A Modest Yet Welcome Thaw for Banking M&A and Financial Stability


mergers-4-18-17.pngAs part of approving the merger of $40.6 billion asset People’s United Financial Inc., with $2 billion asset Suffolk Bancorp, the Federal Reserve stated that, “[t]he [Federal Reserve] Board’s experience has shown that proposals involving an acquisition of less than $10 billion in assets, or that result in a firm with less than $100 billion in total assets, are generally not likely to create institutions that pose systemic risks” and that the Federal Reserve Board now presumes that such a proposal does not create material financial stability concerns, “absent evidence that the transaction would result in a significant increase in interconnectedness, complexity, cross-border activities, or other risk factors.”

Before the recent action, the Federal Reserve had since 2012 imposed very low thresholds under which it would presume no financial stability concerns exist. It only exempted acquisitions of less than $2 billion in assets or where the resulting firm would have less than $25 billion in total assets. Only a small number of transactions met these thresholds. The Federal Reserve reiterated its position, however, that it maintains the authority to review the financial stability implications of any proposal, specifically noting any acquisition regardless of size involving a global systemically important bank.

Through this action, the Federal Reserve has not only liberalized the key asset thresholds it previously established in 2012 for its evaluation of the financial stability factor in banking M&A, but also delegated authority to approve applications and notices that meet the newly revised thresholds to the Federal Reserve Banks. This revision has obvious parallels to recent statements from Chair Janet Yellen, Governor Tarullo and other Federal Reserve officials over the past few years (including as recently as December 2016) that the current $50 billion threshold for designation of a financial company as a systemically important financial institution (SIFI) may be too low. We believe that the delegation of authority to the Federal Reserve Banks could be at least as important, if not more important, as revisions to the financial stability thresholds because delegation should increase the chance that M&A transactions would proceed without the long delays that have recently been the norm in Federal Reserve Board reviews. Of course, all of the other requirements for delegation would also have to be met.

In support of this liberalization, the Federal Reserve cited its approval of a number of transactions over the past two years, including several transactions where the acquirer and/or resulting firm were over $100 billion or where the firm being acquired was over $10 billion and thus exceeded the newly revised financial stability thresholds. The increased thresholds and the delegation of authority to Federal Reserve Banks to process filings are welcome developments, especially for regional and community banking organizations that may be looking to acquire or be acquired. We would not, however, read the Federal Reserve’s actions as a strong signal that it expects or desires increased financial industry acquisitions or consolidation. The financial stability factor is only one of many that must be evaluated and questions will persist over how Community Reinvestment Act or fair lending concerns, anti-money laundering compliance, competition, general supervisory issues or public comment may affect a particular transaction. This action may, however, represent more formal support from the Federal Reserve for efforts to raise the $50 billion thresholds for SIFI designation and other purposes with a financial stability component under the Dodd-Frank Act.

Note: Another version of this article was initially published as a blog post on the Davis Polk FinRegReform blog on March 18, 2017.

Customer Experience Can Make or Break Your Transaction


mergers-4-11-17.pngStudies evaluating the accomplishment of mergers and acquisitions (M&A) consistently show how difficult it is to have a successful transaction. The statistics remain unchanged year-over-year in academic research: 70 to 90 percent of all deals fail to achieve the deal thesis or intended benefits—financial or operational—in the expected timeframe from the announcement of the deal. Yet, even with the deck stacked against them, financial institutions continue to be a source of significant deal activity for a variety of good reasons. So, how do you avoid becoming a statistic in an activity fraught with risk?

Begin with the end in mind—your customers. Customers in this case aren’t limited to just the acquired and existing customers, but include those who tend to be your most vocal customers: your employees. All too often, the mindset of dealmakers in financial services is focused on financials, the credit portfolio, and the capacity to gather deposits or market share. They completely forget that there are customers and clients behind all of those numbers, even though lip service may be paid.

Keeping customers front and center throughout the deal-making process increases your odds of success because it shifts the mindset in all phases: diligence through day one. Thousands of decisions go into transactions: name changes, product and service realignment, integration of sales practices, consolidation of back-offices, branch rationalization and new reporting relationships. But where do you begin?

Focus on Current and Acquired Customers

  • Analyze and segment the combined customer base during diligence. Not all banks have the same customers. Having an early understanding of the customers who are most important will have one of the greatest impacts on achieving deal benefits for the merger.
  • Build a target service model and identify the customer journey during and after integration, based on your customer segmentation.
  • Spend adequate time developing and executing tailored customer communication strategies based on your customer segmentation. Beyond regulatory requirements on minimum communications, successful institutions go beyond the typical change announcement and effectively communicate changes to customers in the way they want to receive such communication.
  • Develop and monitor customer feedback throughout the integration. Waiting until the call center is slammed over conversion weekend is too late.

Turn Your Employees into Advocates
The biggest failure in an integration is ignoring the employee experience since it is often just as important—if not more so—than the experiences your customers will have. Employees are often your biggest marketing asset and neglecting to include them and keep them informed about the transaction can turn employees into detractors. Don’t do that. Instead:

  • Be deliberate with your cultural integration. All too often, culture is overlooked during due diligence and planning, which results in nightmare scenarios later: decision making or alignment is slowed to a drip, detractors rally the masses and slow progress and unsatisfied staff talk to your customers.
  • Remember change management 101. As soon and as clearly as possible, give your employees the answer to the question “what’s in it for me?” Difficult decisions need to be made on tight timelines and employee communication of key changes and impacts throughout the integration is crucial; only communicating major changes through a press release, close announcement, and core conversion is not enough.
  • Establish a separate team to manage cultural integration and change management related efforts. This team, which is not the human resources department but can include members of it, can focus on identifying potential areas of conflict, assessing leadership strengths and weaknesses, and developing a comprehensive communications plan that engages all levels of the organization.

Create Your Own M&A “Playbook”
Successful institutions have playbooks in place and well defined target operating models ahead of a transaction, which consider all customers, external and internal.

The questions you need to answer to minimize the disruptive and risky nature of a deal are:

  • Do you know your customers? Do you know your target’s customers?
  • Do you know your culture? Do you know your target’s culture?
  • Do you know how you want to serve all customers on day one?

Achieve Tangible Results
By following a customer-centric approach, financial institutions can realize tangible benefits: accelerated decision making, faster integrations and less disruption. Making decisions with a customer-centric view minimizes status quo or one-size-fits-all choices that backfire eventually.

Finally, many banks struggle to meet the expectations of regulators who are looking more intently at integration planning and due diligence during and after the transaction. Robust and thoughtful methodologies around managing the customer experience is something regulators will view as evidence of a well-planned and lower-risk transaction. This can also act as a flywheel for execution speed on transactions for those of you that are serial acquirers.

Safeguarding Top Talent Is Key for Making Mergers Succeed


mergers-3-22-17.pngBanks merge because of the obvious benefits—longer client lists, greater real estate holdings, stronger intellectual property, and wider market share, among others. While there is no denying the positives of a merger and acquisition (M&A), a common downside is that change can disengage and drain your talent pool if not managed correctly. It is critical through this unstable transition period that the best talent engage in the transition process, be informed about the long-term vision of the new company, and that business continuity and quality service not be compromised. Complicating matters is that while the window of time to pull off an M&A agreement often is very brief, a long period of employee uncertainty may precede regulatory approval.

Managing Change Properly Starts With Due Diligence
Procedural adjustments, such as changing lock box addresses, are very straightforward. What’s trickier and needs to be a priority is helping employees adopt the associated changes. Closely learning about the culture of the other company—how it is aligned and how it is different from the acquiring company’s culture—can be done by interviewing stakeholders, conducting informal or formal surveys, or even studying the look and feel of employee communications and polices in the employee handbook. These simple exercises will prevent hasty decision-making and will help structure the new company so that objectives are met without unwanted employee turnover.

Taking the time required to get a more intimate understanding of the bank being acquired also will speed things up when it’s time to fit the right people into key roles. The new organization ideally will represent the best of both companies, so it’s critical to identify not just where value was strongest at the former company, but why it developed and who was responsible. Getting that right early in the transition will help make it seamless. Productivity will be less likely to drop, will snap back quickly and unwanted employee turnover will be manageable.

Change Management Fails Because of Poor Communication
When employees are kept in the dark, productivity slacks and resumes start flying out the door. And your best people have the most options. Don’t underestimate the impact change has on long-time employees when they are not involved in the transition as stakeholders. They want to understand where the new company is heading, if it shares the values they are accustomed to, and what role they will play in the days and years ahead. Seventy percent of change initiatives fail due to factors involving employee and cultural resistance. Timing and engagement both matter in preventing discord at the top because it always trickles down.

Unlike in other sectors, regulatory approval can slow the process of bank mergers to a halt, and time can make miscommunication fester. Often when a merger is announced, both parties have to wait five months for approval. The uncertainty of this period can turn into a harmful fog unless handled the right way.

One way to help clear things up is to have employees from both banks interact at social events or give the acquired employees opportunities to learn about the acquiring bank’s culture to see what change looks like in settings that are casual. Another way to keep communication open with key employees from the bank being acquired is to involve employees from both banks in teams to help broker transition objectives. Any step to include employees from the bank being acquired is better than no communication. In the absence of a story, human nature is to make one up, and it’s likely to be negative.

Identify Problems Early
The best way to identify potential issues for the merging organizations is impact analysis, a method that takes a qualitative approach to assessing the way each organization handles different aspects of its business, and then developing a quantitative solution to make both sides sync. For example, an impact analysis of the culture of a lending group—how decisions are made and by whom—would create a working hypothesis about what needs to happen in the group post-integration. Identifying strengths and weaknesses is necessary for closing the gap between the organizations and creating a cohesive roadmap to move forward.

In short, managing change successfully requires focusing on four key areas:

  1. Identify the most effective leaders and transition them to roles where they can thrive. Take advantage of the merger by making needed changes to your organizational structure.
  2. Get in front of the talent most likely to be a flight risk and help them see how they play an essential role in the new company.
  3. Focus on leading employees into the new culture and on their individual transition through incentives, training and new opportunities. Keep communication open and clear.
  4. Make sure payroll and benefits transition by day one. Mishandling paychecks or other mechanics will sabotage all of your prior efforts.

How Future Consolidation Will Change the Value of a Branch


consolidation-3-3-17.pngTwo long-term trends that have helped shape the banking industry as we know it today are consolidation and the shift from physical distribution built around branches to digital channels, including mobile. Although we tend to think of consolidation and the shift toward digital as separate but parallel evolutionary forces, they are beginning to interact in ways that could impact the bank mergers and acquisitions (M&A) market going forward.

The number of bank branches has been steadily declining since 2009, when they peaked at 89,775, according to Federal Deposit Insurance Corp. data. There was a glut of de novo branches from 2004 to 2007 when, according to veteran bank analyst Tom Brown, founder and CEO of the New York-based hedge fund Second Curve Capital, the popular deposit gathering strategy of many banks was to flood their markets with lots of new brick and mortar in order to sell free checking programs. “Before long, the landscape was littered with redundant, expensive, new bank branches,” writes Brown in his February 17 weekly newsletter. “All this at a time, remember, when consumer behavior was starting to move away from branch banking and toward online banking.”

The seminal event in 2008 was, of course, the collapse of the U.S. housing market and the advent of the sharpest economic downturn since the Great Depression. Since 2009, the number of U.S. bank branches has declined to 83,768 at the end of the third quarter of 2016, or by 6.7 percent. Brown has argued for years that the industry needs to reduce the size of its brick-and-mortar distribution system at a much faster pace. “[As] I’ve said many times, that’s still way too many branches,” Brown writes in his newsletter. “Consumer behavior toward online, non-branch banking isn’t growing at a slow, linear pace, but rather exponentially. A mere 7 percent reduction this decade after the reckless expansion the prior decade isn’t nearly enough.”

And this is where these separate trend lines of consolidation and distribution could begin to merge. For one thing, the quickening pace of the industry’s shift toward digital distribution—most banks have been seeing declines in branch traffic for several years now, which is the primary reason they’ve been closing branches in the first place—could have an impact on a seller’s valuations. If branches are a fixed asset of declining importance (and therefore declining value), how much will an acquirer be willing to pay for them? In an interview, Brown says this impact has already begun to occur. “In the ‘80s and ‘90s, when you did your due diligence on a target, you wanted to see that their branches were owned,” he says. “Today when you evaluate a target, the last thing you want to see is branches with long-term leases.”

It could also be that consolidation will hasten the reduction of branches because they offer a plum cost-takeout target in an acquisition. If a bank’s branch system is one of the most significant components of its cost structure, and if branches are of declining value as the industry continues its shift toward digital distribution, then one of the best ways that a buyer can reduce costs in the combined bank is by closing branches. Cost-takeout deals aren’t new in banking. They were very popular back in the ‘80s when they were the principal merger model. But branches were a much more valuable asset back then, and therefore did not bear the brunt of post-merger cost cutting. It’s a different game today. “It’s not going to be about PNC Financial moving out to the West Coast and buying Western Alliance,” says Brown. “It’s going to be a $20 billion bank buying a $5 billion bank and closing all sorts of branches.”

Risk Versus Return in M&A Transactions


transactions-2-20-17.pngMergers and acquisition (M&A) transactions need to be looked at from a risk versus return perspective. Participants in deals, both the buyer and seller, should understand the value proposition of the transaction and determine whether it is better to continue to grow and thrive organically or execute on a deal. Understanding value drivers and how to optimize value is the key to prospering in the future.

1. Know your value and what drives it.
There are both value creators and value detractors that exist for every company. It might be weak internal controls, a consent order or a multimillion-dollar, unfunded pension that weakens your deal prospects. On the other hand, you may have strong core deposits, strong profitability metrics or an experienced and actively engaged management team with deep client relationships that drive growth and value.

Value detractors specific to each company can be corrected over time. As the risk profile of the company improves, it is shown that valuation multiples will also improve. A company that has many value detractors can improve its risk profile over time. By improving its risk profile, the company increases the market’s perception of the value of the company, leading to higher valuation multiples. As your institution’s comparative value to the market changes over time, you must conduct periodic valuations to understand what the company’s current value is and what is driving it.

2. Understand your bank’s strategic paths, value and the execution risks of each path.
Once a company has a better understanding of its current value, it must understand the different decision tree paths available. Each of these paths will have a resultant present value of the company based upon executing on each path into the future. The risks and return associated with each path needs to be assessed. Below is an example of a strategic decision tree with five different paths. Each of these future strategic paths is modeled to determine the resultant present value resulting from each scenario path.

community-bank-chart.png

Not only is a present value calculated for each path, but the key risks and value drivers for each path need to be determined as well. For instance, if the company remains independent (path A), a key risk is that it may not be able to attract and retain key talent necessary for the company to thrive in the future.

In addition to the execution risks associated with each path, the financial value of the company under each scenario is also based upon a set of assumptions. Those assumptions must be reviewed carefully and the management team and the board of directors must critically review and sign off on those assumptions. More specific to M&A transactions, here are some of the major factors that impact an M&A deal:

  • Price: A stronger buyer currency shortens the work-back period of tangible book value dilution in a stock transaction.
  • Form of Consideration: Cash may decrease the work-back period of dilution in a transaction relative to utilizing stock consideration, due to higher earnings per share accretion, but utilizing cash will reduce the amount of capital at the combined entity.
  • Cost Savings: Acquisition of smaller banks and in-market deals will generally have higher savings (30-50 percent), while market or business line expansions generally have somewhat lower savings (25-35 percent).
  • Synergies: Deals can provide many synergies such as higher legal lending limit, greater franchise, new combined customer base, new sources of fee income, complementary loan and deposit products, or additional management bench depth for the combined entity.
  • Transaction Expenses: These are nonrecurring expense items and therefore should not be included in the pro forma combined income statement going forward but will impact tangible book value per share (TBVS) dilution and work-back period. Transaction expenses should generally be 7-12 percent for community bank deals and levels outside the range should be reviewed.
  • Mark-to-Market Assumptions: The target gets marked-to-market in a deal and these marks will initially impact TBVS upward or downward. The marks will be amortized/accreted through earnings over time. The marks generally have a bigger initial impact on TBVS and the earnings impact will be taken over a longer time period.

3. Recognize that a good deal on paper does not translate to a successful resultant entity.
Even with an extensive review of the assumptions, modeling and financial aspects of a transaction, a good deal on paper does not necessarily translate into a successful entity. Merger integration will make or break an institution’s ability to realize value in a transaction. Practical issues including vendor selection, branding and employee retention impact restructuring expenses. Social issues, such as corporate culture and leadership structure, define the bank moving forward.

Remember that there is an inherent risk versus return tradeoff in every M&A transaction. Understanding your institution’s risk profile, corporate culture, and all possible strategic paths will mitigate risk and maximize return.

The Banking Themes of 2017: What to Expect


bank-trends-2-3-17.pngAfter the anemic economic growth and overregulation of the past decade, what banking themes can we expect in 2017 amid current market optimism?

Rates
For an immediate impact, Trump and the Republican Congress need to lower the corporate tax rate first. Other policy agendas will have long-term effects. The true unemployment rate is over 10 percent, not 4.6 percent, when factoring in a normal labor participation rate, which is currently close to a 40-year low. Almost all employment growth from 2005 to 2015 is part-time, temporary or contract work. The economy is still not well, yet inflation continues to build, for example, with rising healthcare costs, government services and education costs. Most assets are overpriced with artificially low rates contributing to a torrid stock market and average price/earnings ratios at a 20-year high. This should keep rate hikes to 1 or 2 percentage points versus the 3 or 4 percentage points most are predicting. Rate hikes will create a nominal positive effect on net interest margin for banks of 5 to 10 basis points.

Credit
Corporate debt ratios are higher, particularly those with high yield. Most banks have thankfully chased high grade customers and credit since the crash. However, many are at or over the 300 percent real estate or 100 percent construction and development loan thresholds. Expect a real estate pullback. If the stock market retreats 5 to 10 percent, a mild recession may result. We are due for a credit correction over the next 6 to 18 months. It will hurt non-bank lenders more than banks. Loan growth should remain steady and provisions need to increase.

Capital
If bank stock prices can stay above 16 times earnings, expect more initial public offerings (IPOs) due to pent-up demand from 2016. Many banks are trading at 20 times price to earnings or more, and banks are in favor with investors. Bank stocks have been a greed and fear trade since 2008 with a near 100 percent correlation. Consumer and investor confidence is running high presently. Optimism abounds about interest rates, the economy, tax cuts and deregulation. While it all seems to be priced into bank stocks right now, investing in government optimism versus company fundamentals feels a bit awkward at best. Expect a pullback, but for the sector to remain strong with good, core earnings growth of 15 percent or more and with more IPOs in quarters two through four. There has been an increasing interest from yield-starved investors in bank stock loans, subordinated debt and preferred stock. Expect that to continue.

M&A
The volatility in the markets in 2016 were driven by China, energy, and Brexit, so renewed confidence could be a good thing for M&A. Do prospective sellers, frustrated with lackluster returns and burdensome regulations, have newfound optimism and upward price exit expectations? Perhaps, but there is room to run here. Volume was down 10 percent in 2016 with 242 deals. But there was an increase in exits or restructuring, as private equity investments matured and investor activists pressured banks to sell. Confidence and high buyer currency should lead to increased volume in 2017, especially given the seller expectations being average to below average, while buyer currencies are at 20-year highs. But if volatility and fear get too high, then M&A will slow.

Deposits
One or two rate hikes shouldn’t be an issue as bankers will wait to raise rates on deposits. At some point, depositors will gain confidence in the market and push for higher returns. This will be interesting as many bankers think they have core deposits, even though they don’t, and will realize they have a liquidity problem when the deposits run.

Regulatory
Complaints about the Dodd Frank Act are still rampant industry wide, but bankers will be found thinking, “Hey, I’ve spent the money and adjusted. I need certainty, not uncertainty.” While there are still parts of Dodd-Frank that haven’t been implemented, deregulation could be the developing theme. Also, what happens to the Consumer Financial Protection Bureau? This is an entity which basically usurped power from the other regulatory agencies, and plenty of senators and representatives would like to curtail its power.

Customers
Lastly, banks will have to work on improving customers’ experience. Take note of the retail industry. After a robust Christmas shopping season, Macy’s is closing 59 stores and Sears even more. If your product is clothing at a good price, then online retailers have stolen your product. Retail needs to provide an experience to differentiate. Some banks are already delivering a coffee shop or networking experience. Amid the fake news perpetuated online, and failed deliverables from Wall Street, the country is desperate for a trusted refuge and harbor of safety they can believe in. Perhaps, banks that deliver an experience anchored in a theme of trust will do well.

 

Rewarding Executives for Successful Bank M&A


compensation-1-29-17.pngMergers and acquisitions (M&A) can create significant value for shareholders. Accordingly, bank executives should be rewarded when completing and integrating successful transactions. However, in today’s environment of heightened executive pay scrutiny, some approaches to providing additional compensation for M&A can result in criticism from shareholders and advisory firms such as Institutional Shareholder Services and Glass Lewis & Co. Clearly documenting the rationale of rewards and how they align with value enhancement can increase the effectiveness and shareholder support for such compensation.

Evaluate the Context

Roles of involved employees: While M&A activity is an expected part of some executives’ responsibilities, others may be required to go beyond their day jobs as part of the due diligence or integration processes. The extent of work required outside an employee’s normal responsibilities and job expectations should impact discussions of additional compensation.

Activities versus results: Another consideration is whether compensation should result from the additional, typically shorter-term activity during the M&A process or the actual longer term results of the transaction. In some cases, additional pay for transaction activities will be important to retain key talent who have been asked to go beyond their normal responsibilities. Larger, more significant rewards should depend on whether the merger produces improved bank performance and value creation.

Timing of additional compensation: Compensation can reward M&A results at different points during the transaction process. While the closing of the deal may be viewed as a trigger point for additional pay, the integration process is critical to ensuring the deal reaches its expected potential. Shareholders will be most concerned with the financial results generated from the transaction, and may be more receptive to additional compensation tied to the long-term financial impact of the deal.

Current programs: The current compensation program may already provide the opportunity to reward M&A, lessening the need for additional one-time pay that can be scrutinized.

Evaluate Rewards
There are many ways to reward M&A activity and results. Where possible, it is preferable to reward executives through existing programs, although special awards may be appropriate in some cases. Creating flexibility within the total pay program in advance of any transactions can help increase the number of tools the bank has to recognize executives. All of the potential components should be considered together since recognition may result from more than one of the following components:

Base Salary Adjustments: M&A activity can result in executives taking on new responsibilities, and pay increases may be appropriate. Since salaries can drive the size of incentive awards, considering the potential target total compensation of the new role can help ensure the executive is rewarded over the short and long-term.

Annual Incentives: Annual incentive plans can recognize short-term contributions and efforts during transactions and through integration. Depending on the plan’s structure, recognition could be incorporated as a component in a goal-based plan (i.e. based on strategic or individual performance) or as a consideration in a discretionary plan. Significant special cash bonuses solely for merger completion are not favored by shareholders.

Long-term Incentives: These programs are designed to recognize the long-term performance and value creation resulting from a company’s business strategy. Prior awards such as stock options and restricted stock will recognize stock price appreciation and shareholder views of the acquisition. Performance shares also recognize the long term value from successful transactions. The structure of the grant process should be considered. Is there flexibility to recognize individual contributions during the M&A process, for example, through a grant of stock? If so, this can be an effective way to reward contributions immediately, with compensation tied to shareholder value creation.

Special Awards: In some situations, additional, one-time awards may be appropriate. The best practice is to provide recognition in the form of long-term equity, preferably with some performance criteria or hurdle. This can help address concerns of some shareholders and advisory firms that are critical of M&A bonuses or grants.

Other Considerations: In more significant M&A transactions, it is appropriate to review the compensation peer group and assess whether compensation opportunities should be adjusted to reflect the new organization’s size and complexity. It is also important to monitor the pay-performance alignment over subsequent years to ensure compensation is appropriately recognizing performance.

Conclusion
Successful M&A, over the longer term, should result in commensurate rewards for the executives that execute the transaction. The key is ensuring that current pay programs have the flexibility to provide such recognition and that the pay levels, over time, are aligned with the company’s performance and shareholder value creation.

Navigating Today’s M&A Market



Bank deal activity in 2017 is likely to be on par with 2016, as the bank executives and board members responding to Bank Director’s 2017 Bank M&A Survey reflect lower levels of optimism for the bank M&A environment. In this video, Rick Childs, a partner at survey sponsor Crowe Horwath LLP, provides his perspective on the survey results and explains why, despite a lower number of sellers, it really is a buyer’s market today.

  • Expected Deal Activity for 2017
  • What Successful Buyers Look For in a Target
  • Factors That Sink a Deal

In accordance with applicable professional standards, some firm services may not be available to attest clients. This material is for informational purposes only and should not be construed as financial or legal advice. Please seek guidance specific to your organization from qualified advisers in your jurisdiction. © 2016 Crowe Horwath LLP, an independent member of Crowe Horwath International. crowehorwath.com/disclosure

M&A Alert for Banks: Preparing to Be a Buyer


strategy-1-27-17.pngBefore a board and management of a bank pursue an acquisition, they should realistically assess their bank, the characteristics of the board and the shareholders, and the alternatives available.

The board and senior management should develop a strategic plan for the bank. The Federal Deposit Insurance Corporation has cited an increasing number of banks for lack of strategic planning in matters requiring board attention. The Office of the Comptroller of the Currency also has focused on strategic planning in the last few years. 

All board members must share a commitment to the strategic plan. Divisiveness in the boardroom often jeopardizes a bank’s ability to achieve its objectives.

The board has a fiduciary duty to make fully informed business decisions as to what is in the best interests of the hypothetical shareholder who is not seeking current liquidity. Management must assume the responsibility of educating the board (or bringing in consultants to do so) regarding the bank’s strengths and weaknesses, its inherent value, and the market(s) for targets. The board and senior management should meet regularly to discuss the bank’s strategic direction.

Debate in the planning process is healthy, but once the board agrees on a course of action, the board and management should speak with a united voice.

The board and management should communicate the bank’s strategic direction to shareholders. If key shareholders disagree with the direction, the board and management should arrange for such shareholders to be bought out or be comfortable that the bank need not do so. It is difficult to achieve strategic objectives if the board and key shareholders are working at cross purposes.

Evaluate Alternatives
The prospective buyer has a number of alternatives for enhancing shareholder value or multiple paths to be pursued at the same time. The board should evaluate such alternatives to identify the most attractive transaction.

Evaluate Your Prospects for Success
In embarking on bank M&A in the current environment, sellers will demand assurances that buyers can close. Here are some of the factors purchasers should consider:

  • Community Reinvestment Act and compliance ratings: Purchasers need to understand the “hot button” issues driving regulatory reviews and stay up to date. Yesterday’s focus on asset quality, anti-money laundering and Bank Secrecy Act compliance and third-party relationships have been joined by redlining, incentive compensation, concentration risk and cybersecurity, among others.
  • Capital levels: Determine whether the bank’s capital is sufficient to support an acquisition. If not, where will your bank obtain the needed funding?
  • Management: Does the purchasing bank have sufficient senior management capacity to staff the acquired bank or will target management be needed to implement the acquisition?
  • Systems and facilities: The purchasing bank’s board should evaluate whether the bank has compliance management systems and an enterprise risk management program that can scale for the acquisition.

Coming up with a good strategic plan while considering the bank’s alternatives is important for the board to discuss before embarking on an acquisition.

Negotiating the Transaction
There still may be a problem: What if there are very few targets that the bank has identified as “fits,” and none of them are in the market to sell?

Increasingly would-be buyers are willing to consider offering stock as part or all of the merger consideration. There are several drivers of this newfound willingness. First, buyers must meet increasingly challenging capital requirements. The exchange ratio in the merger may offer more attractive pricing to the buyer than issuing common equity to the market. Second, sellers have become more willing to accept private or illiquid stock as merger consideration. This may be a function of sellers’ understanding that economies of scale offer potential for greater returns on investment while enabling sellers to refrain from taking their “chips off the table” as would be the case in a cash sale. The recent run up in the stock market indexes has not yet translated into a general increase in M&A pricing. Third, a transaction that provides for a significant stock component allows for more one-on-one negotiations. Lastly, a strategic combination allows for mutuality of negotiation.

Just offering the selling shareholders stock may not be enough to convince a reluctant seller to consider a transaction. Would-be community bank buyers must recognize that there are social issues in any transaction (even when the merger consideration is cash). Accordingly, the buyer must evaluate in advance the roles of senior management of the seller, retention arrangements to proffer, severance to provide as well as bigger picture social issues such as board representation, combined institution name and headquarters.

A focus on the social issues and a willingness to put stock on the table may allow community bank buyers to continue to compete for acquisitions despite the rebounding stock market. Other competitors may be able to offer nominally more attractive pricing, but such an offer may not have better intrinsic value.

Rising Stock Prices Could Impact Deal Market


stock-prices-1-19-17.pngThe year 2016 was filled with tumult and that had a negative impact on activity in the bank mergers and acquisitions (M&A) market, while higher bank stock prices are adding to the uncertainty. Will higher stock prices last? Will they lead to higher valuations in the months ahead? This article takes a look at M&A activity in 2016 with an eye toward how the environment could impact pricing and trends in 2017.

After posting 285 healthy bank acquisitions in 2014 and 279 deals in 2015, the market slipped back to 241 last year, according to data provided by S&P Global Market Intelligence. There are several reasons for this, but they can all be summed up in a single word—uncertainty. And bankers hate uncertainty like dirt hates a bar of soap.

In the first quarter of 2016, the sharp decline in the price of oil and economic softness in China and in Europe led to concerns about how that might impact the U.S. economy. There was even some talk that economic weakness abroad could result in a recession here in the United States by the end of 2016. “When oil fell off, combined with the China thing, it really took the bloom off of the rose,” says Dory Wiley, president and chief executive officer at Commerce Street Holdings, a Dallas-based investment bank. The Southwest, where Wiley works, saw a drop off in deal-making following the fall-off in oil prices. “It kind of froze all the buyers and a lot of deals, and of course sellers are always very reluctant to change their price expectations, so it slowed the amount of deals.”

The U.S. economy did not in fact slip into a recession in the second half of 2016, growing 2.9 percent in the third quarter, according to the U.S. Commerce Department. (Data for the fourth quarter was not available when this article was written.) But there was still plenty of uncertainty entering the second half of the year, which perhaps had an even more paralyzing effect on the M&A market. Once the presidential election campaign between Democrat Hillary Clinton and Republican Donald Trump had gone into full swing (both parties held their nominating conventions in July), it seems that some bank boards decided to hold off on a possible acquisition or sale in hopes that a Trump victory would create a better economic environment for banks, and have a positive impact on bank stocks.

Stocks, indeed, rose. The KBW Nasdaq Bank Index, a compilation of large U.S. national money center and regional bank stocks, expanded from 63.24 on January 19, 2016, to 75.42 on November 7, for an increase of 16 percent. However, immediately following the presidential election the index shot up from 75.42 on November 7 to 92.31 as of January 12 of this year, an increase of 22 percent. While Donald Trump’s election victory might have been received as good news by many bankers, it seems to have brought about a slowdown in M&A activity precisely because bank stock prices were going up. With valuations on the rise, some boards were reluctant to sell out if their franchise could fetch a higher price later on by waiting.

Johnathan Hightower, a partner at the law firm Bryan Cave LLP, supports this theory with data that shows a noticeable slowdown in deal flow in the fourth quarter of 2016. There were 88 announced deals in the fourth quarter of 2014 and 82 in the fourth quarter of 2015. In the final quarter of last year, the number of announced deals dropped off to 62. “I think a good bit of that can be attributed to uncertainty on the political scene,” says Hightower.

As we head into 2017, the biggest question might be how high bank stock prices will go, because continued increases may discourage M&A activity as buyers and sellers alike try to work out how deals should be valued, and what kind of structure should be used. “I think whenever you see a sharp change in valuation like we’ve seen over the past eight weeks or so, it does cause some complication in working out exchange math and exchange mechanics,” says Hightower. For example, does the seller want to lock in a fixed exchange ratio or opt for a structure that would allow the deal price to float higher if its stock price continues to rise? “The seller is doing that same sort of math on its end, so it can be hard to reach agreement, or at least require some creativity in structuring a deal,” he says.

How much higher can bank stock prices go? Jim McAlpin, who heads up the financial services practice at Bryan Cave, says he recently led a strategic planning session for the board of a Texas bank. “I was talking to the CEO about where the board was on a possible sale,” McAlpin recalls. “He said that given the recent changes [in the bank’s stock price], they’re now thinking that three times book value is possible. A year ago I would have laughed hard at that. I only chuckled this time because he said there was a bank across the street that went for 2.3 times book value. We just recently saw a bank in Georgia go for almost 2.7 [times book value] in part because of rising valuations.”

For an industry that has been dogged by low interest rates, margin pressures and economic sluggishness for several years now, the future suddenly seems very bright. But will it last? “The interesting question that no one can answer right now is, will we see a real shift in economic growth that would support an overall lift in those valuations?” asks Hightower. “Can we expect banks to have healthy, sustainable growth because we’ve got healthy, sustainable growth in the overall economy?”

Prices remained fairly steady from 2014 through 2016. According to S&P, average deal pricing was 1.42 times tangible book value in 2014, then went up slightly to 1.43 in 2015 before dipping back down to 1.35 in 2016, despite the steady run up in stock prices through the year. But we’ve now entered a period where, as the mutual fund industry likes to say, past performance may not be indicative of future results. “When you look at what the market has done in the last three to four months, with the election behind us … I don’t know that past pricing is going to be as relevant as it was,” says Wiley.

Other factors that impacted the M&A market last year include a kind of speed control that bank regulators exercise over the pace of deals. While the regulators are generally more receptive to acquisitions than they were in the years immediately after the financial crisis, and are approving deals much faster now, they still limit the frequency of deals for even experienced acquirers. “You’d be lucky to get somewhere between one and three [deals a year now],” according to Wiley. And that has added a layer of complexity to the M&A process, particularly for investment bankers. “So a guy calls you up and says, ‘Hey, run some comps, figure out what I’m worth.’ That’s not enough,” he says. “The investment banker running the deal has to know who’s in the market, who isn’t in the market and when they’re going to be in the market because it’s not an easy answer anymore.”

And because they are limited as to the pace they can string deals together, many acquirers have become more selective in what they are willing to buy. “Even with stock prices rallying like they have the last three or four months … it doesn’t mean that the acquirer can run around and just give his stock away because he’s got to be picky,” says Wiley. “He’s like, ‘Hey, I only get a couple shots at this because the regulators aren’t going to let me do anything.’’’

Does that mean it is now a buyer’s market? “I thought it was a buyer’s market for the last eight years,” says Wiley. “The only thing now is that the buyers are starting to realize it. They’ve got a big stock price now and they’re feeling good about themselves. Somebody told them they were pretty.”