One Risk in M&A You Maybe Have Not Considered


core-provider-9-25-18.pngThe vast majority of middle-market community banks and credit unions will at some point explore acquiring or being acquired because M&As are one of the quickest and most effective ways a bank can scale up, expand reach, and grow. Unfortunately, many of these banks have no choice but to watch lucrative opportunities pass them by because they unwittingly agreed to grossly unfair and inequitable terms in their core and IT contracts.

Financial institutions constantly assess risk from nearly every conceivable perspective to protect shareholder value, but far too many realize too late that hidden astronomical M&A termination fees and other hidden contractual penalties render a deal totally unfeasible. Over and over again, blindsided banks are hobbled by stifled growth.

Simply stated, core and IT suppliers punish banks with excessive termination, de-conversion and conversion fees because they can get away with it. Suppliers also sneak in large clawbacks for discounts awarded in the past as an added pain for measure. Banks fall for it because they don’t know better.

Bank deals are complex procedures with the possibility of extraordinary payoff or extraordinary peril. Terms regarding potential M&As are buried deep within the pages of lengthy and convoluted core and IT supplier contracts. Suppliers are betting that arduous language within these five- to seven-year agreements deter bankers from looking too closely or fully comprehending terms and conditions they contain. Many banks are not thinking about a merger or acquisition when they originally signed those contracts. The suppliers’ bets pay off, and banks either lose the deal or are forced to pay in spades.

Termination fees core and IT suppliers secure for themselves in most contracts with community banks and credit unions border on unconscionable. Banks find themselves saddled with the prospect of paying 50, 80, or even 100 percent of the amount due to the core provider based on what would have been paid if the institution remained with that supplier for the life of the contract.

And these fees apply even if the financial institution they’re merging with or acquiring has the same core IT supplier. Even in cases where the core has virtually nothing to lose in the deal, they still demand a fat check for their “pains.” These fees are so high they can easily kill a potential deal before it even reaches the negotiating table — and they often do.

Banks Have Defendable Rights
A contract isn’t a contract unless there’s some cost for exiting it early. But there’s fair and then there’s fleecing — and let’s just say core and IT suppliers wield a pretty big pair of shears.

The reality is that more than half of all states will not tolerate these termination fees in court, provided they’re challenged by institutions. The maximum amount of liquidated damages a supplier is entitled to legally — provided they can rationalize how they were harmed — is the discounted value of remaining net profit. This might not be more than 18 to 22 percent of remaining contract value, or about one year on a five-year deal. That’s nowhere close to what is often claimed by core suppliers.

But you have to know your rights before you can demand they be respected, and a wealth of knowledge regarding the most favorable core and IT contract terms available can’t be acquired overnight. It’s taken many years for Paladin to amass proprietary core and IT supplier contract data.

Secure Fair Terms Now to Protect Deals Later
By updating your contracts before a transaction, you can speed the M&A process, protect your institution and shareholders, and prevent unforeseen deal risks. But you’ll need to come armed and ready for battle. Core and IT suppliers have enjoyed decades of manipulating the system to their advantage. Going it alone in your next contract negotiation will likely result in ending up with more of the same hidden and unfair terms. That’s how good these guys are at getting what they want from the community banks they call their “partners.”

There are experts with a proven track record of going toe-to-toe with core and IT suppliers and coming out ahead for community financial institutions. Time and again, we’ve approached the table with our clients, advocated for a fair deal, and walked away with terms that make sense for both parties — not just the suppliers.

Acquire or Be Acquired Perspectives: How to Address the Social Issues of M&A


culture-5-4-18.png	Steele_Sally.pngThis is the final installment in a five-part series that examines the bank M&A market from the perspective of five attendees at Bank Director’s Acquire or Be Acquired conference, which occurred in late January at the Arizona Biltmore resort in Phoenix.

Read the perspectives of other industry leaders:
John Asbury, president and CEO of Union Bankshares
Gary Bronstein, a partner at Kilpatrick Townsend & Stockton LLP
Eugene Ludwig, founder and CEO of Promontory Financial Group
Kirk Wycoff, managing partner of Patriot Financial Partners, L.P.


It is tempting to think that last year’s tax cuts will spur deal-making in the bank industry. The cuts have driven up profits and bolstered valuations, with bank stocks trading at their highest earnings multiples since before the financial crisis. But deal volume ebbed instead of flowed last year.

“The tax reform allows potential sellers to wait longer to see how things evolve,” says Sally Steele, chairwoman of Community Bank System, Inc., an $11-billion bank based in Dewitt, New York.

Steele made this point while attending Bank Director’s 2018 Acquire or Be Acquired conference in January at the Arizona Biltmore resort in Phoenix. Her perspective on the M&A landscape is one of five that Bank Director cultivated from attendees at the event.

Whether it is prudent for a bank to sit on the sidelines as things evolve, rather than take advantage of a high valuation, is a risk—particularly when it comes to regulation. “You might have a four-year window where we have a kinder, gentler regulatory environment,” Steele notes.

All of this speaks to the axiom that banks are sold, not bought. “Folks have to come to a decision that selling is a good strategy, whatever the motivation,” says Steele.

Value plays an obvious role in this decision, but it alone is not enough. Social issues involving leadership and culture also play a major role, Steele says.

For instance, succession is a perennial topic of conversation in the industry. As leaders retire, it can be hard to find successors that are qualified to step into the void. One way to address this is to sell the bank.

There are also times when the current leadership is not a good fit, irrespective of retirement. This came up in one of Community Bank System’s recent acquisitions, where the CEO was better suited to be a commercial lender than the CEO.

Steele speaks on these issues from experience, as she has served as a director of banks that have been both buyers and sellers.

Prior to serving on the board of Community Bank System, Steele was a director of Grange National Banc Corp., a Pennsylvania-based bank that grew to $278 million in assets before selling in 2003 to her current bank.

Since then, Community Bank System has acquired seven other banks, the biggest and most recent being Merchants Bancshares, a $1.9-billion bank based in Vermont, acquired last year.

The principal motivation for buyers tends to be growth. The bank industry has consolidated every year since 1984. Prior to that, the number of banks in the country tended to grow on an annual basis. Since then, it has dropped without interruption every year.

Given this, it is easy to understand why banks are so inclined to grow. There comes a point in a consolidating industry when the law of the jungle takes hold, forcing banks to choose between eating or being eaten.

This motivation helps explain the tendency for mergers and acquisitions to impair, as opposed to improve, shareholder value. It was the imperative to grow, after all, that led banks in the prelude to the financial crisis to acquire subprime mortgage originators, as Bank of America Corporation did with Countrywide Financial and Wachovia did with Golden West.

Regardless of the numbers, however, Steele emphasizes the central role that culture plays in the acquisition process. “From a buyer’s perspective, it’s about how the combination fits,” says Steele. “Fits in a lot of different ways, not only monetarily and economically, but also the culture is huge. Bringing in the wrong culture just doesn’t work. I don’t care what anybody says, it doesn’t work.”

As the chairwoman of an acquisitive bank, this is one reason Steele attends the annual Acquire or Be Acquired conference, coming four out of the last five years.

“I’ve been through the acquisition process, and it’s a scary thing,” says Steele. “There is a lot of distrust when folks start approaching you about that kind of thing. So having rapport and thinking, ‘Oh, I met that person at the conference.’ That’s helpful. So much of it is personal. I don’t care what anybody says.”

Well Conceived and Executed Bank Acquisitions Drive Shareholder Value


acquisition-2-21-18.pngRecent takeovers among U.S.-based banks generally have resulted in above-market returns for acquiring banks, compared to their non-acquiring peers, according to KPMG research. This finding held true for all banks analyzed except those with greater than $10 billion in assets, for which findings were not statistically significant.

Our analysis focused on 394 U.S.-domiciled bank transactions announced between January 2012 and October 2016. Our study focused on whole-bank acquisitions and excluded thrifts, acquisitions of failed banks and government-assisted transactions. The analysis yielded the following conclusions:

  • The market rewards banks for conducting successful acquisitions, as evidenced by higher market valuations post-announcement.
  • Acquiring banks’ outperformance, where observable, increased linearly throughout our measurement period, from 90 days post-announcement to two years post-announcement.
  • The positive effect was experienced throughout the date range examined.
  • Banks with less than $10 billion in assets experienced a positive market reaction.
  • Among banks with more than $10 billion in assets, acquirers did not demonstrate statistically significant differences in market returns when compared to banks that did not conduct an acquisition.

Factors Driving Value

Bank size. Acquiring banks with total assets of between $5 billion and $10 billion at the time of announcement performed the strongest in comparison with their peers during the period observed. Acquiring banks in this asset range outperformed their non-acquiring peers by 15 percentage points at two years after the transaction announcement date, representing the best improvement when compared to peers of any asset grouping and at any of the timeframes measured post-announcement.

Performance-chart.png 

Acquisitions by banks in the $5 billion to $10 billion asset range tend to result in customer expansion within the acquirer’s market or a contiguous market, without significant increases in operational costs.

We believe this finding is a significant factor driving the value of these acquisitions. Furthermore, banks that acquire and remain in the $10 billion or less asset category do not bear the expense burden associated with Dodd-Frank Act stress testing (DFAST) compliance.

Conversely, banks with nearly $10 billion in assets may decide to exceed the regulatory threshold “with a bang” in anticipation that the increased scale of a larger acquisition may serve to partially offset the higher DFAST compliance costs.

The smaller acquiring banks in our study—less than $1 billion in assets and $1 billion to $5 billion in assets—also outperformed their peers in all periods post-transaction (where statistically meaningful). Banks in these asset ranges benefited from some of the same advantages mentioned above, although they may not have received the benefits of scale and product diversification of larger banks.

As mentioned earlier, acquirers with greater than $10 billion in assets did not yield statistically meaningful results in terms of performance against peers. We believe acquisitions by larger banks were less accretive due to the relatively smaller target size, resulting in a less significant impact.

Additionally, we find that larger bank transactions can be complicated by a number of other factors. Larger banks typically have a more diverse product set, client base and geography than their smaller peers, requiring greater sophistication during due diligence. There is no substitute for thorough planning, detailed due diligence and an early and organized integration approach to mitigate the risks of a transaction. Furthermore, alignment of overall business strategy with a bank’s M&A strategy is a critical first step to executing a successful acquisition (or divestiture, for that matter).

Time since acquisition. All three acquirer groups that yielded statistically significant results demonstrated a trend of increasing returns as time elapsed from transaction announcement date. The increase in acquirers’ values compared to their peers, from the deal announcement date until two years after announcement, suggests that increases in profitability from income uplift, cost reduction and market expansion become even more accretive with time.

Positive performance pre-deal may preclude future success. Our research revealed a positive correlation between the acquirer’s history of profitability and excess performance against peers post-acquisition. We noted this trend in banks with assets of less than $1 billion, and between $1 billion and $5 billion, at the time of announcement.

This correlation suggests that banks that were more profitable before a deal were increasingly likely to achieve incremental shareholder value through an acquisition.

Bank executives should feel comfortable pursuing deals knowing that the current marketplace rewards M&A in this sector. However, our experience indicates that in order to be successful, acquirers should approach transactions with a thoughtful alignment of M&A strategy with business strategy, an organized and vigilant approach to due diligence and integration, and trusted advisers to complement internal teams and ensure seamless transaction execution.

A New Approach for Bank M&A


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

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

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

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

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

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

Here are six basic rules that should be followed:

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

Should TBV Dilution Be Dead?


TBV-5-29-17.pngAs 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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.

The Window of Opportunity to Sell Is Now


acquisition-5-22-17.pngDespite 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.

  1. 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.
    Interest-rate-chart.png
  2. 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?
  3. 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.

Three Ways to Increase Shareholder Value


shareholder-5-3-17.pngWith the Federal Reserve due to raise interest rates again this year and an administration focused on domestic issues and reducing regulation, community bank stocks are in high demand. The OTCQX Banks Index, a benchmark for community banks traded on the OTCQX market, gained 30 percent in the past 12 months, compared to 15 percent for the S&P 500. How can community banks leverage this positive trend and deliver greater value to their shareholders?

First, achieve a fair valuation for your shares. Fair market value is the price at which a person is willing to buy a company’s stock on the open market. Determining fair market value for a publicly traded stock is relatively straightforward and can be done by, for example, taking the average of the highest and lowest selling prices for the stock that day.

Figuring out fair market value for a stock that is not traded on a public market is a little more complex. For privately held community banks, this typically requires the chief financial officer to call around to multiple investors to negotiate prices in bilateral transactions. Not only is this process opaque and inefficient, but it generally doesn’t yield the highest value for shareholders.

For a publicly traded community bank, achieving fair market value is also a factor of the market on which it is traded and how much information it makes available to investors. A bank that trades on an established public market like OTCQX or OTCQB is helping maximize the value of its shares by providing transparent pricing, access to liquidity and convenient access to its news and financial disclosure.

Second, reduce the risk of owning your securities. Community banks can also maximize shareholder value by reducing the risk of trading their securities. A privately-held bank that trades its stock out of a desk drawer opens itself up to additional risks related to pricing, holding and clearing its securities. In contrast, a bank that trades on an established public market reduces risk for shareholders by allowing them to freely get into and out of its stock.

Public market standards can also help lower shareholder risks. In the OTC markets, the top two markets—OTCQX and OTCQB—have verification processes which allow banks to demonstrate to shareholders that they have met certain standards and that there are risk controls around their securities. In contrast, there is no such verification process for companies on the bottom Pink market, which increases the risks—and costs—of owning these securities.

Third, embrace technology. As community banks struggle to replace an aging shareholder base, technology will play a key role in attracting and retaining a new generation of millennial investors. Millennials, aged 18 to 34 years old, get most of their news online and on their phones, so banks need to embrace technology to make sure their financials and news are widely disseminated.

Trading on an established public market like OTCQX and OTCQB can help community banks ensure their news and disclosure is seen by broker-dealers and investors wherever they analyze, value or trade its securities. OTC Markets Group also works with Edgar Online to provide non-Securities and Exchange Commission reporting banks conversion and distribution of their fundamental data in XBRL format, so it can be more easily consumed and analyzed by investors.

With community bank stocks receiving positive attention, now is the time for banks to capitalize on market demand. Think about your shareholders and what’s important to them. Whether your bank has $100 million in assets or $3 billion, your shareholders should be treated like customers and you need to put their needs first.

Merger of Equals: Does 1 + 1 = 3?


merger-9-12-16.pngGiven today’s burdensome regulatory environment and complex business climate, many banks are evaluating different strategic alternatives as a means to grow. Mergers of equals (MOEs) are not always at the forefront of discussions when bank executives consider strategic alternatives, due to the social and cultural issues that can present roadblocks throughout the negotiation process.

It is vital to the success of a MOE that both parties come to terms on these issues early in the process to minimize the execution risk. When both parties of a MOE develop and align the structure of the transaction as well as the vision of the combined entity, MOEs can be executed successfully.

Historically, these issues have hindered MOE activity. Since 1990, MOEs have made up only 2.43 percent of total M&A transactions, reaching their peak (by number of deals) in 1998 before dropping off with the entire M&A market during the 2008 financial crisis. We are now seeing a resurgence in MOEs. As of Aug. 30, 2016, there have been seven MOEs this year making up 4.41 percent of total M&A activity in the community banking space. The banking industry has become increasingly more competitive in recent years, underscored by net interest margin compression as well as increased regulatory and compliance expenses. MOEs serve as an excellent alternative to cut costs, increase earnings, and gain size and scale.

In our eyes, successful MOEs cannot be forced; they are a marriage that must develop naturally between two institutions and their executives that have an amicable past with one another. They are most successful when the two banks’ philosophies and strategic visions align. While not every bank may be a fit for a MOE partner, we recommend that executives give consideration to merger opportunities, as a well-executed MOE can significantly enhance shareholder value.

MOEs present a significant opportunity to gain immediate size and scale that otherwise may not be achievable through small bank acquisitions. Achieving this size and scale will have a direct impact on the bottom line as the increasing regulatory burden can be spread across the firm while generating cost savings through the reduction of repetitive back office staff, overlapping branches, data processing contracts, and marketing expenses. Moreover, this will further enhance shareholder value through the pooling of talent and increased earnings stream generated by the bank, ultimately providing an opportunity for a higher takeout multiple in the event of a sale of the combined enterprise.

The market performance of MOE parties has reflected the positive impact that MOEs can have. When comparing the stock performance since January 2010 of both the accounting acquirer and accounting target (a merger of equals always has, for accounting purposes, an acquirer and a target), on average they have both outperformed their peers, beating the SNL US Bank & Thrift index three months after the announcement by 1.9 percent and 3.7 percent, respectively. Moreover, the pro forma bank has outperformed the SNL US Bank & Thrift index at both one- and two-year time frames after the mergers have closed; the average stock price change of the pro forma bank one-year post closing is 15.9 percent compared to 8.9 percent for the SNL US Bank & Thrift index and over two years is 22.0 percent compared to 13.3 percent.

Additionally, the combined enterprise has also performed well financially. The average pro forma bank has increased both return on average assets (ROAA) and return on average equity (ROAE) one and two years after the transaction closing.

Average Pro Forma Bank Before and After a Merger of Equals

merger-graph.png

Source: S&P 500 Market Intelligence
Note: ROAA and ROAE for acquirer and target are as of the quarter prior to transaction announcement. Includes select MOE transactions from 1/1/2010 to 8/28/2016 in which the accounting buyer is publicly traded; includes 12 transactions. Transactions in which ROAA and/or ROAE are not available for specific time periods are excluded from average ROAA and/or ROAE calculations.

When a MOE is well executed it can bolster earnings, gain scale, increase efficiency and improve products and practices, ultimately creating a stronger combined institution. In these cases, the whole is greater than the sum-of-the-parts and 1 + 1 = 3.

Mastering the Art of Unsolicited Takeovers


takeover-11-25-15.pngAssume you sit on the board of a bank that has no present interest in being acquired. Without warning, you receive an unsolicited takeover offer. Much as you may find this an annoying distraction, you cannot dismiss the offer out-of-hand. Rather, you must ensure that the board respects the foundational principle that, as a body, it must make decisions that enhance shareholder value. It must accept its decision-making responsibility, and promptly undertake a financial analysis to determine whether the offer is one that could put the shareholders in a better position than maintaining the status quo. If the board concludes that the offer is legitimate and that, once accepted and consummated after negotiations, it could put the shareholders into a more favorable position than retaining their existing bank shares, then a decision is virtually unavoidable.

If You Are the Target
In most states, following their version of the business judgment rule will protect the board’s decision and courts are reluctant to second-guess that decision as long as:

  1. The board has adhered to the bank’s documented governance processes and recusal mechanisms that are consistent with peer institutions and designed to eliminate board member self-interest influences.
  2. The board relied in good faith upon non-conflicted expert advice.
  3. The board minutes establish that it conducted a thoughtful decision-making process. If the financial analysis makes the ultimate decision too close to call, thereby giving good reason to consider non-economic issues, and the bank’s by-laws permit the board to weigh non-economic factors, it is imperative that negotiations over non-economic concerns be carefully documented to mitigate litigation risk regardless of whether a transaction receives a green or red light.

If You Are the Acquirer
Now assume you are a board member of the acquiring bank. Knowing that your unsolicited offer will gain traction only if the target’s board finds the offer to be legitimate, your first concern should be to make certain that you have assembled a team with the necessary expertise willing to devote the resources to due diligence. The better the acquirer understands the target’s governance and attitude, as well as its customer demographics, competitive position and the potential for regulatory concern over market concentration, the more tailored the offer will be to the interests of the target and the more likely the offer will receive favorable consideration. If later challenged, the board’s due diligence will be judged by the investigative standard of reasonableness, where management decisions were ratified by the board only after independent inquiry. The board must uphold its duty of care, and that obligation will have been met if it has made reasonable examination of the totality of available information, including strategic, operational, management, timing and legal considerations.

Using Advisors
Whether you are on the board of the target or the acquirer, you will need to have a level of market, industry and technical expertise that requires engagement of outside advisors, with investment bankers often being the most prominent. The board will need to understand every advisor’s motive. It is essential that the advisors challenge your assumptions, and if their financial incentives depend on closing the deal, you must remain alert to that natural bias. The board must resist investment banker pressure to get a deal done, making sure that board agendas provide adequate time to study implementation progress, to anticipate and mitigate risks and to identify additional and alternative opportunities.

Clarity and open communication among members of the key leadership team and their advisors is imperative, especially with regard to keeping the transaction true to the board’s primary business goals.  These factors will drive contract negotiations, elevate the quality of the due diligence effort and ensure that the initiatives and business elements that create value are prioritized in the integration process.

For both acquirer and target, investment bankers in collaboration with legal counsel can be invaluable in guiding the boards towards successful completion of the transaction. Seasoned investment bankers can help set appropriate price terms and conditions and establish critical protocols for communicating with employees, the media, the market and investors. Experienced legal counsel can negotiate a transition services agreement governing consolidation and systems conversion and provide early, active and competent interaction with regulators to ensure unimpeded processing of all necessary filings and approvals.

Above all, it is vital to remember that failing to close the deal may ultimately be in the best interests of the enterprise. Ego, incentive compensation and deal momentum can all too easily distract the board from its paramount responsibility, namely, to constantly vet all pro forma assumptions of the deal.

Integrating a New Product Line: Asking the Right Questions in the Boardroom


2-13-15-BryanCave.pngAs year-end results are finalized, many financial institutions are now budgeting for the coming year. With many banks struggling to find new revenue sources, these conversations are often focused on operational matters, including diversifying into new loan products and electronic payment applications designed to attract and retain new and existing customers. And while some boards of directors have a productive conversation regarding new products, these detail-rich discussions can result in the board overlooking the impact of the new product line on the bank’s strategic direction.

Directors, as part of their duty to maximize shareholder value, are responsible for charting the strategic course of the bank. Too strong of a focus on operational matters may have the effect of muddling the important distinction between the roles of directors and officers going forward, leaving management feeling micro-managed and directors overwhelmed by reports and data in their “second” job. Instead, a higher-level discussion may be necessary in order to ensure that the board is focused on overseeing the institution’s strategic plan, while management is charged with safely and profitably executing the new business line.

So what are the appropriate questions for directors to ask and resolve when considering a new product? The following can help ensure that the board achieves the right strategic decision for any new product or activity. 

Consider management first.  When evaluating a new line of business, the board should consider whether the institution has the appropriate management needed to supervise the activity in a safe and sound manner. For example, banks looking to diversify their asset portfolios into other types of lending, including C&I and SBA-guaranteed loans, may need to recruit a group of experienced lenders from another institution. But the board should first consider how the new lenders will integrate into the bank’s culture and if the bank’s credit department will have the expertise to underwrite the loans.  

The addition of new loan products is perhaps the simplest example, but for new online customer applications, finding and hiring the right team to manage the related franchise and regulatory risk may be more challenging. With a new mobile banking app, the institution will face new data security and “know your customer” challenges that may exceed the skills of the current staff. In either case, understanding the personnel required to execute the new business safely will give the board an idea of not only the new activity’s cost, but also its risk.     

Project the path to profitability.  After considering the personnel demands of the new product line, the board should then determine the timeline for fully integrating the new activity into the bank’s core business. Depending on the scope of the institution’s current product offerings, some new business lines may be easier to integrate than others, particularly where the bank and its management have prior experience.  

On the other hand, many institutions are now considering acceptance of new online payments products, recognizing these services will be essential to attracting younger customers. Even if ultimately profitable, these new applications can expose the bank’s operating system to new online threats and unfamiliar customer segments, which may result in more risk and expense than benefit for a significant period of time. Evaluating these costs and benefits, particularly within the context of the bank’s strategic plan, is a central component of the board’s role.  

Determine if changes are necessary to the institution’s strategic plan.  Any meaningful strategic plan includes a statement by the board of whether the bank will pursue a “buy,” “sell,” or “hold” strategy over the next three to five years. Depending on the importance, cost and risk of the new product line to the future success of the bank, the board’s discussion of the new product may change its buy, sell or hold determination. In some cases, if it appears too costly or risky to integrate an essential new product into the bank’s core business, the board of directors ought to consider whether a sale or strategic partnership with a larger institution would bring more value to their shareholders.   

So while some discussion of tactics is essential to the board’s consideration of a new product line, directors should stay focused on managing the bank’s risk appetite and strategic direction during these conversations. Boards that focus on the big picture have a great vantage point for considering a new product offering—they can better evaluate the bank’s strengths and weaknesses and have a better understanding of the bank’s core business. Using this perspective, some boards may conclude that staying the course in advance of an eventual sale, rather than steering the bank into the unfamiliar waters of a new product line, may result in the best returns for the institution’s shareholders.