M&A Terms You Need to Know

12-19-14-NaomiDC.pngM&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.

A Few Notable Deals You May Have Missed in 2014

12-12-14-Al.jpgTo successfully negotiate a merger transaction, buyers and sellers normally must bridge the gap between a number of financial, legal, accounting and social challenges. Couple this with significant barriers these days to acquiring another bank—such as gaining regulatory approval— and it’s no wonder that bigger financial deals remained scarce this year. For as much digital ink as was spilled on BB&T Corp.’s $2.5-billion acquisition of Susquehanna Bancshares a few weeks ago, here are three news items that may not have garnered national attention as they should have.

Ford Financial plans to buy up to a 65 percent stake in Mechanics Bank
The $3-billion asset bank will now be used as a platform for other bank acquisitions.
In October, Mechanics Bank of Walnut Creek, California, announced it planned to sell a controlling interest to the Ford Financial Fund, positioning the 109-year-old bank as a platform for other bank acquisitions. The private equity firm Ford Financial, which focuses on financial services, is led by co-managing members Gerald Ford (no relation to the late U.S. president) and Carl Webb. According to a piece in the San Francisco Business Times, Webb acknowledged Ford’s ambitions to use Mechanics Bank as the platform for additional acquisitions: “We’ve always been acquisitive. It’s served us well. As long as you’re growing and creating exponential value, why stop?” So if you’re on the West Coast, I’d keep an eye on Mechanics Bank expansion efforts in 2015.

Sterling Bancorp agrees to buy Hudson Valley
The deal forms a company with slightly more than $10 billion in assets.
Sterling Bancorp. in Montebello, New York, announced a deal in November to buy Hudson Valley Holding Co. in Yonkers, New York. One of the drivers for the deal, according to Jack Kopnisky, president and CEO of Sterling Bancorp. is blending Sterling’s commercial lending expertise with Hudson Valley’s attractive deposit base. As he shared, “the resulting institution will have strong asset generation capabilities, a cost effective funding mix, and a broad footprint in the dynamic marketplace centered on New York City and its surrounding region.” With the deal, Sterling will also cross the $10-billion asset threshold, one most banks seek to avoid. Indeed, banks lose significant interchange income when they hit the mark while adding additional regulatory oversight from the Consumer Financial Protection Bureau. Rather than be deterred by the increased regulatory exposure, it appears the potential value in the combined entity serving small- to middle-market commercial and consumer clients in the New York metro area outweighs the costs. The deal adds 28 branches to Sterling’s 32 and creates the 10th largest bank by deposit market share in the New York area. The deal is expected to generate $34 million in annual cost savings, and be accretive to earnings in the calendar year 2015. Rather than be paralyzed by the $10 billion number, Sterling’s board showed a healthy appetite to grow in both size and potential efficiencies.

United Bankshares completes acquisition of Virginia Commerce Bancorp
United, now with $12.1 billion in assets, has a strong track record of acquiring other banks.
With 46 offices in the greater Washington D.C. market and combined headquarters in D.C. and Charleston, West Virginia, this is one of the stronger regional bank players in the MidAtlantic. Being that D.C.’s economic fortunes have fared considerably better than most, I’d suggest keeping an eye on the acquisitions being done by this financial institution. United has a strong track record of acquiring and successfully integrating other banks into its business and given that its last deal, with Virginia Commerce, closed on January 31, 2014, I wouldn’t be surprised if another deal comes about in the next six to nine months, especially as they compete locally with at least four other strong, growing community banks: Cardinal Financial, Eagle Bancorp, Sandy Spring Bancorp and the Bank of Georgetown.

Certainly, banking acquisitions like these three show a commitment to profitability and efficiency—and reflect solid asset quality and sound capital positions. There is more than one way to grow your bank. These banks are proving it.

Don’t Forget to Consider Deposits in an Acquisition

12-10-14-BryanCave.jpgWith many U.S. markets experiencing slow loan growth, some boards of directors looking to increase the size of their institutions have turned to acquisitions to capture greater scale and efficiencies. While asset growth is important, directors should also consider the deposits acquired as part of a merger. Many banks have found that a careful evaluation of the deposits of the selling bank can spot unexpected issues and also drive earnings for the combined institution. The issues and opportunities raised by the liability side of the balance sheet have implications for both buyers and sellers going forward, particularly as they seek to maximize the scope and franchise value of their institutions.

Gaining Deposit Share and Margin
With many growth opportunities centered in more densely-populated areas, some financial institutions plan to use an acquisition to establish a “beachhead” in a growing market. Unfortunately, many have found that a beachhead may not be enough, particularly with ferocious competition for quality loans in many metro markets. Other banks have taken a different approach by either consolidating market share in their home or adjacent markets, or by acquiring banks in rural areas that have solid earnings performance. For these banks, acquiring lower-cost deposits in slower-growth markets may help generate earnings that can fund loan growth in more competitive markets. What’s more, some banks have been able to diversify their CRE-heavy loan portfolio by picking up agricultural and other types of lending products through these acquisitions.

Managing Interest Rate Risk
An unfortunate side effect of the flat interest rate environment is increased interest rate risk linked to locking in loan rates or investment securities over a significant duration. While this widely forecasted period of rate volatility has not yet occurred, regulators continue to emphasize preparedness for interest rate swings in recent examinations. As a result, banks that have taken on significant amounts of longer-term assets may look to banks with a stable base of local customers with less rate sensitivity and see a way to not only grow their institution, but to also mitigate interest rate risk. A profitable base of “homegrown” loans and deposits can be attractive to a buyer for a variety of reasons, particularly if it can help reduce the acquirer’s existing risk profile.

Knowing Your Customers
Considering the heightened number of compliance-related issues in recent years, many acquirers should consider devoting more upfront diligence to the seller’s deposit portfolio than in the past. The following areas are notorious for adding significant expense and execution risk to any transaction.

  • Bank Secrecy Act (BSA): In the wake of the Department of Justice’s Operation Choke Point, a prospective buyer should take a close look at the deposit customers served by a seller. For example, should due diligence indicate that the seller has a number of payday lenders, offshore or international accounts, or payment processors as customers, the acquirer should immediately assume that a deeper dive into the seller’s BSA compliance program will be warranted before entering into the merger agreement. Regulatory and consumer issues relating to BSA can prove costly and time-consuming to resolve, so identifying a potential stumbling block early can save the acquirer significant transaction costs.
  • Community Reinvestment Act (CRA): Considering a renewed emphasis on CRA-related matters by regulators as part of recent merger applications, a perfunctory review of the seller’s CRA exam history may not identify all potential regulatory obstacles. Depending on the character of the loan and deposit portfolios of the respective institutions, additional analysis may be required to find any issues that might arise on a combined basis in order to avoid a costly delay in obtaining regulatory approval.

Considering the significant rate and margin pressure faced by many banks, it is of little wonder that deposit issues have taken on increased importance in M&A deals in recent years. For buyers, evaluating a potential merger partner should not end simply after a credit review of the loan portfolio, as the deposit portfolio can have a significant impact on the earnings of the combined institution. And for potential sellers, including those in slower growing markets, having a portfolio of low-cost, local deposits can make the institution more attractive to buyers and potentially increase the return to shareholders. In each case, successfully managing the incremental costs and benefits associated with a deposit portfolio can prove crucial to the success of a potential merger.

Shareholder Lawsuits in a Sale: Are They Legit or is it a “Stick-Up” Business?

12-8-14-Hovde.jpgA troubling litigation trend in recent years has been the surge in lawsuits related to mergers and acquisitions. My first introduction to this phenomenon came in 2011 while representing a publicly traded bank in the Southeast that sold to a larger, stronger in-state buyer. Within an hour of announcing the deal, multiple class action lawsuits were filed in a variety of different states. Proponents of these suits contended that the sale process was flawed and that directors breached their fiduciary duties by not maximizing shareholder value. They cited the existence of restrictive deal protections that discouraged additional bids and conflicts of interest, such as change-of-control payments as well as insufficient disclosure in the proxy statement. The suit in 2011 was eventually settled with the selling shareholders receiving “beefed-up” disclosure with no increase in consideration. Plaintiffs’ lawyers, however, were awarded significant fees. These suits have become a given in virtually all transactions involving public sellers, including very small transactions. While essentially none of these lawsuits seem to have any true merit, they must be dealt with and settled in order to avoid costly and protracted litigation, including the risk of injunction that could block a deal.

In a paper originally published in January 2012 and subsequently published in January 2013 entitled “A Great Game: The Dynamics of State Competition and Litigation,” Matthew Cain, a Notre Dame business professor, and Ohio State University Associate Professor of Law Steven Davidoff reviewed all merger transactions since 2005 with over $100 million in deal value that involved publicly traded targets. They found a disturbing trend. According to the research, approximately 40 percent of deals in 2005 attracted litigation, whereas 97.5 percent (78 out of 80) of deals in 2013 resulted in a shareholder lawsuit. As the authors observe, “in plain English, if a target announces a takeover, it should assume that it and its directors will be sued.” The primary driver of this increased litigation, of course, is the money to be made in the settlement process. While fees paid to plaintiffs’ attorneys have been coming down over the years, the median fee paid in 2013 was still a hefty $485,000. The court system does seem to be coming around to the dubious nature of these suits with judges knocking down attorney’s fees, especially on disclosure-only settlements which made up nearly 85 percent of settlements in 2013. With these types of lawsuits following even the smallest bank transactions, there is increasing hope that reduced fees will discourage the practice.

Although there appears to be very little benefit to selling shareholders in these lawsuits, they are likely here to stay since large fees can sometimes be extracted in the process. It’s important for a board to understand this reality and be prepared for it. While these suits rarely derail a well-constructed M&A transaction, settling and paying this “merger tax” often makes the most sense to ensure a smooth close. Buyers should factor in this added cost to their purchase price and deal with the lawsuits accordingly. Until legal fees in unmeritorious lawsuits are knocked down in a way that discourages their filing, they will remain an unfortunate reality in M&A.

Saving Money on IT Contracts

Saving-Money-on-IT-Contracts.pngPreparing for a successful merger or acquisition is complicated enough without the additional burden that comes from poorly managed core services and information technology (IT) contracts. Unfortunately for many banks and credit unions, an existing oligopoly enjoyed by only five major core IT vendors nationwide has led to these contracts having an unnecessarily negative impact on mergers and acquisitions (M&A) in the financial services industry. In many cases, mergers can simply fail or cost shareholders dearly as a result.

According to a recently issued annual report by the Business Performance Innovation Network (BPI Network), “continued vendor consolidation into an oligopoly within the core processing and IT services industry has made it increasingly difficult for community banks and credit unions to negotiate fair market pricing from vendors.”

Paladin fs, LLC takes it a step further, suggesting that few existing agreements are M&A ready, and when institutions attempt to negotiate their own core IT contacts alone, they’re playing a game they are very unlikely to win. There is no efficiency in contract pricing and fair market value cannot be determined hard market intelligence and pricing data. In fact, a Paladin fs survey reveals that most institutions are paying too much for these contracts, sometimes by as much as 40.2 percent. Further, the overpayment amount varies by region.

CommunityBank.pngThe only way to overcome this risk in advance of M&A is to be better informed before opening a negotiation with these critical vendors—positioning contracts now to help with a merger strategy later. To that end, Paladin has created the industry’s only knowledge base of core IT services contract costs and favorable business and legal terms designed to protect shareholders before and during a merger. Called the Paladin Blue Book, the company leverages this intelligence to renegotiate and restructure core IT contracts for clients, saving them, on average, between $960,000 and $1.2 million over the course of a standard five-year term—without the reputational risk that comes from having to reduce staff. Additional profit improves shareholder equity and the future merger position.

“Getting the numbers right can be exceedingly difficult for an institution,” said Aaron Silva, president of Paladin fs, LLC. “Vendor sales teams are meticulouslytrained at advancing complicated contracts and are expert at delaying the contract phase until the institution has lost most of its bargaining power. Paladin has been very successful at short-circuiting this process and putting the institution back in control.”

Silva points out that timing is critical. Most institutions should begin investigating core IT options 24 to 30 months before their contracts expire. The sweet spot for signing the best deal generally falls 18 to 24 months before the existing contract ends. With less than 18 months until the contract renews, bank and credit union leaders find that their switching leverage erodes rapidly should their negotiation fail with the incumbent provider as little time remains to find another vendor, negotiate a new contract or convert services in time.

One common scenario that Paladin’s clients face is a contract that auto-renews unknowingly, saddling the buyer with an early termination fee. These fees can range in the millions of dollars. Another problem occurs when an acquiring bank learns of hidden fees and onerous terms buried in the 150+ page contract that ambush deals at great expense. For example, one recent institution acquired another to learn later that costs to recover archived item processing images exceeded $640,000.

Vendors know that each time one financial institution is acquired by another, one of the core IT vendor contracts will be abandoned. Existing contract language in 90 percent of agreements reviewed by Paladin ensures any exit from services will be as expensive as possible for the institution and even more expensive to acquire. It’s important that banks reposition or renegotiate these contracts in advance of an acquisition with these concerns in mind.

Silva says his company offers an M&A readiness assessment for any institution contemplating a merger in the future. This process has uncovered a number of these scenarios, any one of which could have doomed an M&A transaction.

There are a number of trends currently serving to drive the financial services industry toward more M&A activity. These include market contraction, a flat economy, integration demand and historically high compliance costs. But as firms are driven together, they must first ensure that the contracts governing their most important technology platforms are not positioned to negatively impact the merger. Doing this in advance of a merger has been shown to benefit both the seller and the acquirer.

Selling Your Bank? How to Manage the Regulatory Headaches

11-19-14-ArnoldPorter.jpgIn considering a merger or sale transaction, the board of directors of a bank or bank holding company must consider a variety of factors in order to fulfill its fiduciary duties, but lately, the potential for regulatory hang-ups has to be part of that mix. Over the years, price has traditionally been the primary factor in a board’s consideration of a deal, however, most state corporate laws contain statutory provisions that allow a board to take into account a variety of other factors when evaluating a sale transaction, including impact on consumers, employees and local communities. Boards are also well advised to take into account the ability of the buyer to complete a transaction in a timely fashion, including whether the buyer may face any regulatory delays. In recent years, a number of transactions have experienced significant regulatory delays, and, in a few instances, transactions have been terminated due to buyer regulatory issues. This phenomenon has raised the stakes for boards that have not properly evaluated the regulatory risks of a transaction.

Identify Existing or Potential Regulatory Issues
For the seller, a protracted regulatory approval process can make it extremely difficult to continue business in the ordinary course and can damage employee relationships and morale.  Moreover, a failed transaction can result in a decrease in the value of the seller’s stock and damage to its ongoing business and reputation.

The seller’s board needs to be aware of any existing or potential regulatory issues facing the acquiring institution. While a few years ago regulatory scrutiny was generally limited to financial stability, capital and liquidity levels and Community Reinvestment Act compliance, today there is an increasing focus on the scope and depth of the acquiring bank’s compliance risk management. Material deficiencies identified in any area of regulatory compliance can derail an M&A transaction. Therefore, before approving a transaction, it is important that the board ensure that management has conducted adequate due diligence on the buyer, focusing on a number of key regulatory areas, including:

  • supervisory history of the buyer and the status and effectiveness of any corrective actions that remain outstanding; 
  • buyer’s record of compliance and the adequacy of its programs, policies and procedures, including “hot button” issues such as Bank Secrecy Act/anti-money laundering laws and fair lending;
  • capital levels and stress test results;
  • potential asset quality issues;
  • buyer’s Community Reinvestment Act record and history of consumer activism; and
  • for larger institutions, the absence of systemic risk resulting from the proposed transaction.

The seller must also be aware of its own problems and not rely on the historical rule of thumb that a strong buyer can assuage regulatory concerns about the seller. Sell-side due diligence enables the seller to proactively identify potential issues and resolve them before they escalate, thereby minimizing uncertainty in the sale process. Buyers will be focused on these issues in the diligence phase as well, with significant regulatory issues being factored into pricing and potentially narrowing the field of potential buyers.

Scrutinize Transaction Documents
The seller’s board should review the key terms of the transaction to ensure that the seller has the flexibility to address regulatory deficiencies that are identified in advance of signing the agreement as well as during the pendency of the transaction. Provisions that limit or restrict the seller’s ability to adequately address these issues can be damaging to the institution, particularly if the transaction cannot be completed. These restrictive provisions could include overly broad negative covenants that require the seller to seek the buyer’s approval before taking an action. The board must also be familiar with any termination and no-shop provisions as they may be overly restrictive if a buyer’s regulatory compliance issues delay a transaction. Any provisions that serve to restrict the flexibility of the seller when the transaction may be in regulatory jeopardy could be viewed as inconsistent with the selling board’s fiduciary obligations.

Engage Independent Counsel
It is axiomatic that when negotiating a merger transaction, the seller should engage its own counsel and not share legal counsel with the buyer.  However, a recent trend has emerged with a seller and buyer jointly engaging counsel for the regulatory application process. While sharing regulatory counsel may decrease a portion of the transaction costs, sharing counsel can create risk of conflicts when the buyer is faced with regulatory delay due to compliance issues.  If the regulatory delay causes a drop-dead date to approach, a seller is well advised to rely on independent counsel for advice on the status of the relevant regulatory issues and on the considerations involved in deciding whether to terminate or extend the transaction.

Get the Accounting Right: Valuing Core Deposit Intangibles in an Acquisition

The value of core deposit intangibles (CDIs) acquired in an acquisition is on the rise. When I first wrote about this topic in October 2012, I found that CDIs had declined in value as interest rates stayed low. The opposite is occurring now.

As a refresher, a CDI asset arises when a bank has a stable deposit base of funds from long-term customer relationships. CDI values derive from those customer relationships that provide a low-cost source of funding. CDIs are common assets, as most banks have some level of stable depositors to whom they pay interest at a rate lower than the rate they pay alternative funding sources. CDIs are important for bank boards to understand in an acquisition or sale, because they are the most common recorded intangible asset in a bank or branch acquisition. Boards can get in trouble if this asset is valued incorrectly, as it can impact future earnings.

Core Deposit Values
We compiled the values for CDIs using publicly available data on completed whole-bank and Federal Deposit Insurance Corp.-assisted bank transactions for the period of Jan. 1, 2013, through Oct. 3, 2014. To calculate the ratio of CDIs to core deposits, we aggregated the following deposit types to compute the bases:

  • Noninterest-bearing demand deposit accounts (DDAs)
  • Interest-bearing DDAs
  • Savings accounts
  • Money market accounts

Here is what we found:

Quarter Average CDI%
Q1 2013 1.19
Q2 2013 1.19
Q3 2013 1.93
Q4 2013 1.72
Q1 2014 1.61
Q2 2014 1.34
Q3 2014 1.73
Q4 2014 1.92
Overall Average 1.54

CDI values have increased from when I first wrote about this issue in October 2012, primarily because the long-term forecasts for interest rates have been increasing and the sources of alternative funds assumed have increased. For example, the following chart indicates the rates for seven-year Federal Home Loan Banks (FHLB) advance rates over the same time frame. Although using a single interest rate to value CDIs is a reasonable proxy for alternative funding, it is a simplistic view of how these rates are typically constructed.


Source: Data compiled from public filings

Useful Lives and Amortization Methods 
The Financial Accounting Standards Board guidance provides that if an income-based method is used to develop the value of the intangible asset, the period of projected cash flows should be considered when choosing a useful life. Another source of guidance comes from the Office of the Comptroller of the Currency (OCC), which publishes the Bank Accounting Advisory Series on various accounting issues. In its most recent guidance, the OCC indicated that in most cases, the useful life for CDIs wouldn’t exceed 10 years, although exceptions could be possible. Because banks file call reports on the basis of U.S. generally accepted accounting principles, the ultimate decision rests with the bank in consultation with its external audit firm.

The majority of acquiring banks chose 10 years as a useful life, as illustrated in the following chart for completed acquisitions from Jan. 1, 2013, through Oct. 3, 2014.


 Source: Data compiled from public filings

The method of amortization is another important component of recognizing expense related to CDI through the income statement. The method of amortization for any finite-lived intangible asset is influenced by Accounting Standards Codification (ASC) 350-30-35-6, which states that “the method of amortization shall reflect the pattern in which the economic benefits of the intangible asset are consumed or otherwise used up. If that pattern cannot be reliably determined, a straight-line amortization method shall be used.” The most prevalent method used was accelerated (either sum-of-years digits or some other method of acceleration), as illustrated in the following chart.

As banks plan transactions and consider what assumptions to use for modeling an acquisition, they should consider how the CDI will be calculated and the current level of CDI values. Acquirers that do not adequately consider the ultimate resulting value often find their future earnings to be below the levels projected in their acquisition modeling because they didn’t apply up-to-date assumptions. Reviewing available data should help acquirers better understand what policies are being used.


Source: Data compiled from public filings

Considering CDIs
As banks plan transactions and consider what assumptions to use for modeling an acquisition, they should consider how the CDI will be calculated and the current level of CDI values. Acquirers that do not adequately consider the ultimate resulting value often find their future earnings to be below the levels projected in their acquisition modeling because they didn’t apply up-to-date assumptions. Reviewing available data should help acquirers better understand what policies are being used.

2015 Bank M&A Survey: Plenty of Buyers – but Too Few Sellers?

11-14-14-MandA.jpgThere’s no shortage of financial institutions seeking an acquisition in 2015, but fewer banks plan to sell than last year, according to the bank CEOs, senior officers and board members who completed Bank Director’s 2015 Bank M&A Survey, sponsored by Crowe Horwath LLP. Forty-seven percent of survey respondents reveal that they plan to purchase a healthy bank within the next 12 months, compared to a mere 3 percent who plan to sell their bank.

Are some bank boards and management just waiting for the right deal? Seventy-one percent would consider selling the bank if they received an attractive offer. As bank valuations rise, potential sellers express a growing desire for stock in return for selling the bank—often combined with cash.

There may be fewer fish in the sea—at least not enough to satisfy the appetites of growth-hungry banks—but the survey reveals several positive trends for the industry. Of the two-thirds of respondents who see a more favorable M&A environment, 55 percent cite improved credit quality and 48 percent improved stock valuations. And despite the challenges of a highly competitive growth environment and costly regulations, 64 percent of respondents expect their bank to thrive as an independent entity. Absent a compelling deal, bank leaders express a preference for self-determination: When asked about barriers to selling the bank, more than two-thirds say that the board and/or management want the organization to remain independent.

More than 200 directors and senior executives of banks nationwide responded to the survey, which was conducted by email in September.

Key Findings:

  • Credit quality’s adverse impact on deal-making is lessened in the minds of respondents. A little more than one-third of respondents say that concerns about the asset quality of potential targets impedes the deal, a decline of 41 percent since the 2013 survey.
  • As credit quality continues to improve, 60 percent of bank leaders now reveal that post-merger integration was the most difficult aspect of their most recent deal—up by 33 percent from last year’s survey.
  • Price is still an issue. When asked about barriers to buying another bank, 63 percent say that the pricing expectations of potential targets are unrealistically high. Fifty-six percent say that current pricing is too low to sell the bank.
  • Both buyers, at 53 percent, and sellers, at 45 percent, prefer a mix of cash and stock as payment for the purchased bank. The percentage of potential sellers that would prefer that the transaction include stock has increased by 30 percent since the 2013 Bank M&A Survey, likely a reflection of higher valuations for bank stocks.
  • Eighty-three percent feel that their institution has adequate access to the capital needed to meet the demands of Basel III and fuel the bank’s growth and acquisition strategy.
  • Three-quarters of respondents integrated board members and/or executives from the acquired bank into the surviving institution after their most recent acquisition.

Download the summary results in PDF format.

Why Book Value Isn’t the Only Way to Measure a Bank

11-14-14-Al.jpgA few days ago, I woke up to the announcement that Winston-Salem, North Carolina-based BB&T Corp. has a deal in place to acquire Lititz, Pennsylvania-based Susquehanna Bancshares in a $2.5 billion deal. The purchase price is 70 percent stock and 30 percent cash and includes 0.253 BB&T shares and $4.05 in cash for each Susquehanna share. The implied price of $13.50 per share equates to 169 percent tangible book value, 16.3 times price as a multiple of last-twelve-months earnings per share and a 7.4 percent deposit premium.

While easy to see the deal as being strategically compelling from BB&T’s perspective (the deal makers expect to generate cost savings from the combined institution, targeting $160 million annually or 32 percent of Susquehanna’s non-interest expense), the announcement had me unexpectedly thinking about valuation issues and Warren Buffet.

Yes, Warren Buffet.

Let me explain the correlation between the two. A year ago, Buffet was on CNBC and took a question from a viewer about how he valued banks. In his words, “a bank that earns 1.3 percent or 1.4 percent on assets is going to end up selling above tangible book value. If it’s earning 0.6 percent or 0.5 percent on assets it’s not going to sell. Book value is not key to valuing banks. Earnings are key to valuing banks.

Keep in mind that for many smaller community banks, book value has been the primary determinant of value on a trading basis. As the lion’s share of mergers and acquisitions have involved small community banks over the past few years, talk of book value has been quite prevalent. So the BB&T deal, the second largest so far this year, got me thinking about valuation issues and if an increased focus on price to earnings might be a more appropriate way to value banks.

To get some perspective on this topic, I reached out to Dory Wiley, president and CEO of Commerce Street Holdings. He sees earnings as more important, but was quick to remind me that tangible book value does matter.

John Gorman, a partner in the Washington, D.C.-based law firm of Luse Gorman Pomerenk & Schick, P.C. provided additional context. “Having value driven by earnings is the goal for most publicly traded community banks, and that goal is bearing fruit, but in a discriminating fashion. The market is being selective in terms of which companies it is rewarding with earnings-based valuation on a trading basis. And that reward provides those select companies with a competitive advantage in terms of paying the higher price-to-earnings and price-to-book multiples in the M&A marketplace.”

Andy Gibbs of Mercer Capital opined “it is earnings, after all, that are the source of the capital needed to reinvest in the bank (and grow its value), to pay dividends to shareholders, or to repurchase shares. A well capitalized bank can do those things in the short-run, but without earnings to replenish and expand capital, it’s not sustainable.”

Clearly, a bank that generates greater returns to shareholders is more valuable; thus, the emphasis on earnings and returns rather than book value. To this end, Gorman says: “If a company is a strong earner, and is located in an attractive geographic market, it may be able to obtain a significant M&A premium and thereby realize an earnings-based valuation.”

So investors and buyers will always use book value as a way to measure the worth of banks. But as the market improves and more acquisitions are announced, expect to see more attention to earnings and price to earnings as a way to value banks.

Negotiating Complexity: Executive Compensation Issues in M&A

10-31-2014_BryanCave.jpgUpon reaching a letter of intent to acquire or sell a financial institution, many bank directors will breathe a sigh of relief. Following the economic challenges of the past several years, the directors of each institution have charted a course for their banks that will likely result in their respective shareholders realizing the benefits of a strategic combination. Although directors should be focused on “big picture” issues during the negotiation of a definitive agreement, they should not overlook the resolution of the many issues that can arise from executive compensation arrangements in a potential transaction. While often seemingly minor, compensation matters can raise unexpected issues that can delay or de-rail a transaction.

Procedural Issues
In addition to considering the economic features of a proposed merger, directors should also consider their individual interests in the transaction, including the potential payout of supplemental retirement plans, deferred fee arrangements, stock options, and organizer warrants that are not available to the “rank and file” of the company’s shareholder base. These arrangements may pose conflicts of interest for members of the board and are subject to different types of disclosure:

  • Disclosure of potential conflicts: Early in the negotiation of a potential sale, individual directors should identify deal features that may create the appearance of a conflict of interest or an actual conflict of interest. With help from legal counsel, these personal interests should be disclosed and documented in the board resolutions approving the transaction. Appropriate disclosure and documentation of these actual or potential conflicts usually resolves these issues, but if significant conflicts exist, counsel may advise the use of a special committee or special voting thresholds for the transaction.
  • Shareholder disclosures: While specific requirements may vary for private and publicly-traded companies, compensatory arrangements for directors and officers will need to be disclosed in detail as part of proxy materials mailed to shareholders. In particular, the SEC has begun requiring detailed compensation disclosures for directors and officers, even for deal consideration issued to these individuals simply by virtue of being a shareholder.

Cultural Issues
Directors of the selling bank should also monitor the negotiation of new employment contracts for selected members of its management team. Typically, these contracts will be completed prior to the seller’s entry into a definitive agreement and will indicate which members of its management team will be retained for a transition period or even long-term following the completion of the transaction. The cultural issues arising from the negotiation of these contracts can also require additional attention be paid to those who will not be offered positions following the transaction. These short-term employees can play an important role in preserving the value of the organization prior to closing and may even have value in terms of assisting with the integration of the two institutions, so providing them with clear roles and concrete expectations early in the process can resolve many issues.

Tax Issues
Responsible choices made to manage the economic crisis, including the suspension of director pay, may give rise to unexpected tax issues that must be resolved as the definitive agreement is negotiated. Here are some examples:

  • “Golden parachutes:” If applicable, Section 280G of the Internal Revenue Code will treat most transaction-related payments or accelerated vesting of options or warrants for directors or officers as parachute payments. If these payments exceed a certain percentage the individual’s average compensation over the past five years, then both the individual and the bank will be subject to significant tax penalties with respect to those parachute payments. When financial institutions have previously suspended director compensation, 280G presents an even greater challenge because directors in those situations have little or no average compensation history.
  • Restrictions on changes to existing compensation arrangements: Changes in the timing or form of payment of existing compensation arrangements contemplated or revealed as part of a transaction can also result in significant additional tax liability under Section 409A of the Internal Revenue Code. Few compensatory arrangements are free from 409A issues, but the amendment or termination of employment contracts, bonus plans, supplemental retirement plans, and equity awards are among the deal-related events where this tax liability can be triggered.

Existing compensation arrangements are often highly problematic for a transaction, so developing a strategy for managing the procedural, cultural and tax implications of these arrangements early in the negotiations is key. Resolving these issues can take time and effort, but if the parties do so successfully, they will have taken an important step toward consummating a successful transaction.