A Risk Checklist for M&A


3-26-13_Jack.pngThere was a general consensus among most of the investment bankers and attorneys I spoke with at our Acquire or Be Acquired conference last January that takeovers of healthy banks will accelerate this year because an increasing number of institutions will see this as their best option for growth in the face of poor loan demand from business borrowers and shrinking net interest margins. Sounds good in theory, but one of the problems with this strategy is that acquisitions don’t always achieve their primary objective, which is earnings-per-share (EPS) accretion for the buyer’s shareholders.

Indeed, there are probably many more things that can go wrong in an acquisition than go right, and this places enormous pressure on the acquirer to hit the bull’s eye on each one of its assumptions about asset quality, cost reductions and revenue enhancements. If a buyer misses any of those targets by a wide enough margin, it will essentially have overpaid—and that means it will miss the projected increase post-merger earnings per share that it used to justify the merger in the first place. Few bank chief executive officers want to risk angering their institutional investors by overpaying for a deal.

Recently I asked Stephen Figliuolo, the executive vice president and corporate risk officer at Citizens Republic Bancorp in Flint, Michigan, for a list of questions that every bank chief risk officer (CRO) should be asking in any acquisition. Figliuolo has been on both sides of an M&A deal—transactions that Citizens has done as the acquirer and, of course, the bank’s own sale last year to FirstMerit Corp. Here are his questions, which have been organized into five categories:

  • Loan portfolio: “What is the credit mark on the portfolio? How much is the loan portfolio really worth? This is dependent on the quality of the loans, so you look at loan concentration levels and ask whether the various types of loans fit your strategic need? Are the loans supported with appropriate loan documentation? Is the seller’s credit rating system similar to yours or more liberal? Are there any major reporting discrepancies to impaired loans, nonperforming loan designations or charge-offs? Are they sufficiently reserved? What is the quality of the portfolio monitoring and can it detect deteriorating credits?” These are all good questions and CROs should wave a red flag if they aren’t satisfied with the answers they get back because if you miss big on your analysis of the target’s asset quality, the deal will probably be a bust. All of these categories of risk are important, but gauging the target’s asset quality correctly is probably most important.
  • Balance sheet: “What are the components of the balance sheet? What is the quality and duration of the securities portfolio? What steps will you as a buyer have to take to unwind investments that don’t fit your strategy from a duration, interest rate or risk perspective? How does the target fund itself? Does it rely more on high-cost deposits including brokered versus low-cost core deposits, in which case you will need a plan to eliminate those high-cost deposits over time?”
  • Regulation: “What are the regulatory risks? The hot items in banking today are anti-money laundering/Bank Secrecy Act laws, consumer add-on products, fair lending and consumer compliance. You buy those issues as they exist at the acquired bank and you will need a plan to fix them.” An example of a consumer add-on product would be a situation where an individual takes out a loan to buy, say, a boat and the bank agrees to fund the loan for 5 percent more than the purchase price. The borrower could then use this extra money for some purpose unrelated to the boat purchase itself. “The Consumer Financial Protection Agency is all over this,” he says. “They ask, ‘Does the borrower have the ability to repay that loan?’”
  • Pending legal actions: “Not only do you get an idea of prospective legal costs involving the acquired institution, but an idea on how well the company is managed.”
  • Strategic fit: “What exactly are you buying and why? Is it the deposit base as a source of funding, or are you buying it for market share or to acquire an annuity-like revenue stream, to name a few of the factors? And how much expense can you take out through improved efficiencies?” This might be an especially important concern if the bank is doing an acquisition because it can’t find much organic growth in its market. A bank that feels a self-imposed pressure to do a deal might not exercise as much caution as it should. “Do you understand the strategic fit?” asks Figliuolo. “Does the deal make business sense?”

CROs will normally be an important participant in the due diligence process that precedes an acquisition, but the extent of their involvement probably depends on where they rank in the institutional pecking order. “It depends on the status and experience of the CRO in the organization,” says Figliuolo. “At some banks, the CRO leads the due diligence process. At others, it might be the chief financial officer, and the CRO only contributes to those things under his purview.”

Either way, CROs have a vital role to play when their banks are vetting a possible merger—and they could be the difference between a successful deal and one that blows up?if they ask the right questions.

You Just Got an Unsolicited Offer: Now What?


From Bank Director’s research and popular opinion at our most recent Acquire or Be Acquired conference in January in Scottsdale, Arizona, M&A activity is due to pick up in 2013, even if only slightly. Not every offer is a good offer, and not every bank wants to sell. So whether it’s pricing or timing, we want to know what is actually required from a board when an offer is made.

How should boards respond to unsolicited takeover offers from other banks if they’re not interested in being acquired?

Smith_Phillip.pngThe real question is not how should boards respond, but if they are legally required to respond. That depends on the nature of the proposed unsolicited offer. If it is a mere cocktail conversation or even a friendly overture during lunch, typically there is no duty to respond at all.

On the other hand, if a formal written offer is presented with actual proposed contractual terms, the board of the target organization, from a fiduciary duty standpoint, must respond even if they want to remain independent. The target board often must have a legitimate process that is followed with a financial analysis undertaken to determine if the offer is valid or not.

The decision of whether the organization can remain independent is based on whether the targeted organization can do better for its stockholders over the long-term compared to how the stockholders would fare in the deal. If the board has a legitimate basis to make that determination, then a simple “no thank you” is all that is needed.

— Philip Smith, Gerrish McCreary Smith PC

Schaefer_Kim.pngBoards must make an informed, good faith decision and can’t just ignore the offer. The record must reflect directors’ thoughtful consideration, including reviewing the bank’s strategic plan and value remaining as a standalone entity.

Assemble a team. Hire investment bankers to prepare financial analyses and market checks. Hire legal counsel to assist with proxy fights, public disclosures, securities laws and regulators since a takeover bid will require the bidder to seek regulatory approval. If the offer could become public, hire a media relations firm.

Before information leaks to employees or the public, establish clear communication protocols. Identify specific people authorized to speak on the bank’s behalf and ensure all communications are pre-cleared by counsel.

— Kim Schaefer, Vorys, Sater, Seymour and Pease LLP

Williams_Marcus.pngFor public companies, the public announcement of an unsolicited acquisition proposal can place the target at a significant disadvantage. This is particularly true where the putative buyer announces the offer directly to stockholders, rather than first approaching the board in an attempt to reach a negotiated transaction. In these instances, boards are well-advised to adopt a stockholder rights plan in order to afford ample time to obtain adequate information and advice and, on that basis, to consider an appropriate response.

Ideally, a well-functioning board will have considered and structured such a plan in advance, maintaining it “on the shelf” and reviewing it periodically to assure that it can be adopted quickly should a surprise offer be announced.

Most states also have some combination of control share or business combination statutes that limit a hostile suitor’s ability to quickly acquire control of business corporations, whether public or private. These statutes are less common, however, for states that have separate statutes governing state-chartered stock banks, particularly where the state corporate law does not apply to stock banks.

— Marcus Williams, Davis Wright Tremaine LLP

Zaunbrecher_Susan.jpgA board must exercise its business judgment as that is defined under the law of its state of incorporation. For example, in Delaware, the Revlon doctrine may drive a board’s consideration. In essence, the board must exercise its fiduciary duties with the specific goal of maximizing shareholder value.

Assuming receipt of a bona fide offer, a board should work with its legal and/or financial experts to understand the Revlon doctrine and state law to determine the elements to consider and document the exercise of business judgment in rejecting an offer. Many states permit boards to consider constituencies other than the shareholders, including employees, vendors and the community, in the proper exercise of business judgment.

— Susan Zaunbrecher, Dinsmore & Shohl LLP

Mayer_Frank.pngAs a threshold matter a board needs to understand that it, as a body, must make decisions that enhance shareholder value. A board cannot shift its decision making responsibility to the shareholders. The board must consider through a financial analysis whether the unsolicited offer is one that could put the shareholders in a better position than holding the existing bank shares. If the board’s conclusion is that the offer is legitimate and could put the shareholders into a more favorable position than maintaining the status quo, then the board has decided to sell to some entity.

Most states through their version of the business judgment rule will protect the board’s decision and the courts tend to be reluctant to second guess the board’s decision-making as long as the board adheres to the bank’s established documented governance processes and recusal mechanisms that are consistent with peer institutions so that board member self-interest influences are eliminated, the board in good faith relied upon expert advice without a conflict of interest, and the minutes establish that the board conducted a thoughtful decision-making process. If the financial analysis is close enough that the board seeks to consider non-economic issues and the bank’s by-laws permit non-economic factors, it will be imperative to document the negotiations over non-economic concerns to mitigate litigation risk.

— Frank Mayer, Pepper Hamilton LLP

The Changing Public Markets for Banks


2-15-13_OTC_Markets.pngIn April of last year, Congress enacted the JOBS (Jumpstart Our Business Startups) Act with the purpose of easing the capital raising process for small and growing companies.  While only some of the provisions have been put into effect, many small banks have already taken advantage of the new registration and deregistration threshold. According to the latest numbers released by SNL Financial, more than 100 banks have deregistered with the Securities and Exchange Commission (SEC) following the passage of the enactment of the JOBS Act. Most of the attention has been placed on the amount of money and resources banks save as a result of deregistration, but what has not been addressed is the flip side, the new threshold that will require registration. Going forward, banks won’t need to register until they have 2,000 shareholders of record. This change opens the door for small to mid-sized banks that in the past were reluctant to raise capital or merge in fear of increasing their regulatory burdens. What’s important to note is that for non-bank and non-bank holding companies, the statutory shareholder threshold remains the same. In writing the new laws, Congress purposefully carved out banks, acknowledging not only the need for banks to access capital but also the highly regulated environment that banks already face.

SEC Registration Versus Public Markets

Even with this statutory easing, many banks still view the capital markets with caution and often the hesitation comes from a dearth of information and misunderstanding of how the public markets function for small companies.  The common perception is that a bank must undergo a costly and time-consuming process to become public, one that requires underwriting, SEC registration, and compliance with Sarbanes-Oxley. While that process still exists, it only applies to banks seeking to do an Initial Public Offering (IPO) and trade on a registered national securities exchange such as NASDAQ.  As long as there are freely tradable shares, banks can have broker-dealers quote and trade those shares on OTC Markets without filing with the SEC.

With greater demand and regulatory pressure to hold more capital, it is no longer efficient for banks to sell stocks by pulling out a list of interested buyers from desk drawers.  However, as a company enters the capital markets, the information gap also begins to widen and it becomes infeasible for companies to know each shareholder and conversely, investors become removed from the daily ins and outs of the companies they are investing in. The classical definition of markets assumes that information is widely available, allowing buyers to make informed decisions, and sellers to have access to the capital they need to grow and expand their businesses. Yet, information is not always widely accessible, or the information availability is asymmetric, meaning that one side has more information than the other, making a marketplace inefficient.

An Efficient Marketplace

There are three elements that make a stock market efficient:

  1. Access for investors with widespread pricing and the ability to easily trade through any broker
  2. Availability of publicly disclosed information to allow for fair valuation of the stock
  3. Confidence from investors that companies are reputable and information is trustworthy

All three elements above address the problem of asymmetric information in a marketplace by bridging the knowledge gap between company management and investors. Transparent pricing facilitates the assessment process, letting companies and investors determine whether the valuation is fair and actionable. Markets are self-regulating, and when information is widely available, prices will adjust to reflect a combination of company performance, investor demand, and overall economic conditions. Intrinsically, SEC filings are meant to eliminate the discrepancy of information between companies and their investors, yet the high cost associated with registration doesn’t always seem to match the intended benefits. Banks on a quarterly basis already produce call reports to their regulators, and many of them also publish additional financials and disclosures to their shareholders via public portals such as www.OTCMarkets.com, through SNL, or on their own shareholder relations page. For a small bank, the cost of SEC reporting typically ranges from $150,000 to $200,000 per year, and on annual net income of $1 million, that’s a very significant amount.

The Implication

In the U.S., there are roughly 7,000 banks, a majority of which are small community banks with under $1 billion in assets.  Of the 7,000, about 15 percent are publicly traded, around 450 on registered national securities exchanges such as New York Stock Exchange and NASDAQ, and 600 over-the-counter, primarily on the OTCQB marketplace operated by OTC Markets Group. Fifteen percent is a relatively small fraction, especially given the current economic climate and disposition towards mergers and acquisitions. In general, banks are viewed more favorably and are in better positions to be acquired when the bank’s stock is publicly traded. There is always going to be greater confidence in a deal when valuation is publicly derived (even if the price/book is less than 100 percent).

However, should banks become publicly traded solely for the fact that they would be “more attractive” in an acquisition? Without a doubt being traded on a public market exposes the company to potential market volatility, and there are inherent risks and costs associated with being publicly traded, even with the recent changes outlined in the JOBS Act. A common impediment delaying and preventing companies from going public is the fear that the public valuation will be less than the management’s internally perceived price.  A parent will believe that his or her child is the best, but unfortunately we live in society where individuals are subject to comparison and ability is often determined by some form of standardized testing or arbitrary measurements.  Public scrutiny is hard to swallow, but public acknowledgement can be equally, if not more, gratifying.

Since the financial crisis in 2008, markets have been perceived as the big bad wolf, the visible scapegoat for why companies go bankrupt and why shareholders lose millions of dollars in their investments. However, despite the recent ups and downs, they still remain the best indicator of good investments and the most efficient way to access capital. If the company has a sustainable and profitable business, if a bank’s loan portfolio has consistently provided high returns with minimal default risks, then the well-informed markets should adjust to reflect those successes. 

What Bank Boards and Management Need to Know about M&A in 2013


Freechack_and_Laufenberg.pngJohn Freechack, chairman of the financial institutions group at Barack Ferrazzano Kischbaum & Nagelberg, and Allen Laufenberg, managing director of investment banking at Stifel Nicolaus Weisel, answered some timely questions about mergers and acquisitions at a recent Bank Director conference.

Where are we compared to a year ago?

Bank valuations have improved slightly but they’re still not great, said Laufenberg. Healthy institutions above $1 billion in assets are now trading above book value, improving their ability to become acquirers. The economic outlook is still positive but sluggish. The number of “problem” institutions on the Federal Deposit Insurance Corp.’s list is no longer north of 800, but it is still above 600. Still, there are more buyers in many markets than a year ago. Some markets had only two or three potential acquirers a year ago but now have five or six.

What is an important quality for an acquirer these days?

Patience. Your favorite targets and their boards may need time to digest the fact they need to sell. Many banks will need to raise capital or make tough decisions in the coming years. Dividends will increase on stock sold originally through the Troubled Asset Relief Program or Small Business Lending Fund. Sellers do not want to feel forced to sell. They want to feel they are selling on their own terms. You may need more retained earnings to persuade your regulators that you can be an acquirer.

What steps should you take if you’re interested in being an acquirer?

This is a fabulous time to do planning, and many banks are focused on strategic planning and organic growth, even if they think they will sell in the next two to three years, said Freechack.  Regulators are more willing to discuss getting banks off of regulatory orders and resolving those problems for good, he said. Have those discussions with your regulator now.

Freechack_and_Laufenberg_2.pngWill you need to or be able to raise capital in the foreseeable future?

One aspect of strategic planning is figuring out if you will need capital in the future, either to grow or become an acquirer, for example. What sources of capital might you need? Regulators love common equity but it has been difficult to raise and can dilute existing shareholders. Preferred stock has been popular lately, Laufenberg said. There is a perception that management and directors have been “tapped out” and are no longer willing to put more money into the bank. That was two or three years ago and might not be the case today.

How should you approach other banks about an M&A discussion?

Get a preferred target list of banks together and involve your independent board members in the discussion of strategy and acquisitions. Be careful about how you treat these potential sellers. Don’t hire away their second in command (and possible successor to the current CEO)and expect them to be nice to you later on. Don’t approach boards and management with a pitch that sounds like you know they have a troubled bank or will have a retiring CEO in the next year or two. That can turn people off.  Regulators need to know what you are planning but they might not be of help too early in the planning process.

A Postcard from AOBA 2013


Bank Director recently completed its 19th annual Acquired or Be Acquired (AOBA) conference in Scottsdale, Arizona, and I would describe the mood — not just about the bank mergers and acquisition market, but about banking in general — as generally upbeat. I think the dark clouds that have hung over the industry since 2008 have begun to part and the future looks a little brighter.

We drew a record crowd of 700-plus attendees to the fabled Phoenician resort (once owned, temporarily, by the Federal Deposit Insurance Corp. when the former publisher of Bank Director magazine, the late Bill Seidman, was the agency’s chairman) for four days of peer group discussions, general sessions and breakouts on a wide variety of topics relating to M&A, capital and strategy.  Most of the attendees at this conference are bank chief executive officers and outside directors, so it’s almost impossible to spend a couple of days here and not come away with a strong sense of how the industry’s leadership feels about things. 

Jack_2-6-13.jpg(Unfortunately, the weather was not particularly cooperative during our stay. It rained the first couple of days — which is quite unusual for the Sonoran Desert this time of year — and in an effort to coax out the sun our managing director and executive vice president, Al Dominick, and I opened the conference by walking on stage with opened umbrellas. Our little voodoo trick was marginally successful — the sun finally appeared to stay on the final day of the event.)

If there was general consensus among the attendees about the future of the bank M&A market, it was this: We should see more deals this year than we saw in 2012 — when there were 230 acquisitions of healthy banks totaling $13.6 billion, according to SNL Financial. And one of the primary drivers will be the Federal Reserve’s ongoing monetary policy of keeping interest rates low, which has had the unhappy effect for most banks of squeezing their net interest margins. Remember, most banks make most of their money on the spread between their cost of funds and the interest rates they charge on loans. And even though deposits are dirt cheap at the moment, weak loan demand and intense competition for whatever good loans can be found have driven down loan pricing as well. Several speakers at this year’s conference predicted that the industry’s margin pressure — one might even call it a margin crisis—could last well into 2014.

A second driver could turn out to be the pending Basel III capital requirements, which in their current form apply equally to all sizes of institutions — and would force many community banks to raise capital. More than one speaker said that institutional investors are wary of putting their money into any bank that doesn’t have a compelling growth story to tell. Unless the U.S. regulators decide to apply a less stringent version of the requirements to small banks — let’s call it “Basel III Lite” — many such institutions could find themselves in the unenviable position of needing to raise capital from an unfriendly market. For them, selling out to a more strongly capitalized competitor might be their only option.

A third factor in the M&A market’s anticipated resurgence this year is the oppressive weight of banking regulation, including (but certainly not limited to) the Dodd-Frank Act. Smaller institutions will have a harder time affording the rising cost of compliance, and I’ve even heard some people suggest that banks will need to grow to $1 billion in assets before they begin to achieve what one might call “economies of compliance scale.” Although there are exceptions (including some provisions of Dodd-Frank), most regulations apply equally to all banks regardless of their size, which means it costs small banks disproportionately more as a percentage of revenue to comply than it does bigger banks with larger revenue bases. Will a large number of banks sell out solely because of the rising compliance burden? Probably not. But for an institution that is struggling with intense margin compression and needs to raise capital to meet yet another regulatory mandate, the higher cost of regulatory compliance could be the final straw.

Next year’s AOBA — set for Jan. 26 through Jan. 28 at the Arizona Biltmore resort in Scottsdale — will be the conference’s 20th anniversary and it will be interesting to see how well these predictions held up. Until then, ciao.

M&A Post-Closing Legal Claims: Negotiating the Best Deal


Baird_Holm_1-28-13.pngOne of the most important issues for a buyer in an acquisition is the handling of legal claims following the closing. It is very common for issues to arise after the closing of a purchase of a business that can result in burdensome and expensive lawsuits. The parties tend to focus on negotiating indemnification provisions in the contract late in the negotiation process, and these provisions are often the last significant issue agreed upon by the parties. These provisions generally provide that the seller will indemnify (or hold harmless) the buyer from any and all liabilities incurred after the closing to the extent such liabilities arise in connection with a breach of the representations and warranties made by the seller in the definitive agreement, a breach of the post-closing agreements made by the seller or as a result of the actions of the seller prior to the closing.

As the post-closing liabilities incurred by the buyer can significantly undermine the value of the acquired business, and many of the seller’s liabilities can be difficult to discover in the due diligence process, it is important for buyers to understand the post-closing indemnification provisions and make sure that the indemnification provisions are clear and understandable. In that regard, below are some key considerations with which all buyers should be familiar before negotiating the post-closing indemnification provisions.

No. 1: Require the seller’s principals stand behind representations and warranties.

Sellers will typically prefer that representations and warranties that are subject to indemnification be made solely by the selling entity. As the overall liability of the selling entity will often be limited to any amounts held back or placed in escrow, the incentive of the selling entity to confirm that all representations and warranties are 100 percent accurate may be limited. To the extent that the seller’s individual principals are required to make the representations and warranties with the selling entity, the risk of personal liability will often not only provide another source of funds to pay indemnification claims, but will cause the seller’s principals to take a much more active role in confirming the accuracy of the representations and warranties and any disclosure schedules.

No. 2: Require adequate credit support.

As the selling entity will likely distribute the sale proceeds to its owners shortly after the closing, it is important that the buyer not rely solely upon the credit of the selling entity for the payment of post-closing indemnification claims. The most common method of credit support is for a portion of the purchase price to be placed in an escrow account with a third-party escrow agent to be used to pay future indemnification claims. Buyers should generally request that amounts be held in escrow for a period of not less than 12 to 18 months, and escrowed amounts should not be released to the seller until any and all potential indemnity claims have been fully and finally resolved. An alternative to setting up a potentially expensive and complicated escrow process is to hold back a portion of the purchase price to be paid over time and allow the amounts of any indemnified claims to be set-off against amounts otherwise due as the deferred purchase price. As sellers will be required to rely upon the credit of the buyer to pay the deferred purchase price, it is likely that a buyer will require security with respect to the amounts owed by the buyer as deferred purchase price.

No. 3: Make sure caps and other limits on indemnification make sense.

One of the most highly negotiated aspects of indemnification arrangements is the liability caps, baskets and other limitations on indemnity. Buyers should typically request that the indemnity cap be as high as possible, but no lower than 20 percent of the overall purchase price. In addition, sellers will often request baskets requiring individual indemnity claims and/or the total amount of indemnity claims to be in excess of a specified amount before claims may be made against the seller. While these types of baskets are generally a reasonable protection against small harassing claims by the buyer, buyers need to make sure that the individual amounts are appropriate given the likely nature of the indemnity claims. For example, to the extent a buyer expects a large number of small claims, a basket based upon the total amount of all indemnity claims would be more appropriate than a basket relating to each individual indemnity claim. In addition, to the extent baskets are used, there is no need for a “materiality” qualifier, because the parties have already agreed to what constitutes material damage.

No. 4: Don’t agree to cap claims relating to fraud.

While it is reasonable for the seller to request certain baskets and caps on indemnification claims, buyers should not agree to allow such limits and caps on any breaches of representations and warranties that are fraudulent or intentionally misleading. These types of breaches should be excluded as the potential damages for such claims could be significant and the seller and its principals should be strongly incentivized to act in an ethical manner.

No. 5: Do your due diligence.

While buyers sometimes believe that strong language in the representations and warranties and indemnification provisions will provide adequate protection for undiscovered liabilities, liabilities that turn up post-closing are typically larger and more material than the parties anticipate. In addition, the caps and other limitations on indemnification provisions, as well as qualifications contained in the representations and warranties, may leave the buyer without an adequate remedy. In addition, indemnification claims can be costly and time consuming to enforce. Accordingly, to the extent feasible, buyers should independently verify all information contained in the representations and warranties during the due diligence process. As we often tell our clients, there is simply no alternative to good due diligence.

Winning Over Shareholders with a Well-Constructed Merger


Jefferies_1-23-13.pngSince the financial crisis, investors have looked at falling stock prices following a merger and not been pleased.

While the mixed results of M&A transactions in general have long fueled investor skepticism, banks have fared worse than buyers in other industries since the financial crises.

There are many reasons for the negative reactions that we have seen.  For instance, investors remain focused on tangible book value and have imposed harsh penalties on those acquirers that cannot illustrate the ability to rapidly earn back dilution.  In general, investors have a low level of confidence in the earnings power of the industry and thus have a low tolerance for acquisition-related risks.

The current operating environment, characterized by declining net interest margins and increasing operating expenses, is causing bank boards and bank stock investors to re-evaluate M&A for a number of reasons:

  • Cost savings from merger transactions are one of the few ways to grow earnings in the current rate environment.
  • Credit related purchase accounting adjustments are gradually decreasing.
  • The rally in bank stocks since post-crises lows has made stock buybacks less attractive versus reasonably priced M&A.
  • Earnings per share accretion can help to maintain dividend levels. 
  • The demise of the serial acquirer has reduced seller options.

While circumstances are right for investors to view bank M&A in an improved light, we do not expect to see widespread investor acceptance of high market premiums.  As a result, boards need to study the potential benefits of stock-for-stock mergers that are reasonably priced and often include various nonfinancial aspects.

Banks should not use the “merger of equals” or “strategic merger” labels. The MOE label has been used to describe transactions with a wide variety of financial and governance characteristics causing much confusion in the market.  Using the MOE label will make it more difficult to explain a transaction to the market. Similarly, we think using the word “strategic” can imply that the financial merits of the transaction are lacking and can create ammunition for investor criticism.  

By their nature, stock-for-stock mergers are based on the potential long-term value created by the combined company and do not constitute a change of control as defined by relevant case law.  As long as a board has gone through an appropriate process to evaluate the benefits of a merger transaction versus other options there is no need to further define the transaction as anything other than a merger to shareholders. 

Boards should study past merger deals (no matter what they were called) to gain an understanding of the many ways to balance financial and governance considerations. However, the presentation of the deal to the public must be sensitive to investor expectations that are shaped by the current operating environment and not just what has worked in the past.

The following suggestions can assist the board in structuring a merger that will win over shareholders:

  • The exchange ratio must produce financial benefits to both sides.  
  • Cost savings estimates should be simple to explain and understand.  An acceptable estimate of merger-related savings will be in a range of 5 percent to 15 percent of combined expenses.
  • Be prepared to explain why the merger is better financially than simply buying back stock or increasing the dividend.
  • Proactively explain the impact of purchase accounting adjustments on pro forma financial estimates. 
  • Evaluate the risk of the transaction being “jumped” by an interloper when negotiating the financial and governance deal terms. Investors will be more demanding regarding the financial benefits if they perceive that a materially higher initial premium is available.
  • The exchange ratio may in fact result in a market premium to one side. However, the perceived buyer cannot be seen as paying a full premium while also granting significant governance concessions and the perceived seller can’t be seen as accepting a lower price in order to save management jobs.
  • Governance issues such as board splits, CEO succession and senior management roster must be conducive to a smooth integration. Investors will criticize complicated power-sharing arrangements that can hinder post-transaction performance.
  • Minimize the jargon around the strategic benefit. 
  • Keep in mind that many of the best banks in the country based on long-term shareholder returns have gone through at least one significant and successful merger in their history.  
  • Be careful not to create a written record that can be used against the bank. Avoid exchanging term sheets as a means of negotiating.

This material has been prepared by Jefferies & Company, Inc., a U.S.-registered broker-dealer, employing appropriate expertise, and in the belief that it is fair and not misleading. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified, therefore, we do not guarantee its accuracy. This is not an offer or solicitation of an offer to buy or sell any security or investment. Any opinion or estimates constitute our best judgment as of this date, and are subject to change without notice.  Jefferies & Company, Inc. and Jefferies International Limited and their affiliates and their respective directors, officers and employees may buy or sell securities mentioned herein as agent or principal for their own account.

This communication is being provided strictly for informational purposes only.  Any views or opinions expressed herein are solely those of the institutions identified, not Jefferies.  This information is not a solicitation or recommendation to purchase securities of Jefferies and should not be construed as such.

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Big Bank Mergers: Is the Game Over?


Hourglass_Article.pngNoticeably absent from the bank M&A market in 2012 were the megadeals of years past that have often helped stimulate takeover activity. The market made a modest rebound last year, with 230 acquisitions of healthy banks totaling $13.6 billion, according to SNL Financial. But while there were only 150 bank deals in 2011—the third lowest volume since 1989—they totaled $17 billion. In other words, there were more takeovers in 2012 than the year before, but they were generally smaller in size. 

Also absent last year were traditional acquirers like JPMorgan Chase & Co., Bank of America Corp. and Wells Fargo & Co., three highly acquisitive companies that traditionally have been a driving force behind the industry’s consolidation beginning in the mid-1980s. Indeed, the 15 largest U.S. banks were shut out of the M&A market last year.

The largest transaction in 2012 was the $3.8 billion buyout of Hudson City Bancorp by M&T Bank Corp., the 16th largest U.S. bank, followed by Japanese-owned Mitsubishi UFJ Group’s purchase of Pacific Capital Bancorp for $1.5 billion, according to SNL. When the bank M&A market was really rocking in the 1990s–the high-water mark for the number of transactions was 524 in 1994, and for aggregate deal value, $288.5 billion in 1998—last year’s “big deals” would have been mere chicken feed.

There are good reasons why the big banks were standing on the sidelines last year. For one, JPMorgan and Wells Fargo are dangerously close to the 10 percent nationwide cap on bank deposits—and Bank of America actually exceeds it by 2.62 percent, according to SNL Financial–so those three companies in particular don’t have room to squeeze in another meaningful acquisition. Also, most bank takeovers—particularly very large ones—are paid for with the acquirer’s stock, and of the 10 largest U.S. banks, the common equity of all but two trades below their book value. (The exceptions are Wells Fargo and U.S. Bancorp, whose stock currently trades at a premium to the underlying book value.) With such a weak currency, few of these mega banks are in a position to make a large acquisition even though several of them do have ample room under the deposit cap.

But apparently there is another reason why large banks haven’t been doing deals. According to a Wall Street Journal story that ran last December, the Federal Reserve has been telling very large “systemically important” U.S. banks to forget about doing anything but the smallest of acquisitions for the time being. The Fed, which has been very focused on the issue of systemic risk since the financial crisis of 2008-2009, was given expanded authority under the Dodd-Frank Act to supervise large banks whose failure might tank the U.S. economy. And if the Federal Reserve thinks the growth of very large institutions after decades of M&A-driven consolidation has created a higher level of systemic risk in the banking system, why would it allow them to get any larger?

In a speech last October at the University of Pennsylvania Law School, Federal Reserve Gov. Daniel Tarullo most likely signaled the central bank’s position on large bank mergers for the foreseeable future. “[I] would urge a strong, though not irrebuttable, presumption of denial for any acquisition by any firm that falls in the higher end of the list of globally systemically important banks developed by the Basel Committee for the purposes of assessing capital surcharges,” Tarullo said. “Firms at the lower end of the Basel Committee list, or that U.S. authorities may later designate as domestic systemically important banks…might have a slightly less robust, but still significant presumption against acquisitions.” 

Tarullo said he was speaking “for myself only” and not the Fed’s Board of Governors, although I doubt he would have ventured so far out on a limb if he thought it might be sawed off behind him since Fed governors tend to be pretty cautious in their public statements. 

I have covered the banking industry as a financial journalist since the mid-1980s, including that period of tremendous consolidation in the ‘90s, and now find it somewhat ironic that the Fed apparently has a much less accommodating view of mergers between large banks than it used to. Back in the day (which is to say, the ‘90s), large bank deals were rarely challenged by the regulators—including the Federal Reserve—on grounds other than Community Reinvestment Act considerations. 

The two most important pieces of financial deregulation legislation passed by the U.S. Congress in the 1990s—the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which accelerated a process of nationwide banking that was already underway regionally, and the Gramm-Leach-Bliley Act of 1999, which repealed the Depression-era Glass-Steagall Act and allowed commercial and investment banks and insurance companies to be owned by the same corporate parent—were largely supported by the federal banking regulators.

Riegle-Neal (which imposed the 10 percent cap on bank deposits) helped create the scale, and Gramm-Leach-Bliley (which largely formalized the Fed’s gradual loosening of the Glass-Steagall restrictions on commercial and investment banking that had begun in the 1970s) helped create the complexity that regulators worry about today. The potential havoc that the failure of systemically important institutions like Bank of America, JPMorgan and Citigroup could wreck on the U.S. financial system is a result of their size and complexity, and as a nation we started down this road to perdition decades ago whether we recognized it at the time or not. Consolidation and deregulation were de facto national policies through most of the 1990s, and the growth of large and complex institutions is its natural consequence. 

As their stock prices gradually recover in the years ahead (as I’m sure they will), it will be interesting to see what stance the Fed takes if and when institutions like Citi (which controls just 4.44 percent of U.S. bank deposits), Capital One Financial Corp. (2.58 percent), U.S. Bancorp (2.47 percent), PNC Financial Services Group Inc. (2.27 percent) and BB&T Corp. (1.51 percent) want to reenter the bank M&A market.  All, with the exception of Citi, have been active domestic acquirers in recent years.

If the Federal Reserve can devise a system of regulation for systemically important banks that it has confidence in, then perhaps some of these very large banks will someday be allowed to grow a little larger. But without such confidence at the Fed, we might have reached the end of an era in which the growth of very large and highly diversified financial institutions that could compete on a global stage was something to be encouraged rather than feared. 

Is this just a timeout for large bank mergers, or is this game over?

Bank M&A Expectations in 2013


Bank M&A may face serious challenges in 2013. In this video, Rick Childs of Crowe Horwath LLP highlights findings from the 2013 Bank Director & Crowe Horwath LLP M&A survey, revealing a disconnect between buyers and sellers that may hinder the pace of M&A. Some banks might be willing to look outside of core banking as an avenue for growth – but for smaller banks, branch acquisitions should not be overlooked.