Surging Stock Prices and Your Long-Term Incentive Strategy

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incentive-3-6-17.pngWith the Trump administration, investors are anticipating an easing in banking regulations and modest increases in interest rates. Accordingly, the market response to Trump’s election sent bank stock prices surging. From election to year-end, the Keefe, Bruyette & Woods NASDAQ Banking Index, which is made up of money center banks, as well as regional banks and thrifts, was up 22 percent, alongside a very strong 7 percent increase in the S&P 500. Full year returns were even better, and they were better for many smaller banks as well. For example, banks with total assets between $1 billion and $10 billion saw returns of 20 percent to 65 percent.

In our experience, large swings in stock prices trigger important design considerations for long-term incentive grant strategies and grant policies.

Long-term Incentive Strategies—Target Value Versus Fixed Share
Long-term incentive strategies among banks typically incorporate the use of full-value awards, such as restricted stock or performance shares, or stock options.

There are two common approaches used to determine the number of shares granted under equity awards—a target value approach and a fixed share approach.

  • Target value approach: The bank targets a specific award “fair value.” Thus, as stock prices surge, the number of shares granted is reduced to deliver the same grant value. Conversely, when stock prices decline, more shares are granted. This is the most common method for determining the number of shares awarded.
  • Fixed share approach: The bank targets a specified number of shares. Thus, as stock prices surge, the fair value of the award also increases. The volatility in grant value is one of the reasons this approach is less common.

No matter the approach used, sudden surges in stock prices will result in significant changes in either the number of shares granted or the fair value of the award, assuming no adjustments are made to the grant strategies. For example, the increase in stock prices over the past year for banks with assets between $1 billion and $10 billion will likely result in a 16 to 40 percent decline in shares delivered through a target value approach or a 20 to 65 percent increase in fair values at banks utilizing a fixed share approach.

The advantages in delivering equity through a target value approach include providing tighter controls over the accounting expense of long-term incentive programs, a clearer understanding of the award value to the participant, greater consistency in disclosed compensation values for proxy-reported officers, and maintaining alignment with competitive market compensation levels. However, when stock prices surge, no matter the cause, the resulting reduction in shares under a target value approach may be perceived as a so-called performance penalty by participants. Your participants in the plan might wonder, “The stock price went up and you cut my shares?”

Alternatively, under the fixed share approach the increase in the fair value of the award may result in higher compensation expense, greater variability of disclosed compensation, and compensation levels that are positioned higher relative to the market than the bank’s stated compensation philosophy.

Considerations
In light of the potential variability in grant values or the number of shares issued, banks should thoroughly review the impact of recent stock price changes on their long-term incentive grant strategies to avoid unintended consequences.

Target value programs can be adjusted through an increase in the value delivered or revisions to the approach used to determine shares, or a combination of these two approaches. Generally, an increase in the value delivered would not correspond directly with the increase in stock price, for example award values would increase 20 to 30 percent of the gain in stock price. In adjusting the approach used to determine the number of shares issued, banks can use an average stock price (for example, 90 to 150 days) rather than the price on the date of grant.

Conversely, fixed share programs would be adjusted to reduce the grant value through a reduction in the number of shares issued. For example, shares granted would be reduced by 10 percent to 15 percent of the gain in share price.

In all cases, the impact of adjustments to long-term incentive strategies on total compensation should be evaluated against market compensation and share utilization levels as well as the bank’s stated compensation philosophy. Further, the rationale for adjusting long-term incentive strategies should be communicated clearly to program participants.

Does the Sharp Increase in Bank Stock Prices Create a Seller’s Dilemma?

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stock-1-30-17.pngOh, what a difference a year can make. Or more to the point, what a difference just three months can make. At Bank Director’s Acquire or Be Acquired Conference last year, bank stocks were in the proverbial dumpster having been thoroughly trashed by declining oil prices, concerns about an economic slowdown in China and the slight chance that the slowly growing U.S. economy could be dragged into a recession in the second half of 2016.

Oil prices have since firmed up somewhat and the U.S. economy did not experience a downturn in the second half of the year, but all things considered, 2016 was a bumpy ride for bank stocks—until November 8, when Donald Trump’s surprise victory in the presidential election sent bank stock prices rocketing skyward. Valuations have been slowly recovering ever since the depths of the financial crisis in 2008, with some dips along the way. But since election day, stocks for banks above $250 million in assets have increased 21.2 percent to 24.8 percent, depending on their specific asset category, according to data provided by investment bank Keefe, Bruyette & Woods President and Chief Executive Officer Tom Michaud, who gave the lead presentation on the first day of the 2017 Acquire or Be Acquired Conference in Phoenix, Arizona.

What’s driving the surge in valuations is lots of promising talk about a possible cut in the corporate tax rate and various forms of deregulation, including the possible repeal of the Dodd-Frank Act and dismantling of the Consumer Financial Protection Bureau (CFPB). These tantalizing possibilities (at least from the perspective of many bankers), combined with the expectation that a series of interest rate increases by the Federal Reserve this year could ease the banking industry’s margin pressure and further boost profitability, has been like a liberal application of Miracle Grow to bank stock prices.

Michaud made the intriguing observation that investor optimism over what might happen in 2017 and 2018—but hasn’t happened yet—accounts for much of the jump in valuations since the election. “In my opinion, a lot of the good news is already in the stocks even though a lot of it hasn’t happened yet,” Michaud said. In fact, virtually none of it has happened yet. Investors have already priced in much of the increase in valuations resulting from a tax cut, higher interest rates and deregulation as if they have already occurred, which makes me wonder what will happen to valuations if any of these things don’t come through. I assume that valuations would then decline, although no one knows for sure, least of all me. But it should be acknowledged that the attainment of some of the already-priced-in-benefits of a Trump presidency, such as getting rid of Dodd-Frank and the CFPB, would have to overcome fierce opposition from Congressional Democrats while others, such as the combination of a corporate tax cut and a massive infrastructure spending program (which Trump has also talked about) would have to get past fiscally conservative Congressional Republicans. You’re probably familiar with the old saying that investors buy on the rumor and sell on the news. This could end up as an example of investors buying on the promise and selling on the disappointment.

Here’s the dilemma I think this sharp increase in valuations poses in terms of selling your bank or raising capital. If you’re an optimist, you probably will wait for another year or two in hopes of getting an even higher price for your franchise or stock. And if you’re a pessimist who worries about the sustainability of this industry-wide rise in valuations and the possibility that most of the upside from Trump’s election has already been priced into your stock, I think you’ll probably take the money and run.

Rising Stock Prices Could Impact Deal Market

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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.”

Private Equity Gets Ready to Exit

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A few private equity firms stepped in during the financial crisis and recapitalized struggling banks, but what is private equity doing now that bank stock prices have largely improved? Some private equity firms already have exited their investments, making hefty returns by doing so. Bank Director magazine talked to investment bank Hovde Group’s Joe Fenech and Kevin Fitzsimmons, both managing directors in the equity research department, about recent research the two conducted on private equity ownership of banks and the potential for future M&A activity.

You’ve done some research on private equity ownership in banking companies. What did you find?
Joe: Private equity firms were obviously a sorely needed source of capital for smaller banks during the downturn, and the track record for private equity would seem to suggest that these firms will remain involved for up to five to seven years at most. And, with most of these investments having been made roughly three to five years ago, we think the exiting process for private equity could result in a sale of the company or some other event that is likely to have a meaningful impact on the stock.

What are the possible outcomes for banks with private equity ownership?
Joe: We cite three examples that illustrate the different paths that these PE firms may elect to take to exit their position. First, Sterling Financial Corp. was a classic, textbook-type PE opportunity. PE invested at $13 per share in 2010, they oversaw the cleansing of the balance sheet, and the company was then sold to Umpqua Holdings Corp. earlier this year for $33 per share. Second, in the case of BankUnited Inc., the PE firms partnered up with a highly respected management team, invested at $10 per share in May 2009, and following an early 2011 IPO at $27 per share, opted to divest its stake gradually, and was completely out of the shares by late 2013.

Kevin: And third, in the merger between Yadkin Financial Corp. and VantageSouth Bancshares Inc., we saw PE holders opting to remain with the company through the merger. This could suggest an extended investment time frame or maybe that the PE firms see considerable value still to be realized.

Haven’t there been private equity investments that didn’t do well?
Kevin: In one example, CommunityOne Bancorp has two main private equity backers that have a cost basis of $16 per share, and today the shares trade at about $11 per share [as of mid-November 2014], so it most definitely is underwater as of today. That said, management would emphasize that this was a longer-term project and that private equity was very aware of that from the start.

What do you predict will happen to banks that have private equity ownership in the next year or two?
Joe: A lot of these stocks are at or near post-crisis highs and some of the PE positions are sitting at substantial gains. At the same time, regulators appear to be softening their stance on M&A, particularly for mid-cap acquirers. If we’re right, and the pace of M&A continues to accelerate, it only furthers the notion that we’ll probably see resolution of several of these PE investments over the next couple of years.

Which banks have the highest potential to sell?
Kevin: One example is Palmetto Bancshares Inc., although we should note that the possibility of a sale is just one of the reasons we’re positive on the name. PLMT has a very attractive franchise and management has done an impressive job overhauling the company, and we think it’s possible that private equity could be open to an exit via M&A.

Joe: Stonegate Bank in Florida is another one, although not tied to PE involvement. We think Florida as a whole will have a pickup in volume of M&A deals and pricing given its increasing return to health. South Florida, in particular, is on fire.

What does the future hold for more private equity investments?
Joe: Private equity firms tend to make most of their investments during times of acute stress, so with the stocks nearing post-crisis highs, we think the question is more about how private equity looks to exit these stakes, as opposed to making new investments.

As Stock Prices Rise, Expect Slow and Steady Consolidation in the Banking Industry

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2013-MA-trend-report.pngIs there a mad rush to consolidate the banking industry? The numbers would say no. Bank merger and acquisition (M&A) deal volume in the first half of this year is flat compared to the same time period last year. Aggregate deal value actually has fallen a little bit. Pricing on a tangible book value basis is flat.

That could soon change.

Investment bankers and attorneys attending Bank Director’s upcoming Acquire or Be Acquired conference in Phoenix, Arizona, say they are noticing a pick-up in deal-making discussions that could lead to actual deals in the second half of the year. In fact, the biggest deal of the year was announced in July when PacWest Bancorp agreed to buy CapitalSource Inc., both Los Angeles-based banks, in a combined stock and cash transaction worth $2.4 billion. If that deal had been announced in the first half of the year, aggregate deal value would have risen by about 50 percent.

The environment seems ripe for more activity: net interest margins and high regulatory costs are putting pressure on community bank balance sheets, providing incentives to sell. Buyers have seen stock valuations soar during the last year, which means more banks can afford to pay a premium to buy a bank and potentially overcome one of the biggest hurdles to M&A during the last few years: a lack of agreement between buyers and sellers on a price. Asset quality also has improved during the past year for both buyers and sellers. Capital levels at many banks are high. Basel III rules for U.S. banks and thrifts have been finalized, offering clarity on what capital levels will be required, therefore making it easier to do deals. In another sign of an improving economic environment, failed bank deals have been on the decline, and healthy bank deals have been taking their place.

The slow and steady economic improvement may be leading investors in publicly traded banks to turn their attention away from price to tangible book value metrics, and looking more at earnings accretion and growth potential in M&A deals. Still, regulatory concerns and compliance issues are having more of an impact on M&A than during the financial crisis, when the focus was on asset quality. Both buyers and sellers need to assess the potential for regulatory problems in any M&A deal, as well as closely assess the potential synergies and growth opportunities resulting from a combination. Banks in general are cautious, and investment bankers and attorneys are shying away from predictions of a coming wave of bank M&A. Instead, many predict slow but growing consolidation.

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