, but not all deals are a success. At Bank Director’s 2016 Acquire or Be Acquired Conference, Scott Anderson and Joe Berry of Keefe, Bruyette & Woods moderate a panel discussion with three successful and experienced acquirers: Scott Custer, CEO of Yadkin Financial Corp., James Ryan, EVP and director of corporate strategy at Old National Bancorp and Kirk Wycoff, founder and managing partner of Patriot Financial Partners. Even the best-laid plans don’t always work out, and these seasoned M&A veterans share the lessons they’ve learned.
If your board is considering a sale of the institution, you’re not ready to sell if you’re not prepared to sell. There are a variety of issues that your board will need to consider if it wants to maximize the value of the bank’s franchise in a sale. Many, although not all of these considerations, involve the bank’s balance sheet. Other important issues include cutting overhead costs and dealing with regulatory compliance issues. Sal Inserra, an Atlanta-based partner for the accounting and consulting firm Crowe Horwath LLP, offered the following advice to Bank Director Editor in Chief Jack Milligan.
Take a hard look at impaired loans on your balance sheet. When bank executives consider a sale and analyze the loan portfolio, they are not always looking at it from the perspective of a potential buyer. If there’s a problem customer, they have a sense of the potential collection on that impaired loan. When buyers come in cold, they don’t have that history. They are doing an antiseptic review. It is numbers on a page that lead to a conclusion. They’re not going to accept the backstory as a reason why they should pay more for the loan than they think they should. If you have another appraisal in hand that shows the value higher, they may give credence to that, but not as it relates to the sob story. From the buyer’s perspective, if a loan is leveraged with 100 percent loan-to-value with a five-year life, the prospective buyer will require accretion yield of 9 percent to be attractive given the risk. If the coupon on that loan is only 5 percent, the buyer is only going to pay 75 cents on the dollar to achieve their yield. You have to get past the subjective analysis and get more objective detail about that impaired loan. You need to get the most current financial information possible about that impaired loan and the borrower.
Avoid bad leverage transactions as much as possible. A bad leverage transaction sometimes occurs when the bank has excess deposits and invests in securities of different durations in an attempt to leverage the capital in the financial institution. Depending on how far out into the future the bank is leveraged, it could end up in a bad position where the assets are at a fixed rate, and the liabilities are at a variable rate. And because the bank is maximizing yield, as liabilities start creeping up, net interest margin can erode rather quickly. In the current market, unless the bank wants to go out four or five years or more on a bond and take some credit risk in something other than a U.S. Treasury security, the bank is going to have a pretty narrow net interest margin. Rather than buy low-earning securities, you might benefit your bank’s value by waiting for a buyer with a high loan-to-deposit ratio that needs additional funding. If the seller has excess funding that hasn’t been tied up, that could be a very lucrative purchase to a bank that needs the funding. But once the seller has tied that funding up in something with a narrow net interest margin, the buyer will have to unwind that in order to get value. And if the buyer has to take a hit to unwind that investment, it’s going to impact the seller’s value.
Manage excess capital on the balance sheet. This is really about how you spin the story of selling the bank. Let’s say you have $50 million in capital. So if you sell for two times book value, you would get $100 million. But of that $50 million, let’s say that $10 million has not been deployed, so you’re not going to get two times $50 million. You’re going to get 1.60 times $50 million, which is $80 million. However, if the bank gets rid of that $10 million in excess capital by paying it out in dividends, it will receive $70 million, but because it is now working off a $40 million base, the bank reports a higher premium. Net cash is still $80 million when you consider the dividend.
Another approach would be to try to leverage up that excess capital. Where you may have turned down a loan before because the pricing wasn’t good, but it was still going to create a good margin and a decent return on investment, the bank may want to invest in the loan because at least it becomes an earning asset. This strategy will depend on what is available in the market.
Shed costly assets or debt before attempting to sell the bank. Since the value of the bank is based on future earnings, if the bank is carrying some high cost debt, it’s going to impact future margins. Or if the bank has low yielding assets, that’s going to affect future margins. When buyers come in to price those assets and liabilities, they’re going to knock down the value of the bank. Most high cost debt has a prepayment penalty associated with it, so there’s a net cost to get out of that debt. But when it comes to low yielding assets, the bank can maximize net interest margin by getting rid of assets that are going to cause issues for future earnings.
Focus on cost control prior to a sale. When it comes to cost control, the first thing to look at is the branch network. It’s no secret that branch activity continues to decrease as folks get more and more comfortable with digital banking. I love [author Brett King’s motto], “Banking is no longer somewhere you go, it’s something you do.” And the value of a seller’s branch network may be going down because the cost of maintaining those branches is still significant, not only from a hard cost standpoint but also with training staff, marketing and all the other costs of operating a branch. So take a hard look at those branches that buyers are going to consider exiting. If the bank can start narrowing those costs by closing some of those marginal branches, so that the buyer can see what the run rate is going forward, that will help improve value because the value is going to be driven on the multiple of future earnings.
The other thing I would focus on is staffing. A lot of banks have made big strides in technology, but they haven’t reevaluated their head counts. And they need to do a review of what is necessary to operate and deliver service. A phrase I hear a lot is, “We’re not going to change our head count, we’re going to grow into it.” And that doesn’t necessarily work because as you grow, it doesn’t mean the resources are going to be able to continue to help you get to the next level. So doing a critical analysis of head count is key. Those are the two major variables—branches and people—that when addressed can help you improve your efficiency.
Avoid entering into long-term contracts if you’re considering a sale. The thing that just makes me scratch my head is when a board is thinking about selling the bank and a year before it pulls the trigger, it enters into a four- or five-year core processing contract. The cost associated with exiting a core processing contract, unless it happens to be the same company that they buyer uses, is incredible. I’ve seen millions of dollars spent to exit a core processing contract.
Factor regulatory compliance issues in a potential sale. If the bank knows its potential acquirers, it knows its potential new regulators. The key issue is making sure that regulator knows the seller has its compliance house in order. The seller can put together an in-house review or use external resources to address the issues of that potential regulator. If I’m a $2 billion asset bank and it’s likely that I’m going to become part of an institution that’s over $10 billion in assets, I need to be focused on issues that the Consumer Financial Protection Bureau is focused on, because I know that my portfolio is going to be subject to a CFPB review. If I’m a $200 million asset bank and I’m going to merge into bank that’s in the $2 billion to $3 billion range, that may present a higher level of scrutiny. So knowing my potential acquirer allows for adequate preparation.
Why 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.
Bank executives and board members are feeling the pressure to grow in 2016, according Bank Director’s 2016 Bank M&A Survey, sponsored by Crowe Horwath LLP. In this video, Crowe Horwath Partner Rick Childs highlights the survey results, and addresses how size will continue to influence acquisition activity.
What factors are driving some banks to sell?
Is there a “right size” for the industry?
Which banks are best positioned to make a deal in 2016?
The financial technology boom of the past few years will ultimately lead to opportunities for the banks willing to take advantage of them—either through partnership or acquisition. In November, 145 bank senior executives and board members shared their views on the fintech boom. The poll was conducted at Bank Director’s annual Bank Executive & Board Compensation Conference in Chicago. Additional respondents participated online. We’ve tabulated the results, which we share along with insights from leaders in the fintech space.