How will rising bank valuations and interest rates impact bank merger activity over the next year? Will the Republican administration and Congress come through with regulatory relief for the banking industry? In this video, Dory Wiley of Commerce Street Capital outlines his expectations for deal activity over the next year and explains why he thinks we’ll see more deals.
A successful merger or acquisition involves more than just finding the right match and negotiating a good deal. As essential as those steps are, effectively integrating the two organizations is equally important—and equally challenging.
When participants in Bank Director’s 2017 Bank M&A Survey were asked to name the greatest challenge a board faces when considering a potential acquisition or merger, 26 percent cited achieving a cultural fit between the two organizations as their top concern. Other integration-related issues, such as aligning corporate objectives and integrating technology systems, were also cited by many survey respondents.
Altogether, nearly half (46 percent) of the survey respondents cited integration issues as their leading concern—even more than those who cited negotiating the right price (38 percent).
Banks’ Special Change Management Challenges As employees adapt to new situations, they must work through a series of well-recognized stages in response to change—from initial uncertainty and concern to eventual understanding, acceptance and support for new approaches. One objective of change management is to help accelerate employees’ progress through these phases.
In the case of bank mergers, however, there is a complicating factor—the required regulatory approval. Once a proposed merger or acquisition is announced, both banks must wait for some time—typically a period of five to nine months—before decisions can be announced and the transition can begin. These delays extend the period of doubt and uncertainty for employees, customers and other stakeholders, and can significantly impede employees’ progress through the normal change management stages.
Three Critical Components Successful post-merger integration involves hundreds of individual management steps and processes, and the board of directors must oversee the effectiveness of the effort. Directors can implement a few measures to help make the process a smooth one without micromanaging each step. At the highest level, directors should verify that management has established an environment in which success is more likely. Three organizational attributes merit particular attention:
1. Clear, continual communication. Management must develop a detailed communication plan to make sure merger-related stakeholder messaging is timely and consistent. It should provide employees, customers, the community and other stakeholders the information they need to adjust positively to the merger. This plan should spell out key messages by audience, provide a calendar of events, and use multiple communication tools for each of the stakeholder groups. One tool that has proven useful for customers is a dedicated toll-free phone number, staffed by employees specifically trained to answer customer questions. For employees, bi-weekly email messages that describe the integration process and answer questions have proven very useful.
2. Sound, timely decision-making. Basic decisions about how the organization will be structured, who is on the executive team, and how the post-merger bank is going to operate need to be made as quickly as feasible—but without rushing. Striking the right balance can be difficult. Decisions about key operational issues, such as which technology platforms will be used and how business and operational functions will be consolidated, also must be made promptly—subject to the regulatory constraints mentioned earlier.
3. Effective, comprehensive planning. Based on the key decisions regarding the future organization, management should develop detailed plans for the integration. It is tempting to shortcut the planning process and just “get on with it”—especially in organizations that have gone through a merger before. But overconfidence can lead to complacency and missteps. Successful integrations often involve more than 20 individual project teams. Take the time to make sure each team is capable and prepared, has clear timelines and areas of responsibility and understands its interdependency with other teams.
Finally, board members and executives alike should make it a point to see that there is adequate and active contingency planning. When unexpected challenges or conversion mistakes arise—as they always do—the bank must be ready to move quickly and effectively to address the issues.
As banks contemplate future mergers and acquisitions, we are hearing a common question in our vendor contracts practice: “What should I do in my contracts to prepare for an acquisition opportunity?”
The truth is that whether buying or selling, there are many steps bankers can take to prepare for an acquisition, but they need to be taken well in advance. Here are some secrets from behind the curtain.
For banks that are serial acquirers:
1. Perform serious due diligence on the target’s technology contracts and your own. Review the large technology agreements of the target bank using the 80/20 rule–80 percent of your spending is going to be in a handful of agreements. When you’re done reviewing the target’s contracts, review your own. This will provide a high-level view of your entire vendor relationship. Reviewing the target’s contracts will show your costs to exit their agreements. Looking at the target’s contracts in relation to your own will show opportunities for consolidating vendors and services at reduced rates.
2. Look for opportunities where you can take advantage of your vendor relationships. If you use one vendor for core processing and you are buying a bank that uses another vendor, your onetime costs for the technology conversion and ongoing expenses will be entirely different than if you are both using the same vendor. Understand your leverage in these situations. If your target is using different systems than you are, an acquisition takes a competitor out of business. If your target is using the same systems as you are, then you are going to be paying for processing the same accounts twice for a period if you don’t negotiate differently.
3. Have pricing established that takes advantage of acquisition volume growth. As the acquirer, you need to establish pricing that decreases on a per-customer basis as you grow. Negotiating tiers for your major pricing components is a basic requirement. Your goal should be to negotiate tiers that are market priced and are commensurate with the volume that will be loaded on during a five-year term. This could be substantial if you are in an aggressive growth mode.
4. Establish a firm understanding with your vendor about staffing conversions. Moving quickly during acquisitions is par for the course. Your vendor’s ability to convert your target’s accounts to your system in a timely manner is vital. Best practice would be to negotiate with your vendor in advance for professional services to support your acquisition plan. This could include negotiating for a fixed number of conversions per year along with expectations for how long a conversion will take.
5. Manage your termination costs for acquired technology. Smart buyers know that a vendor is due a fair share of its committed revenue and reasonable termination costs and no more. Negotiate with your current vendor for language that recognizes when you acquire a bank using their technology, you should only have to pay for any given account once. This can materially reduce your liquidated damages and termination penalties when you buy a bank using your vendor’s technology.
For banks that wish to be acquired:
6. Keep your contract terms to two or three years at most. It’s never good to have long terms for your technology contracts if you are looking for a buyer. Even suitors using technology that is similar to yours will not want to pay for your commitments.
7. Keep your terms aligned. I’ve seen a target bank’s contracts with a mix of long and short durations. This can look bad to a potential suitor.
8. Use standard technologies. Buying a one-off solution or technology to get a competitive edge or save a few dollars is a non-starter if you are looking to sell. Software, services or equipment that can’t be reused or interfaced with the new bank’s core will run up your acquirer’s costs.
9. Negotiate decent pricing and known exit costs. Keeping your costs in line is very important. Even if your contracts will be superseded by your buyer’s contracts, the liquidated damages to shut down your contracts are directly related to your pricing. If your pricing is three times market pricing, your buyer’s costs to get out of your agreement are going to be three times market. Your costs to de-convert from the system should be plainly laid out along with a clear and fair definition of what your liquidated damages will be.
Growth that comes to your vendors through acquisition increases their market share without the usual upfront costs associated with bringing on business. They want to see you succeed, so work closely with them to make it happen.
How should banks determine the best way to proceed over the upcoming quarters? While no one can predict the future, there are several critical developments that anyone can keep an eye on. These are the areas that are most impactful to banks and for which they need to strategize and position themselves.
Rising Rates: Obviously, rates are rising but by how much? Banks should position for moderate hikes and a slower pace of hikes than the Fed predicts. The Fed predictions on rate hikes have been overstated for several years running. The yield curve for the 10-year Treasury is flattening as of late, which also indicates fewer hikes are needed. A reduced duration for assets and reduced call risk makes the most sense; but practice moderation and don’t overdo it. Too many banks had their net interest margin crushed by being too asset sensitive and waiting for rates to increase while we had eight years of low rates. Check your bond portfolio against a well-defined national peer group of banks with similar growth rates, loan deposit rates and liquidity needs. Very few banks perform this comparison. They just use uniform bank performance reports or a local peer group. Every basis point matters, and there is no reason to not be a top quartile performer.
Deposits: Buy and/or gather core deposits now. Branches provide the best value. Most banks overestimate what deposits are core deposits, meaning they won’t leave your bank when rates rise. Like capital, gathering core deposits is best done when it is least needed.
Mergers and Acquisitions: If you are planning on selling in the next three years, sell right now, as optimism and confidence are at 10-year highs. If you are a long-term player, go buy core deposits, as they are historically cheap and you are going to need them. They are worth more now than perhaps ever before.
Get Capital While You Still Can: Solve your capital issues now. Investors are probably overconfident, but banks have done well the last seven years and finally, they aren’t taboo anymore. Investors want to invest in banks. That always happens before something bad in the economy occurs, so get it while you can.
Real Estate Carries Risk: With regulators mindful of capital exposure and real estate deal availability being spotty, it’s best that banks be wary of deals in this area. Commercial real estate linked to retail is more and more being viewed as extremely risky. There is an all-out war being waged on store retailers by online retailers. Since retail is a huge sector of the U.S. economy, investment will follow the online trend. Industrial real estate has become “retail extended” with the least amount of real estate risk.
Beware of Relying on Credit Scores: Banks need to be careful of the credit cycle. Consumers are loaded full of debt. Cars and homes are too expensive relative to wages and affordability. Credit scores probably don’t capture the downside risk to the consumer.
Get Ahead of Your Risks: Cyber-risk is a major and very real risk. Get ahead of the curve. Two other areas bearing risk are 401(k) plans and wealth management areas as they are especially exposed to litigation and are a nightmarish mess to be addressed. 401(k)s are overloaded with too many choices, fiduciary risk, performance issues, excessive fees and conflicts of interest. Get help now or you may be painfully surprised.
Marketing: Your bank had better get creative with digital marketing opportunities for your website as well as mobile devices. Why? Billions are being invested into financial technology companies and it’s easier for fintech to learn about banking than it is for bankers to learn about fintech.
Millennials: Surveys from The Intelligence Group and others show that finding young, motivated workers, and then retaining them, may be a challenge.
All of us have heard the horror stories about banks announcing a merger or acquisition, only to have the deal languish for months awaiting regulatory approval or, even worse, having the deal break apart because of a regulatory issue.
Sometimes the issues only become apparent after regulatory approval applications are filed. Since the financial crisis, some regulators have used the applications review process as a “second look” at the parties involved. This is especially true if the transaction would result in an institution that will cross a supervisory threshold (whether $50 billion, $10 billion, or $1 billion in assets), or if a protest is filed in response to the transaction.
But sometimes the issues would be readily apparent if all relevant information regarding the parties could be freely shared during due diligence. Unfortunately, applicable law imposes restrictions on the ability to share confidential supervisory information (CSI) during the due diligence process. In this article, I’ll describe what CSI is and the limits on sharing it, as well as some alternatives to allow parties to move forward without it.
What Is CSI? The definition of CSI and the rules regarding its disclosure vary between each federal and state regulatory agency. But generally, CSI includes any information that is prepared by, on behalf of, or for the use of, a federal or state regulator, including information in any way related to any examination, inspection or visitation of a bank, its holding company or its subsidiaries or affiliates. CSI generally includes documents prepared by the regulator or by the examined entity relating to the regulator’s supervision of that entity. Some examples of CSI include exam and inspection reports, supervisory ratings, non public enforcement actions and commitment letters, such as a memorandum of understanding or board resolutions adopted to address supervisory concerns, as well as any related communications with a regulator and progress reports required by an enforcement action.
What Is Not Confidential Supervisory Information? Certain regulatory actions must be disclosed under applicable law. These include cease and desist orders (or related consent orders), prompt corrective action directives, termination of FDIC insurance, removal or suspension of an institution affiliated party, civil money penalties and any written agreement for which a violation may be enforced by the federal regulator, unless that regulator determines that publication would be contrary to the public interest. Each federal regulatory authority maintains a website at which this information and the relevant documents may be obtained.
Who Can Give Approval to Disclose CSI? The regulators take the position that all CSI, whether prepared by the regulator or the bank, is the property of the regulator, not the bank. As such, CSI may only be disclosed with the prior written approval of the regulator, and each of the federal regulators have adopted regulations setting forth procedures for how to request disclosure of CSI.
What About Sharing CSI in Mergers or Acquisitions? While there are some exceptions to the general rule that a bank can’t disclose CSI, including permitting disclosures to directors, officers, employees, auditors and, in some instances, legal counsel, almost all regulators take the position that a bank can’t share CSI with acquirers or targets in merger or acquisition transactions without prior approval. Further, some regulators, including the Federal Reserve, take the position that disclosure requests in these contexts are denied absent unusual circumstances.
This is a very different stance from other highly sensitive information, such as a consumer’s nonpublic personal information, which may be disclosed in connection with a proposed merger or acquisition.
What Are the Risks of Failing to Comply? Failure to comply with regulator requirements regarding CSI can be a violation of law and could subject a person or entity to supervisory action, including the imposition of civil money penalties. In some instances, disclosure of CSI could also expose a person to criminal penalties.
So How Do the Parties Work Around This? While CSI itself can’t be shared, other reports likely address criticisms arising in an examination. Under generally accepted accounting principles, the bank’s audit will likely describe any informal administrative action to which the bank is subject, and if the bank is a public company, its securities filings will likely describe administrative proceedings and any progress in complying with them. But if a bank is acquiring a bank in troubled condition, there is likely no substitute for seeing the administrative action to which the bank is subject. In that instance, the parties should build into their timetable the request for obtaining that information from the relevant regulator.
Fair lending compliance and community benefit plans are increasingly important factors in the merger and acquisition (M&A) approval process. In 2016 and the first quarter of 2017, the Board of Governors of the Federal Reserve System (Federal Reserve) approved 20 bank or bank holding company M&A applications. Fair lending compliance history was an essential element of the regulatory analysis in these cases. While the Federal Reserve focused on compliance issues beyond fair lending —such as the Bank Secrecy Act, overdraft policies, residential servicing, commercial real estate concentration, and enterprise risk management—fair lending was one of the hottest compliance issues that arose from the merger approval process. Regulators also are reviewing applicants’ combined compliance programs and controls to ensure that the resulting institution will be properly suited to protect against the new risks created through the transaction, particularly where the transaction will result in an acquirer crossing a key regulatory growth threshold. For example, the Bank of the Ozarks received regulatory approval for two M&A transactions in early 2016 and crossed the $10 billion asset threshold while both acquisition applications were pending. As evidenced by the Bank of the Ozarks approval order for the larger acquisition, fair lending compliance was a significant factor in the Federal Reserve’s evaluation of the transaction.
Moreover, many of the institutions that obtained Federal Reserve approval for an acquisition during this period demonstrated a commitment to fair lending compliance beyond receipt of a satisfactory or outstanding Community Reinvestment Act (CRA) rating. Nearly all approved applicants had a designated CRA officer and/or CRA committee, and several applicants described detailed plans for improving community lending in particular assessment areas.
Community Benefit Plans Emerge as Important Factor for Regulatory Approval The 2016 and 2017 M&A approvals also revealed the role of formal community benefit plans, as most clearly demonstrated in KeyCorp’s acquisition of First Niagara Financial Group, and Huntington Bancshares’ acquisition of FirstMerit Corporation. These two transactions received a considerable number of public comments focused on CRA and fair lending, and these large financial institutions used community benefit plans as an effective tool to demonstrate their commitment to fair lending compliance.
KeyCorp worked closely with various community organizations to develop a community benefit plan that was announced in March 2016, prior to KeyCorp’s receipt of regulatory approval for its merger. Under the KeyCorp plan, KeyCorp committed to lending $16.5 billion to low- and moderate-income communities over a five-year period, with up to 35 percent of the total commitment targeted at the areas where KeyCorp and First Niagara overlapped in New York, and to maintaining a vital branch and administrative footprint in western New York. Similarly, after submitting its merger application, Huntington adopted a community benefit plan committing to invest $16.1 billion in its communities, including low- and moderate-income communities, over a five-year period.
Notwithstanding the Federal Reserve’s reliance on the KeyCorp and Huntington community benefit plans in concluding that the relevant institutions are meeting the credit needs of the communities they serve, the Federal Reserve noted in the Huntington approval order that “neither the CRA nor the federal banking agencies’ CRA regulations require banks to make pledges or enter into commitments or agreements with any organization.” Accordingly, the Federal Reserve likely will not require a bank to make any community investment pledge to any organization in the absence of significant negative comments or, more importantly, adverse examination findings or a pending enforcement action. Nevertheless, given their apparent benefits, both for Federal Reserve applications and for general community and regulator relations, community benefit plans likely will remain a factor in the approval process for bank mergers that attract community groups’ attention—and likely will help expedite the approval process in the face of adverse community group comments.
Outlook The 2016 and early 2017 merger approvals make clear that a comprehensive fair lending strategy, which may or may not include a community benefit plan, is likely to be well received by the regulators and considered in applicable approval analyses. We expect the regulatory staff of each of the federal banking regulators to continue to focus on fair lending compliance and that community groups will continue to comment actively on the fair lending compliance issues of bank M&A acquirers and attempt to influence their activities.
As bank executives look to add value through mergers and acquisitions (M&A), a recurring source of frustration is the tendency of investors and analysts to rely on narrow metrics to measure a deal’s value. Simple metrics are inadequate for evaluating the true value of a transaction. One widely used but misleading metric is the dilution of tangible book value (TBV) that occurs as a result of a transaction, coupled with the TBV earn-back period. TBV dilution and earn-back are poor indicators of a transaction’s full effect on the overall value of an organization.
Rather than using a single number to evaluate the success of a transaction, shareholders, boards and analysts should strive toward more comprehensive evaluations. Broader measures, coupled with a more qualitative evaluation of a transaction’s effects on bank strategy and shareholder value, can provide a holistic understanding of the relative worth of a merger or acquisition.
Gaps and Challenges Despite its widespread use, TBV dilution earn-back can produce an incomplete measure of the viability of a bank M&A transaction. Reliance on simple metrics produces gaps and challenges such as the following:
M&A structure: TBV dilution earn-back and other popular metrics are significantly affected by the way an acquisition or merger is structured. An all-cash acquisition will have a different effect on book value and earnings metrics than a deal that involves the issuance of new stock.
External factors: Management actions such as post-deal stock repurchases can influence TBV dilution earn-back and various other earnings-based metrics. These metrics also are shaped by numerous external factors that can affect stock price, such as the run-up in bank stock values in the month after the 2016 election, when the markets began to anticipate regulatory reform.
Regulatory expense: Despite expectations of future regulatory relief, regulatory expense will continue to contribute to banks’ financial pressures in the near term, reinforcing the need for continued growth in order to spread compliance-related costs across a larger base. Moreover, many banks still are likely to find it challenging to price deals fairly, due to the constraints of regulatory capital requirements.
Indirect consequences: The market’s reliance on simple metrics can pose less immediate—but equally serious—indirect consequences. For example, negative perceptions about prior deals can limit a publicly traded bank’s growth opportunities, since its ability to compete in future deals often hinges on the value of its stock. This limitation can be damaging for banks and thrifts whose growth strategies are built around continuing M&A activity.
Measurable Success Serious investors begin their evaluations with an estimate of the deal’s impact on earnings and earnings per share (EPS), but they also consider factors such as projected cost savings, expenses related to the transaction itself, and the speed and costs associated with a successful integration of the two organizations.
Management should lay out meaningful steps with measurable indicators of success. When evaluating cost savings, both the recurring savings and the one-time expenses that will be incurred to achieve them must be considered. An equally stringent standard also should be applied to projected merger-related expenses, such as professional fees and operational costs.
The totality of these various projections should be compared to the actual results achieved in prior transactions. If they vary significantly—or if earlier deals failed to achieve promised results—management should be able to explain the variations and rationale for the current projections.
The financial impact of an M&A transaction also should be compared with its potential return. Management should outline the rationale for the deal compared to alternative uses of capital, and it should be ready to present complete and relatively detailed plans, timetables, and targets. This analysis might be time-consuming, but it produces a clearer picture of a transaction’s true value.
A Comprehensive Approach to Deal Valuation A complete analysis involves studying factors such as a deal’s impact on capital ratios, management’s integration plans and benchmarks, projected cost savings, and the management team’s track record and credibility. Thorough analysis also takes into account unpredictable external factors such as general economic conditions, changing interest rates, new competitive pressures, future technological advances and the changing needs of bank customers.
When management demonstrates a history of competence and a clear and credible rationale for its planned actions, it makes a more compelling case for investor confidence than simple metrics can offer. This more analytic approach can help investors, analysts, and other stakeholders—and ultimately bankers—by encouraging a more disciplined and comprehensive approach to deal valuation.
Despite the recent pullback in bank stocks, valuations are still trading near a 10-year high (up 18.3 percent post-election). The drastic run up in both bank prices and trading multiples has had a direct impact on mergers and acquisitions (M&A) activity. The average price to tangible book value (P/TBV) for transactions is up 27 percent to 1.68 P/TBV since the presidential election. As multiples have expanded, buyers have a currency to pay higher values for targets in transactions. With bank valuations at a high level, both for publicly traded companies and their targets in an acquisition, management teams must evaluate two questions: Will the current optimism among bankers become reality? And, are we currently in a window of opportunity to sell?
To determine answers to these two questions we must first look into what is stoking investor optimism for bank stocks. There are three main drivers: rising interest rates and increased yields on loans, potential regulatory reform reducing associated noninterest expenses, and comprehensive tax reform reducing the overall tax burden on banks.
It would be overly optimistic to assume that all three of these factors would occur. Indeed, there are three main headwinds that should impede banks from increasing earnings to the most optimistic values: historical lessons, the current macroeconomic environment and government execution. These headwinds will not only have an impact on the trading of public bank stocks, but will have a direct impact on M&A pricing.
Historical lessons from a rising rate environment: From 2004 to 2006, rates increased from 100 basis points to 525 basis points. The thought has been that a rising rate environment will allow banks to increase earnings through higher yields on loans. However, from 2004 to 2006, we saw the exact opposite. As rates increased, deposits migrated to higher yielding products, offsetting the benefit from the increased yield on loans, ultimately leading to a decrease in net interest margin. As banks felt the pinch, they began to expand their balance sheets by increasing loan to deposit ratios. The years to come proved challenging as nonperforming assets increased drastically.
Macroeconomic environment: Bull markets have historically lasted approximately seven years. We are more than eight years into the current bull-market run. How much longer can this bull-run last?
Government execution: As the current trading multiples include regulatory and tax reforms that must be implemented by the government, we must ask ourselves if we can truly count on the government to deliver. Given the challenges the Republicans face passing healthcare reform, it is hard to believe that the Trump administration will be able to push through both comprehensive tax and regulatory reform without significant push back and concessions.
The headwinds facing the current optimism will have a direct impact on M&A pricing. If you are a potential seller and believe that the stars will align and all factors surrounding the current optimism will come to fruition, then enjoy the ride. If you are questioning any of these factors, it is likely that you have realized we are in a window of opportunity to sell.
With many financial institutions benefiting from increased stock values and renewed optimism following the November election, merger activity for community banks is on the uptick. Successful acquirers must remain in a state of readiness to take advantage of opportunities as they present themselves.
Whether a prolonged courtship or a pitch book from an investment banker, deals hardly, if ever, show up when it is most convenient for a buyer to execute on them. As a result, buyers need to develop a plan as to what they want, where they want it and what they are willing to pay for it, long before the “it” becomes available. M&A readiness equates to the board of directors working with management to have a well-defined M&A process that includes the internal and external resources ready to jump in to conduct due diligence, structure a transaction and map out integration. Also, M&A readiness requires that buyers have their house in order, meaning that their technology is scalable, they have no compliance issues and the capital is on hand or readily available to support an acquisition.
Technology. In assessing the scalability of an institution’s technology for acquisitions, a buyer should review its existing technology contracts to see if it has the ability to mitigate or even eliminate termination fees for targets that utilize the same core provider. Without this feature, some deals cannot happen due to the costs of terminating the target’s data processing contracts. Cybersecurity is another key element of readiness. As an institution grows, its cybersecurity needs to advance in accordance with its size. Buyers need to understand targets’ cybersecurity procedures and providers in order to ensure that their own systems overlap and don’t create gaps of coverage, increasing risk. Additionally, buyers should understand existing cybersecurity insurance coverage and the impact of a transaction on such policies.
Compliance. Compliance readiness, or lack thereof, are the rocks against which even the best acquisition plans can crash and sink. Ensure that your Bank Secrecy Act/anti-money laundering programs are above reproach and operating effectively, and that your fair lending and Community Reinvestment Act policies, procedures and practices are effective. Running into compliance issues will cause missed opportunities as the regulators prohibit any expansion activities until any issues are resolved.
Conducting a thorough review of compliance programs of a target is critical to an efficient regulatory and integration process. A challenge to overcome is the regulators’ prohibition on buyers reviewing confidential supervisory information (CSI), including exam reports as part of due diligence. While the sharing of this information has always been prohibited, the regulatory agencies have become more diligent on enforcement of this prohibition. Although it is possible to request permission from the applicable regulatory agency to review CSI, the presumption is that the regulators will reject the request or it will not be answered until the request is stale. As such, buyers should enhance their discussions with target’s management to elicit the same type of information without causing the target to disclose CSI. A simple starting point is for the buyer to ask how many pages were in the last exam report.
While stress testing may officially apply to banks with $10 billion or more in assets, regulators are expecting smaller banks to prevent concentrations of risk from building up in their portfolios. The expectation is for banks to conduct annual stress tests, particularly among their commercial real estate (CRE) loans. Because of these expectations, buyers need to know the interagency guidance governing CRE concentrations and how they will be viewed on a combined basis. Reviewing different stress-test approaches can help banks better understand the alternatives that are available to meet their unique requirements.
Capital. An effective capital plan includes triggers to notify the institution’s board when additional capital will be needed and contemplates how it will obtain that capital. Ideally, the buyer’s capital plan works in tandem with its strategic plan as it relates to growth through acquisitions. Recently the public capital markets have become much more receptive to sales of community bank stock, but this has not always been the case. In evaluating an acquisition, the regulators will expect to see significant capital to absorb the target as well as continue to implement the buyer’s strategic plan.
The increase in financial institution stock prices has increased acquisition opportunities and M&A activity since the election. Opportunistic financial institutions have plans in place and solid understandings of their own technology needs and agreements, regulatory compliance issues and capital sources. Although it sounds simple, a developed acquisition strategy will aid buyers in taking advantage of opportunities and minimizing risk in the current environment.
Bank mergers and acquisition (M&A) announcements are no longer a rarity, with more deal announcements coming every month. But for every successful transaction, another 10 transactions have died or stalled. And sometimes these are the deals that can be most educational for community bankers who want to get into the M&A market. For instance, the following five issues are hampering many would-be deals:
1. Many banks have organically grown themselves out of the M&A market due to concentration issues. One of the most overlooked consequences of aggressive organic growth in a low-rate environment is now becoming clear. Most high-growth banks focused on commercial real estate loans (particularly in urban and suburban markets) have maxed out their concentration levels relative to capital, based on regulatory thresholds. In these cases, regulators will hold pending deals hostage unless the acquiring bank agrees to inject more capital. It’s been reported that New York Community Bank’s failed acquisition of Astoria Financial is an example of high concentrations of real estate loans undoing a deal. One thing that helps: Meet with regulators far earlier in the deal process to check their temperature.
2. Buyer beware: the mortgage banks are coming to market. There are many small banks that depend too heavily on their mortgage business to drive earnings. In some cases, the core bank would not even be profitable without its mortgage arm. As a result of the historically low and prolonged rate environment, mortgage companies have been doing well, particularly with refinancings booming in 2011 and 2012, and home purchases picking up in the years since. However, now that we are transitioning to a new environment with rising interest rates, the situation may change.
Most executives and investors in banks with mortgage companies understand this and are looking to exit. The problem is they want their banks to be valued on their recent earnings. But a buyer is not buying a bank’s recent earnings, it is buying its future earnings. In a rising rate environment, refinancing can dry up, and home purchases won’t be able to make up the difference. Smaller banks with mortgage operations tend to be more heavily skewed toward refinancing than other banks, making them even more vulnerable. As a result, their valuations can be grossly overstated, if these issues are not recognized. When negotiating with such a bank, focus on what percentage of a small bank’s business is refinancing versus home purchases, and what percentage of the cost structure is fixed versus variable. Mortgage bankers also are often cut from a different cloth than commercial bankers, so cultural fit should be scrutinized.
3. A deal that appears to be expensive from a price-to-tangible book value perspective is not as expensive as it appears. Most bank acquisitions are structured as a stock purchase of the holding company’s equity. However, in the vast majority of cases, the only true asset acquired is the subsidiary bank. But there is a big difference between the target holding company’s capital structure and the subsidiary’s capital structure, which too many acquirers are ignoring. Acquisitive banks need to educate their investors on the value of such things as inexpensive trust-preferred securities (TruPS) and debt that may be on the holding company’s books. By assuming TruPS and debt, you are essentially purchasing bank capital at tangible book value. Banks must find hidden value by analyzing in detail the differing capital structures between a target’s parent company and its bank subsidiary.
4. Acquiring a bank with equity can introduce control issues. One problem associated with using equity as a currency for the buyer is the selling bank’s shareholders could own a meaningful percentage of the equity in the buyer. This is far less of an issue if the selling bank’s shares are widely held. However, many community banks, particularly on the small side, are controlled by a single shareholder or family. As a result, this single shareholder could become the largest shareholder in the buyer after the deal, especially if he or she is receiving a significant portion of the purchase consideration in stock. The normal playbook is for this shareholder to agree to certain restrictions related to voting, selling of shares in the open market, and other restrictions.
5. Look for more creative transactions that solve problems. Many banks are struggling with financial issues such as concentration issues, high loan-to-deposit ratios and a compressing net interest margin. Acquisition targets that alleviate these problems may not make immediate sense from a strategic perspective. The targets may not be geographically perfect, perhaps they aren’t adjacent to the acquirer’s footprint, or maybe they’re unattractive from a macroeconomic perspective. However, for the reasons previously mentioned, these targets may actually have premium value to the acquirer. It goes without saying that the acquiring bank’s management must come up with an operational plan to manage execution risk, but these outside-the-box deals often create the most value and lead to cutting-edge strategies that fetch higher premiums from investors in the long term.