Overcoming M&A Hurdles in Closely Held Banks

1-6-2014-Baird-Holm.pngThe family dynamic in closely held banks is a powerful driver in bank mergers and acquisitions today, and deals involving closely held financial institutions often take a very different tack than transactions by their publicly traded brethren.

Whether it is the ability to move expeditiously to execute a transaction or to pursue structures that would be impossible in a publicly held bank holding company, closely held financial institutions get deals done differently.

“Family-owned or closely held buyers have the ability to take the long view when they make an acquisition,” says John Zeilinger, a senior banking attorney at Baird Holm LLP. “The flipside has been the case for a number of recent sellers—when pressured to raise capital, family held banks may not have attractive sources from which to raise new investment, which can lead to shotgun marriages and deal structures that are creative by necessity.”

Transaction structure is probably the most salient distinction in such deals. Whereas a purchase-and-assumption transaction typically is used only in FDIC-assisted transactions involving larger financial institutions, closely held banks make use of such structures on a fairly regular basis to exclude toxic assets and obtain stepped-up tax basis when acquiring assets. For example, toxic assets may be held in a liquidating trust, to facilitate the sale of assets post-closing.

While representations and warranties are common across all transactions, buyers of closely held financial institutions enjoy greater opportunities for recourse. Personal indemnities are common in the family banking context, whether or not such indemnities are subject to escrows or holdbacks. It is common to set aside dollar amounts that are tied to assets subject to valuation disputes. For example, other real estate owned (OREO) assets, which often include foreclosed properties, can be subject to specific indemnities and holdbacks to bridge the valuation gap between buyer and seller on such balance sheet items.

Baird Holm LLP attorneys have assisted with recent deals that included creative methodologies for valuations of disputed assets and, in one case, even personal guarantees of loans for a specified period. This kind of cherry picking is impossible in deals involving publicly held financial institutions, but has become very common with closely held banks during the downturn.

Perhaps one of the most striking examples of such deal-making that made the headlines was the so-called good bank-bad bank transaction last March involving First Independent Bank. In that deal, the Firstenberg family, which owned the institution, sold its main banking operations to Sterling Financial of Spokane, Washington According to public reports, the deal required the shareholders to retain $83 million in toxic assets in exchange for a $7 million down payment with a potential $17 million earn-out depending on the ultimate value of those assets.

But transaction structure is not the only consideration to keep in mind when doing deals with closely held banks. Because the owners of family banks often maintain strong ties to the local community, strong non-compete contracts are essential to ensure the premium paid for an institution is justified. Failure to obtain a strong non-compete may result in an owner using proceeds from a transaction to set up shop “across the street” from the sold institution and to begin rebuilding the franchise by poaching key employees and customers.

Furthermore, tax planning opportunities also may exist in connection with transactions involving family held financial institutions. Because many family held banks have elected subchapter S tax status, an S corporation election that has been in force for more than 10 years may enable a buyer to purchase shares from their holders while obtaining a stepped-up tax basis in acquired assets.

However, there are potential roadblocks to doing deals with closely held banks. The internecine deals struck among the shareholder base of closely held banks can be complex. For example, shareholder buy-sell agreements may contain complicated rights of first refusal, drag-along rights and tag-along rights (contract terms that force minority shareholders to go along with a deal or give minority shareholders the right to sell on the same terms as the majority shareholders). Navigating such agreements when dissident shareholders refuse to participate in a transaction can be key to executing a deal. In addition, finding ways to address preemptive rights provisions, which grant certain shareholders the right to purchase shares before the general public, may be essential to facilitating an influx of new capital.

“Preemptive rights provisions were the bane of many banks seeking to bring on TARP investments several years ago, and they frequently forced struggling institutions to incur additional expense in connection with capital raises required by regulators,” said Amber Preston, a banking and securities lawyer at Baird Holm LLP. “Our advice to the shareholders of closely held banks today is definitely colored by the many challenges banks faced in the recent downturn.”

Time to Dust Off Those Change-in-Control Agreements

1-3-14-Pearl-Meyer.pngThe best time to address compensation issues related to a potential change in control (CIC) is when you don’t need to: that is, when there’s not an imminent likelihood of being acquired. Too often, CIC provisions that appeared reasonable when written can yield unpleasant surprises for bank shareholders and/or executives in the heat of a potential transaction. From the shareholder perspective, surprises might be significant enough to unwind the deal or lead to unfavorable pricing, while executives may be unpleasantly surprised by net benefits far lower than anticipated, due to automatic cut-backs or excise taxes.

That’s especially true now that we’re in a perfect storm for CIC:

  • Many bank executives during the financial crisis had reductions in compensation in the form of smaller (or zero) incentive payouts and realized value from equity awards. This could result in lower base amounts from which golden parachute excise taxes are calculated (i.e., the individual’s five-year average W-2 earnings);
  • As banks have returned to consistent profitability in the last year or two, they are granting more equity-based awards and bank stock prices are starting to rebound, leading to potentially higher CIC payouts; and
  • merger and acquisition (M&A) activity is heating up in the community bank marketplace.

If your organization has any possibility of being pursued by a potential suitor in the foreseeable future, now would be a good time to review the CIC agreements and related provisions in your equity and supplemental retirement arrangements.

The general rationale behind a CIC agreement is pretty straightforward: to reduce potential management resistance to a transaction that is in shareholders’ best interests. If executives fear losing their jobs (and related future compensation opportunities) as a result of the transaction, they may be more likely to drag their proverbial feet and find reasons not to do the deal. Providing reasonable protection to executives in the form of CIC agreements and related benefit provisions can mitigate this risk. Common benefits promised upon termination following a CIC include cash severance; acceleration of vesting on outstanding equity awards and deferred compensation; and either the continuation of health and other benefits or payment of their cash value.

The unexpected consequences of CIC payments/benefits are mostly attributable to their potentially adverse income tax treatment. Under Internal Revenue Code §280G, punitive excise tax penalties are triggered for the employee and what’s referred to as “excess parachute payments” are not deductible for the company if the present value of all payments related to the CIC totals more than 2.99 times the individual’s base amount. For this reason, most CIC agreements are very clear about how CIC payments will be handled if this limit is exceeded. Historically, CIC payments by the company often included 280G excise tax gross-ups, where the company reimbursed the executive for the taxes owed, to keep the executive whole if the parachute limit was exceeded. As such, the most common bombshells at transactions were the eye-popping, nondeductible gross-up bonuses required to reimburse the executive.

Under extreme pressure from regulators and the investing community, excise tax gross-up provisions at most community and regional banks have been replaced more recently either by a cap on the present value of CIC benefits at the 2.99 limit, or by payout of severance benefits that will result in the most advantageous payout to the executive from an after-tax perspective (often called the best after-tax approach). However, such provisions can create another major challenge—forfeiture by the executive of a large portion of the intended benefits. This is particularly problematic in an environment in which the base amount is already likely to be low given the recent financial crisis.

If addressed far enough in advance of a CIC transaction, banks may be able to make adjustments to CIC provisions to ensure that a much greater portion of the intended benefits is delivered in a tax-efficient manner. At a minimum, reviewing your CIC agreements and performing a few scenario-based calculations can protect against being caught by surprise when a potential deal is in the works.

Don’t wait until a transaction is on your doorstep—dust off those CIC agreements and explore their potential real-life impact now, before it’s too late.

How to Handle Loan Portfolio Valuation and Avoid Trouble Later

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

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

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

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

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

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

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

Efficiency and Its Impact

11-25-13-Hovde.pngThe banking industry is consolidating. This is not shocking news to most people. The number of financial institutions in the U.S. has declined from 15,158 in 1990 to 6,940 as of June 30, 2013, according to the Federal Deposit Insurance Corp. Not a single de novo institution has been approved in more than two years. This is astonishing considering 144 were chartered in 2007 alone. However, a look below the surface is required to get a better understanding of bank consolidation and how it is reshaping the industry.

The economics of the banking business have changed. Discussions about increased regulatory burdens and higher capital requirements have been common during the past few years. We believe the financial impacts of producing an acceptable return to shareholders in spite of these challenges will continue to be an integral theme in the banking industry. Earnings from traditional spread income are under pressure for most banks due to a prolonged low interest rate environment (especially for those banks without a robust lending team to generate loans with good yields). Furthermore, increased regulation and compliance requirements have driven up fixed operating costs. These factors, collectively, have resulted in lower returns on tangible common equity for shareholders—arguably the most important measure of profitability from an investor’s perspective.

To adjust to the changing regulatory and operating environment, bankers are looking for strategies to cope with these challenges. With margins under pressure and increased fixed operating costs, many bankers are looking to achieve economies of scale and utilize more technology to manage more earning assets and more cheap liabilities per dollar of operating expense. While there are many strategies to pursue to improve shareholder returns in a challenging operating environment, empirical evidence shows that focusing on efficiency is certainly an effective strategy. Below is a chart illustrating the stock prices of publicly traded banks with assets of between $1 and $25 billion with efficiency ratios in the third quarter of 2013 in excess of 80 percent (we’ll call those inefficient banks) and those with efficiency ratios below 60 percent (we’ll call those efficient banks). Although 2013 has been a good year for bank stocks overall; the stock prices of efficient banks have increased by nearly 40 percent on average, while inefficient banks have only increased by 17 percent on average. Simply put, efficient banks have bested the market while inefficient banks have lagged behind.

The efficient banks have stronger earnings (averaging more than a 12 percent return on tangible shareholders’ equity versus 5 percent for inefficient banks). Currently, inefficient banks are trading at an average price-to-tangible book ratio of 113 percent versus 190 percent for the efficient banks group. Having a stronger currency (e.g., a stock trading at a higher multiple) is an advantage when structuring a merger; it allows the transaction to be more accretive (or less dilutive) to tangible book value per share for an acquirer when stock is used as consideration. Thus, efficient banks also have an advantage in pursuing acquisitions over the inefficient banks.

This leads to our next point: During the past year, 74 percent of public buyers have seen their stock prices appreciate during the month following the announcement of an acquisition. Additionally, buyers that have announced deals representing about 10 percent or greater of the buyer’s pro forma assets have seen their stock prices appreciate 8.4 percent on average during the next 90 days post-announcement. In short, the market has been rewarding buyers for pursuing efficiency through size and scale. While a deal can make sense if it has financial merit alone, it is truly great if there is a combination of strategic and financial rationale.

The industry is in the best shape in five years and continues to strengthen. Stressed and troubled institutions are being placed in the hands of strong, capable buyers. The number of failed banks has declined from 157 in 2010 to only 23 during the first 10 months of 2013. The landscape is changing from an environment dominated by FDIC-assisted deals and open-bank acquisitions of stressed banks to a much healthier M&A landscape. While buyers have been rewarded for pursuing accretive FDIC-assisted transactions, they are now also being rewarded for paying a fair premium for high-quality community banks that offer strategic value and make financial sense. The industry dynamics today are ripe for continued consolidation. The efficiencies gained through strategic M&A will continue to be noticed and appreciated by bank shareholders.

What’s Ahead for Bank M&A? Results of the 2014 Bank M&A Survey

2014-MA-Survey.pngIs it harder to get regulatory approval for a deal these days? Fifty-eight percent of respondents to Bank Director’s 2014 Bank M&A Survey, sponsored by Crowe Horwath LLP, believe it is more difficult than five years ago. Specifically, bank executives and directors find that regulators have increased their scrutiny on aspects of the deal such as regulatory compliance and capital adequacy.

So will the regulators impede bank M&A, preventing that long-predicted increase in deals from happening in 2014? Bankers don’t seem to think so. In fact, 76 percent of respondents expect to see more bank M&A deals in 2014. Just 7 percent expect activity to decrease.

Will Basel III have an impact on M&A deals? Forty-one percent of survey participants believe that Basel III will result in an increase in deals, while 32 percent don’t think that Basel III will impact bank M&A at all. When asked about their own bank’s strategy, 54 percent feel that Basel III will have little impact, and 29 percent are unsure what the impact will be.

The survey is based on emailed responses this fall from 231 senior executives and directors of the nation’s banks on issues related to mergers and acquisitions, specifically focusing on what challenges and opportunities face buyers and sellers in the banking industry. Bank leaders were also asked to weigh in on what they expect the environment to yield in 2014, both for the industry and for their own institutions.

So what do potential buyers and sellers have to say about bank M&A for the coming year?

Findings include:

  • More than half, 52 percent, of respondents say that their bank plans to purchase a healthy bank this year. Will their plans come to fruition? Last year, the 2013 Bank M&A Survey found that 46 percent of respondents planned to purchase a healthy bank, while this year’s survey finds that just 24 percent purchased a healthy bank in 2013.
  • What are the barriers to making a deal? Thirty-five percent say that coming to an agreement on price is the single greatest challenge their boards face when considering an acquisition or merger of equals. Potential buyers, at 63 percent, say that pricing expectations are just too high. Forty percent worry about asset quality, and 38 percent say that the boards of targeted banks just aren’t willing to sell.
  • Will more banks consider a sale in 2014? Only 5 percent of respondents indicate that they’re willing to sell a bank. There are a number of reasons that these banks won’t sell out: Forty-eight percent say that the bank’s board and management want to remain independent, and 42 percent say that current pricing is too low.
  • When asked to provide the top three reasons for selling their bank, almost half of respondents say they would entertain a sale if the bank received an attractive offer. The second and third most popular reasons for a possible sale are the high cost of regulation, at 25 percent, and limited organic growth opportunities, at 23 percent.
  • Once the deal is done, what are the most difficult aspects of the acquisition? Assessing credit quality issues at the acquired institution is cited as a challenge for 53 percent of respondents. Post-merger integration, at 45 percent, and cultural compatibility, at 43 percent, continue to be problematic for buyers. However, many respondents report that they are satisfied with some of the stickier points of the deal, like cultural fit, growth in market share and technology integration.

Download the summary results in PDF format.

M&A: Avoiding Compliance Sinkholes

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

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

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

Institutional History

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

Compliance Management

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

Third-Party Service Providers

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

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

Product Sets and Features

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

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

Post-Conversion Compliance Activities

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

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

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

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


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

Dealing with M&A: What You Don’t Know Can Hurt You

Dealing with a potential sale or acquisition can be a stressful time for a bank’s board. Bank Director asked speakers at its upcoming Acquire or Be Acquired conference in Phoenix, Arizona, to describe what bank boards understand the least about M&A transactions, with an eye toward improving a board’s readiness to deal with these issues.

What aspect of M&A transactions do bank boards understand the least?

Kanaly-Mark.pngThe most misunderstood part of the M&A process, from a board perspective, is the difference between the current deal environment—where deals are priced as a function of tangible book value, and are measured by the earn-back period and the cost savings—versus deals in the ‘90s and early 2000s, which were priced based upon earnings and opportunity (growth). This leads to large disconnects on pricing, opportunity, etc.

— Mark Kanaly, partner, Alston & Bird LLP

Plotkin_Ben.jpgGenerally, boards struggle with the concepts related to relative valuation. In other words, how do you evaluate the currency you are receiving in return for the sale of the company? This involves much more than simply looking at the stock market trading values of both involved companies. In particular, the growth prospects and quality of earnings of an acquirer should be important considerations in the analysis of relative valuation.

— Ben A. Plotkin, executive vice president and KBW vice chairman, Stifel Financial Corp.

Quad-Rich.pngShareholder value in an M&A transaction is more about what happens after closing than the multiple achieved at signing. For sellers, it means acquiring an attractively priced currency with upside potential, a strong dividend and liquidity. It means finding an experienced partner to navigate the regulatory approval process, access additional capital if necessary, and treat new customers, employees, shareholders and communities like their own. For buyers, it means setting, and then exceeding, reasonable financial expectations, executing the operational integration flawlessly, blending two cultures into one, and putting customers first. Many high multiple transactions have turned out poorly for the seller and low multiple transactions have turned out poorly for the buyer because of a lack of planning and execution.

— Richard L. Quad, senior managing director & co-head, Financial Institutions Group, Griffin Financial Group LLC

Hay_Laura.pngWe often find that directors are surprised at the impact golden parachute provisions have for the bank and the executive. As boards continue to eliminate gross-up provisions, they often make decisions on how to handle change-in-control severance payments that would be subject to excise tax without any financial analysis or review of the other agreement provisions. We have found situations where the aggregate cost of all severance payments could be a barrier or that payments to certain executives are far lower than intended. Digging into the change-in-control provisions and running financial scenarios can help to avoid surprises that could derail a deal.

— Laura A. Hay, managing director, Pearl Meyer & Partners Comprehensive Compensation

Duffy-John.pngI would have to believe that the aspect of M&A transactions that is truly least understood by most directors of bank boards is the accounting. Hopefully, the financial expert and lead director on the board understand the financial and accounting issues on any merger, but I doubt that most directors really grasp the nuances of merger accounting in a mark-to-market world. The impact that certain accounting assumptions can have on the pro forma balance sheet and the forward income statement are material and it is critical that board members grasp those issues if they want to understand how their shareholder constituency will react to an announced transaction.

— John Duffy, vice chairman, Keefe, Bruyette & Woods, Stifel Financial Corp.

Dugan-John.pngSmith-Scott.pngBank boards (and management) do not always appreciate the need to brief regulators early about a potential transaction, well before an agreement is signed and the transaction is announced. Post-financial crisis, regulators are taking a much more active role in scrutinizing transactions for issues, and it is far easier than it used to be for deals to get delayed or even scuttled based on regulatory concerns. In this climate it is much better to vet transactions early so that any regulatory concerns can be identified and addressed early—or, if the regulatory obstacles are insurmountable, to learn that early, before wasting time and resources.

— John C. Dugan, partner and Scott F. Smith, partner, Covington & Burling LLP

McCollom-Mark.pngMany times, boards do not appreciate the level of capital required to make a transaction happen. In many deals, the mark-to-market adjustments and merger-related costs (including but not limited to management contracts, technology contract costs, balance sheet restructurings, severance, branch closure costs and professional fees) are too large, and a deal becomes prohibitive. Purchase price as a percentage of tangible book value (P/TBV) is sometimes misleading, as adjusted P/TBV may show a much higher net purchase price for a target.

— Mark R. McCollom, senior managing director & co-head, Financial Institutions Group, Griffin Financial Group LLC

Murphy-Jared.pngColeman-Samuel.pngM&A transactions invariably require decision making under uncertainty. The time available to buyers to evaluate target companies or lines of business is generally compressed. Sellers face analogous uncertainty as to whether markets are adequately valuing their business. A by-product, and an arguably unintended positive consequence of the current phase of regulatory scrutiny, is that banks are putting in place comprehensive, rigorous, and extensively tested and validated risk models. As these modeling regimes come on stream and become routinized, buyers and sellers alike (and their boards) will be armed with powerful new tools to make decision making far more transparent and efficient than in the past.

— Jared Murphy, managing director and Sam Coleman, managing director, BlackRock

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

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

As Stock Prices Rise, Expect Slow and Steady Consolidation in the Banking Industry

2013-MA-trend-report.pngIs there a mad rush to consolidate the banking industry? The numbers would say no. Bank merger and acquisition (M&A) deal volume in the first half of this year is flat compared to the same time period last year. Aggregate deal value actually has fallen a little bit. Pricing on a tangible book value basis is flat.

That could soon change.

Investment bankers and attorneys attending Bank Director’s upcoming Acquire or Be Acquired conference in Phoenix, Arizona, say they are noticing a pick-up in deal-making discussions that could lead to actual deals in the second half of the year. In fact, the biggest deal of the year was announced in July when PacWest Bancorp agreed to buy CapitalSource Inc., both Los Angeles-based banks, in a combined stock and cash transaction worth $2.4 billion. If that deal had been announced in the first half of the year, aggregate deal value would have risen by about 50 percent.

The environment seems ripe for more activity: net interest margins and high regulatory costs are putting pressure on community bank balance sheets, providing incentives to sell. Buyers have seen stock valuations soar during the last year, which means more banks can afford to pay a premium to buy a bank and potentially overcome one of the biggest hurdles to M&A during the last few years: a lack of agreement between buyers and sellers on a price. Asset quality also has improved during the past year for both buyers and sellers. Capital levels at many banks are high. Basel III rules for U.S. banks and thrifts have been finalized, offering clarity on what capital levels will be required, therefore making it easier to do deals. In another sign of an improving economic environment, failed bank deals have been on the decline, and healthy bank deals have been taking their place.

The slow and steady economic improvement may be leading investors in publicly traded banks to turn their attention away from price to tangible book value metrics, and looking more at earnings accretion and growth potential in M&A deals. Still, regulatory concerns and compliance issues are having more of an impact on M&A than during the financial crisis, when the focus was on asset quality. Both buyers and sellers need to assess the potential for regulatory problems in any M&A deal, as well as closely assess the potential synergies and growth opportunities resulting from a combination. Banks in general are cautious, and investment bankers and attorneys are shying away from predictions of a coming wave of bank M&A. Instead, many predict slow but growing consolidation.

Download the full white paper in PDF format.

Analyst Forum Interview: Collyn Gilbert

Gilbert_4-22.pngCollyn Gilbert, a managing director at Keefe, Bruyette & Woods, first talked to Bank Director magazine at the launch of Analyst Forum two years ago when she was with Stifel Nicolaus. Stifel purchased KBW in February and she moved over to KBW, which is focused on the financial sector. She still covers small to mid-sized bank stocks and revisited in March what she said then.

We talked to you in the first quarter of 2011 for our first Analyst Forum interview. You said at the time that there was a great opportunity to own a basket of potential sellers, and that you expected considerable amounts of M&A in 2012 and beyond. How do you feel about that now?

I do think M&A is going to be a key component of the industry. Why did it not take place starting in 2012? I think what we missed was the unwillingness of management teams to pull the trigger.  In 2012, you still had good earnings growth for the sector but as we look to 2013 and 2014, earnings growth is going to slow considerably. That could be the catalyst we need to facilitate M&A. It’s a real struggle to grow earnings, especially for the small and mid-sized community banks that may be more real estate dependent and dependent on net interest margins. There is, finally, some degree of capital clarity and what the future looks like for growth. I think we’ve definitely seen a pickup in M&A. In our universe of small and mid-tier banks, we have had 11 acquisitions close in the last 12 months. It’s there. It’s not the big names like the Fifth Thirds and the BB&Ts. The median asset size for sellers has been in the couple hundred million dollar range.

What have those deals looked like?

Because they are so small, some of these [sellers] were trading at tangible book value. [Their stocks] are illiquid in nature. It allowed buyers to get decent pricing on them. You actually have seen these deals accrete book value for the buyers. We have not seen the premium M&A, where banks trading at 1.5 tangible book sell for 1.7 to 2 times tangible book. There is still a lot of bottom feeding. There are banks still challenged and management teams that are fatigued. There is no need to acquire deposits right now because there are a lot of deposits and not much growth in lending. If interest rates rise, that will be a factor to help M&A.

When we talked last, you predicted the banks that would do well would do so because of declines in non-performing assets and reserve levels and net interest margin improvement.

That was true. Now, looking at 2013, we’ve sort of exhausted that. There are some situations where banks are carrying higher-cost funding, which they can re-price lower, but materially lower deposit costs in 2013, I don’t think it’s going to happen. Margins are going to continue to come under pressure this year. I hope we start to see the trough by the end of the year but that’s tough to say.

You will see fewer banks that are able to improve their margins?

It’s virtually impossible. If they are getting better margins, how are they doing that? Are they getting riskier assets? You kind of have to wonder. Are they going farther out on the interest rate curve? You have to be a little bit cautious. {Editor’s note: The latest issue of Bank Director magazine has a story on this topic.}

Two years ago, we had a high level of capital in the industry. It’s still high. Do you see banks using this effectively?

The industry is sufficiently capitalized at this point. The small and midsized banks still follow the trends at the larger banks and keep an eye on what the regulators are saying at the larger bank level. I think that you’ve seen some [regulatory] relief there, and you’ll see more banks move to deploy capital, either in buybacks or increasing dividends. 

We talked two years ago about efficiency. What do you see banks doing with their efficiency levels now and is that a focus for investors or not?

It should be a focus [for investors]. With margins under pressure and growth being limited, these banks really need to think about their efficiency level. The past couple of years they have been cutting some of the fat. Now, we’re in a position where banks have to take a hard look at the expense level and the biggest part of that is the branch network. The one thing I don’t hear enough of from the banks I follow is: How are you rationalizing your branch networks? With consumer behavior evolving at a very rapid clip, if you’re not addressing that, you’re going to be taken to the woodshed. I’m kind of surprised banks aren’t talking about it. Banks have been so wedded to bricks and mortar through so many different cycles and technology has not been the hallmark for the banking industry at the mid-tier level. It’s going to take some time to kick in. [Waterbury, Connecticut-based] Webster Financial Corp., which we follow, is doing a good job shrinking the branch network and [expanding] mobile banking and responding to changing consumer behavior. They said they would reduce investment in branch infrastructure by 20 percent. The theme is starting to trickle down from the bigger banks. The smaller banks, their behavior lags the bigger banks by nine to 12 months.

What should small and medium sized banks do to make themselves more attractive to investors?

You have to be a lot more efficient and look at what the expense structure is. At the same time M&A needs to be an important part. No bank wants to sell. No CEO or board wants to give up their position and their compensation, or whatever the case may be. If putting two institutions together allows you to cut costs and improve returns, that is certainly beneficial to the shareholder.