The number of bank M&A transactions completed in 2020 represent a stark decline compared to those that have closed in recent years. Dory Wiley of Commerce Street Capital believes that deal activity will rebound in 2021 — but notes that buyers and sellers may find it even more difficult to come to terms on price. In this video, he provides guidance on how banks can meet their goals.
In the current banking environment, two areas are receiving heavy attention from financial institutions large and small: risk management from regulators, and mergers and acquisitions. As I assist my clients with both, I think about the concept of risk management in an acquisition setting. The following are four tips for managing risk in financial institution mergers and acquisitions.
Tip 1: Get your ducks in a row prior to a transaction.
Whether buying or selling a financial institution, it will lessen risks if both sides are prepared and have a team identified and educated. The team should consist of internal employees and management along with external legal counsel, accountants and investment bankers. A qualified team should ensure that the cost of the acquisition will be more predictable. A prepared internal team will provide better due diligence materials for the seller, and, ultimately, better disclosure schedules. An educated and engaged board of directors is also essential to managing risk. Both the buyer and seller boards of directors have a fiduciary duty to maximize shareholder value, along with their duty of care.
Tip 2: Identify “deal breaker” issues early.
Whether a buyer or seller, there are issues or terms that a financial institution may consider unacceptable, and it is prudent to identify them at the beginning. For a buyer, these may include regulatory problems, large loan issues, expensive change of control agreements, and contracts with large termination payments or outstanding litigation. For a seller, deal breakers typically are more financial in nature regarding purchase price adjustments, but they can also include employee issues, as well as indemnification and survival provisions (past the closing date of the seller’s representations and warranties).
Tip 3: Build risk mitigation into the definitive purchase agreement.
Management and boards of directors should be aware of what is being included in purchase agreements to understand and mitigate the risks. In the typical acquisition scenario, the buyer obtains all of the assets and the liabilities by law. What that means is the buyer gets the good, the bad and the ugly. An asset purchase can reduce the liability and narrow the scope of the purchase, but most financial institution transactions are mergers.
One way the acquirer can mitigate risk is through due diligence. If certain assets in the loan portfolio do not pass muster, there may be opportunities to sell those loans prior to the consummation of the deal. Robust indemnification provisions in the purchase agreement also can protect the buyer from some problems and should be considered carefully. In a merger scenario, there typically is no surviving entity to pay indemnification to the buyer, so it may be prudent to consider an escrow of some of the purchase price to cover claims post-closing. There are a multitude of ways to structure indemnification, survival of representations and warranties and purchase price hold-backs, and the buyer should contribute to the discussion of the best avenue for their institution.
Another risk mitigation strategy is to consider offering key employees of the seller bonuses to stay with the combined company. From the time a transaction is announced to closing can take four to six months or longer, and bonuses may help maintain stability.
The most important thing a seller can do is prepare complete and accurate disclosure schedules. Full disclosure is the seller’s insurance policy against indemnification or other claims in the future. Couple this with a tail insurance policy for directors and officers, and seller risk should be fairly well mitigated.
Tip 4: Understand that integration is the most difficult aspect of an acquisition.
Where do most bank mergers fail? It isn’t in the transaction itself. Failure is far more likely after the two institutions become one. The risk of post-merger failure should be mitigated early in the transaction process. Much like getting prepared ahead of a merger deal, it’s crucial to pull the proper integration team together to concentrate on culture, personnel, policies and procedures, as well as training. There also are consultants who specialize in acquisition integration. This effort should not be short changed or undervalued and requires a robust plan to incorporate the merged or acquired bank into the existing company. The planning should begin as early as possible and the integration effort may take a year or two to complete.
There are many more risks to be contemplated when embarking on the purchase or sale of a financial institution, but emphasis on these four should help ensure a successful transaction for both sides.
Merger and acquisition activity was flat for financial institutions in 2013, with whole bank deal volume down 2 percent from the previous year to 241 deals in 2013, according to SNL Financial. However, the average price to tangible book value increased by 7 percent to 123.89.
Prices aren’t headed up for everyone, though. In 2013, the average price to tangible book value for banks rose 7 percent, while it only rose 3 percent for thrifts. Why? Thrifts tend to be smaller and have less diverse portfolios. Plus, thrifts are now regulated under the Office of the Controller of the Currency (OCC), which adds a degree of regulatory pressure that many buyers would prefer to avoid.
Strategy Is Not Just in the Numbers
Many banks are looking to grow to survive. But prudent organic growth of more than 10 to 15 percent a year is difficult. That leaves acquisition as an alternative growth strategy.
Much of the consolidation occurring in the industry is in response to questions boards are asking due to the financial crisis and the resulting regulatory and market changes, including:
Are we the appropriate size to survive in today’s regulatory environment?
Are we in the appropriate markets to support operations and growth?
Do we have enough capital based upon increasing regulatory expectations?
Do we have the right management team to achieve growth?
Can we afford the specialized expertise to meet rising regulatory standards?
Do we have economies of scale and infrastructure to be competitive?
Do we have the right products, services and technology to meet the evolving needs of our customer base?
Do we have the energy and motivation necessary to move our organization to the next level?
The answers to these questions are the real drivers for transactions. Success in the M&A market isn’t driven by average multiples. It’s driven by strategy. That strategy should start long before a target is identified and must continue well beyond any transaction.
Buyers are not looking to buy just any bank. Most buyers are looking for acquisition targets that are:
Clean. Increased regulatory attention means that buyers are more sensitive than ever to clean loan portfolios, low non-performing assets and compliance concerns. CAMELS 1 or CAMELS 2-rated banks are attractive targets.
Well located. Attractive facilities in the right markets are vital. Urban and suburban banks are selling for higher multiples than rural banks. That doesn’t mean there are no opportunities in rural areas, though. With larger national banks abandoning many low-population areas, some rural banks are seizing the opportunity to use acquisitions to become the dominant brand in their specific markets.
Appropriate size. Larger banks are choosing larger acquisition targets. Smaller transactions take too much time and capital. This trend removes some of the historic active buyers in the smaller community bank space.
Market demographics and product mix. Banks looking to branch out into new customer segments or to expand their product offerings may consider these issues the same or even more heavily than the target’s geographical footprint.
Solid management. Banking has seen a talent drain in recent decades as many candidates who once might have chosen a banking career have instead opted for investment banking or other options. The result is a shortage of management talent in the banking industry today. Banks with solid management teams who are likely to stay on after the transaction are particularly attractive.
Sellers have their own set of motivations. Sales are driven by a variety of concerns, including:
Age. Older owners, board members and executive management may want out of the industry.
Regulatory concerns. Many smaller banks are finding it hard to deal with the increased regulatory burden using their limited resources. Constraints on their activities due to new regulations are also squeezing profits. Finally, the risks associated with regulatory failures are an increasing concern. Directors, too, are concerned about their increased liability exposure.
Return on investment. For banks with the right risk and market characteristics, the current deal environment offers an excellent opportunity to realize a solid return for their investors.
New buyers are also entering the market, including payday and other specialty lenders, off-shore buyers and Native American tribes, but thus far with limited success. Based on increasing values and regulatory issues, we anticipate more growth in M&A activity in 2014 than we saw in 2013. In any case, it’s a good time to consider your options.