The Uncertain Impact of COVID-19 on the Bank M&A Playbook

As banks across the country grapple with market and economic dynamics heavily influenced by COVID-19, or the new coronavirus, separating data from speculation will become difficult.

The duration and ultimate impact of this market is unknowable at this point. The uncertain fallout of the pandemic is impacting previously announced deals and represents one of the biggest threats to future bank M&A activity. It will force dealmakers to rethink risk management in acquisitions and alter the way deals are structured and negotiated.

As we have seen in other times of financial crisis, buyers will become more disciplined and focused on shifting risk to sellers. Both buyers and sellers should preemptively address the impact of the coronavirus outbreak on their business and customers early in the socialization phase of a deal.

We’ve compiled a non-exhaustive list of potential issues that banks should consider when doing deals in this unprecedented time:

  • Due Diligence. Due diligence will be more challenging as buyers seek to understand, evaluate and quantify the ways in which the coronavirus will impact the business, earnings and financial condition of the target. Expect the due diligence process to become more robust and protracted than we have seen in recent years.
  • Acquisition Funding. Market disruption caused by the virus could compromise the availability and pricing of acquisition financing, including both equity and debt financing alternatives, complicating a buyers’ ability to obtain funding.
  • Price Protections. For deals involving publicly traded buyer stock, the seller will likely be more focused on price floors and could place more negotiating emphasis around caps, floors and collars for equity-based consideration. However, we expect those to be difficult to negotiate amid current volatility. Similarly, termination provisions based upon changes in value should also be carefully negotiated.

In a typical transaction, a “double trigger” termination provision may be used, which provides that both a material decline in buyer stock price on an absolute basis (typically between 15% and 20%) and a material decline relative to an appropriate index will give the seller a termination right. Sellers should consider if that protection is adequate, and buyers should push for the ability to increase the purchase price (or number of shares issued in a stock deal) in order to keep the deal together and avoid triggering termination provisions.

  • Representations and Warranties. As we have seen in other economic downturns, expect buyers to “tighten up” representations and warranties to ensure all material issues have been disclosed. Likewise, buyers will want to consider including additional representations related to the target business’ continuity processes and other areas that may be impacted by the current pandemic situation. Pre-closing due diligence by buyers will also be more extensive.
  • Escrows, Holdbacks and Indemnities. Buyers may require escrows or holdbacks of the merger consideration to indemnify them for unquantifiable/inchoate risk and for breaches of representations and warranties discovered after closing.  
  • Interim operating covenants. Interim operating covenants that require the seller to operate in the ordinary course of business to protect the value of their franchises are standard provisions in bank M&A agreements. In this environment we see many banks deferring interest and principal payments to borrowers and significantly cutting rates on deposits. Sellers will need some flexibility to make needed changes in order to adapt to rapidly changing market conditions; buyers will want to ensure such changes do not fundamentally change the balance sheet and earnings outlook for the seller. Parties to the agreement will need focus on the current realities and develop reasonable compromises on interim operating covenants.
  • Investment Portfolios and AOCI. The impact of the rate cuts has created significant unrealized gains in most bank’s investment portfolio. The impact of large gains and fluctuations in value in investment securities portfolios will also come into focus in deal structure consideration. Many deals have minimum equity delivery requirements; market volatility in the investment portfolio could result in significant swings in shareholders’ equity calculations and impact pricing.
  • MAC Clauses. Material Adverse Change (MAC) definitions should be carefully negotiated to capture or exclude impacts of the coronavirus as appropriate. Buyers may insist that MAC clauses capture COVID-19 and other pandemic risks in order to provide them an opportunity to terminate and walk away if the target’s business is disproportionally affected by this pandemic.
  • Fiduciary Duty Outs. Fiduciary duty out provisions should also be carefully negotiated. While there are many variations of fiduciary duty outs, expect to see more focus on these provisions, particularly around the ability of the target’s board to change its recommendation and terminate because of an “intervening event” rather than exclusively because of a superior proposal. Likewise, buyers will likely become more focused on break-up fees and expense reimbursements when these provisions are triggered.
  • Regulatory approvals. The regulatory approval process could also become more challenging and take longer than normal as banking regulators become more concerned about credit quality deterioration and pro forma capitalization of the merged banks in an unprecedented and deteriorating economic environment. Buyer should also consider including a robust termination right for regulatory approvals with “burdensome conditions” that would adversely affect the combined organization.

While bank M&A may be challenging in the current environment, we believe that ample strategic opportunities will ultimately arise, particularly for cash buyers that can demonstrate patience. Credit marks will be complex if the current uncertainty continues, but valuable franchises may be available at attractive prices in the near future.

3 Reasons to Partner With an Advisor on Your Investment Portfolio

strategy-8-10-18.pngAs rising short-term interest rates flatten the yield curve, the resulting squeeze in bank margins is leading executives to look in every nook and cranny seeking cost savings. But as bank management teams tenaciously put some vendor relationships under a microscope, why do the bond portfolio and investment management processes typically escape scrutiny?

Bankers often and instinctively evaluate the performance of a securities portfolio by considering investment returns in comparison to an appropriate benchmark. But hidden in the overall yield are many expenses associated with managing the bond portfolio. Because transaction execution costs are not visible as an expense “line item,” financial institutions often overlook these when it comes time to tighten the expense belt. Even when the portfolio catches the eye of senior management, the idea of bringing in an independent party to assist is rarely considered. While most banks see no issue with leveraging an outside partner’s expertise on items considered “new” and “non-core” (such as loan review, derivatives and hedging), they see managing the investment portfolio as “core” and are therefore naturally reluctant to consider working with an outside partner.

With the potential for significant savings, here are some reasons to keep investment portfolio management as a “core” function, while also working with an outside party to gain efficiency:

  1. Same Side of the Table – Regardless of your desire to keep the investment management process in-house, the numerous and diverse responsibilities shouldered by the individual carrying the dual titles of chief financial officer and treasurer make it essential to lean on someone for help. When the time comes to deploy cash generated from maturing securities and prepayments, the path of least resistance for the CFO is to depend upon the broker who is selling the bonds to assist in an advisory capacity. While brokers can provide valuable assistance with security selection and analysis, their compensation is difficult to quantify, as it is built into the bonds purchased as an undisclosed mark-up to the price. Rather than sitting across the table from you when it comes time to transact, the independent investment advisor sits on your side of the table, is accountable only to you, and is compensated in a clear and direct fashion. By overseeing the execution process for the purchase and sale of securities, the independent investment advisor can free up valuable time for the CFO, while ensuring that compensation for the brokers involved is reasonable, consistent and improves security yields. The advisor can also help establish a process for quantifying average annual transaction costs for the portfolio based on projected turnover and expected growth.
  2. Retain Strategic Control – Involving an independent investment advisor in the investment management process may feel like a sacrifice of control if the advisor works in a discretionary capacity. However, finding a non-discretionary advisor enables you to cede control of time-consuming, tactical tasks, while holding on to important strategic decisions such as asset allocation, duration and credit profile. Retaining an independent investment advisor on a non-discretionary basis alleviates concerns that a core function is being “outsourced.” Instead, the relationship can be viewed as a partnership that provides the bank with increased operating leverage, while leaving you in complete control of the process.
  3. Equipping Resource – Through daily interactions with a variety of clients and trading partners, the independent investment advisor brings a unique vantage point on the fixed-income markets that benefits you when it comes time to execute a bond purchase or sale. The breadth of experience of the advisor can also be leveraged to strengthen the skills of the internal team at the bank. As you grow, you may identify an employee you would like to groom to take on more treasury responsibilities. The advisor can serve as an educating coach, teaching best practices while performing advisory duties until the time comes to gradually hand over the reins to the new treasurer. This also relieves the CFO from finding time to be the employee’s exclusive mentor.

Whether out of concerns about pushing a core function out of the bank, or perhaps due to sheer oversight, many banks have not yet taken a close look at the investment management process as a potential source of earnings improvement. By partnering with an independent investment advisor on a non-discretionary basis, banks invite a resource to their side of the table while remaining in the strategic driver’s seat for all investment decisions. This can lead to meaningful savings, thanks to new-found price transparency, and can liberate the CFO to focus on other critical priorities.