A respected bank CEO and a veteran investment banker discuss the process and decisions that resulted in a landmark merger transaction during Bank Director’s 2014 Acquire or Be Acquired conference in January. The presenters share their thoughts on deciding to merge, selecting a partner and overcoming challenges on the path to closing the deal.
Video Length: 46 minutes
About the Speakers
C. K. Lee, Managing Director, Commerce Street Capital, LLC C. K. Lee is a managing director in the financial institutions group of Commerce Street Capital, LLC. In that capacity, he assists clients with mergers and acquisitions, capital raising, balance sheet restructuring, business plan development and regulatory matters. Prior to joining Commerce Street in 2010, Mr. Lee was regional director for the Office of Thrift Supervision, Western region, headquartered in Dallas with offices in Seattle, San Francisco and Los Angeles.
Thomas L. Legan, Chairman – Central Oklahoma Region, Prosperity Bank Tom Legan is chairman of the Central Oklahoma Region for Prosperity Bank. He was previously president and CEO of Coppermark Bank and Coppermark Bancshares, Inc. for over 34 years. He has over 56 years of banking and credit related experience. Mr. Legan was formerly a board member of the Oklahoma Bankers Association.
There has been an enormous upswing in shareholder litigation following acquisitions. A survey by Ohio State University professor Steven Davidoff and Securities and Exchange Commission fellow Matthew Cain found that 97.5 percent of acquisition deals of a publicly traded company in 2013 resulted in a shareholder lawsuit, an increase from 39 percent in 2005. Why all the lawsuits? Well, there is money to be had in settling such lawsuits, as the acquirer and seller are very eager to carry on with their deal and not be held up by expensive litigation. Bank Director asked a panel of attorneys whether banks should settle such lawsuits, or fight them to avoid encouraging more lawsuits.
Should banks settle when they are hit with a M&A lawsuit?
The question of whether a bank should settle when hit with a lawsuit in connection with an M&A deal, and if so when, depends heavily on the circumstances. The reality is, however, that these shareholder class action suits are essentially a given in any transaction involving a publicly traded seller. In nearly all cases, regardless of the circumstances, the plaintiffs’ lawyers will assert, first, that the directors breached their fiduciary duties in connection with the sales process that was followed and in accepting the deal terms that were agreed and, two, that the disclosure in the proxy statement issued in connection with the shareholder meeting to approve the transaction is deficient. A well advised board will be aware of this reality and plan accordingly. As a practical matter, these suits rarely are an impediment to a transaction and should certainly not dissuade a board from pursuing a transaction that is in the best interests of the shareholders.
—William L. Taylor, Davis Polk & Wardwell LLP
Like so many questions the answer lies in the particular facts and circumstances. But the automatic inclination to settle these strike suits has dissipated somewhat as management, and more importantly judges, have shown less patience with these types of suits, and as a consequence, awarded increasingly nominal amounts of attorney fees, if any at all. This cottage industry of the plaintiffs’ bar grew up in the era of large bank mergers where these types of suits and settlement amounts were viewed simply as mere nuisances. As the transactional activity has moved to the smaller bank market, so have the plaintiffs lawyers. But these suits have also taken on greater meaning for middle market transactions. The CEO of a bank that intends to engage in multiple acquisitions should seriously consider contesting the first strike suit to send the signal to the plaintiffs’ bar that this bank will not be easy prey.
—Michael Reed, Covington & Burling, LLP
While these actions ostensibly seek monetary relief, such as an increase in the merger consideration, most of them ultimately settle on terms that call for some additional disclosures to the shareholders in advance of the vote on the transaction, and, of course, an attorney’s fee award for the plaintiffs’ lawyers. There are two primary reasons for these settlements. First, the risk, however small, of having a large transaction enjoined or otherwise disrupted is often seen as outweighing the relatively minimal nature of the settlement relief. Second, a settlement is not without its benefits, as, once approved by the court, the settling defendants can obtain a full and complete release of any claims that were or could have been brought by the shareholders in connection with the merger transaction.
—John Bielema and Mike Carey, Bryan Cave LLP
Unfortunately, settling these suits is a necessary evil. Judges are often reluctant to dismiss shareholder suits on the basis of a pre-trial motion, so settling is the only way to avoid the risk of an injunction that blocks the deal or the expense of litigating through trial. Refusing to settle and hoping the plaintiff goes away is probably more of a gamble than the parties are willing to take. The good news is that judges are beginning to doubt the value of many of these disclosure-only settlements in which the companies agree to provide additional disclosure to shareholders, and they are knocking down the attorney’s fees. Reducing the fees that accompany these settlements is the best way to discourage these questionable suits.
—Aaron Kaslow, Kilpatrick Townsend & Stockton LLP
The decision to settle depends, in part, on the nature and size of the deal. Why settle an unmeritorious lawsuit? The threat of delaying a merger transaction can kill the deal, so settling by agreeing to provide some additional disclosures, paying the plaintiffs’ attorneys’ fees and making a token payment to shareholders often makes sense. Acquirers often factor this so-called merger tax into their purchase price considerations to assure that the transaction gets completed. Be careful, though—paying the merger tax can result in higher future directors and officers (D&O) insurance premiums, or larger retentions under those policies. On the other hand, some acquirers in states with favorable business judgment statutes and a reasonable judiciary are fighting unmeritorious lawsuits. Those challenges show an impressive win-loss ratio for boards. Also encouraging is that some courts have dismissed the suits outright or refused to approve settlements and the attorneys’ fees provided in them.
While the future is starting to look brighter for the banking industry, compressed net interest margins, slow loan demand and regulatory compliance continue to plague many financial institutions. Based on the results of an audience poll conducted at Bank Director’s Acquire or Be Acquired conference in Arizona in January, Molly Curl reviews how banks are dealing with these ongoing growth challenges.
Last year I wrote an article for BankDirector.com entitled “Winning Over Shareholders with a Well-Constructed Merger.” In it, I laid out several suggestions for boards on how to structure a merger transaction that investors support. Also at this time last year, several investment bankers who presented at the Acquire or Be Acquired Conference advocated reasonably priced stock-for-stock mergers as the best M&A alternative for community and regional banks. In an instance of investment bankers correctly predicting a trend (many would say a rare instance), 2013 was in fact characterized by a series of well-structured mergers which produced a dramatic improvement in shareholder reaction to bank M&A.
Banks under $10 billion in assets have had an unprecedented opportunity to pursue merger transactions while larger regional banks have remained on the sidelines.
The preferred transaction structure of 2013 and early 2014 has been the friendly all stock (or nearly all stock) merger with the following characteristics:
two banks of similar size
exchange ratio and financial projections that produce shared long term upside
price to tangible book value premiums below historic bank M&A averages
meaningful non-financial deal terms for seller
continuity of interest for both sides rather than a full change of control
I think there are a number of factors that will change the bank M&A environment as we move through 2014. In general, I expect a more competitive environment to emerge as the number of willing buyers gradually increases and the ability of sellers to pick the “friendliest” potential merger partner decreases. There will be more focus on price by selling shareholders and greater scrutiny of merger transactions, especially those labeled as mergers of equals (MOEs).
This is not to disparage the shared upside merger model or the many excellent transactions that have been announced in the past year. Rather, it is to caution boards that they will need to adjust their M&A planning as the environment changes.
Boards should consider the following environmental changes:
Large regional banks (assets greater than $20 billion) will gradually become more active in traditional bank M&A assuming a successful round of regulatory stress testing and capital reviews.
Banks that have already announced and integrated a recent merger and benefited from increased market valuation and balance sheet capacity are better positioned to be aggressive pursuing their next target and will be less likely to make major concessions on non-financial issues.
Investors have become more tolerant of buyers paying market premiums.
Banks that have not been able to execute a well-received M&A transaction will be under increased pressure to find a deal that works.
Fewer potential buyers are feeling restrained by concerns over regulatory approval.
The overall health of the industry continues to improve and more banks are able to consider acquisitions.
Also, a potential risk to M&A transactions is the possibility of an interloper disrupting an announced transaction. Boards need to consider a gradual increase in the number of potential buyers and in the capacity of these buyers to pay a meaningful premium. This risk remains limited but it is increasing.
For many healthy banks in good markets there has been only one viable buyer or merger partner. This situation will change and a merger may be more difficult to justify to shareholders if they perceive that a higher price is available from another bank.
Thus, selling banks may find more willing buyers and higher prices than was the case in the past several years. However, they will have less ability to merge with their preferred long term partner if that partner cannot be competitive on price.
Buying banks will encounter more competition and those with weaker relative multiples or less balance sheet capacity will not be able to structure deals that work.
The level and nature of M&A activity that we will see in 2014 and beyond is of course governed by many difficult to predict factors. For instance, a volatile bank stock market is always detrimental to deal activity. Also, if any of the 2013 vintage deals run into integration problems, investor receptivity to new deals will decline.
The window of available deals for smaller banks may be closing, but likely will remain open for at least the first half of 2014. However, boards should not be lulled into assuming that they can execute their preferred merger at any time and in any market. Do it while you can.
With the number of bank mergers thus far in 2014 marginally ahead of the pace set in the same period last year, it is tempting to think that this could be the year when the much-anticipated mergers and acquisitions (M&A) wave finally materializes. SNL Financial reported that 14 deals were announced in January, two more than the 12 in the same period last year, and—perhaps more interestingly—the median price-to-tangible book ratio of the deals had risen 43 basis points to 140.86 percent, compared to January 2013.
As encouraging as that report might be, no one at this point can say with any confidence that the M&A engine is primed to roar. Nevertheless, KPMG LLP’s view of the marketplace allows us to suggest that, if nothing else, it makes sense for hundreds of banks and thrifts to merge, acquire or form strategic alliances. Let’s list a handful of factors we believe auger well for the M&A pace to pick up:
Not a week has gone by in the past several months, it seems, without any of us hearing about the growing popularity of a “merger of equals’’ in the industry as a way for the smaller-asset banks to combine strengths to compete with bigger, stronger banks. After all, that “if-you-can’t-beat-‘em-join-‘em’’ posture fits with one of the key findings of KPMG LLP’s 2013 Community Banking Outlook Survey. A hefty 77 percent of respondents in the November 2013 survey said they believe a bank must achieve an asset level of at least $1 billion or more to remain independent in today’s market.
Then, there are the other reasons in the litany of drivers arguing that smaller banks join with peers or sell to bigger brethren in more deals: the escalating costs associated with staying in compliance with regulatory demands, the attractiveness of spreading into new geographies where specific demographics would make sense for expansion, and the attractiveness of acquiring a competitor that holds rich talent to drive new sources of revenue or to enhance technological capabilities.
On the flip side, it’s always prudent to be aware of “deal fever,’’ a desire to do a deal just to do a deal— which can be brought on by a sometimes poorly thought out plan to buy or sell just because others around you are doing deals. Our belief is that the chances of a successful deal are enhanced when the board and management team maintain a rigorous target-selection process that strictly focuses on strategic alignment. There must be a fit, a focus, and a follow through—without shortcuts.
As part of our panel discussion at Bank Director’s recent Acquire or Be Acquired conference, Roberto Herencia, chairman at FirstBancorp and FirstBank Puerto Rico, also reminded us that, because banks are sold, and not bought, acquirers will need to sharpen their business cases. An acquirer, therefore, must frequently convince a reluctant target that a sale make sense for both parties, and equally must respect the emotions of the sellers as much as dollar and cents, because of the role that smaller banks play in the fabric of smaller communities.
That said, we also believe that deals today must be game changers, given that so much time and effort is required in the current highly regulated environment, and that many targets may still struggle with possible toxic assets on the books. Such realities, in our view, mean most of the sellers will be in the $500-million to $2.5-billion asset range, which encompasses about 1,000 banks.
Through it all, we would argue that bank directors must have comfort that management presents the board with documentation that a target is aligned with the bank’s strategic objectives, that the deal has passed through the critical pre-signing phase where significant value drivers have been vetted, and that there has been an aggressive focus on risk and synergy implications. Further, no deal can be successful without the board having evidence that an effective governance structure— complete with realistic processes—has been established.
Bank executives, boards and industry experts have long debated—and disagreed—on exactly how big a bank needs to be to survive in today’s harsh operational and regulatory environment, with bank CEOs typically reporting that the perfect size is “a little bigger than [their bank],” quipped Curtis Carpenter, managing director at Austin, Texas-based Sheshunoff & Co. Investment Banking, during a presentation to more than 500 attendees. But William Wallace, vice president of equity research at Raymond James & Associates Inc., would argue that the size of the bank doesn’t matter.
“You don’t have to get bigger. You need to get more profitable,” said Wallace during a separate session.
The Acquire or Be Acquired Conference, held January 26-28 in Phoenix, attracts many banks seeking to make deals—many as a buyer, some as sellers. Most attendees were bank CEOs, senior executives, chairmen or directors, with an average bank size of $682 million in assets.
If size is indeed any indicator of strength, then banks with assets between roughly $1 billion and $15 billion have seen rising stock values and have the currency to make deals. John Duffy, vice chairman at Keefe, Bruyette and Woods, a Stifel Company, told the audience that banks with between $5 billion and $10 billion in assets are the most highly valued and profitable, making this size the sweet spot for investors. Many banks of this size are regional banks, whose stocks Duffy said have “exceeded our expectations both for the overall market and the banking sector.” Carpenter predicted that institutions with more than $2 billion in assets will be tempted to pursue an initial public offering (IPO) after seeing the high pricing commanded by similarly sized institutions—particularly those active in the M&A market.
The market responded more positively to deals in 2013, making both all-stock deals and strategic mergers more attractive. Carpenter noted that the response was particularly positive when those deals resulted in market expansion for the surviving bank, at a median stock price gain just shy of 6 percent 20 days after the deal was announced, versus almost 4 percent when there was a partial overlap in the market and little gains—less than 0.5 percent—when the deal was entirely in-market.
Overall, the industry could be looking at brighter days ahead as banks emerge from the dark days of the credit crisis. Margin pressure likely won’t get much better, but net interest margins have stabilized, though they remain historically low, said Duffy. And many institutions have learned to live with shrinking margins, Billy Beale, CEO of $7.1-billion asset, Richmond, Virginia-based Union First Market Bankshares Corp., said during a panel discussion. Rates are expected to rise this year, albeit gradually, and higher rates should result in greater profitability for the industry. For board members, executives and investors at small and mid-cap banks, there is much to be optimistic about: The industry saw deposit growth of 6.2 percent, despite low rates on deposits, and Duffy predicted that these banks will see better loan growth than bigger banks.
Overall the industry is healthier, with FDIC–assisted deals shrinking from a high of 157 in 2010 to just 24 in 2013, according to Carpenter. Credit has improved. “Asset quality issues are becoming a thing of the past,” said Duffy. And healthy sellers will command a better price in the market, though coming to terms on price will likely remain a point of contention for buyers and sellers.
“Things feel better today,” Frank Cicero, managing director at Jefferies LLC, said during a panel discussion of bank stock analysts.
However, banks with less than $1 billion in assets face challenges. According to Duffy, these small banks are less profitable, with a median return on assets of 0.47 percent, half that of mid-cap banks with between $5 billion and $10 billion in assets. The diminished importance of branch networks underlines the importance of further investments in technology. Small banks barely trade at book value, and they are less efficient. Ben Plotkin, vice chairman at Stifel Financial Corp. told attendees that banks with less than $1 billion in assets have a median efficiency ratio of more than 71 percent. In contrast, banks with between $5 billion and $15 billion in assets had a median efficiency ratio of 59.8 percent.
Given these challenges, it’s not surprising that banks with less than $1 billion in assets comprised 89 percent of total deals in 2013. Ben Plotkin expects further shrinking in the industry, predicting that there will be less than 5,000 banks in the next 5 years.
Smaller banks need to gain size and scale to absorb costs and increase profitability, or resign themselves to selling to another bank.
Last November, Bank Director published the 2014 Bank M&A Survey, which found that 76 percent of bank senior executives and directors expect to see more deals in the year ahead, and much of that activity will take place among community banks. With that in mind, Bank Director further explored these results among banks with less than $5 billion in assets to examine how community banks plan to approach acquisitions in 2014.
Over 230 officers and directors of banks across the U.S. responded to the survey, which was conducted by email in the fall of 2013. Of these, 202 represented banks with less than $5 billion in assets. The 2014 Bank M&A Survey was sponsored by Crowe Horwath LLP.
Planned M&A in 2014 by Asset Size
The Growing Serial Acquirers: Banks with Assets of $1 Billion to $5 Billion
Many banks with between $1 billion and $5 billion in assets are gaining reputations as serial acquirers. These banks have a little wiggle room before they hit the $10-billion asset threshold when they will be subject to new regulations, and many find that growing through acquisitions is a quicker route to expanding market share than organic growth. Rick Childs, a director at Crowe Horwath, says that the average size of the seller—at roughly $200 million in assets—fits right into the size of acquisition that these banks are willing to make. “They’re looking to build themselves a better footprint and franchise, and so they’re being active acquirers, and there’s really not a lot of competition [for deals from larger institutions] like there would have been maybe 10 years ago” says Childs. “It’s just fortunate that the size of the seller fits the size that they are probably the most comfortable in acquiring.”
As many of these banks are seasoned acquirers, it’s not surprising that 96 percent of board members have M&A experience, either within the banking industry or within their own business, compared to 81 percent in the industry overall. And M&A is a key part of the strategic direction of these institutions: More than half of respondents from banks between $1 billion and $5 billion in assets report that deal-making is a regular part of their board’s agenda, while banks with less than $1 billion in assets are more likely to only discuss deals as opportunities arise or as part of the institution’s annual strategic planning process.
Banks with assets between $1 billion and $5 billion did more transactions in 2013 than banks overall, according to the survey.
More than half report the purchase of a healthy bank in the previous 12 months, versus 24 percent overall.
One-quarter participated in a FDIC-assisted deal, while just 8 percent of total participants participated in a FDIC transaction last year.
Thirty-four percent of respondents report their bank purchased one or more branches last year, compared to 23 percent overall.
Twenty-seven percent purchased at least one non-depository line of business, like an investment management business or an insurance brokerage, compared to 11 percent of total participants.
Looking ahead to 2014, participants indicate that their institutions will likely keep up this pace, with almost 70 percent of banks of this size planning a healthy bank acquisition.
Still Independent: $500-Million to $1-Billion Asset Banks
Respondents from banks with between $500 million and $1 billion in assets reveal a commitment to independence. Forty-six percent of participants from these banks indicate plans to buy a bank in 2014, but few plan to sell.
Childs says banks need three qualities to become an acquirer:
Adequate capital and earnings for regulatory approval of the deal
Infrastructure in place to both acquire and grow the institution
Available sellers in the bank’s target market
Banks closing in on $1 billion in assets may have adequate capital and the appropriate infrastructure in place, but might have a hard time finding the right target geographically close enough to make sense. “If you’re in a state where there are very few sellers, and you look at your surrounding states and it’s not much better, you may never be able to execute a strategy for growth because you just don’t have a significant number of available sellers,” says Childs.
When asked about plans to sell a bank, branch, loan portfolio or non-depository line of business, 94 percent of respondents from banks between $500 million and $1 billion in assets reveal that they don’t plan to sell anything, compared to 80 percent overall. Just 3 percent plan to sell their bank, and 56 percent cite the fact that the management and board wish to remain independent as a barrier to a potential sale. Childs adds that many of these banks hold a strong position in their markets, supporting their choice to stay independent and build a strategy for growth. “There’s still the possibility for them to build a franchise and build a lot of value for their organization.”
Ripe for the Acquisition: Less Than $500-Million Asset Banks
Looking ahead to 2014, 10 percent of respondents from banks with less than $500 million in assets plan to sell their institution—double the 5 percent of respondents overall.
Why sell? Respondents from these banks are more likely to cite the high cost of regulation, at 39 percent compared to 25 percent of overall respondents.
While regulations currently place a strain on bank management and boards, Childs believes this burden will level off as the environment settles and technology allows smaller banks to be more effective and efficient. “While I agree that right now it feels really oppressive at times…I don’t think that would be a reason that I would want to sell. I’d want to sell for a variety of other reasons,” says Childs, citing as examples liquidity and diversification of investments, succession concerns and the need for scale to manage costs.
Limited growth opportunities are pushing small bank respondents to want to sell, at 32 percent of respondents from banks below $500 million in assets, compared to 23 percent overall. Twenty-nine percent of officers and directors of the smallest banks say that they’d sell because banking just isn’t enjoyable anymore, compared to 18 percent overall.
“Management and directors are telling us that banking’s not fun anymore,” says Childs.
Pricing Barriers by Asset Size
Those willing to sell still face barriers. The smallest banks, at 56 percent, are more likely to think pricing remains too low than banks overall, at 42 percent. In contrast, 63 percent of all respondents say that potential targets have unrealistic expectations for a high price. Meanwhile, 40 percent of potential buyers overall cite concerns about the asset quality of potential targets as a barrier to making a deal, and 10 percent of respondents from banks with less than $500 million in assets say that their bank’s asset quality is subpar, compared to just 5 percent overall.
Childs says that while asset quality has improved, “it’s still historically too high, in terms of the level of non-performing assets to total assets.” The economic recovery remains sluggish in some parts of the country. All this ties to the price, and boards waiting for a significant increase in pricing may be disappointed. Some small institutions “may still be longing for the glory days of two-times book value, which I don’t think are going to come back. We may see some really positive pricing here in the next several years, but it’s never going to get back to the heyday that it was,” says Childs.
Brad Milsaps is managing director with Sandler O’Neill + Partners, L.P. in Atlanta covering small and mid-cap banks, mostly in the Midwest and Texas. He talks about M&A deals in his coverage area, what size banks are most likely to acquire, and what investors like to see in a deal. A shorter version of this interview appeared in the first quarter issue of Bank Director magazine.
What kind of M&A activity are you seeing?
The bulk of the activity has come from the west and Texas. They had better earnings multiples and the banks they were targeting had better asset quality [than other parts of the country]. It was easier to make the deals work. Most recently, ViewPoint Financial, Independent Bank and Prosperity Bancshares have all been very active acquirers. M&A for the largest banks is really not in the cards. The regulators are not going to allow those banks to get larger. What you are seeing is the emergence of these super-regional banks, the $2-billion [asset] to $25-billion [asset] banks are the ones with the best currency because efficiency is so much more important now. They have the currency to acquire and they can go in and get cost savings pretty easy.
What about the level of deal activity?
The deal activity is kind of on pace this year with last year. Our hope is it accelerates. I think it can as other markets get healthy. As Florida and the Pacific Northwest continue to get better, their banks will get better currencies. The banks that could sell will see asset quality continue to improve, and I think you will see more deals.
How has the market perceived the deals on the banks you cover?
Generally the reaction has been pretty positive. The Texas market deals have been very well received. The Texas banks get a premium to everywhere else in the country but they are still trading at less than before the financial crisis.
What do you look for in a deal?
First and foremost, you look at pricing. What are you getting for what you paid? I look at tangible book value dilution. What are the strategic merits? How much earnings accretion will the buyer get out of it? What is the driver of that earnings accretion? If you are making a lot of assumptions about the target’s growth, those deals I’m less enthused about it. You don’t know what’s going to happen in the future. If you lay the maps over each other and there is overlap, there are easy-to-see cost savings, and you take some capacity out of the system, those are my favorite deals.
Is M&A thawing?
The acquirers are telling me there are a lot more conversations. A lot of the social issues are tough to work through. What happens to the executive management team of the target? If they don’t own a lot of stock, what’s the incentive for them to sell? Those have historically been the big stumbling blocks. But to the extent the regulatory environment is the way it is, more costs are getting driven down to the smaller institutions, your costs are going up and to earn a reasonable return is going to be tougher and tougher to do. That’s going to drive M&A.
What size bank is going to have a tough time making a reasonable return?
Certainly anything below $1 billion will have a tough time. It’s going to be more costly for everyone. We did an equity conference in Florida a couple weeks ago and John Kanas [the CEO of BankUnited in Miami Lakes, Florida] spoke at our conference. He was the CEO of NorthFork Bank before they sold. They were a $63 billion bank, they had 27 people working in risk management, and that cost $5.5 million per year. Now he’s at BankUnited, a $14 billion bank, and he has more than 100 people working in risk management, and it costs him $30 million per year. It’s costing six times as much money.
Do you think banks don’t want to go above $10 billion in assets because of the increased regulatory burden at that level?
There is more stress testing and the Durbin amendment applies, which is less revenue. It’s a big decision. MB Financial hung out for several reporting periods in that $9-billion to $9.5-billion [asset] range, but they said if they were going over $10 billion, they were going to do it with gusto and go way over. They did that with the Taylor acquisition.
What do investors want in deals?
If you start to see less accretion from the deal, those are the ones people will start to scratch their heads on. Cost savings are things people can get their arms around. You can eliminate branches and achieve efficiencies. But if you say the bank is going to grow X, well, it may or it may not.
Two of the biggest obstacles to merger activity are mismatched pricing expectations and regulatory impediments. With the dramatic increase in banking stock prices and trading multiples, buyers now have much better stock currency and thus, the capacity to pay more. The driver of this improvement has been better earnings and improved credit quality resulting in lower credit marks.
With these improving conditions, one might expect a wave of merger activity that advisors dream about. However, we have to keep in mind that equity markets are pricing in the expected future results while banking regulators are focused on past exam results and potential future market stresses. Therefore, regulators are not caught up in the current market euphoria. Regulatory issues can materially delay deals as evidenced by the pending M&T Bank and Hudson City transaction.
Limitations of Joint Meetings with Regulators
Regulatory factors will continue as impediments to deals. One common approach in addressing regulatory factors is a pre-filing meeting with regulators prior to announcement. This pre-filing meeting serves multiple purposes. It provides a courtesy to regulators and helps strengthen the relationship and trust between banker and regulator. Bankers and their advisors also view the meeting as a due diligence tool. Managers report to their boards of directors that they meet with the regulators on the transaction and did not hear any objections. However, it is important to realize that the usefulness of this meeting from a due diligence perspective will depend upon the attendees of the meeting. Regulators are prohibited by law from discussing examination findings with anyone other than the management of the regulated institution and their regulatory advisors, so regulators must limit what is said in a joint meeting with both management teams and advisors. As a solution, the pre-filing meeting should be a two-part meeting. One part should allow for an open dialog on examination matters between the regulator and regulated institution. The second part will allow the buyer, target and their advisors to discuss the application and processing matters with the regulator.
From my experience, regulatory impediments toward mergers revolve around three areas: 1. safety and soundness, 2. compliance and 3. golden parachute restrictions. From a safety and soundness perspective, regulators require that the combined entity be at least pro forma CAMELS rated 2. The key to addressing regulatory concerns from a safety and soundness standpoint is compiling a pro forma enterprise risk management (ERM) analysis. The ERM analysis will provide a framework for management to discuss the resulting entity’s risk profile in a CAMELS format. Regulators will be interested in discussing the impact of any new lines of business, concentrations and new staffing models of the combined entity.
Material buyer compliance issues will usually delay or prevent a transaction. Management teams of buyers have to be vigilant with regulatory compliance and resolve issues pre-announcement, even if the delay is weeks or months. Compliance issues at sellers are easier to resolve. Regulators will be evaluating whether the buyer’s management and policies and procedures are sufficient to provide a sound compliance framework going forward. However, correcting compliance going forward does not absolve buyers from the target’s past issues as JPMorgan Chase & Co. and Bank of America have found in their purchases of Washington Mutual Inc. and Countrywide Financial Corp. Therefore, due diligence remains key in identifying these issues while deal structure helps manage liability. For example, we recently advised two different acquirers that were purchasing banks with significant Bank Secrecy Act/anti-money laundering violations. In the first case, the acquirer built in a walk-away provision in the merger agreement which allowed the acquirer to terminate the deal if fines exceeded a threshold. In the second case, the buyer could not determine the potential liability and elected to structure the transaction as a purchase of assets and assumption of certain liabilities. In this second case, the regulatory fines amounted to almost the entire deal consideration. The buyer was immune from the fines, but the sellers received almost nothing.
Golden Parachutes as a Problem
One factor used to induce the management teams of sellers to go along with (and sometimes promote) the sale of their institution are golden parachute agreements. However, a renewed focus by regulators on Section 359 of the Federal Deposit Insurance Corp.’s rules and regulations has led to deal hurdles. Section 359 limits the payment of golden parachutes to the management team of institutions in troubled condition. Historically, payments were structured so the acquirer made the payment, not the troubled institution, as a means of sidestepping the issue. But now, the FDIC has strictly limited payments to no more than twelve months salary, regardless of which entity pays it. Therefore, sellers either have to improve their risk profile to remove the regulatory troubled condition or management teams have to accept the severance limitations.
While the market is improving and conditions are ripe for deal making, addressing and evaluating regulatory position needs to be a continued focus.
Merger and acquisition activity was flat for financial institutions in 2013, with whole bank deal volume down 2 percent from the previous year to 241 deals in 2013, according to SNL Financial. However, the average price to tangible book value increased by 7 percent to 123.89.
Prices aren’t headed up for everyone, though. In 2013, the average price to tangible book value for banks rose 7 percent, while it only rose 3 percent for thrifts. Why? Thrifts tend to be smaller and have less diverse portfolios. Plus, thrifts are now regulated under the Office of the Controller of the Currency (OCC), which adds a degree of regulatory pressure that many buyers would prefer to avoid.
Strategy Is Not Just in the Numbers
Many banks are looking to grow to survive. But prudent organic growth of more than 10 to 15 percent a year is difficult. That leaves acquisition as an alternative growth strategy.
Much of the consolidation occurring in the industry is in response to questions boards are asking due to the financial crisis and the resulting regulatory and market changes, including:
Are we the appropriate size to survive in today’s regulatory environment?
Are we in the appropriate markets to support operations and growth?
Do we have enough capital based upon increasing regulatory expectations?
Do we have the right management team to achieve growth?
Can we afford the specialized expertise to meet rising regulatory standards?
Do we have economies of scale and infrastructure to be competitive?
Do we have the right products, services and technology to meet the evolving needs of our customer base?
Do we have the energy and motivation necessary to move our organization to the next level?
The answers to these questions are the real drivers for transactions. Success in the M&A market isn’t driven by average multiples. It’s driven by strategy. That strategy should start long before a target is identified and must continue well beyond any transaction.
Buyers are not looking to buy just any bank. Most buyers are looking for acquisition targets that are:
Clean. Increased regulatory attention means that buyers are more sensitive than ever to clean loan portfolios, low non-performing assets and compliance concerns. CAMELS 1 or CAMELS 2-rated banks are attractive targets.
Well located. Attractive facilities in the right markets are vital. Urban and suburban banks are selling for higher multiples than rural banks. That doesn’t mean there are no opportunities in rural areas, though. With larger national banks abandoning many low-population areas, some rural banks are seizing the opportunity to use acquisitions to become the dominant brand in their specific markets.
Appropriate size. Larger banks are choosing larger acquisition targets. Smaller transactions take too much time and capital. This trend removes some of the historic active buyers in the smaller community bank space.
Market demographics and product mix. Banks looking to branch out into new customer segments or to expand their product offerings may consider these issues the same or even more heavily than the target’s geographical footprint.
Solid management. Banking has seen a talent drain in recent decades as many candidates who once might have chosen a banking career have instead opted for investment banking or other options. The result is a shortage of management talent in the banking industry today. Banks with solid management teams who are likely to stay on after the transaction are particularly attractive.
Sellers have their own set of motivations. Sales are driven by a variety of concerns, including:
Age. Older owners, board members and executive management may want out of the industry.
Regulatory concerns. Many smaller banks are finding it hard to deal with the increased regulatory burden using their limited resources. Constraints on their activities due to new regulations are also squeezing profits. Finally, the risks associated with regulatory failures are an increasing concern. Directors, too, are concerned about their increased liability exposure.
Return on investment. For banks with the right risk and market characteristics, the current deal environment offers an excellent opportunity to realize a solid return for their investors.
New buyers are also entering the market, including payday and other specialty lenders, off-shore buyers and Native American tribes, but thus far with limited success. Based on increasing values and regulatory issues, we anticipate more growth in M&A activity in 2014 than we saw in 2013. In any case, it’s a good time to consider your options.