Acquire or Be Acquired Perspectives: A Bank Investor Talks M&A

acquisition-4-13-18.pngWycoff, Kirk.pngThis is the second in a five-part series that examines the bank M&A market from the perspective of five attendees at Bank Director’s Acquire or Be Acquired conference, which occurred in late January at the Arizona Biltmore resort in Phoenix.

Read the perspectives of other industry leaders:
John Asbury, president and CEO of Union Bankshares
Gary Bronstein, a partner at Kilpatrick Townsend & Stockton LLP
Eugene Ludwig, founder and CEO of Promontory Financial Group

It’s tempting to think that rising profits and higher stock valuations will spur merger and acquisition (M&A) activity in the bank industry. But that isn’t necessarily the case, says Kirk Wycoff, managing partner of Patriot Financial Partners L.P., a Philadelphia-based private equity fund that invests in banks with between $500 million and $5 billion in assets.

Wycoff characterizes the current M&A landscape as lukewarm. He gives it a grade of B. “About 4 percent of the industry consolidates every year,” he notes. “So 25 years ago, when there were 15,000 banks, there were 600 bank transactions a year. Now there are 6,000 banks, which translates into 240 transactions a year. The investment bankers always say, ‘Next year is going to be the best year ever,’ yet it’s always around 4 percent.”

There is no way to predict future transaction volumes with precision, of course, but Wycoff brings a lot of experience to bear on the issue. From 1991 to 2004, he was chairman and CEO of Progress Financial Corp., growing the Philadelphia-based bank from $280 million in assets to $1.2 billion before selling it to FleetBoston Financial Corp. After Bank of America Corp. bought FleetBoston in 2005, Wycoff founded Philadelphia-based Continental Bank. It became the fastest-growing de novo bank opened in the four years before the crisis and was sold in 2014 to Bryn Mawr Bank Corp., a $4.5 billion bank in neighboring Bryn Mawr, Pennsylvania. And since 2007, Wycoff has been a managing partner at Patriot Financial Partners.

Wycoff shared his perspective as a private equity investor on the M&A landscape with Bank Director at its latest Acquire or Be Acquired conference, held earlier this year at the Arizona Biltmore resort in Phoenix, Arizona. Wycoff’s perspective is one of five Bank Director has cultivated about the M&A landscape following the annual conference.

“I’ve been coming here for 24 years, both for the industry data that the presenters present and for the ideas on how to improve my companies,” says Wycoff. “I was a CEO the first 13 years I came here, so I used a lot of the ideas I picked up to improve the banks I was running. Since I’ve been an investor for the last 11 years we’ve been meeting our banks here, encouraging some of our banks and their boards to come here to learn about mergers and acquisitions, about concepts around accretion and dilution, about governance and the whole process of, if you need to do something strategically, how to do it right.”

Wycoff has a unique perspective on the relationship between profitability and M&A activity. The typical assumption is that higher profitability will spur transactions. It’s at the top of the cycle, after all, when buyers are flush with cash and sellers salivate at the prospect of high valuations. But Wycoff thinks there’s another way to look at this.

People should think about the value of their bank as if M&A didn’t exist,” he says. “When banks return 15 percent on equity, which they’re on their way to doing, M&A becomes a much less necessary part of the plan because at that rate you’re going to double your capital every six years.”

Given the salutary impact of last year’s tax cuts, combined with the favorable operating environment, the industry could soon find itself in this situation. “As an investor, what struck me at this year’s conference is how good things are,” says Wycoff. “We’ve been in a very, very good credit environment, the industry has tremendous amount of capital, people are very optimistic and earnings are going up because of the tax bill.”

It’s in times like these that investors and board members need to avoid being lulled into a false sense of security, says Wycoff.

“CEOs will tell boards they deserve bonuses based on more earnings from tax reform when they maybe didn’t drive deposits or customer engagement or more margin.” Wycoff’s point is that now isn’t the time to become complacent. Instead, banks should be vigilant about operating expenses.

As an investor, Wycoff is also watching the evolution of bank stock ownership. The proliferation of exchange-traded funds and robo-advisors could detach bank valuations from fundamental performance, says Wycoff. This would create arbitrage opportunities for savvy investors, but it would break the feedback loop between the market and executives running banks. “That’s difficult because you like to think as a CEO or an investor that if a company does the right things, you get rewarded in your stock price.”

Fuller coffers also raise the importance of capital allocation. Should rising profits be used to increase dividends, accelerate stock buybacks, invest in the business or a combination of the three? That’s the question, notes Wycoff. “I hope that this additional profitability, which will inevitably drive stock prices higher for the banks that are doing well, isn’t frittered away on things that don’t create long-term value for shareholders.”

Should Banks Focus on Potential Acquirers, or Future Partners?

partnership-2-22-18.pngEvidence of how intertwined banking and technology have become could be seen at Bank Director’s 24th annual Acquire or Be Acquired Conference in Arizona, where nearly 20 percent of all sessions at the M&A event were devoted to technology. And while the results of audience response surveys showed that this shift is well-founded, they also uncovered lingering resistance to explore new capabilities and partnerships from the many bank C-Suite executives in attendance. Given the rapid decline in the number of U.S. banks and the fact that the build-to-sell model is still alive and well, perhaps a community bank’s time is better spent courting potential acquirers than potential fintech partners.

The audience at the Acquire or Be Acquired Conference is a powerful industry sampling, with over 650 bank CEOs, senior executives and directors from both private and publicly held financial institutions across the nation. Much can be gleaned from the inclinations of this crowd with regard to the broader banking industry in the U.S., so Bank Director takes several audience polls throughout the conference to harness that collective insight. Some interesting statistics emerged from this year’s conversations. The bankers polled indicated that:

  • The primary driver of bank M&A activity in 2018 will be limited growth opportunities (45.9 percent). Only 7.2 percent of the audience cited the rise in technology-driven competition as the primary force behind M&A.
  • Yet, when asked about what 2018 holds for online-only lenders, 29.9 percent said that banks will lose business to them and they may become even greater competitive threats.
  • In addition, bankers at the conference believe their officers and directors will spend the most time talking about new technologies in 2018 (33.3 percent). Talent issues are potentially the second biggest topic for discussion (31.8 percent), which makes sense given that banks are working hard to compete against technology companies for talent. (See Bank Director’s 2017 Compensation Survey to learn more.)
  • While fintech is acknowledged as a competitive threat, 57.6 percent of the audience disagreed with the premise that using fintechs to improve profits and attract customers is critical for their bank’s near-term success.
  • What’s more, 65 percent of those polled rate their key vendors (payments, digital, core, lending, risk/fraud, etc.) as merely adequate—but still plan to re-sign with them when the time comes.

Is this the portrait of an industry that’s resistant to change, more risk averse than driven to grow, or does a closer look reveal pragmatic reasons for avoiding the headlong rush to adopt new technology solutions?

On day one of Acquire or Be Acquired, Curtis Carpenter, principal and head of investment banking at Sheshunoff & Co. Investment Banking, shared some stark statistics about the shrinking banking industry. We currently see both a lack of de novo bank openings (just eight new banks since 2010) and rapid consolidation, which Carpenter said is creating larger community banks and a focus on exit planning. Another audience poll confirmed that over half (52.8 percent) of the audience still believe the build-to-sell business model is viable. In addition, a majority of the crowd (42.4 percent) believes that the banks with the best chance to thrive operate an acquisition-driven growth model. If bankers think their best bet is to build their bank into an attractive acquisition target and wait to be bought, it’s no wonder they’re in no rush to bear the time and expense of adopting new technologies focused on organic growth.

From the stage, Carpenter posed a startling if central question: “Is this the end of community banking?” With consolidation on the rise and de novos all but extinct, the answer seems to trend to yes. If that’s true, are fintechs better served by targeting the banks with active acquisition programs as potential partners instead of potential sellers?

As consolidation continues, banks and fintechs need to keep a weather eye on one another. Each side of the equation has valuable information and strategies to offer the other, and the fates of these two industries are inextricably linked. Whatever course the banking industry takes, Bank Director and FinXTech will be there to help explore the strategies and relationships that unfold.

Are We on the Cusp of the Next De Novo Wave?

de-novo-12-26-17.pngThe process of establishing a de novo bank always has been complicated and time-consuming, and occasionally even painful. But since the beginning of the financial crisis, it seems that obtaining deposit insurance for a de novo bank has become a nearly impossible task. The Federal Deposit Insurance Corp. received 1,738 applications for deposit insurance from 2000 through 2008, and approved 1,258 of those applications—an approval rate of 72 percent. From 2009 through mid-2016, the number of applications was a paltry 49—33 of which were in 2009—and only three were approved—an approval rate of 6 percent.

Part of the reason for the dearth of de novos in the post-crisis decade has been the understandable recoil by the regulators from any action that could increase systemic risk to the industry. FDIC research reveals that de novos failed at twice the rate of longer tenured banks during the crisis. Further, with the number of problem institutions the regulators were working through, there were limited resources available to analyze and process de novo applications. As a result, the industry has gone nearly 10 years without real new bank creation.

However, the tide seems to be turning, and starting a bank from scratch may be a viable business endeavor again.

The FDIC clearly has signaled it is open for business. In numerous speeches over the past 12 to 18 months, FDIC chairman Martin Gruenberg has conveyed a supportive message on the topic of new bank formation. He has acknowledged the importance of new financial institutions in preserving the vitality of communities across America, especially those negatively affected by bank failures or branch closures resulting from consolidation. Further, Gruenberg has emphasized that new bank startups help preserve the vitality of the community banking sector, which is crucial to the future success of the banking industry. We should note that Gruenberg’s term as chairman ended in November 2017. However, we believe that his expected successor—Jelena McWilliams, chief legal officer of Fifth Third Bancorp—will carry on the outgoing chairman’s pro-de novo, pro-community bank policies.

The FDIC’s support for de novo bank charters goes beyond mere lip service from its former chairman. The agency has put its money where its mouth is by designating staff in each regional office to handle de novo applications, returning the heightened supervisory period back to three years, from the crisis-era seven, and importantly, publishing a new handbook for de novo organizers. The FDIC published the handbook, titled Applying for Deposit Insurance: A Handbook for Organizers of De Novo Institutions, in April of 2017. The handbook is divided into three main sections: Pre-Filing Activities, Application Process and Pre-Opening Activities. With less than 40 pages, it is concise and written in a manner that organizers of all levels of banking experience can easily understand. While it’s not a substitute for digging into the details of the applicable statutes and regulations, and seeking the advice of counsel and other advisors, it provides potential bank organizers with valuable information, considerations and guidance on assembling an effective board and management, developing the bank’s business plan, and navigating the application process, among other things.

Arguably the two most important factors affecting the success of a startup bank are access to sufficient capital, and identifying and hiring talented management. Based on the de novo banks opened over the past 18 months, the capital required to open likely will be in the $30 million to $50 million range, but a proposed bank’s business plan will significantly affect its capital requirements. Over the past few years, investors have shown a great interest in investing in community banks. From January 2016 through September 2017, community banks have raised over $7 billion in fresh capital. Potential startups can be optimistic that investors will have an appetite for their equity offerings.

Looking at the past two and a half years, more than 650 banks have been merged or acquired as the wave of bank consolidation continues. As a result, a large number of experienced, successful and talented bank executives and managers have become free agents. Many of these bankers are not yet ready to get out of the banking game and are looking for their next challenge. Certainly, organizers will need to do their diligence, especially when it comes to non-competition and non-solicitation agreements, but one or more successful de novo bank executives likely lies in this pool of displaced bankers.

The FDIC’s favorable change in sentiment toward bank startups, along with the availability of financial and human capital in the marketplace, should bode well for organizers looking to catch the next de novo bank wave.

A New Dawn for De Novo Banks?

denovo-3-11-16.pngOn March 17, 2015, the Federal Deposit Insurance Corporation (FDIC) conditionally approved a de novo charter for the first time in several years. Primary Bank, based in Bedford, New Hampshire, opened its doors for business on July 28, 2015, after raising $29 million in capital.

And Primary Bank is not alone. There are two additional de novo applications awaiting action by the FDIC. Clearly, there are investors who see opportunities for new banks. Even the FDIC is speaking publicly to signal its openness to de novo activity. The FDIC recently noted that it “welcomes proposals for deposit insurance and staff are available to discuss the application process and possible business plans with potential applicants. In addition, former FDIC Chairman Sheila Bair noted earlier this year that the FDIC recognizes the importance of new institutions being formed, but wants to see very well capitalized banks with good business plans and managers that have diversified lending platforms.

The question is whether these recent de novo entrants will open the gates for other investors across the country.

A De Novo Drought
During the five years immediately prior to the start of the financial crisis in 2008 (2003-2007), there were a total of 629 de novo banks formed in the United States, averaging nearly 126 new banks each year.  That number tapered precipitously as the financial crisis began in 2008 and 2009, during which only 73 and 20 de novos opened for business, respectively. Since 2009, forming a new bank has been nearly out of the question, with only three new charters approved between 2010 and 2014 (compared to 15 new credit unions during that same period). This de novo drought, coupled with ongoing M&A activity and failures, has accelerated the decline in the number of bank charters in recent years.

Looking at the fate of many of the de novos formed just before the last recession, one can understand why regulators remain hesitant to allow new investor groups to enter the market.  Of the 629 charters in the five years prior to 2008, 238 no longer exist, either due to failure (75), M&A activity (157) or liquidations (5). Although a large portion of this decline was due to M&A activity rather than failure, no doubt many of those selling institutions were forced into a sale as the result of a deteriorating financial condition during the crisis. It is well documented that de novos formed during the years immediately prior to the financial crisis constituted a disproportionate number of the resulting bank failures and troubled institutions.

Why Start a De Novo?
Besides the traditional factors that have motivated bankers and investors in the past, there are a couple of unique reasons why now might be one of the best times for a group of visionary investors to form their own bank.

Community banks are in the midst of a once-in-a-generation inflection point with respect to their operations. The branch is being de-emphasized as a result of new technology, and branches of the future look more like interactive work spaces than traditional locations. Some new branches emulate coffee shops, Apple stores, or start-up incubators. Morphing a traditional branch location into one of these new conceptual branches requires a major capital investment and shift in culture and thinking. A de novo would have the luxury of creating its own culture, location, products, and services to take advantage of new technologies and branching trends, which would immediately distinguish it from existing bank franchises and position it for growth.

The next handful of de novos will enjoy tremendous publicity, both locally and, perhaps, nationally. That publicity drives more interest and opportunities from investors, talent, and prospective customers. Primary Bank exemplified this phenomenon. Due in part to all the attention it received, it exceeded its capital raising expectations and received national media attention. With the right people and message, the next few de novos could gain a similar strategic advantage.

What Will It Take?
In September of 2015, the FDIC held a joint training session with state bank regulators across the country to ensure such regulators are on the same page when it comes to de novo applications. It is safe to assume the application process will be more rigorous than in the past, including the need for more start-up capital and a superior management team. However, regulatory agencies appear to be preparing themselves to approve worthy applicants.

It is not a question of whether there will be another de novo bank, but when. Despite the challenges of running a community bank, a unique opportunity to start a new bank awaits the right investor group.

Is The Time Right for De Novo Banks?

1-23-15-BryanCave.pngTen years ago, business was booming for community banks—profitability driven by a hot real estate market, a wave of de novo banks receiving charters, and significant premiums paid to sellers in merger transactions. Once the community bank crisis took root in 2008, however, the same construction loans that once drove earnings caused significant losses, merger activity slowed to a trickle, and only one new bank charter has been granted since 2008. But as market conditions improve and with Federal Deposit Insurance Corporation’s (FDIC) release of a new FAQ that clarifies its guidance on charter applications, there are some indications that an increase in de novo bank activity may not be far away.

To understand the absence of new bank charters in the last six years, one must look to the wave of bank failures that took place between 2009 and 2011, which involved many de novo banks. Many of these banks grew rapidly, riding the wave of construction and commercial real estate loans, absorbing risk to find a foothold in markets saturated with smaller banks. This rapid growth also stretched thin capital and tested management teams that often lacked significant credit or loan work-out experience. When the economy turned, these banks were not prepared for a historic decline in real estate values, leading to a wave of FDIC enforcement actions and bank failures.

In light of these factors, as well as heightened regulatory expectations for operating financial institutions, many observers have questioned whether regulatory or market demands would allow for any new bank charters. Senior FDIC officials have maintained in public comments that there is no moratorium in the approval of de novo applications and that they would consider all new applications that were consistent with FDIC policy. These officials have also indicated that interest in de novo banks typically increased when acquisition pricing  reached roughly 1.25 times book value. With acquisition premiums trending upward in response to greater deal activity, the new FAQ is well-timed to anticipate additional de novo applications in the coming years.

With much having changed since 2007, what would a viable de novo bank look like in 2015? The FDIC’s current guidance, as well as its enforcement actions with respect to some troubled banks, may provide a blueprint:

  • Increased capital will slow aggressive growth. In the public comments of its senior supervisory officials and its recent FAQ, the FDIC indicates that a viable de novo charter will not be required to exceed a Tier 1 Leverage Ratio of more than 8 percent, provided the proposal “displays a traditional risk profile.” In our reading, de novo institutions focused on construction lending or with a concentration in commercial real estate lending will likely be required to maintain a leverage ratio more in line with those imposed by FDIC consent orders, which is typically at least 10 percent. The net effect will be to moderate business plans that call for higher-risk lending or growth in excess of market rates.
  • Business plans and market footprint. As noted in the FDIC’s FAQ, de novo applications must contain only a three-year business plan, rather than a seven-year business plan. Although there is often little value to projections that fall outside of this three-year window, applicants should make sure that their business plans describe a distinct need for a new bank in the market that can generate a sustainable pattern of growth and earnings into the future. Identifying strong community support, a healthy market footprint, and a clear niche for the bank will be integral to any business plan.
  • Experienced management a must. While the FDIC’s guidance does not place any added emphasis on the senior management of a proposed de novo bank, we expect significant scrutiny to be devoted to the qualifications of the applicant’s management team prior to a de novo application being approved. In the wake of the crisis, de novo banks will need to demonstrate they have strong leadership to weather a potentially volatile market.

In light of the FDIC’s new guidance and its public comments, we believe that as market conditions improve and merger activity continues, de novo banks will begin to re-appear. However, with higher regulatory expectations and without double-digit annual growth, these new banks will need to grow more slowly, gaining a foothold in their market footprint organically. This focus on the generation of franchise value will distinguish these new banks from many of the de novo institutions of ten years ago.