If your board is considering a sale of the institution, you’re not ready to sell if you’re not prepared to sell. There are a variety of issues that your board will need to consider if it wants to maximize the value of the bank’s franchise in a sale. Many, although not all of these considerations, involve the bank’s balance sheet. Other important issues include cutting overhead costs and dealing with regulatory compliance issues. Sal Inserra, an Atlanta-based partner for the accounting and consulting firm Crowe Horwath LLP, offered the following advice to Bank Director Editor in Chief Jack Milligan.
Take a hard look at impaired loans on your balance sheet.
When bank executives consider a sale and analyze the loan portfolio, they are not always looking at it from the perspective of a potential buyer. If there’s a problem customer, they have a sense of the potential collection on that impaired loan. When buyers come in cold, they don’t have that history. They are doing an antiseptic review. It is numbers on a page that lead to a conclusion. They’re not going to accept the backstory as a reason why they should pay more for the loan than they think they should. If you have another appraisal in hand that shows the value higher, they may give credence to that, but not as it relates to the sob story. From the buyer’s perspective, if a loan is leveraged with 100 percent loan-to-value with a five-year life, the prospective buyer will require accretion yield of 9 percent to be attractive given the risk. If the coupon on that loan is only 5 percent, the buyer is only going to pay 75 cents on the dollar to achieve their yield. You have to get past the subjective analysis and get more objective detail about that impaired loan. You need to get the most current financial information possible about that impaired loan and the borrower.
Avoid bad leverage transactions as much as possible.
A bad leverage transaction sometimes occurs when the bank has excess deposits and invests in securities of different durations in an attempt to leverage the capital in the financial institution. Depending on how far out into the future the bank is leveraged, it could end up in a bad position where the assets are at a fixed rate, and the liabilities are at a variable rate. And because the bank is maximizing yield, as liabilities start creeping up, net interest margin can erode rather quickly. In the current market, unless the bank wants to go out four or five years or more on a bond and take some credit risk in something other than a U.S. Treasury security, the bank is going to have a pretty narrow net interest margin. Rather than buy low-earning securities, you might benefit your bank’s value by waiting for a buyer with a high loan-to-deposit ratio that needs additional funding. If the seller has excess funding that hasn’t been tied up, that could be a very lucrative purchase to a bank that needs the funding. But once the seller has tied that funding up in something with a narrow net interest margin, the buyer will have to unwind that in order to get value. And if the buyer has to take a hit to unwind that investment, it’s going to impact the seller’s value.
Manage excess capital on the balance sheet.
This is really about how you spin the story of selling the bank. Let’s say you have $50 million in capital. So if you sell for two times book value, you would get $100 million. But of that $50 million, let’s say that $10 million has not been deployed, so you’re not going to get two times $50 million. You’re going to get 1.60 times $50 million, which is $80 million. However, if the bank gets rid of that $10 million in excess capital by paying it out in dividends, it will receive $70 million, but because it is now working off a $40 million base, the bank reports a higher premium. Net cash is still $80 million when you consider the dividend.
Another approach would be to try to leverage up that excess capital. Where you may have turned down a loan before because the pricing wasn’t good, but it was still going to create a good margin and a decent return on investment, the bank may want to invest in the loan because at least it becomes an earning asset. This strategy will depend on what is available in the market.
Shed costly assets or debt before attempting to sell the bank.
Since the value of the bank is based on future earnings, if the bank is carrying some high cost debt, it’s going to impact future margins. Or if the bank has low yielding assets, that’s going to affect future margins. When buyers come in to price those assets and liabilities, they’re going to knock down the value of the bank. Most high cost debt has a prepayment penalty associated with it, so there’s a net cost to get out of that debt. But when it comes to low yielding assets, the bank can maximize net interest margin by getting rid of assets that are going to cause issues for future earnings.
Focus on cost control prior to a sale.
When it comes to cost control, the first thing to look at is the branch network. It’s no secret that branch activity continues to decrease as folks get more and more comfortable with digital banking. I love [author Brett King’s motto], “Banking is no longer somewhere you go, it’s something you do.” And the value of a seller’s branch network may be going down because the cost of maintaining those branches is still significant, not only from a hard cost standpoint but also with training staff, marketing and all the other costs of operating a branch. So take a hard look at those branches that buyers are going to consider exiting. If the bank can start narrowing those costs by closing some of those marginal branches, so that the buyer can see what the run rate is going forward, that will help improve value because the value is going to be driven on the multiple of future earnings.
The other thing I would focus on is staffing. A lot of banks have made big strides in technology, but they haven’t reevaluated their head counts. And they need to do a review of what is necessary to operate and deliver service. A phrase I hear a lot is, “We’re not going to change our head count, we’re going to grow into it.” And that doesn’t necessarily work because as you grow, it doesn’t mean the resources are going to be able to continue to help you get to the next level. So doing a critical analysis of head count is key. Those are the two major variables—branches and people—that when addressed can help you improve your efficiency.
Avoid entering into long-term contracts if you’re considering a sale.
The thing that just makes me scratch my head is when a board is thinking about selling the bank and a year before it pulls the trigger, it enters into a four- or five-year core processing contract. The cost associated with exiting a core processing contract, unless it happens to be the same company that they buyer uses, is incredible. I’ve seen millions of dollars spent to exit a core processing contract.
Factor regulatory compliance issues in a potential sale.
If the bank knows its potential acquirers, it knows its potential new regulators. The key issue is making sure that regulator knows the seller has its compliance house in order. The seller can put together an in-house review or use external resources to address the issues of that potential regulator. If I’m a $2 billion asset bank and it’s likely that I’m going to become part of an institution that’s over $10 billion in assets, I need to be focused on issues that the Consumer Financial Protection Bureau is focused on, because I know that my portfolio is going to be subject to a CFPB review. If I’m a $200 million asset bank and I’m going to merge into bank that’s in the $2 billion to $3 billion range, that may present a higher level of scrutiny. So knowing my potential acquirer allows for adequate preparation.