Keeping Benefits Simple During M&A

Mergers and acquisitions are an attractive growth strategy for many banks, but deals are increasingly and needlessly complicated by existing employee benefit plans.

The United States entered the longest economic expansion in history during the third quarter of 2019, surpassing the 120-month run between March 1991 to March 2001. There have been parallels of economic events and potential perils between then and now: a strong housing market, corporate tax cuts, low interest rates, and a mergers and acquisitions environment that rivals the 1990s, resulting in a loss of more than 4% of the nation’s banks per annum on average. From March 1991 to today, the number of U.S. banks has decreased by over 60%. The industry is not only used to M&A but expects it.

But in recent years, we’ve seen a growing burden and complexity in navigating through bank M&A deals, in part due to existing nonqualified benefit plans and bank-owned life insurance, or BOLI, programs. Burdens include heightened regulations on allowable plan designs, evolving tax laws and stricter compliance and due diligence requirements.

Now more than ever, it has become increasingly likely that BOLI or nonqualified benefit plans will be involved in a transaction, and odds are that the acquired portfolio and plans were part of a previous deal.

About 64% of banks across the country owned BOLI at the end of 2018, according to data from S&P Global Market Intelligence, including 63% of banks under $2.5 billion in total assets, 82% of banks between $2.5 billion and $35 billion, and 64% of banks over $35 billion.

The BOLI market continues to expand as banks continue to consolidate, and new premium sales have averaged over $3.5 billion annually in the past five years. Additionally, approximately 65% of banks have a nonqualified benefit plan, split-dollar life insurance plan or both, based on records of Newcleus’ 750 clients.

Program sponsorship continues to expand, because BOLI and nonqualified benefits continue to be important programs for institutions. Implementing nonqualified benefit plans can serve as a valuable resource for banks looking to attract and retain key talent. Both selling and acquiring institutions need to understand the mechanics of benefit and BOLI programs in order to avoid inaccurate plan administration and mismanagement following a combination. This includes:

Non-Qualified Benefit Plans

  • Reviewing the plan agreement: Complete a thorough analysis of the established plan agreements. Understand all triggering events for benefits, available options to exit the plan and the agreement’s change-in-control language.
  • Accounting implications: The bank, in partnership with their plan administrator, should properly vet the mechanics and assumptions used in existing plan accounting. For example, change-in-control benefits could specify a discount rate that must be used for benefit payments, which may differ from rates used on existing accounting reports. They should also ensure that all plan benefits deemed de minimis have been accounted for, such as small split-dollar plans.
  • 280G: Complete a 280G analysis to understand the possible implications of excess parachute payments, including limitations (i.e. net best benefit provisions) caused by existing employee agreements and related non-compete provisions.

BOLI Programs

  • Insurance carrier due diligence: Bankers should complete a thorough review to ensure that acquired BOLI meets the holding requirement that is outlined by the bank’s existing BOLI investment policy, if applicable.
  • Active/inactive BOLI population: As the insured and surviving owner relationship becomes more separated, it is paramount that executives maintain detailed census information, including Social Security numbers, for mortality and insurable interest purposes.
  • Policy ownership: Many banks have implemented trusts to act as the owner of certain BOLI policies. While this setup is permissible, changes in control can impact a trust’s revocability. Institutions should review this information prior to closing, given that there may be limited options to directly manage those policies post-deal close.

These programs are not in the executives’ everyday purview, nor should they be. That’s why it’s so important for institutions to establish partnerships that help guide them through the analysis, documentation and due diligence process for BOLI and nonqualified benefit plans.

Banks may want to consider working with external advisors to conduct a thorough review of existing programs and examine all plan details. They may also want to consider administrative systems, like Newcleus MINTS, that streamline reporting and compliance requirements. Taking these steps can help reduce unnecessary headaches, and create a solid foundation for future BOLI purchases and new nonqualified benefit plans.

2019 Mid-Year Bank M&A Outlook


merger-8-5-19.pngWhat might the second half of 2019 bring for bank mergers and acquisitions (M&A)?

The favorable drivers in the first half of 2019 — the regulatory landscape, enhanced earnings as a result of tax reform, desire for scale and efficiency, and the search for digital capabilities — will likely continue to be the catalysts for bank M&A activity in the second half of 2019. While the market has not seen a spike in the bank M&A deal volume, overall deal values continue to rise because of a few large transactions, including mergers with price tags of a $28 billion and a $3.6 billion. The following trends and drivers are expected to continue to have an impact on banking M&A activity in the second half of 2019 and beyond.

Intensifying Battle for Secured Customer Deposit Bases
U.S. banks’ deposit costs rose far more quickly than loan yields in the first quarter of 2019; further increases in deposit costs may prevent net interest margins from expanding in 2019. As the competition for deposits intensifies, buyers are increasingly looking for banks with a secured deposit base, especially those with a significant percentage. Moreover, as deposit betas accelerate — even as the Federal Open Market Committee slows rate hikes — it becomes more difficult for banks to grow deposits.

With the largest banks attempting to grow their deposit market share via organic customer growth, the regional and super regional banks are trying to develop similar presences through acquisitions. Banks that can navigate this rate environment ably should emerge as better-positioned acquirers via their stock currency, or sellers through the attractiveness of their funding base.

Favorable Regulatory Environment
Dodd-Frank regulations have eased over the past 12 months, increasing the threshold for added oversight and scrutiny from $50 billion in assets to $250 billion. Easing bank regulations and tax reforms that create surplus capital could continue driving regional and super regional consolidation. Moreover, banks with $250 billion to $700 billion in assets may continue to benefit in the second half of 2019 from a more-favorable regulatory landscape.

MOE’s Potential Change on the Competitive Landscape
There were a couple of mergers of equals (MOE) in the first half of 2019 that were welcomed by investors — an indication that the industry could be likely to see a rise in the volume of larger transactions in 2019. Regional banks that miss the MOE wave in the near term may soon find themselves without a “partner” after the initial wave of acquisitions occurs.

As the banks pressure-test their MOE strategy, the key may be to find a partner with strategic overlap to drive the synergies and justify the purchase price premium yet also provide an opportunity for growth and geographic footprint. Furthermore, unlike smaller tuck-ins, MOE requires additional strategic diligence and capabilities. This includes the ability to successfully integrate and scale capabilities, the ability to cross-sell to newly acquired segments, the ability to consolidate branches in overlapping markets and integrating divergent management processes and culture.

The Hunt for Digital Capabilities
Evolving consumer wants and the table stake needed to provide an integrated digital ecosystem are compelling many bank executives to differentiate themselves via technology and digital channels growth. Investors typically place a premium on digital-forward banks, driving up multiples for banks with efficient ecosystems of digital capabilities. The hunt for digital capabilities may provide an opportunity to not only add scale, but also transform legacy banks into agile, digital-first banks of the future.

Bank boards and executives should remain cognizant of above trends as they progress through their strategic M&A planning. Their resulting decisions — to be buyer, seller or an observer on the sidelines — may shape bank M&A activity in the second half of 2019 and into 2020.

Moreover, while the banks continue to assess the potential impact of the current expected credit loss (CECL) standard, the general market consensus is CECL may require a capital charge. As such, M&A credit due diligence should be treated as an investment in reducing future losses, even though the loan quality is currently viewed as benign. Successfully driving value from acquisitions while mitigating risks requires a focused lens on M&A strategy with the right set of tools, teams and processes to perform due diligence, execute and integrate as needed.

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How CECL Impacts Acquisitive Banks


CECL-7-30-19.pngBank buyers preparing to review a potential transaction or close a purchase may encounter unexpected challenges.

For public and private financial institutions, the impending accounting standard called the current expected credit loss or CECL will change how they will account for acquired receivables. It is imperative that buyers use careful planning and consideration to avoid CECL headaches.

Moving to CECL will change the name and definitions for acquired loans. The existing accounting guidance classifies loans into two categories: purchased-credit impaired (PCI) loans and purchased performing loans. Under CECL, the categories will change to purchased credit deteriorated (PCD) loans and non-PCD loans.

PCI loans are loans that have experienced deterioration in credit quality after origination. It is probable that the acquiring institution will be unable to collect all the contractually obligated payments from the borrower for these loans. In comparison, PCD loans are purchased financial assets that have experienced a more-than-insignificant amount of credit deterioration since origination. CECL will give financial institutions broader latitude for considering which of their acquired loans have impairments.

Under existing guidance for PCI loans, management teams must establish what contractual cash flows they expect to receive, as well as the cash flows they do not expect to receive. The yield on these loans can change with expected cash flows assessments following the close of a deal. In contrast, changes in the expected credit losses on PCD loans will impact provisions for loan losses following a deal, similar to changes in expectations on originated loans.

CECL will significantly change how banks treat existing purchased performing loans. Right now, accounting for purchased performing loans is straightforward: banks record loans at fair value, with no allowance recorded on Day One.

Under CECL, acquired assets that have only insignificant credit deterioration (non-PCD loans) will be treated similarly to originated assets. This requires a bank to record an allowance at acquisition, with an offset to the income statement.

The key difference with the CECL standard for these loans is that it is not appropriate for a financial institution to offset the need for an allowance with a purchase discount that is accreted into income. To take it a step further: a bank will need to record an appropriate allowance for all purchased performing loans from past mergers and acquisitions that it has on the balance sheet, even if the remaining purchase discounts resulted in no allowance under today’s standards.

Management teams should understand how CECL impacts accounting for acquired loans as they model potential transactions. The most substantial change relates to how banks account for acquired non-PCD loans. These loans first need to be adjusted to fair value under the requirements of accounting standards codification 805, Business Combinations, and then require a Day One reserve as discussed above. This new accounting could further dilute capital during an acquisition and increase the amount of time it takes a bank to earn back its tangible book value.

Banks should work with their advisors to model the impact of these changes and consider whether they should adjust pricing or deal structure in response. Executives who are considering transactions that will close near their bank’s CECL adoption date not only will need to model the impact on the acquired loans but also the impact on their own loan portfolio. This preparation is imperative, so they can accurately estimate the impact on regulatory capital.

Building a Stronger Bank



Following an acquisition or merger, many banks struggle to build and strengthen their brand. The branch channel is an important part of the franchise for most institutions, so determining which locations to keep, and which to close, is a key strategic decision post-merger. In this video, Anthony Burnett of Level 5 explains how to approach these decisions. He also shares how banks can position themselves for future growth by evaluating opportunities and staffing, and developing a long-term growth plan for the back office.

  • Strategies that Strengthen Your Bank’s Brand
  • Making Decisions About Branch Redundancies
  • Addressing the Back Office
  • Positioning the Bank for Future Growth

Consolidating Technology for a Merger of Equals


merger-4-24-19.pngMergers of equals are gaining in popularity, judging by the flurry of recently announced deals, but a number of tough decisions about technology have to be made during the post-merger integration phase to set up the new bank for success.

After every deal, management teams are under a great deal of pressure to realize the deal’s projected expense savings as quickly as possible. While the average industry timeline to select and negotiate a core processing contract is nine months, a bank merger team has about a third of that time—the Cornerstone framework estimates 100 days—to choose not just the core, but all software as well, and to renegotiate pricing and contract terms for the most critical systems so that integration efforts can begin.

Start with the Core
A comparison of core systems is often the first order of business. These five factors are the most relevant in determining which solution will provide the best fit for the post-merger institution:

  • Products and services to be offered by the continuing bank. If one institution has a huge mortgage servicing portfolio or a deeper mix of commercial lending, complex credits and treasury management, the core system will need to support those products.
  • Compatibility and integration with preferred digital banking solutions. If one or both merger partners rely on the delivery channel systems offered by their core providers, the integration team should evaluate the core, online and mobile solutions as a bundled package. On the other hand, if the selection process favors a best-of-breed digital channel solution with more-sophisticated service offerings, that decision emphasizes the need for a core system that supports third-party integration.
  • Input from system users. The merger team must work closely with other departments to evaluate the functionality of the competing core systems for their operations and interfacing systems.
  • Contractual considerations. The costs of early contract termination with a core, loan origination, digital channel or other technology provider can be significant, to the point of taking priority over functionality considerations. If it is going to cost $4 million to get out of a digital banking contract, the continuing organization may be better off keeping that system, at least in the near-term.
  • Market trends. Post-merger, the combined bank will be operating at a new scale, so it may be instructive to look at what core systems other like-size financial institutions have chosen to run their operations.

A lot of factors come into play when the continuing bank is finalizing what that solution set looks like, but at the end of the day, it is about functionality, integration, cost and breadth of services.

Focus on the Top 20
The integration team should use a similar process to select the full complement of technology required to run a modern financial institution. Cornerstone suggests ranking the systems currently in operation at both banks by annual costs, based on accounts payable data sorted by vendor in descending order. Next, identify contract lifecycle details to compare the likely costs of continuing or ending each vendor relationship, including liquidated damages, deconversion fees and other expenses.

That analysis lays the groundwork to assess the features, functionality and pricing of like systems and rank which options would be most closely aligned with customer service strategies, system capabilities and cost efficiencies. It might seem that an objective, side-by-side comparison of technology systems should be a straightforward exercise, but emotions can get in the way.

A lot of people are highly passionate and have built their bank on being successful in the market. That passion may come shining through in these discussions—which is not necessarily a bad thing.

Working with an expert third party through the processes of system selection and contract negotiations can help provide an objective perspective and an insider’s view of market pricing. An experienced business partner can help technology integration teams and executives set up effective decision-making processes and navigate the novel challenges that may arise in realizing a central promise in a merger of equals—to create value through vendor cost reductions.

Toward that end, the due diligence process should identify about 20 contracts—for the core, online and mobile banking, treasury management, card processing and telecom systems, to name a few—to target for renegotiation in advance of the official merger date. A bank has hundreds of vendors to help run the enterprise, but it should focus most of the attention on the top 20. The bank can drive down costs through creative economies of scale by focusing on those contracts that are the most negotiable.

With its choice of two solutions for most systems and the promise of doubling volume for the selected vendors, the new bank can negotiate from an advantageous position. But its integration team must work quickly and efficiently to deliver on market expectations to assemble an optimal, cost-effective technology infrastructure—without cutting corners in the selection process and contract negotiations.

Think of this challenge like a dance. It is possible to speed up the tempo, but it is not possible to skip steps and expect to end up in the right place. The key components—the proper due diligence, financial reviews and evaluations—all still need to happen.

Download the free white paper, “Successfully Executing a Merger of Equals,” here.

Credit Due Diligence Is Even More Important Now


due-diligence-4-17-19.pngWith loan quality generally viewed as benign while M&A activity continues into 2019, is any emphasis on credit due diligence now misplaced? The answer is no.

With efficiency driving consolidation, bank boards and management should not be tempted to take any shortcuts to save time and money by substituting credit quality through recent loan reviews and implied findings of regulatory exams.

The overarching reason is the nature of the current business and credit cycle. The economy is strong right now, and among many banks net recoveries have replaced net charge-offs.

But it is not a matter of if but when credit stress rears its head.

And time truly is money when trying to stay ahead of the turn of the credit worm. That means now is the time to highlight a few buy- or sell-side justifications for a credible M&A credit due diligence.

Some challenges always require vigilance. These include:

  • Heightened correlated lending concentrations
  • Superficial underwriting and/or servicing
  • Acquired third-party exposures through participations or syndications
  • Insider lending (albeit indirect)
  • Getting upside down on commodity or collateral valuations
  • Covenant-light lending
  • Credit cultural incongruity

New Risks, New Assessments
The emergence of a portfolio-wide macro approach to credit risk during the past decade has ushered in a flurry of statistical disciplines, such as calculating probabilities of default, loss-given defaults, risk grade migrations, and probability modeling to project baseline and stress loss credit marks for investors and acquirers.

Credible due diligence now provides rich assessments of various pools and subsets of loans within a target’s portfolio. These quantitative measures provide a precise estimate of embedded credit losses, in parallel with the adoption of the current expected credit loss (CECL) standard, to project life of portfolio credit risk and end deficiencies in the current allowance guidance.

Good credit assessment is capped by qualitative components. There are several factors to consider in the current credit cycle.

  • Vintage of loan originations: Late-cycle loans to chase growth goals or to entice investors carry higher risk profiles.
  • Exotic lending: Some banks have added less conventional loan products to their offerings, which may require specialized talent.
  • Leveraged financial transactions: For some banks, commercial and industrial (C&I) syndications have replaced the real estate participation of a decade ago. They have recently grown in leverage and stress, and would be susceptible to an economic downturn.
  • Hyper commercial real estate valuation increases: Recent studies have shown significant increases in commercial property values, well over the pace of residential 1-4 family properties, along with the headwinds of higher interest rates and the advent of diminished real estate requisites accompanying the tech-driven virtual marketplace.
  • Dependence on current circumstance as proxies for future credit quality: We must accept that we are affected by trailing, rather than by leading, credit metric indicators.
  • Lending cultural protocols: Knowing the skill sets and risk appetites of prospective teammates is imperative. Some would argue that in today’s consolidation environment, cultural incongruity trumps loan quality as the biggest determinant of success.

What Should Lie Ahead
Credit due diligence should provide a key strategic forerunner to the financial and cultural integration between institutions that might have disparate lending philosophies.

It should include an in-depth quantitative dive combined with a skilled assessment of qualitative factors, both of which are critical in providing valuable insight to management and the board. Yet, to reduce costs some have difficulty swallowing any in-depth credit diligence, given the de minimis nature of recent losses and low levels of problem loans.

Many economic indicators point to tepid economic growth in 2019. At some point, the current credit cycle will turn. A lesson learned from the financial crisis has been to be proactive in risk management to stay ahead of the risk curve—and not be left to be reactive to negative effects.

During the crisis, many banks suffered greater losses due to their reluctance to initiate remediation in response to deteriorating credit. M&A credit due diligence must be treated as an anticipation of the future, not a validation of the past, and an investment in curtailing future losses.

Integration: Keeping The Best



Bank leadership teams that approach an acquisition with an open mind will have the best odds for successfully integrating the target, says Kim Snyder of KBS Results. In this video, she shares the three most common misconceptions held by acquirers. She also outlines how banks should communicate to employees and customers about an acquisition, and explains how to approach technology integration—so acquirers can ensure the target’s customers stay with the merged institution.

  • Common Misconceptions
  • Communicating to Employees
  • Explaining Benefits to Customers
  • Getting Technology Integration Right

 

Preserving Franchise Value



The factors that help banks maximize value—including growth and profitability—are relatively timeless, though the importance of each value driver tend to change with the operating environment. But the way a bank pursues a sale impacts its valuation. In this video, Christopher Olsen of Olsen Palmer outlines the three ways a bank can pursue a sale. He also explains why discretion is key to preserving franchise value.

  • Factors Driving Today’s Valuations
  • The “Goldilocks” Process for Selling Banks
  • The Importance of Discretion

 

Bank M&A in 2019: Is It a New World?


Much like the countless dystopian novels and movies released over the years, the environment today in banking begs the question of whether we’ve entered a so-called new world in the industry’s M&A domain.

Deal volume in 2018 was roughly equal to 2017 levels, though many regions in the country saw a decline. And while it’s still early in 2019, the first two months of the year have been marked by a pair of large, transformative deals: Chemical Financial Corp.’s merger with TCF Financial Corp., and BB&T Corp.’s merger with SunTrust Banks. These deals have raised hopes that more large deals will soon follow, creating a new tier of banking entities that live just below the money-center banks.

Aside from these two large deals, however, M&A volume throughout the rest of the industry is down over the first two months of the year. As you can see in the chart below, this continues a slide in deal volume that began at the tail end of 2018.

Announced Bank Deals.png

Bank Director’s 2019 Bank M&A Survey highlights a number of the factors that might impact deal volume in 2019 and beyond.

Fifty-seven percent of survey respondents indicated that organic growth is their current priority, for instance, though respondents were open to M&A opportunities. This suggests that banks are more willing to focus on market opportunities for growth, likely because bank management can more easily influence market growth than M&A. The strength of the economy, enhanced earnings as a result of tax reform, easing regulatory oversight and industry optimism in general also are likely contributing to the focus on market growth.

The traditional chasm between banks that would like to be acquirers and banks that are willing to be sellers seems to be another factor influencing banks’ preference for organic market growth. In all the surveys Crowe has performed of bank directors, there always are more buyers than sellers.

The relationship between consolidation and new bank formation also weighs on the pace of acquisitions. If the pool of potential and active acquirers remains relatively stable, the determiner is the available pool of sellers. Each year since 2008, the number of acquisitions has exceeded the number of new bank formations. The result is an overall decrease in the number of deals. It stands to reason, in turn, that this will lead to fewer deals each year as consolidation continues.

Current prices for bank stocks also have an impact on deal volume. You can see this in the following chart, which illustrates the “tailwind” impact on deal volume for publicly traded banks. Tailwind is the percentage by which a buyer’s stock valuation exceeds the deal metrics. When the percentage is high, trading price/tangible book value (TBV) exceeds the deal price/TBV and deal volume is positively affected. The positive impact sometimes is felt in the same quarter, but there can be a three-month lag.

Deal Volume.png

In the beginning of 2019, bank stock prices recovered some of the declines they experienced in the latter half of last year, but they still are at a negative level overall. If bank stock prices continue to lag behind the broader market, as they have over the past year (see the chart below), deal volume likely will be affected for the remainder of the year.

Bank Stock Prices.png

It’s still too early to predict how 2019 will evolve for bank M&A. Undoubtedly there will be surprises, but it’s probably fair to assume a slightly lower level of deals for 2019 compared to 2018.

Advice for Buyers & Sellers in 2019



The need for stable, low-cost deposits is driving deals today, and the increasing use of technology is changing how banks should approach integrating an acquisition. In this video, Bill Zumvorde of Profit Resources shares what prospective buyers and sellers need to know about the operating environment. He also explains how bank leaders can better integrate an acquisition and how potential sellers can get the best price for their bank.

  • Today’s M&A Environment
  • Common Integration Mistakes
  • Maximizing Acquisition Success
  • Tips for Prospective Sellers