How CECL Impacts Acquisitive Banks


CECL-7-30-19.pngBank buyers preparing to review a potential transaction or close a purchase may encounter unexpected challenges.

For public and private financial institutions, the impending accounting standard called the current expected credit loss or CECL will change how they will account for acquired receivables. It is imperative that buyers use careful planning and consideration to avoid CECL headaches.

Moving to CECL will change the name and definitions for acquired loans. The existing accounting guidance classifies loans into two categories: purchased-credit impaired (PCI) loans and purchased performing loans. Under CECL, the categories will change to purchased credit deteriorated (PCD) loans and non-PCD loans.

PCI loans are loans that have experienced deterioration in credit quality after origination. It is probable that the acquiring institution will be unable to collect all the contractually obligated payments from the borrower for these loans. In comparison, PCD loans are purchased financial assets that have experienced a more-than-insignificant amount of credit deterioration since origination. CECL will give financial institutions broader latitude for considering which of their acquired loans have impairments.

Under existing guidance for PCI loans, management teams must establish what contractual cash flows they expect to receive, as well as the cash flows they do not expect to receive. The yield on these loans can change with expected cash flows assessments following the close of a deal. In contrast, changes in the expected credit losses on PCD loans will impact provisions for loan losses following a deal, similar to changes in expectations on originated loans.

CECL will significantly change how banks treat existing purchased performing loans. Right now, accounting for purchased performing loans is straightforward: banks record loans at fair value, with no allowance recorded on Day One.

Under CECL, acquired assets that have only insignificant credit deterioration (non-PCD loans) will be treated similarly to originated assets. This requires a bank to record an allowance at acquisition, with an offset to the income statement.

The key difference with the CECL standard for these loans is that it is not appropriate for a financial institution to offset the need for an allowance with a purchase discount that is accreted into income. To take it a step further: a bank will need to record an appropriate allowance for all purchased performing loans from past mergers and acquisitions that it has on the balance sheet, even if the remaining purchase discounts resulted in no allowance under today’s standards.

Management teams should understand how CECL impacts accounting for acquired loans as they model potential transactions. The most substantial change relates to how banks account for acquired non-PCD loans. These loans first need to be adjusted to fair value under the requirements of accounting standards codification 805, Business Combinations, and then require a Day One reserve as discussed above. This new accounting could further dilute capital during an acquisition and increase the amount of time it takes a bank to earn back its tangible book value.

Banks should work with their advisors to model the impact of these changes and consider whether they should adjust pricing or deal structure in response. Executives who are considering transactions that will close near their bank’s CECL adoption date not only will need to model the impact on the acquired loans but also the impact on their own loan portfolio. This preparation is imperative, so they can accurately estimate the impact on regulatory capital.

“The Best Strategic Thinker in Financial Services”


strategy-7-19-19.pngThe country’s most advanced bank is run by the industry’s smartest CEO.

Co-founder Richard Fairbank is a relentless strategist who has guided Capital One Financial Corp. on an amazing, 25-year journey that began as a novel approach to designing and marketing credit cards.

Today, Capital One—the 8th largest U.S. commercial bank with $373.2 billion in assets—has transformed itself into a highly advanced fintech company with national aspirations.

The driving force behind this protean evolution has been the 68-year-old Fairbank, an intensely private man who rarely gives interviews to the press. One investor who has known him for years—Tom Brown, CEO of the hedge fund Second Curve Capital—says that Fairbank “has become reclusive, even with me.”

Brown has invested in Capital One on and off over the years, including now. He has tremendous respect for Fairbank’s acumen and considers him to be “by far, the best strategic thinker in financial services.”

I interviewed Fairbank once, in 2006, for Bank Director magazine. It was clear even then that he approaches strategy like Sun Tzu approaches war. “A strategy must begin by identifying where the market is going,” Fairbank said. “What’s the endgame and how is the company going to win?”

Fairbank said most companies are too timid in their strategic planning, and think that “it’s a bold move to change 10 percent from where they are.” Instead, he said companies should focus on how their markets are changing, how fast they’re changing, and when that transformation will be complete.

The goal is to anticipate disruptive change, rather than chase it.

“It creates a much greater sense of urgency and allows the company to make bold moves from a position of strength,” he said.

This aggressive approach to strategy can be seen throughout the company’s history, beginning in 1988 when Fairbank and a former colleague, Nigel Morris, convinced Richmond, Virginia-based Signet Financial Corp. to start a credit card division using a new, data-driven methodology. The unit grew so big so fast that it dwarfed Signet itself and was spun off in 1994 as Capital One.

The company’s evolution since then has been driven by a series of strategic acquisitions, beginning in 2005 when it bought Hibernia Corp., a regional bank headquartered in New Orleans. Back then, Capital One relied on Wall Street for its funding, and Fairbank worried that a major economic event could abruptly turn off the spigot. He sought the safety of insured deposits, which led not only to the Hibernia deal but additional regional bank acquisitions in 2006 and 2008.

Brown says those strategic moves probably insured the company’s survival when the capital markets froze up during the financial crisis. “If they hadn’t bought those banks, there are some people like myself who don’t think Capital One would be around today,” he says.

As Capital One’s credit card business continued to grow, Fairbank wanted to apply its successful data-driven strategy to other consumer loan products that were beginning to consolidate nationally. Over the last 20 years, it has become one of the largest auto lenders in the country. It has also developed a significant commercial lending business with specialties like multifamily real estate and health care.

Capital One is in the midst of another transformation, to a national digital consumer bank. The company acquired the digital banking platform ING Direct in 2011 for $9 billion and rebranded it Capital One 360. Office locations have fallen from 1,000 in 2010 to around 500, according to Sandler O’Neill, as the company refocuses its consumer banking strategy on digital.

When Fairbank assembled his regional banking franchise in the early 2000s, the U.S. deposit market was highly fragmented. In recent years, the deposit market has begun to consolidate and Capital One is well positioned to take advantage of that with its digital platform.

Today, technology is the big driver behind Capital One’s transformation. The company has moved much of its data and software development to the cloud and rebuilt its core technology platform. Indeed, it could be described as a technology company that offers financial services, including insured deposit products.

“We’ve seen enormous change in our culture and our society, but the change that took place at Capital One’s first 25 years will pale in comparison to the quarter-century that’s about to unfold,” Fairbank wrote in his 2018 shareholders letter. “And we are well positioned to thrive as technology changes everything.”

At Capital One, driving change is Fairbank’s primary job.

The Evolving Buyer Landscape in Bank M&A


buyer-7-16-19.pngThe recent acquisition of LegacyTexas Financial Group by Prosperity Bancshares serves as a microcosm for the changing bank M&A landscape.

The deal, valued at $2.1 billion in cash and stock, combines two publicly traded banks into one large regional institution with over $30 billion in assets. Including this deal, the combined companies have completed or announced 10 acquisitions since mid-2011. Before this transaction, potential sellers had two active publicly traded buyers that were interested in community banks in Texas; now, they have one buyer that is likely going to be more interested in larger acquisitions.

The landscape of bank M&A has evolved over the years, but is rapidly changing for prospective sellers. Starting in the mid-1990s to the beginning of the Great Recession in late 2007, some of the most active acquirers were large publicly traded banks. Wells Fargo & Co. and its predecessors bought over 30 banks between 1998 and 2007, several of which had less than $100 million in assets.

Since the Great Recession, the largest banks like Wells and Bank of America Corp. slowed or stopped buying banks. Now, the continued consolidation of former buyers like LegacyTexas is reducing the overall buyer list and increasing the size threshold for the combined company’s next deal.

From 1999 to 2006, banks that traded on the Nasdaq, New York Stock Exchange or a major foreign exchange were a buyer in roughly 48 percent of all transactions. That has declined to 39 percent of the transactions from 2012 to the middle of 2019. Deals conducted by smaller banks with over-the-counter stock has increased as a total percentage of all deals: from only 4 percent between 1999 and 2006, to over 8 percent from 2012 to 2019.

Part of this stems from the declining number of Nasdaq and NYSE-traded banks, which has fallen from approximately 850 at the end of 1999 to roughly 400 today. At the same time, the median asset size has grown from $500 million to over $3 billion over that same period of time. By comparison, the number of OTC-traded banks was relatively flat, with 530 banks at the end of 1999 decreasing slightly to 500 banks in 2019.

This means that small community banks are facing a much different buyer landscape today than they were a decade or two ago. Many of the publicly traded banks that were the most active after the Great Recession are now above the all-important $10 billion in assets threshold, and are shifting their focus to pursuing larger acquisitions with publicly traded targets. On the bright side, there are also other banks emerging as active buyers for community banks.

Privately traded banks
Privately traded banks have historically represented a large portion of the bank buyer landscape, and we believe that their role will only continue to grow. We have seen this group move from being an all-cash buyer to now seeing some of the transactions where they are issuing stock as part or all of the total consideration. In the past, it may have been challenging for private acquirers to compete head-to-head with larger publicly traded banks that could issue liquid stock at a premium in an acquisition. Today, privately traded banks are more often competing with each other for community bank targets.

OTC-traded banks
OTC-traded banks are also stepping in as an acquirer of choice for targets that view acquisitions as a reinvestment opportunity. Even though OTC-traded banks are at a relative disadvantage against the higher-valued publicly traded acquirers when it comes to valuation and liquidity, acquired banks see a compelling, strategic opportunity to partner with company with some trading volume and potential future upside. The introduction of OTCQX marketplace has improved the overall perception of the OTC markets and trading volumes for listed banks. This has helped OTC-traded banks compete with the public acquirers and gain an edge against other all-cash buyers. Some of these OTC-traded banks will eventually choose to go public, so it could be attractive to reinvest into an OTC-traded bank prior to its initial public offering.

Credit Unions
In the past, credit unions usually only entered the buyer mix by bidding on small banks or distressed assets. This group has not been historically active in community bank M&A because they are limited to cash-only transactions and subject to membership restrictions. That has changed in the last few years.

In 2015 there were only three transactions where a credit union purchased a bank, with the average target bank having $110 million in assets. In 2018 and 2019, there have been 17 such transactions with a bank, with the average target size exceeding $200 million in assets.

The bank buyer landscape has changed significantly over the past few years; we believe it will continue to evolve over the coming years. The reasons behind continued consolidation will not change, but the groups driving that consolidation will. It remains important as ever for sellers to monitor the buyer landscape when evaluating strategic alternatives that enhance and protect shareholder value.

Information contained herein is from sources we consider reliable, but is not guaranteed, and we are not soliciting any action based upon it. Any opinions expressed are those of the author, based on interpretation of data available at the time of original publication of this article. These opinions are subject to change at any time without notice.

Building a Stronger Bank



Following an acquisition or merger, many banks struggle to build and strengthen their brand. The branch channel is an important part of the franchise for most institutions, so determining which locations to keep, and which to close, is a key strategic decision post-merger. In this video, Anthony Burnett of Level 5 explains how to approach these decisions. He also shares how banks can position themselves for future growth by evaluating opportunities and staffing, and developing a long-term growth plan for the back office.

  • Strategies that Strengthen Your Bank’s Brand
  • Making Decisions About Branch Redundancies
  • Addressing the Back Office
  • Positioning the Bank for Future Growth

Credit Due Diligence Is Even More Important Now


due-diligence-4-17-19.pngWith loan quality generally viewed as benign while M&A activity continues into 2019, is any emphasis on credit due diligence now misplaced? The answer is no.

With efficiency driving consolidation, bank boards and management should not be tempted to take any shortcuts to save time and money by substituting credit quality through recent loan reviews and implied findings of regulatory exams.

The overarching reason is the nature of the current business and credit cycle. The economy is strong right now, and among many banks net recoveries have replaced net charge-offs.

But it is not a matter of if but when credit stress rears its head.

And time truly is money when trying to stay ahead of the turn of the credit worm. That means now is the time to highlight a few buy- or sell-side justifications for a credible M&A credit due diligence.

Some challenges always require vigilance. These include:

  • Heightened correlated lending concentrations
  • Superficial underwriting and/or servicing
  • Acquired third-party exposures through participations or syndications
  • Insider lending (albeit indirect)
  • Getting upside down on commodity or collateral valuations
  • Covenant-light lending
  • Credit cultural incongruity

New Risks, New Assessments
The emergence of a portfolio-wide macro approach to credit risk during the past decade has ushered in a flurry of statistical disciplines, such as calculating probabilities of default, loss-given defaults, risk grade migrations, and probability modeling to project baseline and stress loss credit marks for investors and acquirers.

Credible due diligence now provides rich assessments of various pools and subsets of loans within a target’s portfolio. These quantitative measures provide a precise estimate of embedded credit losses, in parallel with the adoption of the current expected credit loss (CECL) standard, to project life of portfolio credit risk and end deficiencies in the current allowance guidance.

Good credit assessment is capped by qualitative components. There are several factors to consider in the current credit cycle.

  • Vintage of loan originations: Late-cycle loans to chase growth goals or to entice investors carry higher risk profiles.
  • Exotic lending: Some banks have added less conventional loan products to their offerings, which may require specialized talent.
  • Leveraged financial transactions: For some banks, commercial and industrial (C&I) syndications have replaced the real estate participation of a decade ago. They have recently grown in leverage and stress, and would be susceptible to an economic downturn.
  • Hyper commercial real estate valuation increases: Recent studies have shown significant increases in commercial property values, well over the pace of residential 1-4 family properties, along with the headwinds of higher interest rates and the advent of diminished real estate requisites accompanying the tech-driven virtual marketplace.
  • Dependence on current circumstance as proxies for future credit quality: We must accept that we are affected by trailing, rather than by leading, credit metric indicators.
  • Lending cultural protocols: Knowing the skill sets and risk appetites of prospective teammates is imperative. Some would argue that in today’s consolidation environment, cultural incongruity trumps loan quality as the biggest determinant of success.

What Should Lie Ahead
Credit due diligence should provide a key strategic forerunner to the financial and cultural integration between institutions that might have disparate lending philosophies.

It should include an in-depth quantitative dive combined with a skilled assessment of qualitative factors, both of which are critical in providing valuable insight to management and the board. Yet, to reduce costs some have difficulty swallowing any in-depth credit diligence, given the de minimis nature of recent losses and low levels of problem loans.

Many economic indicators point to tepid economic growth in 2019. At some point, the current credit cycle will turn. A lesson learned from the financial crisis has been to be proactive in risk management to stay ahead of the risk curve—and not be left to be reactive to negative effects.

During the crisis, many banks suffered greater losses due to their reluctance to initiate remediation in response to deteriorating credit. M&A credit due diligence must be treated as an anticipation of the future, not a validation of the past, and an investment in curtailing future losses.

Integration: Keeping The Best



Bank leadership teams that approach an acquisition with an open mind will have the best odds for successfully integrating the target, says Kim Snyder of KBS Results. In this video, she shares the three most common misconceptions held by acquirers. She also outlines how banks should communicate to employees and customers about an acquisition, and explains how to approach technology integration—so acquirers can ensure the target’s customers stay with the merged institution.

  • Common Misconceptions
  • Communicating to Employees
  • Explaining Benefits to Customers
  • Getting Technology Integration Right

 

Preserving Franchise Value



The factors that help banks maximize value—including growth and profitability—are relatively timeless, though the importance of each value driver tend to change with the operating environment. But the way a bank pursues a sale impacts its valuation. In this video, Christopher Olsen of Olsen Palmer outlines the three ways a bank can pursue a sale. He also explains why discretion is key to preserving franchise value.

  • Factors Driving Today’s Valuations
  • The “Goldilocks” Process for Selling Banks
  • The Importance of Discretion

 

Bank M&A in 2019: Is It a New World?


Much like the countless dystopian novels and movies released over the years, the environment today in banking begs the question of whether we’ve entered a so-called new world in the industry’s M&A domain.

Deal volume in 2018 was roughly equal to 2017 levels, though many regions in the country saw a decline. And while it’s still early in 2019, the first two months of the year have been marked by a pair of large, transformative deals: Chemical Financial Corp.’s merger with TCF Financial Corp., and BB&T Corp.’s merger with SunTrust Banks. These deals have raised hopes that more large deals will soon follow, creating a new tier of banking entities that live just below the money-center banks.

Aside from these two large deals, however, M&A volume throughout the rest of the industry is down over the first two months of the year. As you can see in the chart below, this continues a slide in deal volume that began at the tail end of 2018.

Announced Bank Deals.png

Bank Director’s 2019 Bank M&A Survey highlights a number of the factors that might impact deal volume in 2019 and beyond.

Fifty-seven percent of survey respondents indicated that organic growth is their current priority, for instance, though respondents were open to M&A opportunities. This suggests that banks are more willing to focus on market opportunities for growth, likely because bank management can more easily influence market growth than M&A. The strength of the economy, enhanced earnings as a result of tax reform, easing regulatory oversight and industry optimism in general also are likely contributing to the focus on market growth.

The traditional chasm between banks that would like to be acquirers and banks that are willing to be sellers seems to be another factor influencing banks’ preference for organic market growth. In all the surveys Crowe has performed of bank directors, there always are more buyers than sellers.

The relationship between consolidation and new bank formation also weighs on the pace of acquisitions. If the pool of potential and active acquirers remains relatively stable, the determiner is the available pool of sellers. Each year since 2008, the number of acquisitions has exceeded the number of new bank formations. The result is an overall decrease in the number of deals. It stands to reason, in turn, that this will lead to fewer deals each year as consolidation continues.

Current prices for bank stocks also have an impact on deal volume. You can see this in the following chart, which illustrates the “tailwind” impact on deal volume for publicly traded banks. Tailwind is the percentage by which a buyer’s stock valuation exceeds the deal metrics. When the percentage is high, trading price/tangible book value (TBV) exceeds the deal price/TBV and deal volume is positively affected. The positive impact sometimes is felt in the same quarter, but there can be a three-month lag.

Deal Volume.png

In the beginning of 2019, bank stock prices recovered some of the declines they experienced in the latter half of last year, but they still are at a negative level overall. If bank stock prices continue to lag behind the broader market, as they have over the past year (see the chart below), deal volume likely will be affected for the remainder of the year.

Bank Stock Prices.png

It’s still too early to predict how 2019 will evolve for bank M&A. Undoubtedly there will be surprises, but it’s probably fair to assume a slightly lower level of deals for 2019 compared to 2018.

Advice for Buyers & Sellers in 2019



The need for stable, low-cost deposits is driving deals today, and the increasing use of technology is changing how banks should approach integrating an acquisition. In this video, Bill Zumvorde of Profit Resources shares what prospective buyers and sellers need to know about the operating environment. He also explains how bank leaders can better integrate an acquisition and how potential sellers can get the best price for their bank.

  • Today’s M&A Environment
  • Common Integration Mistakes
  • Maximizing Acquisition Success
  • Tips for Prospective Sellers

How A New Court Decision Could Change Bank M&A


merger-3-11-19.pngA recent decision by the Delaware Supreme Court relating to a merger between two pharmaceutical companies that was terminated before closing could have implications on bank mergers and acquisitions.

On Dec. 7, 2018, the Delaware Supreme Court affirmed the lower court’s ruling in Akorn v. Fresenius Kabi that a Material Adverse Effect (“MAE”) had occurred with respect to Akorn under the terms of its merger agreement with Fresenius.

The Supreme Court upheld the lower court’s determination that (1) Akorn had suffered an MAE under the terms of the agreement that excused Fresenius from its obligation to close the transaction, and (2) Fresenius properly terminated the merger agreement because of Akorn’s breach of its regulatory representations and warranties under the merger agreement, which gave rise to an MAE, and Fresenius had not materially breached the merger agreement (which would have prevented it from exercising its termination rights).

Why the Akorn Case Is Important

  • This is the first ruling in Delaware that an MAE had occurred in a merger transaction, allowing the buyer to walk away from a signed merger agreement.
  • The lower court’s opinion provides unprecedented guidance for future negotiation and litigation of MAE clauses.
  • The decision is applicable to all industries, including the banking industry, and makes it clear that, first, the heavy burden to establish an MAE with respect to the target remains with the buyer.

How The Case Impacts Bank M&A

  • Merger partners should carefully consider the categories of events or changes, as well as any specific events, that should be excluded from the MAE definition, ensuring that the definition accurately reflects the agreed upon allocation of risk between the parties.
  • Sellers should exclude industry-wide changes impacting the seller, while buyers should be mindful to provide that broad industry changes that disproportionately affect the seller are not carved out from the definition.
  • Typical carve-outs from the MAE definition in a bank merger agreement include: changes in laws and regulations affecting banks or thrift institutions, changes in GAAP, changes in the value of securities or loan portfolio or value of deposits or borrowings resulting from a change in interest rates, and changes relating to securities markets in general.
  • Buyers who are uncomfortable with the broad definition of an MAE, even following Akorn, and are significantly larger than the seller may wish to consider inclusion of a few specific financial closing conditions to supplement the broad MAE clause.
  • Buyers in the bank M&A context should in good faith continue the regulatory approval process even while contemplating terminating the deal over a possible MAE — having “clean hands” matters.

How the Court Found an MAE
Fresenius, a German pharmaceutical company, and a U.S. generic drug manufacturer, Akorn, formally agreed in April 2017 to merge.

Shortly after, Akorn’s financial performance “fell off a cliff;” its revenues declined the next four quarters by 29 percent, 29 percent, 34 percent and 27 percent, respectively. Its operating income plummeted 84 percent, 89 percent, 292 percent and 134 percent, respectively, during the same period.

Fresenius terminated the merger agreement in April 2018, asserting that Akorn had suffered a general MAE. Fresenius further asserted it had an explicit right to terminate the merger agreement because Akorn breached its regulatory compliance representations and warranties. Akorn’s lawsuit followed, seeking for the court to force Fresenius to close the transaction.

The Court of Chancery determined Akorn suffered a general MAE, which resulted from issues that disproportionately affected Akorn compared to similar companies in its industry. Focusing on the plain text of the merger agreement, the court determined that Akorn bore the general risk of the MAE and through several carve-outs to the provision, Fresenius bore the “systemic” risks related to Akorn’s industry. However, through specific exclusions from these carve-outs, the risk was shifted back to Akorn in the event that the risks disproportionately affected Akorn’s business as compared to other participants in its industry. In analyzing whether the effect was “material,” the court stated the effect should “substantially threaten the overall earnings potential of the target in a durationally-significant manner.”

In other words, the court determined that Akorn’s dramatic downturn in performance was significant because it had persisted for a year and had no sign of abating, rejecting Akorn’s argument that any assessment of the decline in its value should be measured not against its performance as a standalone entity but against its value to Fresenius as a buyer.

Conclusion
This case is directly applicable to the banking industry. Many banks suffered dramatic declines in earnings during the financial crisis that would be considered durationally significant within the framework reinforced by Akorn. Causes included massive credit losses, drastic margin compression and the regulatory reaction to the crisis. Banks need to take into account their risk profile and that of their merger partner when negotiating the MAE definition and consider how it would work under a variety of adverse economic environments.