Mind These Gaps

5-13-15-Al.pngProbably one of the worst moments for a bank board and management team is to make an acquisition and find out it was a bad one. Over the past few years, it strikes me that three pitfalls typically upend deals that, on paper, looked promising:

  • Loss of key talent/integration problems;
  • Due diligence and regulatory minefields; and
  • Bad timing/market conditions.

While timing is everything, I thought to address the first two pitfalls here.

Losing Key Talent
A CEO with experience selling a bank tells me that number one on her list is to “personally reach out to top revenue generators ASAP and let them know they are going to have a great future in the combined company. It always amazes me how key leaders think they can wait on that while they talk to staff folks.”

But don’t stop there. If the merger is designed to significantly reduce costs and there is a lot of overlap, your staff will know that there are going to be significant job losses. “My advice, be honest,’’ the CEO says. “If you have a plan or process, tell them what it is. If you don’t tell them, you will let them know the second you do. Don’t sugar coat it. Call the key ones you know you will need with a retention offer ASAP.”

This advice had me seeking the counsel of Todd Leone, a principal with the management consulting firm of McLagan. Leone suggests those in key positions with change-in-control contracts usually stay as they are going to get paid.  Also, those in true key positions negotiate at the time of the deal to stay on after the merger. However, it can be complicated to retain the next level of staff.  As Todd says, “[It’s best to] negotiate at time of deal.”

Regulatory and Due Diligence Minefields
Now, as much as the drain of talent threatens the long-term success of a deal, there are other minefields to navigate. Bill Hickey, principal and co-head of the Investment Banking Group at Sandler O’Neill + Partners, cautions me that in today’s interest rate environment, significant loan pay-downs could be looming.

Another due diligence matter is an IT contract that requires large termination fees. Aaron Silva, the president and CEO of Paladin fs, says that banks need to implement terms and conditions into their agreements ahead of time that protect shareholders from unreasonable termination risk, separation expense and other obligations that may impact any M&A strategy.

Building on these talent and technology risks, John Dugan and Rusty Conner, both partners at the law firm of Covington & Burling, say that in today’s bank M&A market, “all of the historical issues related to pricing, diligence, and integration remain very relevant, but there are three issues that have taken on new prominence thereby impacting execution and certainty of closing.”  They are:

  • The reaction of the regulators to the proposed transaction—particularly if the acquiring institution is approaching a designated size threshold;
  • Protests by community groups—which can materially delay a transaction even if the complaint is without merit—especially [since] these groups are now targeting much smaller deals than ever before; and
  • Shareholder suits by the acquired institution’s shareholders—which are also increasingly making their way to smaller deals.

As Dugan opines, “parties need to anticipate and build into their pricing and timing the impact of these factors.”

Their views complement those of Curtis Carpenter, managing director of Sheshunoff & Co. He’s of the opinion that in today’s market, “regulatory and compliance matters have become critical components for both the seller and buyer. It is more important than ever for sellers to put in place generous pay-to-stay bonuses for key personnel who are in positions likely to be eliminated in the merger. The heightened regulatory scrutiny surrounding the merger process can result in long approval periods—sometimes many months.” 

Where most bank mergers fail isn’t in the transaction itself. No two deals are alike, but addressing these challenges is simply good business.

M&A 101 for the Board

Whether your financial institution is looking to buy or sell, the board of directors has several important responsibilities during an M&A transaction. In this video, Steve Kent of River Branch Capital LLC outlines the board’s role in the M&A process including negotiations, due diligence and after the deal is done.

Understanding M&A Accounting: What to Watch For

9-29-14-Crowe.pngOne of the worst things for an acquirer to find out after the fact is that the target wasn’t worth what the acquirer thought it was. That egg is on the board’s face and can cause significant headaches. The following are key trends and issues we have found recently in merger and acquisition (M&A) due diligence reviews.

Asset Quality
There is no better indicator of credit quality than a thorough loan review. We have seen a significant rise in collateral values in areas that were the hardest hit and modest recovery in others. Once-troubled institutions are recovering and finally are beginning to move other real estate owned and problem loans that sat unmarketable for several years. While the cleanup might not lead to a recapitalization of a bank for a variety of financial and legacy reasons, it has positioned many institutions as attractive acquisition targets at reasonable franchise values.

However, the not-so-happy news is that weak loan demand and the need to deploy capital efficiently have led to easing credit standards in commercial and industrial (C&I) and commercial real estate loans. It is important to check for deficiencies such as borrower base certificate compliance, waived or reset covenants, and lack of field audits. Also, current underwriting with extended amortizations and lower debt service requirements can present long-run risk to an acquirer. Additionally, we see institutions engaging in new loan products, which can present long-term risk if lender qualifications and track records have not been tested through a variety of economic cycles.

Quality of Earnings and Balance Sheet
Tangible book value (TBV), a common metric within the financial services industry, is used as an anchor for pricing a potential acquisition. Understanding the ways in which improper accounting or one-time income or expense items may skew this figure is important in arriving at a proper value for the bank. In the private company setting, we often find the rigor applied to interim accounting records does not match that applied to the annual audited financials. As management teams are more focused on normalizing yearly results, non-operating expense items might level out over the course of the year to not dramatically affect monthly results. We’ve observed a number of improperly capitalized items buried in other assets and underaccrued liabilities that can significantly distort the net book value of a bank. When establishing a fair purchase price based on a multiple of TBV, a $1 million interim balance sheet misstatement could mean a $1.5 million to $2 million purchase price adjustment.

Similarly, a $100,000 overstatement of core earnings could be a $1.6 million to $2 million purchase price adjustment using current multiples. We continue to see earnings supported by reserve releases, investment security salesA, and various other anomalies that have to be deciphered in order to get a true picture of normalized earnings. Determining a bank’s core earnings potential is more difficult in the current landscape because many acquisition targets have completed bank acquisitions of their own in the past few years. Both open-bank and failed-bank acquisitions come with accounting complexities related to recognition of interest income on the loans acquired. It’s imperative to understand the difference between the accounting yields and the cash income created from these acquired assets in order to avoid overestimating core earnings.

If a target bank has completed a failed-bank acquisition with loss-share agreements in place, significant consideration should be given to the accounting and record keeping of the loss-share arrangement. Acquirers should focus on understanding the remaining terms of any loss sharing, the ability to collect under the loss-share terms, and the potential hole that might be created from overstatement of the indemnification asset. Many of these arrangements may not be completely settled with the Federal Deposit Insurance Corp. (FDIC) for several more years, and many agreements contain a “true-up” provision whereby the FDIC could be owed significant sums of money if the loans perform better than expected. Each loss-share contract is unique, and potential acquirers need to fully understand the complexities associated with these agreements during the due diligence phase.

The issues highlighted here are just a few of the more common issues we’re seeing in current due diligence findings. Execution of a well-conceived due diligence plan can help eliminate surprises from an accounting, operational and credit perspective and lead to a successful transaction.

How to Handle Loan Portfolio Valuation and Avoid Trouble Later

12-23-13-Crowe.pngIn most acquisitions, the selling bank’s loan portfolio generally is the largest asset. Valuing it often consumes the majority of the valuation team’s effort. Achieving consensus on fair value can be challenging, as there typically isn’t an observable market price for most bank loan portfolios. In fact, the acquirers’ management often is surprised by the difference between its pro forma balance sheet projections and the final independent, third-party valuations. These unexpected changes in valuation could have a significant impact on the acquiring institution’s regulatory capital requirements and future earnings potential.

In most acquisitions, the valuation of the loan portfolio primarily is performed using a discounted cash flow method and various assumptions such as probability of default, loss given default, prepayment speeds, and required market rates of return on the projected loan cash flows.

What should management teams think about as they approach acquisitions and determine pricing and purchase price allocations? Here are a few considerations:

  1. To achieve a result that can be managed on an ongoing basis, loan valuations require a balance between the acquiring bank’s various internal management teams. For example, in many cases, finance teams significantly rely on the credit review due diligence team to assign the fair value marks on the loan portfolio. Note that the credit review team must provide its input for the results to be consistent with how the credits will be managed post-acquisition. An issue sometimes arises because most credit review teams typically provide identified loss ranges that are more applicable to an allowance for loan loss method. Alternatively, consider a range of life-to-date loss projections that can be presented to the board and management as best-case/worst-case scenarios to evaluate the overall merits of the transaction.
  2. The absolute credit mark might be fine for due diligence, but to be in compliance with U.S. generally accepted accounting principles (GAAP) and Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 805, “Business Combinations,” the timing and amount of expected loan cash flows need to be projected, and the market-required rates of return on the cash flows must be considered. Both the credit review and finance teams need to keep this distinction in mind, because incorporating both the timing and amount of loan cash flows and market-required returns often will decrease the values from the basic credit marks.

    Consider market factors other than credit, timing, and market pricing in the analysis. ASC 805 and the fair value standard ASC 820, “Fair Value Measurement,” require acquirers to value loans using an “exit pricing” method, which loosely translates to what a willing buyer would pay a willing seller for that loan. This differs from other methods such as asset/liability fair values that often use a bank’s own new loan rates as the basis for discounting the cash flows. Under GAAP, using the current interest rate for the institution to make a loan is labeled as an entrance price, while acquisition accounting GAAP requires an exit price, or the price to sell the asset or assume the liability.

  3. One of the primary market factors to consider in addition to the basic valuation inputs (such as discount rate, credit loss factors, prepayments and the contractual loan principal and interest payments) is the liquidity discount applied to each loan. It takes time and effort to sell a loan or a loan portfolio, and that time affects pricing. The more difficult a loan portfolio is to sell, the higher the liquidity discount that is factored into the required rate of return. Additionally, market perception is a factor that affects pricing no matter the credit quality. For example, loan portfolios with heavy concentrations of home equity or construction loans are discounted regardless of credit quality because of the market’s negative perception of this lending type.
  4. Plan for the post-acquisition accounting processes in advance of due diligence and deal completion. Accounting for loans in an acquisition after the deal is closed is complicated and requires systems, processes and coordination with the various teams within the bank. For credit impaired loans, the teams working on those loans must provide feedback to the accounting team on the timing of cash flows and the ultimate values that might be realized for each loan.

Because loan valuations are complex, it is crucial that banks coordinate between their internal teams and external resources. Proper planning and process development can result in due diligence expectations that are consistent with post-completion valuations.

M&A: Avoiding Compliance Sinkholes

11-11-13-Moss-Adams.pngWith interest rates on loans at an all-time low and fee income significantly diminished as a result of a new focus on consumer protections, many banks, credit unions and other financial services companies are looking to acquisitions to supply needed growth in balance sheets and income sources. But along with acquisitions come many potential regulatory pitfalls, including consumer protection risks.

Without appropriate levels of due diligence, your bank could end up with a number of hidden compliance nightmares, such as violations of the Truth in Lending Act, Real Estate Settlement Procedures Act, or flood insurance rules that result in consumer restitution, fines or civil monetary penalty assessments from your banking regulator.

Here are a few key compliance considerations to keep in mind during your preliminary evaluation of an acquisition target. Think about these things well before seeking approval of the acquisition from regulators and shareholders.

Institutional History

Has the acquisition target historically had regulatory issues? Be sure to check for published enforcement actions regarding products, services or practices that may affect the combined institution’s compliance and reputational profile. Don’t forget to use simple Internet searches, including social media outlets, through readily available search engines. You might be surprised by the results of your searches.

Compliance Management

Does the acquisition target have a well-run compliance management system? Include an evaluation of key compliance management components in your due diligence. Always consider risk assessments, policies, monitoring schedules, training, and complaint-management practices. Is the institution’s program comprehensive? Is reporting to the board regarding program activities concise and detailed? Are issues reported and resolved in a timely manner?

Third-Party Service Providers

Does the acquisition target offer a large inventory of consumer products, and does it use third-party service providers to sell and deliver some or all of those products? With consumer products come a variety of laws, rules and regulatory expectations regarding consumer protection. Significant levels of risk may reside in third-party relationships the institution has developed to sell and service consumer products.

Evaluate management’s assessment of risks associated with service providers and the strength of the institution’s vendor management program as well as key provisions of contracts, including recourse related to noncompliance. Allocating time in this area could help prevent significant issues after a transaction has been completed.

Product Sets and Features

Does the target institution have multiple deposit and lending products with complex features? Conversion of products is a significant risk factor related to consumer compliance. The more complex features become, the more challenging converting accounts and providing accurate disclosures will be.

Stories of failed customer account conversions and public relations disasters are all too common. Address details regarding conversion of products as early as possible in acquisition planning. Include consideration of required timing of consumer disclosures and alternatives for accommodating customers when eliminating or adding key products and services.

Post-Conversion Compliance Activities

How will the acquisition affect your current compliance management activities? How will your institution ensure appropriate staffing is maintained in the compliance function after the merger is complete?

Compliance management activities change considerably in the months following an acquisition or merger. Besides the fact the merged institution will have an expanded customer and employee base, there are a number of factors that affect the personnel requirements after a merger, including heightened customer service activities, monitoring new employees and changes in procedures and processes.

Budget significant time for your compliance department to review consumer disclosures, particularly periodic statements, after conversion of the acquired institution’s accounts. For example, are interest accruals correct and in accordance with the contractual requirements of the loan or deposit account agreement? Are payments being applied as originally disclosed and properly allocated between interest and principal? Are Web sites and mobile applications functioning as planned and are consumer disclosures accurate?

Also plan an increased budget for compliance training. It should be tailored and conducted in person with new staff regarding key regulatory requirements and your institution’s procedures regarding handling of customer inquiries, complaints and other important aspects of your compliance program.


In the push for new revenue, it can be easy to see acquisitions as the path of least resistance, especially as other financial levers (fees and loan interest rates) cease to be as powerful as they once were. But clearly, for those who haven’t taken the time and care to evaluate the details well ahead of time, taking the plunge with another institution is fraught with risk. Only by performing sure-eyed due diligence can you hope to make the combination a happy marriage.

Tax Due Diligence: It’s Not Just for Acquisitions

11-1-13-Crowe.pngWhen you hear the phrase “tax due diligence,” you probably think about investigating the tax situation of a target company in a potential acquisition transaction. But what about performing due diligence on your own management’s ability to accurately administer, account for, and report your company’s tax positions? Taxes are typically one of a bank’s largest expenses. Deferred tax assets are often a sizable balance sheet asset and regulatory capital component. Taxes also are a key focus of Securities and Exchange Commission financial statement reviews and a frequent cause of financial statement restatements and material weakness citations. So perhaps a bank’s board of directors, or at least its audit committee, should perform periodic tax due diligence on its own organization.

But what questions would you ask, particularly given a board’s role is one of policy-setting, strategic direction, and high-level oversight rather than daily management? If you understand what management should be doing to control risk in this area and where or why controls malfunction, you can tailor your queries to effectively address your organization’s tax complexity profile.

What Should the Controls Be?

Consider these four areas of risk and control in the administration and financial reporting of income taxes:

  • Are the bank’s tax expense and balance sheet positions accurately computed?
  • Are these positions recorded in the general ledger and reported in financial statements accurately and adequately?
  • Are tax payments and tax filings made timely and accurately? Are tax notices responded to promptly?
  • Are the individuals involved in tax administration staying abreast of and adequately addressing developments in tax law, accounting rules, and the company’s own activities?

Critical to the first three items are adequate checks and balances. That means management should be making sure that tasks are actually completed and completed correctly, and that there is a reconciliation of general ledger tax activity to the financial statement computations and to the return filings, particularly if the three areas are handled by different people or groups.

Vital to the fourth item is knowledge about changes in tax or accounting rules and the firm’s activities. For instance, the bank might have opened a loan production office in a new state or bought an investment banking firm in a new country that will affect the company’s taxes. Do the relevant people have a process to discover the event, the requisite skills and resources to understand how it affects the company’s taxes, and the ability to incorporate those effects into tax computations and returns?

Another due diligence focus for the board is oversight of the company’s internal controls.

Where or Why Do Internal Controls Malfunction?

There are myriad reasons controls break down, but consider these three factors:

  • Personnel turnover might lead to replacements who might not bring the same level of tax knowledge and who need time to learn the company and establish internal communication channels. Additionally, balls could drop while vacated positions are being filled.
  • The company is large and dynamic, has many personnel in many divisions and locations, is taxable in many jurisdictions, and undertakes numerous acquisitions or other changes in processes, service offerings and markets. It has a complex tax profile where application of the law is not always clear and tax authorities could easily disagree.
  • Internal auditors, whose job it is to test the effectiveness of company processes and controls, might lack the requisite specialized tax knowledge to adequately assess the tax function and controls, thus missing potential warning signs.

Tailoring Queries to Your Organization

For a smaller community bank, the personnel issue might be most critical and the board more hands on about tax matters. Ask about the tax qualifications of the people performing the work, particularly those reviewing it, and what management’s process is for making sure there is adequate internal tax knowledge and coverage. Ask whether outside experts are involved if needed.

For a large organization with sizable tax and finance departments, the ever-changing and complex environment might lead you to ask about management’s process for identifying and determining whether to take any aggressive tax positions and how tax personnel learn of corporate developments.

For an organization of any size, you might inquire how comfortable the internal auditor is with assessing the effectiveness of the tax function and its controls and whether a third-party expert should be used for this purpose. Don’t hesitate to ask the financial statement audit team for comments on management’s tax processes and abilities.

Consider the potential for sizable error in your company’s tax positions, and don’t hesitate to perform a little in-house tax due diligence.

What’s Under the Hood: The Audit Committee’s Role in M&A Due Diligence

As the regulators become more inquisitive about the due diligence process during an M&A deal, audit committee members should play a role when reviewing a proposed transaction.  In this video, Justin Long, a partner with the Bracewell & Giuliani law firm, discusses some key areas and red flags that the board should focus on when evaluating a target bank’s compliance environment.

Avoiding Valuation Problems During an Acquisition

Crowe_WhitePaper.pngAll too often after an acquisition, an acquirer’s management team is surprised by the difference between its pro forma balance sheet projections and the final independent, third-party valuations. These unexpected changes in valuation could have a significant impact on the acquiring institution’s regulatory capital requirements and future earnings potential.

To avoid such last-minute surprises, more institutions are involving their third-party valuation teams earlier in the process—during the due diligence phase—in order to provide preliminary valuations. Involving valuation teams earlier in the process has grown more popular as the pace of Federal Deposit Insurance Corporation-assisted acquisitions has slowed and as banks accelerate the pace of open-bank transactions, which allow more time for planning and due diligence.

An acquiring bank’s management team needs a clear understanding of the valuation issues that are likely to arise during the due diligence process.  Read more from Dan McConaughy and Chad Kellar from Crowe Horwath LLP on the benefits of making valuation an early part of the due diligence process.

M&A Post-Closing Legal Claims: Negotiating the Best Deal

Baird_Holm_1-28-13.pngOne of the most important issues for a buyer in an acquisition is the handling of legal claims following the closing. It is very common for issues to arise after the closing of a purchase of a business that can result in burdensome and expensive lawsuits. The parties tend to focus on negotiating indemnification provisions in the contract late in the negotiation process, and these provisions are often the last significant issue agreed upon by the parties. These provisions generally provide that the seller will indemnify (or hold harmless) the buyer from any and all liabilities incurred after the closing to the extent such liabilities arise in connection with a breach of the representations and warranties made by the seller in the definitive agreement, a breach of the post-closing agreements made by the seller or as a result of the actions of the seller prior to the closing.

As the post-closing liabilities incurred by the buyer can significantly undermine the value of the acquired business, and many of the seller’s liabilities can be difficult to discover in the due diligence process, it is important for buyers to understand the post-closing indemnification provisions and make sure that the indemnification provisions are clear and understandable. In that regard, below are some key considerations with which all buyers should be familiar before negotiating the post-closing indemnification provisions.

No. 1: Require the seller’s principals stand behind representations and warranties.

Sellers will typically prefer that representations and warranties that are subject to indemnification be made solely by the selling entity. As the overall liability of the selling entity will often be limited to any amounts held back or placed in escrow, the incentive of the selling entity to confirm that all representations and warranties are 100 percent accurate may be limited. To the extent that the seller’s individual principals are required to make the representations and warranties with the selling entity, the risk of personal liability will often not only provide another source of funds to pay indemnification claims, but will cause the seller’s principals to take a much more active role in confirming the accuracy of the representations and warranties and any disclosure schedules.

No. 2: Require adequate credit support.

As the selling entity will likely distribute the sale proceeds to its owners shortly after the closing, it is important that the buyer not rely solely upon the credit of the selling entity for the payment of post-closing indemnification claims. The most common method of credit support is for a portion of the purchase price to be placed in an escrow account with a third-party escrow agent to be used to pay future indemnification claims. Buyers should generally request that amounts be held in escrow for a period of not less than 12 to 18 months, and escrowed amounts should not be released to the seller until any and all potential indemnity claims have been fully and finally resolved. An alternative to setting up a potentially expensive and complicated escrow process is to hold back a portion of the purchase price to be paid over time and allow the amounts of any indemnified claims to be set-off against amounts otherwise due as the deferred purchase price. As sellers will be required to rely upon the credit of the buyer to pay the deferred purchase price, it is likely that a buyer will require security with respect to the amounts owed by the buyer as deferred purchase price.

No. 3: Make sure caps and other limits on indemnification make sense.

One of the most highly negotiated aspects of indemnification arrangements is the liability caps, baskets and other limitations on indemnity. Buyers should typically request that the indemnity cap be as high as possible, but no lower than 20 percent of the overall purchase price. In addition, sellers will often request baskets requiring individual indemnity claims and/or the total amount of indemnity claims to be in excess of a specified amount before claims may be made against the seller. While these types of baskets are generally a reasonable protection against small harassing claims by the buyer, buyers need to make sure that the individual amounts are appropriate given the likely nature of the indemnity claims. For example, to the extent a buyer expects a large number of small claims, a basket based upon the total amount of all indemnity claims would be more appropriate than a basket relating to each individual indemnity claim. In addition, to the extent baskets are used, there is no need for a “materiality” qualifier, because the parties have already agreed to what constitutes material damage.

No. 4: Don’t agree to cap claims relating to fraud.

While it is reasonable for the seller to request certain baskets and caps on indemnification claims, buyers should not agree to allow such limits and caps on any breaches of representations and warranties that are fraudulent or intentionally misleading. These types of breaches should be excluded as the potential damages for such claims could be significant and the seller and its principals should be strongly incentivized to act in an ethical manner.

No. 5: Do your due diligence.

While buyers sometimes believe that strong language in the representations and warranties and indemnification provisions will provide adequate protection for undiscovered liabilities, liabilities that turn up post-closing are typically larger and more material than the parties anticipate. In addition, the caps and other limitations on indemnification provisions, as well as qualifications contained in the representations and warranties, may leave the buyer without an adequate remedy. In addition, indemnification claims can be costly and time consuming to enforce. Accordingly, to the extent feasible, buyers should independently verify all information contained in the representations and warranties during the due diligence process. As we often tell our clients, there is simply no alternative to good due diligence.