Don’t Let Fear of Missing Out Guide Tech Due Diligence

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In September 2021, JPMorgan Chase & Co. purchased the college financial planning platform Frank for a cool $175 million. For that price, the big bank expected to gain a purported five million potential new customers — students, parents and low-to-moderate income households. The bank kept Frank CEO Charlie Javice as head of student solutions as part of the deal, paying her a $20 million retention fee, according to The New York Times.

But JPMorgan said it didn’t get what it was promised. In a lawsuit filed in December 2022, the bank alleged Frank had fewer than 300,000 customers — roughly four million had been faked. JPMorgan shut down Frank’s website in early 2023.

Jamie Dimon, JPMorgan’s CEO, called the acquisition “a huge mistake” in the bank’s fourth quarter 2022 earnings call, and indicated that more details would be disclosed after the litigation has been resolved. JPMorgan didn’t respond to Bank Director’s request for information. Javice is suing JPMorgan; her lawyer told The New York Times that the bank realized it couldn’t work around student privacy laws and tried to “retrade” the deal.

The cost of the Frank acquisition seems eye-popping, but it’s a mere drop in the bucket for the big bank. JPMorgan reported $34.5 billion in net revenue in the fourth quarter 2022; that’s around $375 million earned daily. It’s an experienced fintech acquirer, with seemingly endless resources it can dedicate to vetting these deals. If a fintech company managed to trick the largest of the big banks, what does that mean for other banks looking to acquire tech companies in 2023? 

The number of financial institutions acquiring technology companies remained few in 2021-22, according to an analysis from information from Piper Sandler & Co. using compiled for Bank Director with data from S&P Global Market Intelligence. Those buyers are primarily above $50 billion in assets. Crispin Love, senior research analyst at Piper Sandler, says those deals tend to complement the bank’s strategy, via deposit, lending or payments platforms, or niche services. “It tends to be the larger players buying some of these smaller fintech players to enhance solutions at the bank, rather than being [a] big transformational deal,” he says.

Sixteen percent of the bank executives and directors responding to Bank Director’s 2023 Bank M&A Survey, sponsored by Crowe LLP, say their institution is likely to acquire a technology firm in 2023. Due to last year’s drop in fintech valuations, it could be a great time to buy, says Crowe Partner Rick Childs. But price isn’t the only factor in an acquisition, and acquiring a technology company requires additional due diligence.

Dion Lisle, director of corporate ventures at $183 billion Huntington Bancshares, has more than 100 items on his due diligence checklist for any fintech the Columbus, Ohio-based bank may choose to invest in or acquire. At a high level, he and his team want to know:

  • Who are the founders, and what are their backgrounds? Who are the investors?
  • Is the tech stack modern, and will it fit with the bank?
  • How much technology has been outsourced?
  • Does the company own its intellectual property?
  • Have there been lawsuits against the company?
  • What about the company’s books? How much money do they have, and how have they spent it?

Lisle also seeks customer references. This was easy with Huntington’s recent acquisition of Digital Payments Torana, which worked with two of the bank’s customers. “We had assurance from that,” says Lisle. “We knew the people that said, ‘Yeah, this product uniquely solves this business case.’”

Code review is also part of Lisle’s checklist and is among the few items he’s willing to outsource. Most is covered by the bank’s ventures unit. “We’re a team of 10 folks with expertise around banking, venture investing, due diligence [and] compliance, so we’re able to do a pretty good job in house,” says Lisle.

Clayton Mitchell, a principal at Crowe, says banks should examine controls, processes and potential compliance gaps, particularly where the technology could pose significant regulatory, legal, financial or reputational risk, including potential fair lending or Unfair, Deceptive, or Abusive Acts or Practices (UDAAP) violations. And he advises banks to build a team that includes the CFO and finance staff, relevant business leaders, technology and information security, and risk and compliance. “Don’t get enamored with the tech,” he cautions. “[Fintechs have] been pitching for money since the day they were born. It’s the only way they’ve existed. So, they’re really good at sales.”

Banks should also take time with due diligence, and shouldn’t cave in to FOMO, or fear of missing out. “That’s never a good way to do deals,” says Lisle. “You never skip basic DD [due diligence].”

Earlier in his career, Lisle worked for Citigroup, which sent him to Brazil to check out a payments company that boasted a million signups. The company even paid soccer star Ronadinho Gaúcho $5 million to be its spokesperson. But Lisle dug deeper and uncovered just $10,000 in transactions — a low figure given the large user base the fintech claimed to have. Citi pulled the plug on the deal.

Lisle says it took 24 hours to pull the plug on the multi-million-dollar transaction. Problems aren’t always hard to spot, he explains. At JPMorgan, a few thousand emails would have quickly revealed the authenticity of Frank’s user base. “[It’s] literally two days of due diligence.”

2021 Compensation Survey Results: Fighting for Talent

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Did Covid-19 create an even more competitive landscape for financial talent?

Most banks increased pay and expanded benefits during the pandemic, according to Bank Director’s 2021 Compensation Survey, sponsored by Newcleus Compensation Advisors. The results provide a detailed exploration of employee benefits, in addition to talent and culture trends, CEO performance and pay, and director compensation. 

Eighty-two percent of respondents say their bank expanded or introduced remote work options in response to Covid-19. Flexible scheduling was also broadly expanded or introduced, and more than half say their bank offers caregiver leave. In addition, most offered bonuses to front-line workers, and 62% say their bank awarded bonuses tied to Paycheck Protection Program loans, primarily to lenders and loan production staff.     

And in a year that witnessed massive unemployment, most banks kept employees on the payroll.

Just a quarter of the CEOs, human resources officers, board members and other executives who completed the survey say their bank decreased staff on net last year, primarily branch employees. More than 40% increased the number employed overall in their organization, with respondents identifying commercial and mortgage lending as key growth areas, followed by technology.

The 2021 Compensation Survey was conducted in March and April of 2021. Looking at the same months compared to 2020, the total number of employees remained relatively steady year over year for financial institutions, according to the U.S. Bureau of Labor and Statistics.

Talent forms the foundation of any organization’s success. Banks are no exception, and they proved to be stable employers during trying, unprecedented times.

But given the industry’s low unemployment rate, will financial institutions — particularly smaller banks that don’t offer robust benefit packages like their larger peers — be able to attract and retain the employees they need? The majority — 79% — believe their institution can effectively compete for talent against technology companies and other financial services companies. However, the smallest banks express less confidence, indicating a growing chasm between those that can attract the talent they need to grow, and those forced to make do with dwindling resources. 

Key Findings

Perennial Challenges
Tying compensation to performance (43%) and managing compensation and benefit costs (37%) remain the top two compensation challenges reported by respondents. Just 27% say that adjusting to a post-pandemic work environment is a top concern.

Cultural Shifts
Thirty-nine percent believe that remote work hasn’t changed their institution’s culture, and 38% believe the practice has had a positive effect. However, one-quarter believe remote work has negatively affected their bank’s culture.

M&A Plans
As the industry witnesses a resurgence of bank M&A, more than half have a change-in-control agreement in place for their CEO; 10% put one in place in the last year.

Commercial Loan Demand
More than one-quarter of respondents say their bank has adjusted incentive plan goals for commercial lenders, anticipating more demand. Ten percent expect reduced demand; 60% haven’t adjusted their goals for 2021.

CEO Performance
Following a chaotic and uncertain 2020, a quarter say their board exercised more discretion and/or relied more heavily on qualitative factors in examining CEO performance. More than three-quarters tie performance metrics to CEO pay, including income growth (56%), return on assets (53%) and asset quality (46%). Qualitative factors are less favored, and include strategic goals (56%) and community involvement (29%).

CEO Pay
Median CEO compensation exceeded $600,000 for fiscal year 2020. CEOs of banks over $10 billion in assets earned a median $3.5 million, including salary, incentives, equity compensation, and benefits and perks. 

Director Compensation
More than half of directors believe they’re fairly compensated for their contributions to the bank. Three-quarters indicate that independent directors earn a board meeting fee, at a median of $1,000 per meeting. Sixty-two percent say their board awards an annual cash retainer, at a median of $21,600. 

To view the full results of the survey, click here.

Deal Integration Can Transform Finance, Risk and Regulatory Reporting

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A number of banks announced mergers and acquisitions in 2020, capitalizing on growth opportunities against a forbidding backdrop of chronically low interest rates and anemic economic growth during the Covid-19 pandemic.

The deals ranged from more moderately sized with a few headline-grabbing mega-mergers —a trend that expected to continue through 2021.

The appeal of M&A for regional and superregional institutions in the United States is that the right transaction could create big benefits from economies of scale, and enhance the proforma company’s ability to gain business. While the number of deals announced in this environment are modest, the stakes involved in contemplating and executing them certainly are not. Nor is the work that banks will face after a combination. Once the transaction has been completed, the hard work begins.

A Closer Look From Regulators
One potential outcome is added scrutiny from the authorities; a new merged entity, with more assets and a broader range of activities, could have more complex risk calculations and reporting obligations to deal with.

Overall, regulators have sharpened their focus on banks during and after the merger process by performing additional audits, more closely scrutinizing key figures and ensuring that the M&A plan is being adhered to. Even if there are no significant changes to a firm’s profile with regulators, or if any needed changes in risk and reporting obligations are manageable, the formidable task of combining the operations of two organizations remains. A single, seamless whole must be assembled from two sets of activities, two work forces with their own culture and two sets of technological assets.

Merging the Parts, Not Just the Wholes
None of these issues is distinct from the others. Consider the technology: The proforma company will have to contend with two data systems — at least. Each company’s data management architecture has staff that makes it run using its own modus operandi developed
over years.

And that is the best-case scenario. Joining so many moving parts is no small feat, but it provides no small opportunity. Deal integration forces the constituent institutions to reassess legacy systems; when handled correctly, it can assemble a comprehensive, fully integrated whole from existing and new tech to meet the combined entity’s compliance and commercial needs.

Creating the ideal unified finance, risk and reporting system starts with an honest evaluation of the multiple systems of the merging partners. Executives should take particular care to assess whether the equipment and processes of the merged entity are better than the acquirer’s, or have certain features that should be incorporated.

Management also should consider the possibility that both sets of legacy systems are not up to present or future challenges. It could be that the corporate combination provides an opportunity to start over, or nearly so, and build something more suitable from the ground up. Another factor they should consider is whether the asset size of the new unified business warrants an independent verification process to supplement the risk and regulatory reporting program.

Understanding What You Have and What You Need
To get the evaluation process under way for the operational merger, a bank should list and assess its critical systems — not just for their functionality, but with respect to licensing or other contractual obligations with suppliers to determine the costs of breaking agreements.

Managers at the combined entity should look for redundancies in the partners’ systems that can be eliminated. A single organization can have a complicated back-end systems architecture, with intricate workarounds and many manual processes. Bringing together multiple organizations of similar complexity can leave the combined entity with expensive and inflexible infrastructure. A subledger and controlling functions can simplify this for finance, risk and regulatory reporting functions. They can consolidate multiple charts of accounts and general ledgers, relieving pressure on the general ledgers. Organizations in some cases can choose to migrate general ledgers to a cloud environment while retaining detailed data in a fat subledger.

Whatever choices executives make, a finance, risk and reporting system should have the latest technology, preferably based in the cloud to ensure it will be adaptable, flexible and scalable. Systems integration is critical to creating a unified financial institution that operates with optimal productivity in its regulatory compliance, reporting efforts and general business.
Integrating systems helps to assure standardization of processes and the accuracy, consistency,
agility and overall ease of use that result from it.

With Sector Primed to Consolidate Further, Large Mergers Magnify Opportunity, Risk

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The highly competitive and regulated US banking industry has grown increasingly concentrated over the past few decades, and continued ultralow interest rates will spur increased consolidation over at least the next two years, particularly among small and midsized banks that rely heavily on net interest income. Mergers and acquisitions (M&A) offer these banks opportunity to achieve greater scale, efficiency and profitability, a credit positive, but also introduce execution and integration risks that can erode these benefits.

Low interest rates are not the sole driver of consolidation but they increase the likelihood of a jump in M&A activity. The pace of sector consolidation slowed in 2020 as the coronavirus pandemic subdued business activity. But small and mid-sized banks retain a particular motivation to pursue M&A because their earnings potential rests more heavily on net interest income, which is hobbled in the current low interest rate environment. Other motivations for M&A include opportunities to cut expenses and the need to obtain and invest in emerging technologies.

In-market transactions present the greatest cost-saving opportunities. Acquisition targets that present the opportunity for efficiency gains have greater relative value. They are also easier for management teams to assess and evaluate, particularly because loan growth and business activity remain hard to forecast in the present economic environment. Branch reductions are a primary means of reducing expenses.

Banks have warmed up to larger deals and so-called ‘mergers of equals.’ The attractiveness of these transactions has grown in the past couple of years, partly because of favorable equity market response. However, execution risk grows with the size of a transaction because issues such as cultural fit become more prominent, with the potential to erode the credit benefits of the combination.

Click here to explore these trends further as part of Moody’s research.

The Uncertain Impact of COVID-19 on the Bank M&A Playbook

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As banks across the country grapple with market and economic dynamics heavily influenced by COVID-19, or the new coronavirus, separating data from speculation will become difficult.

The duration and ultimate impact of this market is unknowable at this point. The uncertain fallout of the pandemic is impacting previously announced deals and represents one of the biggest threats to future bank M&A activity. It will force dealmakers to rethink risk management in acquisitions and alter the way deals are structured and negotiated.

As we have seen in other times of financial crisis, buyers will become more disciplined and focused on shifting risk to sellers. Both buyers and sellers should preemptively address the impact of the coronavirus outbreak on their business and customers early in the socialization phase of a deal.

We’ve compiled a non-exhaustive list of potential issues that banks should consider when doing deals in this unprecedented time:

  • Due Diligence. Due diligence will be more challenging as buyers seek to understand, evaluate and quantify the ways in which the coronavirus will impact the business, earnings and financial condition of the target. Expect the due diligence process to become more robust and protracted than we have seen in recent years.
  • Acquisition Funding. Market disruption caused by the virus could compromise the availability and pricing of acquisition financing, including both equity and debt financing alternatives, complicating a buyers’ ability to obtain funding.
  • Price Protections. For deals involving publicly traded buyer stock, the seller will likely be more focused on price floors and could place more negotiating emphasis around caps, floors and collars for equity-based consideration. However, we expect those to be difficult to negotiate amid current volatility. Similarly, termination provisions based upon changes in value should also be carefully negotiated.

In a typical transaction, a “double trigger” termination provision may be used, which provides that both a material decline in buyer stock price on an absolute basis (typically between 15% and 20%) and a material decline relative to an appropriate index will give the seller a termination right. Sellers should consider if that protection is adequate, and buyers should push for the ability to increase the purchase price (or number of shares issued in a stock deal) in order to keep the deal together and avoid triggering termination provisions.

  • Representations and Warranties. As we have seen in other economic downturns, expect buyers to “tighten up” representations and warranties to ensure all material issues have been disclosed. Likewise, buyers will want to consider including additional representations related to the target business’ continuity processes and other areas that may be impacted by the current pandemic situation. Pre-closing due diligence by buyers will also be more extensive.
  • Escrows, Holdbacks and Indemnities. Buyers may require escrows or holdbacks of the merger consideration to indemnify them for unquantifiable/inchoate risk and for breaches of representations and warranties discovered after closing.  
  • Interim operating covenants. Interim operating covenants that require the seller to operate in the ordinary course of business to protect the value of their franchises are standard provisions in bank M&A agreements. In this environment we see many banks deferring interest and principal payments to borrowers and significantly cutting rates on deposits. Sellers will need some flexibility to make needed changes in order to adapt to rapidly changing market conditions; buyers will want to ensure such changes do not fundamentally change the balance sheet and earnings outlook for the seller. Parties to the agreement will need focus on the current realities and develop reasonable compromises on interim operating covenants.
  • Investment Portfolios and AOCI. The impact of the rate cuts has created significant unrealized gains in most bank’s investment portfolio. The impact of large gains and fluctuations in value in investment securities portfolios will also come into focus in deal structure consideration. Many deals have minimum equity delivery requirements; market volatility in the investment portfolio could result in significant swings in shareholders’ equity calculations and impact pricing.
  • MAC Clauses. Material Adverse Change (MAC) definitions should be carefully negotiated to capture or exclude impacts of the coronavirus as appropriate. Buyers may insist that MAC clauses capture COVID-19 and other pandemic risks in order to provide them an opportunity to terminate and walk away if the target’s business is disproportionally affected by this pandemic.
  • Fiduciary Duty Outs. Fiduciary duty out provisions should also be carefully negotiated. While there are many variations of fiduciary duty outs, expect to see more focus on these provisions, particularly around the ability of the target’s board to change its recommendation and terminate because of an “intervening event” rather than exclusively because of a superior proposal. Likewise, buyers will likely become more focused on break-up fees and expense reimbursements when these provisions are triggered.
  • Regulatory approvals. The regulatory approval process could also become more challenging and take longer than normal as banking regulators become more concerned about credit quality deterioration and pro forma capitalization of the merged banks in an unprecedented and deteriorating economic environment. Buyer should also consider including a robust termination right for regulatory approvals with “burdensome conditions” that would adversely affect the combined organization.

While bank M&A may be challenging in the current environment, we believe that ample strategic opportunities will ultimately arise, particularly for cash buyers that can demonstrate patience. Credit marks will be complex if the current uncertainty continues, but valuable franchises may be available at attractive prices in the near future.

Radius Bank CEO Talks LendingClub Acquisition

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Last week, a $1.4 billion asset community bank sent shockwaves through the financial industry when it agreed to be acquired by national fintech, LendingClub Corp.

What most people are talking about is what LendingClub will gain — access to a cheaper and more secure funding, freedom from loan sponsorship fees it pays to its current partner, Salt Lake City-based WebBank, and the ability to wade into other traditional banking activities. But what does the deal mean for the acquisition target, Boston-based Radius Bank? And what does it say about the future of banking?

I caught up with Mike Butler, president and CEO of Radius Bancorp, to find out. The following excerpts from our conversation are edited for brevity, clarity and flow.

BD: What does this deal mean for Radius Bank’s business model?
MB: We think we’re a fintech company with a bank charter. And LendingClub is obviously a fintech that’s thinking about banking. When you bring them together, it’s a nice combination of two companies looking to do the same thing.

Radius will have an opportunity to plug itself into the infrastructure of LendingClub and leverage a lot more of what we’ve built to provide both of our clients with better products and services. We will be operating out of our Boston location here in the Innovation District, not only driving our direct-to-consumer business, but also our commitment to fintechs on the strategic partnership side. As part of our early discussions with LendingClub,there was a lot of interest in our banking-as-a-service model, and we think that’s a great opportunity for us to expand further.

What a lot of people haven’t been paying as much attention to are our commercial lines of business and the opportunity for us to provide LendingClub with the diversification on the loan side that everybody’s looking for.

BD: You mentioned that Radius will be plugging into LendingClub’s infrastructure. What are your thoughts on how the companies will meld their teams?
MB: We’re going to help accelerate what is a fairly strong knowledge base inside LendingClub about regulatory and traditional banking. So we get a chance to leapfrog based on our work and our relationship with our regulator.

This is nothing like a traditional bank merger where cost saves are part of it. Things like overlapping technology and elimination of headquarters or branches are all distractions inside a traditional merger that keep you away from leveraging the beauty of a combination.We’ve got an acute focus on our objective of delivering superior products and services into the marketplace, and we won’t be distracted by those other issues, which will allow us to be more successful.

BD: I know Radius is run a lot like a tech company. Did that play a part in the relationship with LendingClub?
MB: It’s a big part of it. There is a cultural connection in any good merger. We’ve hired a lot of people from outside the banking industry and are teaching them banking. LendingClub has a whole group of technology people that they are teaching banking to as well. So, there’s a lot of cultural connections with what we’re trying to accomplish.

Beyond the cultural connection of people and mission, our national deposit gathering with industry-leading online banking and the awards we win for our product, make us a perfect match for a company like LendingClub, who also does business nationally.

As fintechs have evolved, they’ve done a great job in proving that they can take some banking products and produce them in a much more consumer-friendly way. But I think what we always thought is there would be a rebundling, in which companies would recognize that operating within a bank charter allows them more flexibility and profitability to deliver their products and services to clients. This deal reflects that; it’s the first step in the rebundling of financial services.

BD: How have regulators responded to the deal?
MB: LendingClub has been in the de novo application process for over a year, predominantly with the Office of the Comptroller of the Currency. And I think it’s safe to say that the regulators were positioned to issue a de novo charter to LendingClub, but LendingClub felt — and did feel all along — that an acquisition was a faster path. We were lucky enough to find each other over six months ago to start talking about this. And so a lot of work has been done behind the scenes.

In our discussions about the opportunity for a fintech to buy a bank, we’re extremely confident that the Federal Reserve and the OCC — and both of their offices of innovation — recognize the inevitability of this type of event and want to participate in helping the future and being a part of it, rather than not being part of it. So, we’re excited and optimistic about how the process will go.

BD: Do you think your model might be a clearer path to getting fintechs involved in traditional banking activities?
MB: I obviously do; we’re a fintech company with a bank charter. I always said, “Why wouldn’t a fintech company want to acquire a bank that had forward-looking people and technology as a path to create what we see as the future of the industry?”

You’ve got to be careful about the number of banks that may be out there that are really prepared to help accelerate a fintech to get to the next level. That will be the challenge with  people pursuing this avenue, and that’s why we’re excited to be the first one. But I do think the combination of fintechs and banks will become more and more prevalent.

BD: Is this the start of a new trend?
MB: I think it is, and I think you’ll see a couple of things happen. I can’t tell the future, but I think there will be several more banks that have considered developing more digital technology accept and move forward on doing that. And I think you will see more fintechs taking a look at banks as a way to rebundle and provide themselves with a path to profitability.

I do think there will be many that wait to see how the approval process takes place. I don’t think there’ll be a rush to it. Matter of fact, we like our competitive advantage. Another year with a competitive advantage would be good for us. So that’s OK by us.

BD: What does this deal say about the future of banking?
MB: It signals that technology has to become the number one component and driver to acquiring and servicing clients at the level that today’s consumer demands.

If banks haven’t been believing that technology is going to be a big player, then they need to start developing something quicker, rather than later, as it relates to their own business — to think about how they will participate in the future.

What I tell bankers is that transforming a bank into a digital platform is not an insurmountable task. I hope that I’ve proven to people that it can be done, and it can be done very successfully.

The Choice Facing Every Bank

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Has your executive team been approached by leaders of another bank interested in an acquisition? It likely means your bank is doing something right. But, now what?

Many CEOs’ visceral response to being asked to consider a deal is to say, “Thanks, but no thanks” and continue running the bank. While this may be the correct response, this overture is a chance for leadership to objectively revisit the bank’s strategic alternatives to determine the best option for its shareholders and other stakeholders.

Stay the Course
Boards must objectively identify where their bank is in its life cycle — be it turn-around, growth or stability — and what will be needed to successfully compete at the next stage. Ultimately, they must determine if the bank can drive more long-term shareholder value staying independent than it could with a partner. They must also weigh the risk of remaining independent against the potential reward.

Directors should prepare five-year projections, ideally with the help of a financial advisor, that assume the bank continues to operate independently. They should forecast growth and profitability that reasonably reflect current marketplace dynamics and company strategy, and are generally consistent with past performance. Consider opportunities to lower funding costs, consolidate or sell unprofitable branches, add lines of business, or achieve economies of scale through acquisitions or organic growth. However, be cognizant of market headwinds: low interest rate environment, slower projected loan growth, increasing cost of technology and cybersecurity, regulatory burden, competition, demographic trends, upcoming presidential election and so on. The board should also consider organizational issues such as succession planning — a major issue for many community banks. How do these factors impact the future performance of your institution? Will your bank be able to meet shareholder expectations?

Merge with Peer
Peer mergers have been a hot topic of late. The bank space has seen several high-profile transactions: the merger between BB&T Corp. and SunTrust Banks to form Truist Financial Corp.; Memphis, Tennessee-based First Horizon National Corp. and Lafayette, Louisiana-based IBERIABANK Corp.; Columbia, South Carolina-based South State Corp. and Winter Haven, Florida-based CenterState Bank Corp.; and McKinney, Texas-based Independent Bank Group and Dallas-based Texas Capital Bancshares.

The opportunity to double assets while achieving economies of scale can drive significant shareholder value. But these transactions can be tough to nail down because both parties must be willing to compromise on key negotiation topics. Which side selects the chairman? The CEO? How will the board be split? Where will the company be headquartered? What will be the name of the future bank?

Peer mergers can be risky propositions for banks, as cultures don’t always match and integration can take several years. However, the transaction can be a windfall for shareholders in the long run.

Sell
A decision to sell almost always generates the greatest immediate value for shareholders. Boards must ascertain if now is the right time, or if the bank can do better on its own.

Whether or not selling creates the highest long-term value for shareholders depends on several factors. One factor is the consideration mix, if any, between stock and cash. Cash gives shareholders the flexibility to invest and diversify the net proceeds as they see fit, but capital gains will be taxed immediately. Stock consideration is generally a tax-free exchange, when structured correctly, but it is paramount to select the right partner. Look for a bank with a strong management team and board, a proven track record of building shareholder value and a plan to continue to do so. That partner may not offer you the highest price today, but will most likely deliver a better return to shareholders in the long run, compared to other potential acquirers. Furthermore, a partner that is likely to sell in the near-term could provide a double-dip — a potential homerun for your shareholders.

It is crucial to consider what impact a sale would have on other stakeholders, like employees and the community. Prepare your bank to sell, well in advance of any conversations with potential acquirers. Avoid signing new IT contracts with material termination costs; it is an opportune time to sell when core processing contracts are nearing expiration. In addition, review existing employment agreements and consider establishing a severance plan to protect employees ahead of time.

Being approached by a potential acquirer gives your bank an opportunity to objectively reflect on its strategy and potentially adjust it. Even if your bank hasn’t been contacted by a potential acquirer, the board should still review the bank’s strategic alternatives annually, at a minimum, and determine the best path forward.

Getting your Digital Growth Strategy Right from the Start

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Digital growth is only as good as the metrics used to measure it.

Growth is one of an executives’ most important responsibilities, whether that comes from the branch, through mergers and acquisitions or digital channels. Digital growth can be a scalable and predictable way for a bank to grow, if executives can effectively and accurately measure and execute their efforts. By using Net Present Value as the lens to evaluate digital marketing, a bank’s leadership team can make informed decisions on the future of the organization.

Banks need a well-thought-out digital growth strategy because of the changing role of the branch and big bank competition. The branch used to spearhead an institution’s growth efforts, but that is changing as branch sales decline. At the same time, the three biggest banks in the country rang up 50% of the new deposit account openings last year (even though they have only 24% of branches) as they lure depositors away from community banks, given regulators’ prohibition on acquisition.

Physical Branch Decline chart.pngImage courtesy of Ron Shevlin of Cornerstone Advisors

Even in the face of these changes, many institutions are nervous about adopting an aggressive digital growth plan or falter in their execution.

A typical bank’s digital marketing efforts frequently rely on analytics that have been designed for another business altogether. They may want to place a series of ads on digital channels or social media sites, but how will they know if those work? They may use data points such as clicks or views to gauge the effectiveness of a campaign, even if those metrics don’t speak to the conversion process. They will also track metrics such as the number of new accounts opened after the start of a campaign or relate the number of clicks placed in new accounts.

But this approach assumes a direct link between the campaign and the new customers. In addition, acquisition and data teams will spend valuable time creating reports from disparate data sources to get the proper measurement, instead of analyzing generated reports to come up with better strategies.

Additionally, a bank’s CFO can’t really measure the effectiveness of an acquisition campaign if they aren’t able to see how the relationships with these new customers flourish and provides value to the institution. The conversion is not over with a click — it’s continuous.

This leads to another obstacle to measuring digital growth efforts: communication. Banks use three internal teams to generate growth: finance to fund the efforts; marketing to execute and measure it; and operations to provide the workflow to fulfill it.

Each team measures and expresses success differently, and each has its inherent shortcomings. Finance would like to know the cost and profitability of the new deposits generated, to assess the efficiency of the spend. Marketing might consider clicks or views. Operations will report on the number of accounts opened, but do not know definitively if existing workflows support the market segmentation that the bank seeks.

There is not a single group of metrics shared by the teams. However, the CEO will be most interested in cost of acquisition, the long-term profitability of the accounts and the return on investment of the total efforts.

But it’s now possible for banks to see the full measurement of their digital campaigns, from the disbursement of funds provided by the finance group to the success of these campaigns, in terms of deposits raised and net present value generated. These ads entice prospects into the account origination funnel, managed by operations, who open accounts and deposit initial funds. Those new customers then go through an onboarding process to switch their direct deposits and bill pay accounts. The new customer’s engagement can be measured six to 12 months later for value, and tied back to the original investment that brought them in the first place.

Bank leadership needs to be able to make decisions for the long-term health of their organizations. CEOs tell us they have a “data problem” when it comes to empowering their decisions. For this to work, the core system, the account origination funnel and the marketing channels all need to be tied together. This is true Integrated Value Measurement.

How Subchapter S Issues Could Snag a Sale

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acquisitions-5-2-19.pngNearly 2,000 banks in the U.S. have elected Subchapter S tax treatment as a way of enhancing shareholder value since 1997, the first year they were permitted to make the election. Consequently, many banks have more than 20 years of operating history as an S corporation.

However, this history is presenting increasingly frequent challenges during acquisition due diligence. Acquirers of S corporations are placing greater emphasis on due diligence to ensure that the target made a valid initial Subchapter S election and continuously maintained eligibility since the election. Common issues arising during due diligence typically fall into two categories:

  • Failure to maintain stock transfer and shareholder records with sufficient specificity to demonstrate continuous eligibility as an S corporation.
  • Failure by certain trust shareholders to timely make required Qualified Subchapter S Trust (QSST) or Electing Small Business Trust (ESBT) elections.

A target’s inability to affirmatively demonstrate its initial or continuing eligibility as an S corporation creates a risk for the acquirer. The target’s S election could be disregarded after the deal closes, subjecting the acquirer to corporate-level tax liability with respect to the target for all prior periods that are within the statute of limitations. This risk assessment may impact the purchase price or the willingness of the buyer to proceed with the transaction. In addition, the target could become exposed to corporate tax liability, depending on the extent of the compliance issues revealed during due diligence, unless remediated.

Accordingly, it is important for S corporation banks to ensure that their elections are continuously maintained and that they retain appropriate documentation to demonstrate compliance. An S corporation bank should retain all records associated with the initial election, including all shareholder consents and IRS election forms. S corporation banks should also maintain detailed stock transfer records to enable the substantiation of continuous shareholder eligibility.

Prior to registering a stock transfer to a trust, S corporation banks should request and retain copies of all governing trust instruments, as well as any required IRS elections.

It is also advisable to have the bank’s legal counsel review these trust instruments to confirm eligibility status and any required elections. Banks that are relying on the family aggregation rules to stay below the 100 shareholder limitation should also keep records supporting the family aggregation analysis.

While S corporation banks have realized significant economic benefits through the elimination of double taxation of corporate earnings, maintaining strong recordkeeping practices is a critical element in protecting and maximizing franchise value, especially during an acquisition. Any S corporation bank that is contemplating selling in the foreseeable future should consider conducting a preemptive review of its Subchapter S compliance and take any steps necessary to remediate adverse findings or secure missing documentation prior to exploring a sale.

Finding Loans in All the Right Places

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loan-growth-11-17-16.pngPennsylvania, Ohio, and New York might not offer the same growth opportunities as some other parts of the country, but that didn’t prevent Bank Services member S&T Bancorp from reporting record earnings in the third quarter of this year. Well managed institutions usually find a way to perform even when the conditions are less than optimal, or they’re located in slower growing markets. With $6.7 billion in assets, S&T is headquartered in Indiana, Pennsylvania, a small college town located about 50 miles northwest of Pittsburgh. It is an area that depends on manufacturing, service companies and Indiana University of Pennsylvania—the community’s largest employer—for jobs. Natural gas exploration in the Marcellus Shale formation, which runs through the region, also has been an ascending industry.

In recent years, S&T has expanded its lending activities into Ohio and Western New York, while also expanding its branch network west to the outer rim of Pittsburgh and east to Lancaster, Pennsylvania. Todd D. Brice, who has served as president and chief executive officer since 2008, talked recently with Bank Director Editor in Chief Jack Milligan about a range of issues, including loan growth in S&T’s three-state region.

What’s happening in the loan market in your three-state area?
Brice: I think it’s pretty steady. We’ve made some pretty significant investments over the last four years or so to diversify the company. Our roots are in Western Pennsylvania, but in 2012, we opened up a loan production office in Akron, Ohio, and in ’14 we jumped down to Columbus, Ohio, with another team of bankers. Last year we acquired Integrity Bank in the Harrisburg/Lancaster market, which was about an $800 million institution. That got us into the Central Pennsylvania market. We also opened up a loan production office in Rochester, New York.

What we’re finding out is that each market provides different opportunities, and it gives us the ability to shift. If you’re seeing a softness in one market, you can focus attention in another market. I think one of the hallmarks of our company has been our ability to grow organically over our history, and then augment that with select M&A.

Were these lending teams recruited away from other organizations?
Brice: Yes. In Akron, we originally had three people; today we have eight people in that office. In Columbus we started out with four people and we have eight. Western New York is a market that we’ve been lending into probably for 15 years. Our philosophy is not so much just to get into a market, but get into it with the right people. We were finally able to land a gentleman to lead the team up there, and then he was able to go out and recruit other high caliber bankers to the organization. All the bankers that we brought on board have very extensive experience in their respective markets.

In markets like Columbus and Akron, would it be logical to follow up those loan production offices with acquisitions at some point, if you found something that made sense?
Brice: We just haven’t found the right fit for us. I think if you look at our history, we’ve been pretty disciplined, and try and stick to a model that has seemed to work for us, but we’ll continue to keep our eyes open.

In Akron, we haven’t been able to find the right partner so we decided to open a full-service branch that will use a private banking-type model.

Are you worried about a recession?
Brice: I think you’re always worried about a slowdown. That’s why we’ve made significant investments over the last six years on the risk management side of the business. We monitor the loan portfolio in a number of different ways to try and keep an eye on concentrations, by product type or by markets, so if there is a downturn we can weather it a little better than some of the other folks.

The consumer financial services market is increasingly becoming mobile in its focus. Does that present challenges for S&T, or do you feel like that doesn’t really impact you because you’re [more of a commercial] bank?
Brice: Mobile is an important distribution channel for us. I won’t say we’re going to be the first to market with a new technology, but we have a good partner in FIS and they get us up to speed pretty quickly, so we feel we have a pretty competitive suite of products. We just did an analysis on how we rank in different categories, whether it be online, mobile, bill pay, online account openings on deposit side and loan side, online financial management tools, text alerts, mobile deposit, remote deposit capture. We think that we compare favorably with our competitors, but it’s something we definitely need to keep an eye on going forward because while commercial banking gets a lot of the spotlight, consumer has been a very strong line of business for us for many years. We’re a 114-year-old company and we’ve built up a nice little franchise over that period of time.

Is the demand for mobile-based products, or mobile-based services, as strong in a smaller market like Indiana, Pennsylvania, as it would be in a larger urban area?
Brice: Some of the things you’re seeing in the metropolitan markets, like branches that rely more on technology than people, I would say some of the rural markets we’re in are probably not quite ready for that. We are looking at taking that approach in some of our urban markets. Everybody has a mobile phone and they want to stay connected, so it’s important for us to make sure that we have those products to offer them. Fifty percent of our customer base use our online baking product, and another 15 percent also use our mobile banking product, which compares favorable to the utilization rates of our competitors.

The bank reported record third quarter earnings in October. What were the two or three things that helped drive that performance?
Brice: We had a lot of things go our way. We were up 20 percent over the second quarter and another 9 percent over the third quarter of last year. Our average loan book was up about $100 million for the quarter. That helped to grow [net] interest income by about $1.7 million. Another area that we focus on pretty extensively is expense management. We were down approximately $400,000 quarter over quarter. We had a recovery on a prior loan that helped us out, but also our data processing costs are down about $600,000 a quarter. We renegotiated a contract which was effective July 1.

Then we had a nice little lift on fee income which was up about a $1 million quarter over quarter. Some of that was driven by mortgage activity and also increased debit card income. Credit costs were down about $2.3 million quarter over quarter. We had a little bit of a spike in the first quarter in credit losses, but we’re seeing that kind of come back into line.

How does the fourth quarter look?
Brice: I like how we’re positioned. I think we’ve demonstrated that we have a good team of bankers that is able to go out and grow the business organically. I like the markets that we’re in; they are going to provide varying degrees of opportunity. I think long-term, we’ll keep our eyes open. We don’t feel we have to go out and do anything immediately on the M&A side. If the right opportunity pops up, we’ll certainly take a look, but we’re going to be disciplined on how we evaluate it.

What do you expect from your board? How can the board be helpful to you?
Brice: When you look at the makeup of the board, we have three former bank CEOs. All of them have extensive knowledge of the industry, so they are great mentors, great sounding boards, and they give me a different perspective on how I would evaluate things from time to time. Our other board members who are not former bankers bring different skill sets, whether it’s specific industry knowledge or an understanding of the markets we operate in. I think we have a very effective board. They challenge management, but at the same time, they support us to make sure our management team is doing a good job for our shareholders.

Last question: What is your dream vacation?
Brice: I like to spend some time in the Del Mar, California, area. You get down by the beach in August and it’s 75 degrees in the afternoon and 65 at night. It’s just a nice little quiet getaway. My wife and I and the kids like to get out there from time to time.

You’ll have to do an acquisition in Southern California so you have a reason to go there.
Brice: (laughs) If I did that, then I’d have to go out there and work! That’s why I like to get out there and get away.