The M&A Limitations of Privately-Held Banks


More than half of bank executives and directors responding the Bank Director’s 2018 Bank M&A Survey see an environment that’s more favorable to deal activity, but those at privately-held institutions—which comprise 52 percent of survey respondents—are slightly more likely to see a less favorable environment for deals, and significantly more likely to expect limitations in their ability to attract an acquisition partner and complete the transaction.

In the survey, 30 percent of respondents from private banks say their bank has acquired or merged with another institution within the past three years, compared to 53 percent of respondents from publicly traded institutions. Respondents from private banks—which, it should be noted, also tend to be smaller institutions—are also less likely to believe that their bank will acquire another institution in 2018, with 47 percent of private bank respondents saying their institutions are somewhat or very likely to acquire another bank within the next year, compared to 61 percent of public bank respondents.

Rising bank valuations are largely to blame for dampened enthusiasm on the part of private banks that would like to consider acquisitions as a growth strategy, but feel excluded from the M&A market. Higher valuations mean two things. Potential sellers have higher price expectations, according to 84 percent of survey respondents. And public buyers—whose currency now holds more value in a favorable market—could have an edge in making a deal. Half of private bank respondents say that rising bank valuations have made it more difficult for the institution to compete for or attract acquisition targets, compared to 36 percent of respondents from public banks looking to acquire.

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For the most part, private buyers “have to do an all-cash deal,” says Rick Childs, a partner at Crowe Horwath LLP, which sponsored the 2018 Bank M&A Survey. Banks under $1 billion in assets have some flexibility in leveraging their holding company to lessen the impact on the bank’s capital ratios in such a transaction, as a small bank holding company can use debt to fund up to 75 percent of the purchase price. “I can borrow fairly easily in today’s environment at the holding company, then fuse it down into the bank and make the capital ratios acceptable, and be able to use those cash funds,” says Childs. “But it does mean that there’s an upper limit on how much [the bank] can pay because of the goodwill impact, and that I think is having a detrimental impact on [privately-held] institutions.”

Thirty-five percent of private bank respondents say they would favor an all-cash transaction if their bank were to make an acquisition, compared to 5 percent of public respondents. More than half of private bank respondents would want to structure a transaction as a combination of cash and stock—despite these banks’ stocks being thinly traded at best and relatively illiquid. Equity in the transaction “potentially adds to the pool of available shareholders who might want to buy stock back and produce a more liquid market,” says Childs. While some sellers may prefer to take stock in a deal to defer taxes until the stock can be sold, shareholders still want to know that they will be able to take that stock and cash out if desired. Private buyers that want to issue stock in the transaction should have a plan for that stock to become more liquid within a relatively short period of time, says Childs. Remember, boards have a fiduciary duty to represent their owners’ best interests. If another bank is willing to offer a deal that provides more liquidity, that’s going to be of more interest to most sellers.

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For a private bank, offering a cash deal has its benefits, despite limiting the size of the target the bank can acquire. Just 39 percent of private bank directors and executives responding to the survey say they would agree to an all-stock or majority-stock transaction if the board and management team sold the bank, compared to 63 percent of public bank respondents. “For some sellers, that’s actually easier to understand, because it gives you ultimate liquidity and takes some of the decision-making anxiety out of the seller’s hands” in terms of how long the seller should hold onto the stock and how it fits within that person’s portfolio, says Childs. The tax repercussions are immediate, but the seller is also paying today’s tax rates, versus an unknown future rate that could be higher.

That’s not to say that private banks won’t make deals in 2018. Some will, of course, buy other banks. But other types of transactions could pique the interest of private institutions and be particularly advantageous. Branch deals allow banks to cherry-pick the markets they want to enter and pick up deposits at a better price, says Childs. Thirty-nine percent of respondents from privately-held banks say their institution is likely to buy a branch in 2018, compared to 30 percent of public bank respondents.

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Private banks are also more inclined to acquire nondepository lines of business, as indicated by 30 percent of survey respondents from private banks, compared to 20 percent from publicly traded institutions. Acquiring wealth management firms and specialty lending shops are of particular interest to private banks, according to Childs. Both allow the institution to expand its services to customers and generate fee income without going too far afield of the bank’s primary strategic focus.

Both branch and nondepository business line acquisitions carry fewer due diligence and integration burdens as well.

Potential regulatory reform on the horizon could make the deal environment even more competitive, says Childs. Bank boards and management teams that worried about the impact of the regulatory burden on the sustainability of their bank may feel that the viability of their institution as an independent entity is suddenly more certain. “That likely lowers the pool of institutions that feel like they have to sell,” says Childs. And most bank executives and directors indicate that they want to remain independent—in this year’s survey, just 18 percent of respondents say they’re open to selling, with another 4 percent indicating their institution is considering a sale or in an agreement with another bank, and 1 percent actively seeking an acquirer.

The 2018 Bank M&A Survey gathered responses from 189 directors and executives of U.S. banks to examine the M&A landscape, M&A strategies and the economic, regulatory and legislative climate. The survey was conducted in September and October of 2017, and was sponsored by Crowe Horwath LLP. Click here to view the full results of the survey.

How Community Banks Can Fund M&A


bank-manda-6-13-16.pngAs bank mergers and acquisitions (M&A) have increased over the past several years, many banks are considering how to participate as buyers and take advantage of growth opportunities. One critical impediment for banks hoping to participate in M&A is funding the purchase. Many community banks lack a publicly traded stock to use as consideration, so they have to offer all cash in a transaction. When common stock is not used in a transaction, no additional capital is created and it becomes difficult to complete the transaction while maintaining adequate capital. Some banks use their holding company as a source of cash through a loan from a correspondent bank or other lender.

The Federal Reserve has a long-standing Small Bank Holding Company Policy Statement indicating that it does not look at capital ratios on a consolidated basis for institutions with consolidated assets under a certain threshold. Initially this threshold was $150 million in consolidated assets, but it increased to $500 million in February 2006. In April 2015, the consolidated assets threshold was increased again to $1 billion. This change is significant because as of March 31, there were more than 3,700 holding companies with less than $1 billion in consolidated assets, according to S&P Global Market Intelligence, formerly SNL Financial. As a result, the overwhelming majority of bank holding companies can take advantage of the Fed’s policy to engage in bank M&A and use leverage to fund acquisitions.

Between Jan. 1, 2015, and May 6, 2016, 183 acquisitions were announced in which the selling bank had less than $250 million in assets. Almost 69 percent of those transactions were not common-stock based. More than two-thirds were deals in which a small bank holding company (by the Federal Reserve’s definition) could have been competitive because consideration did not require common stock for the selling institution to accept the deal.

Funding M&A With Holding Company Debt
As a bank considers its long-term growth plans, acquisitions are a viable option when the size of the seller lends itself well to the type of consideration a bank can use: cash. As banks consider using holding company debt, it would be helpful to be aware of what qualifies a bank holding company to use holding company debt to fund acquisitions under the Fed’s policy statement:

This policy statement applies only to bank holding companies with pro forma consolidated assets of less than $1 billion that (i) are not engaged in significant nonbanking activities either directly or through a nonbank subsidiary; (ii) do not conduct significant off-balance sheet activities (including securitization and asset management or administration) either directly or through a nonbank subsidiary; and (iii) do not have a material amount of debt or equity securities outstanding (other than trust preferred securities) that are registered with the Securities and Exchange Commission.

For most holding companies, these qualifiers won’t have an impact on their ability to rely on the policy statement. When applying the policy for using bank holding company debt in an acquisition, the Fed also includes the following parameters:

  • Acquisition debt should not exceed 75 percent of the purchase price, meaning a minimum 25 percent down payment should be provided by the acquirer.
  • All acquisition debt must be paid off within 25 years.
  • The debt-to-equity ratio at the holding company should be less than 30 percent within 12 years.
  • No dividends are expected to be paid out of the holding company until the debt-to-equity ratio is less than 1:1.

The simplicity of the small bank holding company acquisition debt policy is that it allows holding companies with less than $1 billion in assets to use the cheapest form of capital for corporate level transactions. Subordinated debt, which counts as Tier 2 capital (with limits), is a good source of available capital. However, it should be used to fund an acquisition purchase only if a holding company’s pro forma assets will exceed $1 billion, because the costs and limitations on the debt make it a more expensive and more restrictive type of debt than a simple bank holding company loan.

Additionally, even if acquisitions are not a part of a holding company’s long-term strategic plan, the bank still should consider holding company debt under the small bank holding company policy to:

  • Fund stock repurchases at the holding company to provide liquidity for shareholders.
  • Provide capital for organic bank growth (the repayment can come from future bank earnings).
  • Retire more expensive forms of holding company capital or debt that no longer is needed as a result of the increase in consolidated asset limits.

Industry observers often are critical of regulatory policy. However, this recent change to the small bank holding company policy should be viewed as positive for the industry and the future of community banks.

New Rules Benefit Small Bank Holding Companies


holding-companies-12-25-15.pngConfirming an important regulatory concession Congress previously granted to community banks, the Federal Reserve Board recently amended its regulation and related Policy Statement governing “small bank holding companies” (SBHCs) to include companies up to $1 billion in total assets, up from $500 million. The Policy Statement now applies to about 90 percent of all U.S. bank holding companies.

Significance of the Change
This is good news for community banks because the regulation was designed to cut smaller banks and bank owners some slack when it comes to using internal leverage as a source of capital funding. Effectively, Congress has given community banks an “ownership” advantage to help balance against the marketplace advantages enjoyed by larger banks.

Key Benefit of SBHCs
The regulation basically exempts qualifying SBHCs (but not their bank subsidiaries) from the higher consolidated capital generally required for larger banks. Stated differently, the SBHC is deconsolidated from its bank subsidiary, such that only the subsidiary bank is subject to minimum capital ratios. This enables SBHCs to offset the investment inefficiency of maintaining excess capital at the bank level by incurring debt at the holding company level.

Investment Advantage
For shareholders, the principal advantage of the SBHC structure is that it allows the shareholder’s investment to be internally leveraged with holding company debt, which simultaneously reduces the amount of common equity required from shareholders to support the bank’s capital while increasing the shareholders’ return on the capital invested. Moreover, the cost to the issuer of debt capital is typically about half that of equity capital, partly because interest on the debt would be tax deductible whereas dividends on preferred stock would not. In addition, leverage provides a non-dilutive source of bank-level capital to support growth, as compared to common stock. Accordingly, taking advantage of the opportunities afforded to SBHCs can have a material and lasting impact on shareholder value.

Operational Flexibility
An even more important attribute is operational flexibility, because management can readily tap holding company debt to meet common strategic challenges and opportunities, such as:

  • Providing growth capital for a bank subsidiary,
  • Buying another bank or branch, and
  • Repurchasing stock to support shareholder liquidity.

These situations often demand more rapid and decisive action than might be possible if funding must wait for a successful equity stock offering, especially one undertaken in a small community. In fact, having ready access to capital funding through holding company debt could be the key resource that enables some community banks to preserve their independence. The 1,500 community banks without a bank holding company should consider this advantage as well.

Benefit for Subchapter S Banks
The SBHC advantage will be especially helpful for growing Subchapter S banks because it enables these banks to raise capital without affecting the constraints on numbers and types of shareholders permitted for S corporations.

Regulatory Leverage Limits and Conditions
Holding companies are not required normally to obtain regulatory approval to incur debt up to 100 percent of the holding company’s net equity (typically 50 percent of bank equity). The Policy Statement sets out various conditions and requirements that become applicable when debt exceeds that level or when the company has previously been instructed not to incur debt.

In practice, most SBHCs needing capital for any reasonable purpose (except perhaps to cover loan losses) will be eligible under the rule to borrow more money than their directors would have imagined possible or considered desirable. The limiting factor is more likely to be the marketplace’s appetite for the holding company’s debt rather than regulation. 

Sources of Funding
The best resource for senior debt financing will often be an up-stream correspondent or bankers’ bank. These lenders normally expect borrowers to amortize principal over 5 to 10 years, maintain acceptable ratios throughout the financing period and pledge the bank stock owned by the holding company as collateral for the loan. Because of the latter requirement, these loans are often referred to as “bank stock” loans.

Longer term, less restrictive and unsecured or subordinated debt financing could also be sought from major shareholders or other local investors as well as from institutional investors. These instruments tend to provide more flexibility in terms (fixed vs. floating) and can be structured to include conversion features. Moreover, bank holding companies have the ability to issue subordinated debt without the onerous covenants and events of default typically inherent in senior debt instruments.

The Takeaway
Well-managed community banks of tomorrow will wish to use every tool possible to deliver value for shareholders. The SBHC could prove to be the most important tool in the box for many smaller banks.