Bank M&A: Pricing Considerations for 2018



Forty-four percent of the bank executives and directors responding to Bank Director’s 2018 Bank M&A Survey indicate that rising bank valuations made it more difficult to compete for acquisition targets, and higher prices didn’t result in a significant increase in deal activity in 2017. Rick Childs, a partner at survey sponsor Crowe Horwath LLP, explains how today’s environment fuels his expectations for the year, and why he thinks regulatory relief could result in fewer transactions.

  • Bank Valuations and Pricing
  • Impact of Regulatory Relief on M&A

In accordance with applicable professional standards, some firm services may not be available to attest clients. © 2018 Crowe Horwath LLP, an independent member of Crowe Horwath International. crowehorwath.com/disclosure

Strengthening Your Bank’s M&A Strategy



Bank M&A activity will likely increase in 2018, but many banks don’t have the in-house expertise and procedures to successfully navigate a deal. Phil Weaver of PwC explains the factors that will fuel deal volume and why banks need to update their M&A playbooks.

  • Why 2018 Will See More Deals
  • Beefing Up the Bank’s M&A Playbook
  • Talent Considerations in Executing a Deal

Acquirers Cautious and Disciplined in 2017


merger-1-8-18.pngThe bank M&A market was no doubt a disappointment to buyers and sellers alike in 2017, because it failed to rocket skyward on the strengths of a steady economy and the Republican Party’s control of both the White House and Congress, factors that helped boost bank stock valuations for most of the year. However, higher valuations didn’t translate into a surge in deals compared to the recent past. There were 261 healthy bank acquisitions in 2017 compared to 240 deals in 2016 and 278 in 2015. If buyers had more money to spend thanks to their higher stock valuations, then sellers were expecting a higher price for the same reason, and the two factors helped cancel each other out.

Notably absent from the list of deals were the mega-transactions that in decades past both drove and defined the bank M&A market. The largest deal in 2017 was Montebello, New York-based Sterling Bancorp’s $2.3 billion acquisition of Astoria Financial Corp. in Lake Success, New York. The second largest deal last year was Memphis, Tennessee-based First Horizon National Corp.’s $2.2 billion purchase of Capital Bank Financial Corp. in Charlotte, North Carolina. Of the 25 largest deals in 2017, according to S&P Global Market Intelligence, all but the top five were valued at less than $1 billion. One reason for this has been the absence of large banks over $50 billion in assets from the market, which have largely been blocked from doing deals by their regulators since the financial crisis and passage of the Dodd-Frank Act of 2010, which subjected them to a much higher level of government oversight. Deal activity has since been driven by smaller regional banks with more limited buying capacity.

Top 10 Bank M&A Deals in 2017

Buyer State Seller State Deal Value (Millions)
Sterling Bancorp NY Astoria Financial Corp. NY $2,230
First Horizon National Corp. TN Capital Bank Financial Corp. NC $2,189
Pinnacle Financial Partners TN BNC Bancorp NC $1,732
IBERIABANK Corp. LA Sabadel United Bank N.A. FL $1,028
First Financial Bancorp. OH MainSource Financial Group IN $1,006
Valley National Bancorp NJ USAmeriBancorp FL $852
Home BancShares AR Stonegate Bank FL $781
PacWest Bancorp CA CU Bancorp CA $706
Union Bankshares Corp. VA Xenith Bankshares VA $700
South State Corp. SC Park Sterling Corp. NC $694

Source: S&P Global Market Intelligence

But even without the absence of large acquirers, bank M&A has also become a more cautious and disciplined market in recent years, including 2017. “Because there is a limited group of buyers, they can be choosey,” says Gary Bronstein, a partner at the law firm of Kilpatrick Townsend & Stockton. “They tend to be disciplined, and what we’ve experienced from representing sellers is that many times when you contact that group of buyers, they’ll give you any number of reasons why they’re not interested. Could be because they’re working on something else. Could be that they have five other deals that they’re looking at, and this doesn’t fit their criteria.”

Twelve of the 25 largest deals were market extensions where the acquirers crossed state lines in search of growth. “Serial acquirers are continuing to bolt on sensible market extension transactions, with a few in-market deals,” says Steve Kent, a managing director in the financial services group at Piper Jaffray. For example, Nashville-based Pinnacle Financial Partners’ acquisition of BNC Bancorp gives it a significant presence in North Carolina. “The deal provided Pinnacle with a new geography and reasonable market share entry into North Carolina and a platform to support future growth across a larger geographic footprint,” says Bill Hickey, a principal and co-head of investment banking at Sandler O’Neill + Partners. “Pinnacle is a very good lender on the commercial side. Bank of North Carolina is very good on the commercial real estate side, so they fit together quite well. This bank has one of the best platform for growth in the country and the team to execute on that growth strategy.”

First Horizon’s acquisition of Capital makes it the fourth largest bank in the Southeast and was the company’s first acquisition of a commercial bank since the financial crisis, when its performance suffered after the collapse of the residential mortgage market. “This is a clear announcement that they are back and looking to play in the broader Southeast again,” says Robert Klingler, a partner at the law firm Bryan Cave.

The largest acquisition last year—Sterling’s takeover of Astoria—was actually more of an in-market deal, although Sterling’s presence was largely in metropolitan New York and counties to the north, while Astoria operated primarily on Long Island. “You have a pretty nice business combination between an asset generator, which is Sterling, and a pretty good funding base, which is Astoria, with very attractive markets in Long Island and the New York metro market,” says Hickey. The deal also has the marked distinction of being just one of five transactions in the top 25 that were immediately accretive to shareholders.

One interesting footnote to the M&A market in 2017 was the decision by three active acquirers to become sellers. Capital Bank, BNC Bancorp and Park Sterling Corp. in Charlotte, which was acquired by Columbia, South Carolina-based South State Corp. in a $640 million deal, cashed out after building attractive franchises through a series of deals. That all three banks are located in North Carolina might create a dilemma for small banks in the Tar Heel State that were hoping to sell themselves to one of those institutions and now must look elsewhere for a buyer.

Are You Overlooking a Major M&A Obstacle?


merger-1-1-18.pngPeople often think about the Herfindahl-Hirschman Index (HHI) in relation to its effect on large, public transactions. However, as smaller community banks look to merge with other small banks in their markets or in adjacent communities, the HHI is increasingly becoming an issue. This often overlooked component of a merger could cause significant regulatory impacts on the structure and success of a transaction. For example, one small community bank recently had to withdraw from a bid process because of insurmountable HHI concerns cited by the federal regulators.

What is the HHI?
The HHI is a commonly accepted measure of market concentration that is generally used when evaluating business combinations. It is calculated by squaring the market share of each bank competing in a given market and then summing the resulting numbers. As the number of banks in a market decreases or the disparity in size increases, the HHI will increase proportionately. A moderately concentrated market has an HHI of 1,500 to 2,500 points, and anything greater than 2,500 is considered heavily concentrated. Generally, if an acquisition will increase the HHI by more than 200 points, it will be heavily scrutinized by the federal regulators and may ultimately be rejected.

How Can You Assess Your Bank’s HHI Market?
The U.S. Department of Justice and the Federal Reserve created the Competitive Analysis and Structure Source Instrument for Depository Institutions (CASSIDI) to allow financial institutions to easily determine the effect that a proposed merger would have on the market’s HHI. It is a simple tool that allows anyone to run the HHI calculation on the financial institution of his or her choosing. The CASSIDI calculation can help bank management teams determine the necessary steps they may have to undertake in order to get a deal approved.

As explained above, the HHI calculation takes into account all banks in a certain market. CASSIDI allows users to search the markets to determine which market that a deal would fall into. However, the DOJ and the Federal Reserve have the ability to amend the market to include a larger or smaller area in the HHI calculation. Therefore, while CASSIDI may be very helpful, it can be an imperfect indicator of the validity of your transaction under the HHI calculation. It is important to contact your local regulator to determine the exact market that would be used for your proposed transaction. Your regulator will be able to assist you in running a more exact calculation if you suspect your proposed transaction may increase the HHI by over 200 points.

Are Credit Unions Included in the HHI?
At this time, the CASSIDI calculation does not include any market share held by credit unions. However, regulators may consider including credit unions in the structural concentration calculations in the event an application exceeds the delegation criteria in a given market. Generally, credit unions may be included in these calculations if two conditions are met: first, the field of membership includes all, or almost all, of the market population, and second, the credit union’s branches are easily accessible to the general public. In such instances and at the regulator’s discretion, a credit union’s deposits will be given 50 percent weight. If a credit union has a significant commercial lending presence and staff available for small business services, then its deposits may be eligible for 100 percent weighting, though such an outcome is very rare.

How Can You Fix an HHI Issue?
If you perform an HHI calculation and find that your proposed transaction will exceed the 200 point threshold, there are a few options to consider. You can assert that there are mitigating factors at play, or that a broader market should be considered. Another common solution is to divest certain legacy or acquired assets. For example, financial institutions will sometimes sell a branch in markets where the two parties compete directly in order to complete a merger. Over the past 40 years, divestiture has become an important antitrust remedy for parties looking to complete their deals. That being said, divestiture may not always be practical in a merger of two small banks with limited branch locations.

Financial institutions continue to see a large volume of merger activity. The current costs of operating a bank indicate that this activity will continue to grow. While the HHI is an obvious concern for large deals, it should be on the radar of small community banks as well. Your bank’s board and management team should analyze the anti-competitive effects of any proposed transaction early in the negotiation process.

The M&A Limitations of Privately-Held Banks


More than half of bank executives and directors responding the Bank Director’s 2018 Bank M&A Survey see an environment that’s more favorable to deal activity, but those at privately-held institutions—which comprise 52 percent of survey respondents—are slightly more likely to see a less favorable environment for deals, and significantly more likely to expect limitations in their ability to attract an acquisition partner and complete the transaction.

In the survey, 30 percent of respondents from private banks say their bank has acquired or merged with another institution within the past three years, compared to 53 percent of respondents from publicly traded institutions. Respondents from private banks—which, it should be noted, also tend to be smaller institutions—are also less likely to believe that their bank will acquire another institution in 2018, with 47 percent of private bank respondents saying their institutions are somewhat or very likely to acquire another bank within the next year, compared to 61 percent of public bank respondents.

Rising bank valuations are largely to blame for dampened enthusiasm on the part of private banks that would like to consider acquisitions as a growth strategy, but feel excluded from the M&A market. Higher valuations mean two things. Potential sellers have higher price expectations, according to 84 percent of survey respondents. And public buyers—whose currency now holds more value in a favorable market—could have an edge in making a deal. Half of private bank respondents say that rising bank valuations have made it more difficult for the institution to compete for or attract acquisition targets, compared to 36 percent of respondents from public banks looking to acquire.

manda-bank-valuations-chart.png

For the most part, private buyers “have to do an all-cash deal,” says Rick Childs, a partner at Crowe Horwath LLP, which sponsored the 2018 Bank M&A Survey. Banks under $1 billion in assets have some flexibility in leveraging their holding company to lessen the impact on the bank’s capital ratios in such a transaction, as a small bank holding company can use debt to fund up to 75 percent of the purchase price. “I can borrow fairly easily in today’s environment at the holding company, then fuse it down into the bank and make the capital ratios acceptable, and be able to use those cash funds,” says Childs. “But it does mean that there’s an upper limit on how much [the bank] can pay because of the goodwill impact, and that I think is having a detrimental impact on [privately-held] institutions.”

Thirty-five percent of private bank respondents say they would favor an all-cash transaction if their bank were to make an acquisition, compared to 5 percent of public respondents. More than half of private bank respondents would want to structure a transaction as a combination of cash and stock—despite these banks’ stocks being thinly traded at best and relatively illiquid. Equity in the transaction “potentially adds to the pool of available shareholders who might want to buy stock back and produce a more liquid market,” says Childs. While some sellers may prefer to take stock in a deal to defer taxes until the stock can be sold, shareholders still want to know that they will be able to take that stock and cash out if desired. Private buyers that want to issue stock in the transaction should have a plan for that stock to become more liquid within a relatively short period of time, says Childs. Remember, boards have a fiduciary duty to represent their owners’ best interests. If another bank is willing to offer a deal that provides more liquidity, that’s going to be of more interest to most sellers.

manda-transaction-chart.png

For a private bank, offering a cash deal has its benefits, despite limiting the size of the target the bank can acquire. Just 39 percent of private bank directors and executives responding to the survey say they would agree to an all-stock or majority-stock transaction if the board and management team sold the bank, compared to 63 percent of public bank respondents. “For some sellers, that’s actually easier to understand, because it gives you ultimate liquidity and takes some of the decision-making anxiety out of the seller’s hands” in terms of how long the seller should hold onto the stock and how it fits within that person’s portfolio, says Childs. The tax repercussions are immediate, but the seller is also paying today’s tax rates, versus an unknown future rate that could be higher.

That’s not to say that private banks won’t make deals in 2018. Some will, of course, buy other banks. But other types of transactions could pique the interest of private institutions and be particularly advantageous. Branch deals allow banks to cherry-pick the markets they want to enter and pick up deposits at a better price, says Childs. Thirty-nine percent of respondents from privately-held banks say their institution is likely to buy a branch in 2018, compared to 30 percent of public bank respondents.

acquisition-chart.PNG

Private banks are also more inclined to acquire nondepository lines of business, as indicated by 30 percent of survey respondents from private banks, compared to 20 percent from publicly traded institutions. Acquiring wealth management firms and specialty lending shops are of particular interest to private banks, according to Childs. Both allow the institution to expand its services to customers and generate fee income without going too far afield of the bank’s primary strategic focus.

Both branch and nondepository business line acquisitions carry fewer due diligence and integration burdens as well.

Potential regulatory reform on the horizon could make the deal environment even more competitive, says Childs. Bank boards and management teams that worried about the impact of the regulatory burden on the sustainability of their bank may feel that the viability of their institution as an independent entity is suddenly more certain. “That likely lowers the pool of institutions that feel like they have to sell,” says Childs. And most bank executives and directors indicate that they want to remain independent—in this year’s survey, just 18 percent of respondents say they’re open to selling, with another 4 percent indicating their institution is considering a sale or in an agreement with another bank, and 1 percent actively seeking an acquirer.

The 2018 Bank M&A Survey gathered responses from 189 directors and executives of U.S. banks to examine the M&A landscape, M&A strategies and the economic, regulatory and legislative climate. The survey was conducted in September and October of 2017, and was sponsored by Crowe Horwath LLP. Click here to view the full results of the survey.

2018 Bank M&A Survey: Will Bank M&A Pick Up?


merger-survey-12-4-17.pngDriven in part by expectations for modest growth in the U.S. economy, almost half of the bank executives and directors participating in the 2018 Bank M&A Survey believe that the current environment for bank M&A is more favorable for deals, and 54 percent say their institution is likely to purchase another bank by the close of 2018. U.S. banks announced 191 deals through October 27, 2017, according to S&P Global Market Intelligence, and is on track to close the year on par with 2016, which closed with 241 deals. With that in mind, it’s perhaps no surprise that 40 percent expect a stagnant deal environment.

The 2018 Bank M&A Survey, conducted through September and in early October of 2017, is sponsored by Crowe Horwath LLP. It features the views of 189 chief executive officers, directors and senior executives of U.S. banks on the U.S. economy, the bank M&A environment and their own M&A strategies.

The unfettered optimism felt by the banking industry in the wake of the election of expected deregulator-in-chief Donald Trump has been tempered with the reality that regulatory relief largely hinges on the actions of the U.S. Congress. One-third of bank executives and board members lack confidence that the Republican majority will be able to push through regulatory relief for the banking industry by the end of 2018. But hope springs eternal for most bank leaders. Fifty-nine percent expect modest relief for the industry.

Where President Trump and his administration can best impact the nation’s banks is through his appointment of regulators. Fifty-eight percent believe that Donald Trump has had a positive impact on the banking industry. As of November 30, 2017, Trump has appointed Randy Quarles, who’s viewed as a moderate deregulator, as vice chairman of supervision for the Federal Reserve, and former OneWest CEO Joseph Otting as Comptroller of the Currency. Janet Yellen will leave the Fed when she is replaced as chairman by current Fed board member Jerome Powell in February 2018. Trump has nominated economist Marvin Goodfriend to fill an open seat on the Fed Board of Governors, and announced he will nominate Fifth Third Bancorp Chief Legal Officer Jelena McWilliams to chair the Federal Deposit Insurance Corp. The permanent leadership of the Consumer Financial Protection Bureau—not addressed in the survey—is also in flux. Ninety-seven percent of respondents believe that these regulatory appointees will be more sympathetic to the banking industry.

Additional Findings

  • Forty-four percent indicate that rising bank valuations have made it more difficult for their bank to compete for or attract suitable acquisition targets.
  • When asked about the kinds of acquisitions the bank is willing to make, 83 percent say their board and management team would consider a market extension, and 78 percent an in-market deal. Twenty-eight percent would consider an out-of-market deal.
  • Few—just 7 percent—are likely to acquire a fintech company by the end of 2018.

To view the full results to the survey, click here.

Sellers: Be Vigilant About Stock in a Deal


bank-stock-11-10-17.pngThrough the first nine months of 2017, the pace of bank merger and acquisitions has been up slightly from prior years in terms of the number of deals, and the strong performance of bank stocks since the U.S. Presidential election—the KBW Nasdaq Bank Index is up almost 40 percent—has led to an increase in deal prices for bank sellers in 2017. Price to tangible book value for all deals through Sept. 30, 2017, is up approximately 24 percent compared to the same nine-month period in 2016. Although sellers are happy about rising deal prices and bank stocks trading at high levels, they should consider how to protect the value of a deal in an all- or mostly-stock transaction negotiated in the period after the announcement and beyond the deal closing. Here are three considerations for boards and management teams.

1. Use a stock collar.
A stock collar allows the selling institution to walk away from the transaction without penalty, given a change in the buyer’s stock price. A double trigger often is required, meaning an agreed-upon decline in the buyer’s stock price along with a percentage deviation from a set market index. A 15 to 20 percent trigger often is used. The seller may require that a cap be used if a collar is requested. A cap would act in a similar manner as a collar and provide the buyer with the chance to walk away or renegotiate the number of shares should the buyer’s stock increase 15 or 20 percent from the announcement date. While collars and caps often are symmetrical, they do not need to be, and a higher cap percentage can be negotiated. The need for a collar tends to be driven by the buyer’s recent stock trends and financial performance.

2. Consider trading volumes and liquidity in your deliberations.
In an all-stock or a combination stock and cash deal, the seller makes a significant investment for their shareholders in the stock of the buyer. For many shareholders, this represents a significant opportunity for liquidity and wealth diversification. But these goals can be thwarted if the buyer’s stock is not liquid or doesn’t trade in enough daily volume to absorb the shares without detrimental impact. The table below indicates some of the volume and pricing differences between exchanges. The total number of shares to be issued in a transaction should be considered in comparison to the number of shares that trade on a weekly basis.

Exchange Avg Weekly Volume/Shares Outstanding (%) Number of Banks Median Price/LTM Core EPS (x) Median Price/Tangible Book (%) Median Dividend Yield (%)
Grey Mkt 0.00 8 13.60 92.38 2.07
OTC Pink 0.07 433 15.02 109.55 1.79
OTCQB 0.14 36 15.34 130.59 2.00
OTCQX 0.20 76 16.06 126.04 2.00
NASDAQ 1.18 344 19.35 184.02 1.69
NYSE MKT 0.98 6 18.88 197.00 2.10
NYSE 3.10 51 16.40 197.75 1.99

Source: S&P Global Market Intelligence as of Sept. 30, 2017
LTM: Last 12 months

3. Request reverse due diligence.
The larger a seller is in comparison to the buyer and the more stock a seller is asked to take, the more there is a need for reverse due diligence. Boards and management should require the opportunity to dig into the books and records of the buyer, when appropriate, to make sure the stock investment will provide the returns and values promised by the buyer. However, the request for reverse due diligence may be denied if the transaction is fairly small in scale for the buyer or only token amounts of stock are offered.

Reverse due diligence tends to be abbreviated compared to typical due diligence, and it’s more focused on the items that can materially affect stock price. Reverse due diligence tends to focus on items such as earnings and credit performance, regulatory issues that the risk committee is monitoring, pending litigation or other potential unrecorded liabilities, review of board and committee minutes, and dialogue around future performance and initiatives. Also, sellers should review a buyer’s stock characteristics, including reading equity analyst reports, transcripts of earnings calls, conference presentations and other public sources of information that could help to develop a holistic view of how the market might react to the transaction once it’s announced.

While no one can predict what will happen with stock prices over the next 12 months, it does seem that many believe the current run-up in bank stock prices is the result of the general election, the Federal Reserve’s increase in interest rates and expected additional rate increases. Stocks are trading at high levels, but bank sellers still need to be cautious about which stock they take in a deal.

Handling the Risk of M&A



Atlanta-based State Bank Financial Corp. is fairly unique in that it uses a corporate psychologist who helps the bank assess the personalities that are the right fit for State Bank. Steven Deaton, the executive vice president and enterprise risk officer of State Bank, talks with Bank Director digital magazine’s Naomi Snyder about how the bank approaches due diligence and the risk of M&A.

He describes:

  • the importance of assessing culture in the organization you acquire
  • how the bank uses a corporate psychologist
  • the bank’s approach to M&A strategy
This article first appeared in the Bank Director digital magazine.

Compensation Issues That Can Determine the Success of Your Acquisition


compensation-9-6-17.pngMergers and acquisitions continue to be an important business strategy for many community and regional banks. The compensation areas that receive the most attention are change-in-control (CIC) related severance payments and the equity holdings that typically increase in value upon the change. The CIC severance payments that are covered under employment and severance agreements are often estimated and are frequently a part of the conversation prior to the actual CIC. Equity and deferred compensation programs that have accelerated vesting upon a CIC are also generally reviewed ahead of time. The executive groups that have these compensation programs get plenty of attention from the key parties involved in a transaction. However, there are also many non-executive related compensation issues that can have a big impact on the ultimate success of a merger or acquisition.

Once the transaction is complete and the executive related compensation payouts have been settled, there is a combined organization that needs to operate successfully. It is possible that the two organizations had significantly different compensation philosophies in place and one of the key first steps is to clearly identify and communicate the compensation philosophy of the merged bank going forward. For example, if one organization believes in leading the market and the other likes to “lag” the market on pay, you’ll need to determine the future direction. A strong compensation philosophy that guides the compensation decisions and clearly communicates the preferences of the organization will help accelerate the pace of the transition.

Additionally, the combined organization will need to determine the appropriate market benchmarking data to utilize. The bank is now larger following the the transaction and this creates a situation where new peers may be appropriate and new benchmarking surveys or data cuts may be necessary. The bank may have expanded into new states and/or regional markets, which impacts the external market benchmarking process. It is critical to identify the appropriate market data to use for external benchmarking and market competitiveness.

Another potential challenge after an acquisition is the possible need to combine and/or introduce formal salary grade structures. If both organizations had a salary structure system in place there will need to be a determination on whether adjustments need to be made to the future structure. If one organization did not have any salary grades in place, then they will likely need to be introduced to the concept. It can take some time to educate managers and employees as to how these salary systems work. The bank should have a non-discriminatory, market competitive, easily manageable and communicated salary structure to use.

Another common challenge is the realization that the actual pay ranges for certain positions within the combined organization are significantly different. This could be attributed to the differing compensation philosophies of the organizations, differing market locations and competitiveness, or simply differing pay practices that have developed over time. The first step to resolving these potential issues is to review the various positions and identify the significant pay differentials that exist. After identification, the challenge is to assess why the differences have occurred and if there isn’t a clear reason—for example, a geographical differential like a rural versus urban location–then the tough part becomes what to do about these internal pay differences. For example, should the pay grade be changed and/or different levels created for a job title?

Possibly the most significant challenge after a transaction is the combination and/or introduction of incentive-based pay methodologies. Most likely there are some differences in place between the two organizations. One may have a completely discretionary system and the other a true performance-based system. These differences often lead to cultural challenges, because formal systems generally emphasize the importance of pay for performance more heavily than discretionary systems. If both banks have formal performance-based incentives in place, then the challenge will be combining the plans and identifying the key differences that need to be resolved. Examples of differences would be the award opportunity levels, participants included in the various tiers and plans, types of goals used, documentation of the plans, and the award tracking systems in place. Someone will need to review the various incentive plans and determine how to best mesh the current practices for the future.

There are a number of compensation related challenges that can impact a successful merger. The challenges spread beyond the executive related severance payments, and continue well after the change-in-control event occurs. Careful consideration and planning should be used to harmonize differing compensation philosophies and practices through the compensation landscape of the combined entities. Compensation philosophies need to be reviewed, salary structures and market benchmark methodologies may need adjustment, and incentive plans will need to be combined or revamped. Finally, a timeline and communication strategy will need to be developed to ensure a successful compensation environment going forward.

A New Approach for Bank M&A


merger-8-31-17.pngThe post-recession world has created a series of new challenges for community banks, including declining margins, rising loan-to-deposit ratios and loan concentration issues. The economic climate has made it nearly impossible for banks to work through these issues through traditional means such as organic growth.

And despite what most analysts say, community banks will not find earnings relief when interest rates rise. They will instead find more trouble. Different factors influence the rate of recovery after an interest rate trough, including its duration and depth. Deposit volume and rates, existing loan portfolio half-lives, and the expected economic environment and its impact on loan demand must also be weighed.

Community bank balance sheets have been poisoned by loans that were issued in the last decade, and it will take years—not quarters, as in the past—for a normalization period to change this dynamic. Community bank CEOs and boards have limited strategic options to separate themselves from the pack and maximize relative shareholder value.

Normal organic growth will not give community banks sufficient flexibility to adjust the asset portfolio, with the potential rising costs and declining availability of deposits compounding the problem.

The only way management can substantially restructure their asset and liability base is through acquisitions. However, these M&A deals have to be structured to compliment the bank’s asset and liability strengths and weaknesses, using the proper analytics to evaluate the impact on the bank’s existing capital structure. Loan mix, portfolio maturities, fixed versus floating distribution and concentrations are just some of the factors that have to be taken into consideration in valuing both acquirer and target assets.

Properly analyzed and structured M&A transactions can be a very powerful tool in helping community banks overcome their profitability issues and other limitations. But many community banks are making mistakes when it comes to M&A.

Here are six basic rules that should be followed:

  1. Don’t pay attention to investment bankers spouting multiples-of-book suggestions for how much a bank is worth. These change based on expected market conditions, with multiples declining in strong expected operating markets and increasing in difficult pro forma market environments. Furthermore, every bank for sale has a different value proposition for each individual buyer. This value proposition is a function of how the target’s unique asset and liability mix strengthens and weakens the acquirer’s unique asset and liability mix, as well as its eventual pro forma profitability.
  2. Don’t focus your pre-due diligence analysis on traditional financial and operating accounting statements and extrapolated financials derived from these statements. Traditional financial statements are accounting translations of raw bank data that meet certain required reporting guidelines. While they might be an excellent summary of monthly, quarterly or annual performance, they lack the critical vintage information embedded in different layers of loans that directly affect their pro forma risk, return and maturity schedules.
  3. Don’t wait for deals to be delivered to your doorstep, generally in the form of auctions. The probability of finding the right deal and winning the auction at a reasonable price is extremely low. The time resources that are committed to these unsuccessful and questionable bids can be easily spent in more productive directions. Instead, take a proactive approach that evaluates all banks within the acquirer’s desired geographic footprint, which can be far less time-consuming and far more effective in identifying the ideal target consistent with the bank’s own operating performance and financial strength.
  4. Do evaluate every acquisition against the baseline of equivalent organic growth and its impact on shareholder value. Without this baseline, even a reasonably accurate estimate of impact on shareholder value is a time-wasting exercise in number crunching. Comparing the value of transactions of different sizes can only be done consistently against an equivalent organic growth baseline.
  5. Do compartmentalize the value proposition of a target into the value of loans, value of deposits, value of existing excess/deficit capital and so on. Some of these value propositions are directly incremental to the purchase value, such as loan portfolios with their inherent pro forma yields and maturities; others indirectly contribute to value by eliminating operating constraints such as low loan-to-deposit ratios and high commercial real estate concentrations. Categories that contribute to value by eliminating operating constraints have to be evaluated in the context of the bank’s strategic plan and its ability to capitalize on these reduced constraints.
  6. Do focus on regulatory capital adequacy, both pre-and post-acquisition, to ensure that there are no unpleasant surprises as the target is consolidated into the acquirer’s operations. A fairly meaningful portion of the purchase price can be affected negatively or positively by the target’s existing capitalization.