M&A has become a frequent topic of discussion among bank boards as deal volume begins to pick up and pricing strengthens, a reflection of improved asset quality and modest gains in the U.S. economy. Even those banks that don’t immediately plan to enter the fray want to know what is happening in the market and what that means for them. Aaron DiRusso, a senior vice president in the Financial Services Investment Banking division of Raymond James Financial, says M&A is the number one topic he was asked to speak on this year during bank board strategic planning meetings, much more so than in previous years.
Many board members already understand most of the terms of deal-making from experience in other sectors, but there are a few terms that are rarely spoken outside of banking, such as price to tangible book value. Other industries might focus more on cash flow and dividends when analyzing a deal, whereas in banking, you will hear more about earnings and book value. This guide will give you a run-down of M&A terms you need to know if your board is contemplating either an acquisition or sale of the bank. DiRusso and Mark McCollom, the co-head of the financial institutions group at investment bank Griffin Financial Group in Reading, Pennsylvania, helped prepare this list.
Structure of the Deal
Whole bank acquisition: In this transaction, the entire bank is being purchased. Alternatives include the acquisition of various assets, including branches, loan portfolios or lines of business.
Merger of equals (MOEs): Two companies of roughly equal size merge. The two companies decide which company’s stock will survive (the buyer), and give the other company (the seller) stock in the surviving company using an exchange ratio based on the seller’s relative contribution to the combined company. The seller may receive a modest premium on its stock value in the deal, but because the deal focuses on shared boards, management teams, and operations going forward, neither side receives a so-called control premium in the deal. MOEs generally happen when each party contributes 40 to 60 percent of the combined entity in terms of a combination of metrics, including net income, tangible common equity and market capitalization, says McCollom.
Triangular merger: This happens when the acquirer creates a holding company to acquire the target and both the acquirer and the target become subsidiaries of the holding company.
Pricing of the Deal
Cost of capital: You could say this is the cost to a company of its capital, but another way to look at it simply is this: The minimum return you need to generate for your investors, both shareholders and debt holders. This is what it costs you to operate and pay them back for their investment. One way to calculate this is to figure a risk-free investment return, such as a 30-year U.S. Treasury note, and add a risk-based premium, say 500 to 600 basis points, to represent what institutional investors need to justify making the investment. In addition to that, if you have any kind of volatility or lack of liquidity in your stock, you need to add another premium on top of that, says McCollom. Knowing your cost of capital goes a long way toward figuring out the kind of financial metrics you need to achieve for a successful deal.
Consideration: This is the form of payment to be paid by a buyer to a seller, typically cash, stock, or a combination of both. Other forms of consideration (e.g., preferred stock) may also be included as consideration in a transaction.
Consideration mix: This is the proportion of the form of consideration to be paid by a buyer to a seller, e.g. 100 percent cash, 100 percent stock or a combination of both.
Goodwill: This is the value of the premium paid to the seller over and above the seller’s tangible book value. It comes onto the acquirer’s balance sheet as goodwill, an intangible asset that assumes the seller’s brand, customers and employees have some additional value to the buyer.
Pro forma: These are figures given for current or projected financials, including earnings per share, to reflect the results of a potential transaction. These generally don’t follow GAAP (generally accepted accounting principles) and should be taken with a grain of salt. They will be used by management teams to project future earnings of the combined company.
Earnings per share accretion/dilution: This measures the impact, or difference, between earnings per share on the stand-alone versus a pro forma basis for the combined company. Accretion or dilution is expressed as a percentage increase (or decrease) in earnings per share for the acquirer before and after the deal is completed. Investors generally don’t appreciate deals that aren’t accretive to earnings within the first full year of operations for the combined company. If you aren’t improving earnings, why are you doing the deal?
Cost savings: The cost savings of a deal contribute to the pro forma income and, therefore, the expected earnings per share accretion (or dilution). Cost savings commonly range from 25 to 40 percent of the target’s operating expenses. “Typically, cost savings over 40 percent would be viewed as on the high end, and 15 percent on the low end,” says DiRusso.
Tangible book value: Reported book value excluding intangibles, such as goodwill.
Tangible book value accretion/dilution: This measures the impact, or difference, between tangible book value on the stand-alone versus a pro forma basis for the combined company. Accretion or dilution is expressed as a percentage increase (or decrease) in stand-alone tangible book value when compared to the pro forma tangible book value. “Consideration mixture can be as important as valuation when measuring the pro forma impact to tangible book value in a transaction,” DiRusso says. “Investors will generally tolerate some book value dilution, but earn-back periods should be within a reasonable period, viewed today as three to five years. Beyond that timeframe, a buyer may be taking a risk that the deal will not be well received by the Street.”
Premium on core deposits: Often referred to as deposit premium, this measures the value of any premium paid on the core deposits of the selling bank and is commonly expressed as a percentage of core deposits. Core deposits are the deposits from customers that will likely stay with the bank even if short-term interest rates rise.
Terms of the Deal
Break-up fees: This is the price you pay for walking away from an agreement, typically less than 4 percent of the deal price paid in cash. Your contract should explain the circumstances where a break-up fee would be paid, but it generally only applies when the seller gets a better deal to sell to someone else. This is sometimes called the “fiduciary out.” Keep in mind, if the deal doesn’t close, there are other expenses incurred in addition to the break-up fee, such as legal costs, due diligence expenses and management time spent.
Walk-away rights: Your contract will offer circumstances where you can walk away from the deal, such as if regulators or shareholders don’t approve of the agreement. The “drop dead” date is the date where the deal must get done, or the parties will have the right to walk away.
Fixed exchange ratio: This is the fixed amount for which the seller exchanges its shares for the acquirer’s shares. If the buyer’s stock price falls significantly post-announcement, that could mean the seller is getting significantly less value. In order to protect both parties, sometimes floors, caps and collars are used, which provide a way to adjust the exchange ratio or number of shares to protect both parties from volatility.