Investor Pressure Points for the 2018 Proxy Season

proxy-2-9-18.pngInvestors need to stay focused on long-term performance and strategy in 2018. So says Larry Fink, the chief executive of BlackRock, the world’s largest asset manager with $6.3 trillion in assets under management, in a recent and well-circulated letter. “Companies must be able to describe their strategy for long-term growth,” says Fink. “A central reason for the risk of activism—and wasteful proxy fights—is that companies have not been explicit enough about their long-term strategies.”

Focusing on long-term success isn’t controversial, but Fink’s letter underlines the fact that proxy advisors and investment management firms are more frequently looking at broader issues—gender diversity and equality, and other cultural and environment risks—that can serve as indicators of long-term performance.

Board composition will continue to be a growing issue. BlackRock, along with State Street Global Advisors, the asset management subsidiary of State Street Corp., both actively vote against directors where boards lack a female member. “[Institutional investors] are tired of excuses,” says Rusty O’Kelley, global leader of the board consulting and effectiveness practice at Russell Reynolds Associates. “Regional banks [in particular] need to take a very close look at board quality and composition.” Fink, in his letter, said that diverse boards are more attuned to identifying opportunities for growth, and less likely to overlook threats to the business as they’re less prone to groupthink.

The use of board matrices, which help boards examine director expertise, and disclosure within the proxy statement about the use of these matrices, are increasingly common, according to O’Kelley. The varied skill sets found on the board should link to the bank’s overall strategy, and that should be communicated to shareholders. Expertise in cybersecurity is increasingly desired, but that doesn’t necessarily mean the board should seek to add a dedicated cybersecurity expert. “Institutional investors view cybersecurity as a risk the entire board should be paying attention to,” says O’Kelley. “They want all directors to be knowledgeable.”

Some investors are pursuing gender equality outside of the boardroom. On February 5, 2018, Bank of New York Mellon Corp. disclosed the pay gap between men and women—the fourth bank to do so in less than a month, following Citigroup, Bank of America Corp. and Wells Fargo & Co. “Investors are demanding gender pay equity on Wall Street, and we have no intention of easing up,” said Natasha Lamb, managing partner at the investment firm Arjuna Capital, in a release commenting on BNY Mellon’s gender pay disclosure. These banks, along with JPMorgan Chase & Co., Mastercard and American Express, rejected Arjuna’s proposals last year to disclose the pay gap between male and female employees, along with policies and goals to address any gap in compensation.

A domino effect can occur with these types of issues. “[Activist investors will] move on to the next bank,” says Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware.

Shareholders are aware that cultural risks can damage an organization. This includes bad behavior by employees—Wells Fargo’s account opening scandal, for example—as well as an organization’s approach to sexual harassment and assault, an issue that has received considerable attention recently due to the “Me Too” movement. “Shareholders are very focused on whether or not boards and management teams are doing a sufficient job in trying to understand what the tone is throughout the organization, understand what the corporate culture is,” says Paul DeNicola, managing director at PwC’s Governance Insights Center. Metrics such as employee turnover or the level of internal complaints can be used to analyze the organization’s culture, and companies should have a crisis management plan and employee training program in place. Boards are more frequently engaging with employees also, adds DeNicola.

Investors are keenly aware of environmental risks following a year that witnessed a record-setting loss estimate of $306 billion due to natural disasters, according to the National Oceanic and Atmospheric Administration. Institutional investors expect boards to consider the business risk related to environmental change, says O’Kelley, particularly if the bank is at greater risk due to, for example, a high level of real estate loans in coastal areas.

Finally, investors will be looking at how organizations use the expected windfall from tax reform. “What will you do with the increased after-tax cash flow, and how will you use it to create long-term value?” said Fink in his letter. It’s an opportunity for companies to communicate with shareholders regarding how additional earnings will be distributed to shareholders and employees, and investments made to improve the business.

In an appearance on CNBC’s “Squawk Box,” Fink explained that BlackRock votes with the companies it invests in 91 percent of the time due to the engagement that occurs before the proxy statement is released. Fink’s preference is that engagement occurs throughout the year—not just during proxy season—to produce better long-term results for the company’s investors.

Engaging with shareholders—and listening to their concerns—can help companies succeed in a serious proxy battle. “If you have good relations with your investors, you’re apt to, in a contest, fair a bit better,” says Elson.

Why Banks Need to Control the M&A Process

manda-process-8-15-16.pngAll transactions are not created equal. At the end of the day, the party that has the better understanding of the transaction and has actively controlled the process from the start wins and unlocks maximum value. The bank that is better equipped to enter negotiations with all of the information will likely get the better end of the deal. From a practical standpoint, this means that the bank’s management and third-party advisor(s) have driven the process and timeline, and have clearly articulated expectations. It is imperative to have a single, centralized point of contact to control information, communications and negotiations. For most banks a third-party investment banker is the primary contact, allowing key executives to focus on running the bank. In these instances, it is incumbent upon the CEO to control the M&A process through logistics, modeling assumptions and strategy.

This begins with M&A process documentation. A CEO should work early on with the investment banker to identify key dates and contacts. For a seller, this will also include potential buyers to contact, confidential information memorandum recipients, dates on which access to data room and due diligence materials were granted, as well as comprehensive notes on when and why institutions exited the bidding process. The board of directors should participate periodically in status updates to ensure that it has fulfilled its fiduciary responsibilities through regular involvement in the process. The importance of documenting meetings and formal discussions, both internally and with the counterparty, cannot be overemphasized.

From a modeling perspective, every assumption in a pro forma model should have a corresponding status column. FinPro Capital Advisors (FCA) utilizes three levels of assumptions: information based on public filings for preliminary analysis, assumptions from due diligence and assumptions that have been formally signed off on by management. Below are ways you can control the process and assess the merits of a transaction to proceed with confidence to closing.

Retain a financial advisor that you can trust and have the discipline to walk away from a deal. FCA actively advises its clients to pass on deals that do not make sense, from either a financial or strategic perspective. Even a highly accretive deal can create social issues or be detrimental to the bank or its stockholders in the long run. Examples may include franchise dilution, conflicting corporate cultures, lack of a surviving brand or poor market reception.

Identify M&A parameters based on your strategic objectives. FCA makes the following recommendations:

  • Tangible book value per share (TBVS) dilution less than 10 percent, and preferably 7 percent or less.
  • TBVS work back period of five years or less. Three years or less is recommended.
  • Immediately accretive to core earnings, excluding one-time charges.
  • Internal rate of return equal to or greater than 10 percent.

Understand your bank’s risk profile. Opportunities must be assessed on a transaction-by-transaction basis, and there can be instances when a transformative deal can make sense with the rationale clearly explained to investors and the market. That said, here are some guidelines that potential acquirers should keep in mind:

  • Acquirer must be able to demonstrate an in-depth understanding of its risk profile.
  • Pro forma combined entity should be no less than a CAMELS 2 rated institution.
  • Tier 1 leverage ratio must be greater than 8 percent.
  • Coverage ratio (defined as total classified loans as a percentage of Tier 1 capital plus the allowance for loan and lease losses) of less than 40 percent.
  • Proactive and strong relationship with the regulators.

These guidelines are not a one-size-fits-all proposition. Some banks have a higher tolerance for TBVS dilution while others have strict parameters on the work back period (TBVS dilution divided by earnings accretion created by the deal, or the time it takes to “earn back” TBVS dilution) or minimum hurdles for earnings accretion. Banks with a clear idea of cutoff points for pricing, TBVS dilution and EPS accretion are generally better prepared to control the process and negotiate a transaction that adheres to their strategic principles.

Know your value. An accurate value assessment for both the buyer and the target is critical for any analysis. Require your advisor to incorporate trading valuation analyses in any pro forma analysis with a stock consideration component to determine a reasonable value for buyer currency. Require a comparable acquisition analysis to determine a valuation range for the target. These two analyses are standard in all FCA pro forma analyses and a critical discussion point with CEOs. It is also vital for targets to know their independent stand-alone value to help determine whether a sale at this time is a stronger strategic option than remaining independent. This can help evaluate whether the consideration price offered is likely fair, from a financial standpoint, to stockholders.

Understand what is going into your transaction adjustments. The transaction adjustments column is often the black box of pro forma analysis. An array of assumptions, including interest rate and credit marks, purchase price allocation, cost savings and transaction expenses are usually shown aggregated into a single column and it can be extremely difficult to identify the exact adjustments. FCA includes a detailed breakout of every single adjustment so that CEOs can track and understand the assumptions driving the deal. Management should critically review and sign off on all assumptions.

Request that your advisor incorporate custom sensitivity analyses with all pro formas. FCA incorporates single and multi-variable sensitivity analyses with all pro formas to show the impact of changes to buyer currency, consideration price and mix, and cost savings to stress test the impact of changing variables across a range of values.

By following these steps and proactively controlling the M&A process you can unlock maximum value in your transaction.

Getting Started With Third-Party Risk Management: Two Key Questions

risk-manangement-12-22-15.pngBanks often outsource technology services to third-party vendors. In light of increased regulatory attention and third-party involvement in day-to-day business operations, many bank boards and senior management teams are considering their approach to developing a third-party risk management program. A thoughtful approach based on an initial assessment of the bank’s current state can result in better risk management and compliance that aren’t overly burdensome. Addressing two important questions will help begin the process of successfully launching an effective third-party risk management program.

Does our bank have a full inventory of its contracts and agreements?
While most banks have some type of contract management system, many typically use low-tech storage facilities—like databases of scanned copies or even hard copies in file cabinets—from which data can’t be extracted. Such storage facilities rarely contain complete records of all executed contracts, and even simple data like contract renewal notification and expiration dates are not tagged or automated. In such environments, contract terms and conditions don’t keep pace with changes to regulations and the business environment, and financial reporting and accounting concepts, such as unrecorded liabilities, contingencies, and financial commitments, exist but may not be understood or monitored.

To address such drawbacks, banks should do a complete inventory of critical relationships to ensure that they have a complete inventory of current contracts. The contracts should meet current regulatory and business requirements, and data within the contracts should be metatagged, meaning tagged with coding in a web page so it can found with a search engine. Banks should consider establishing standard, required contract terms and using technology to track compliance. Increasingly, contracts are being moved into third-party risk management systems for a “single-book-of-record” view and improved risk management beyond basic compliance.

How do we identify all relevant third parties and manage the overall effort?
The potential universe of third parties in an organization can seem endless—from global companies to intercompany affiliates to mom-and-pop providers. On top of that, the potential universe of third parties is never constant. Companies regularly are onboarding and terminating third parties and expanding or reducing third-party services. While it is important to build data and artifacts (certificates of insurance, documentation of financial viability, or Service Organization Control reports, for example) that support a risk assessment at the third-party relationship level, it is easy to lose sight of the entire population of third-party relationships. Depending on how a bank defines third parties, that population could include franchisees, external salespeople and debt holders, among others. This is one area of risk management where completeness counts.

To make such a project manageable, banks should create a strategy and roadmap to systematically identify third parties using an inclusive definition. Banks should invest in the initial data-gathering phase and make it an enterprise-wide endeavor. Effective sources of relevant information include surveys conducted by the various lines of business, contract facilities and databases, accounts-payable systems, and legal counsel. The process needs to be sustainable or the population soon will become invalid. Banks should conduct an initial review of third-party relationships by identifying categories and potential risk factors to assist with prioritizing the evaluation. The project strategy and roadmap should start with the third parties that pose a higher risk. The project roadmap should include necessary activities and the timing and resource needs related to existing and future third-party due diligence and assessments.

Moving Forward
As financial institutions work to effectively comply with the regulatory guidance and manage the risks associated with third-party relationships, creating a strategy and roadmap will help achieve compliance and avoid an overly burdensome process.

How Many Mobile Wallets Are Too Many?

mobile-wallet-12-22-15.pngFor many years, the mobile wallet landscape was filled with small niche offerings that tested some important ideas, but never really gained much national traction. However, over the past 15 months, four major players have introduced their wallets and the tipping point for widespread mobile wallet adoption appears close. Apple Pay, Android Pay, Samsung Pay and Chase Pay have extended the technology and functionality of those early wallets and have started to close the gap on a wallet that would deliver value to the trifecta of stakeholders: consumers, merchants and the wallet providers.

Should every bank be preparing to support one or more of the existing mobile wallets? CG sees five prerequisites for widespread adoption of mobile wallets.

  1. Better security. Consumers have well documented doubts about the security of mobile payments versus more traditional payment methods. Mobile wallets must implement improved authentication processes (e.g., biometrics, account number tokenization) to allay these fears as the price of admission.
  2. More large-scale mobile wallet providers. The recent addition of providers (including Chase Pay) offers the market a wide range of mobile wallet options and a key move toward critical mass for merchant acceptance.
  3. More smartphones. By 2020, there will be 6.1 billion smartphones in the global market (most with biometric security features). That’s a stark difference from the 2.6 billion smartphones in today’s market—most of which do not have biometric capabilities.
  4. More merchant acceptance of contactless payments. Many of the new terminals that merchants are implementing support both contactless payments and the EMV chip.
  5. A good reason to keep using the mobile wallet. The new wallets either have or are planning to implement rewards programs into their product, which will give consumers a compelling reason to habitually use their mobile wallets.

Each of these prerequisites to mass adoption is trending in the right direction, which means every bank should be working to support one or more of the large mobile wallets as part of their future strategy.

Many banks seem content to support the provisioning of their card accounts into Apple, Android and Samsung. The announcement of Chase Pay at the payments-focused conference Money20/20 in Las Vegas in October sent shock waves through the 10,000 conference participants. If Chase felt it needed its own proprietary wallet, will other large banks follow?

The decision to invest in a proprietary wallet should be based on three key elements in each bank’s strategic direction.

  1. Does the bank have a customer profile that wants a mobile wallet offering and would that group prefer a proprietary wallet over a large national wallet like Apple or Android?
  2. Does the bank have the internal resources or external partnerships required to develop and sustain a wallet in a very dynamic environment? (The wallet of 2020 is likely to be very different from the wallet of 2016).
  3. What are the banks’ competitors inclined to do and how will their actions affect the banks’ customers?

Each bank must consider its own strategic differentiation when determining whether to build or borrow. What distinguishes it in the marketplace and how might that change in the future? What will draw new customers to the bank in the next five or ten years?

One feasible strategy is to let others pave the way in developing new products and then figure out when and how to offer them to your own customers. It’s an approach that can minimize risk without necessarily jeopardizing the reward.

The bottom line is, mobile wallets are coming. (We really mean it this time.) Most banks must allow their card accounts to be provisioned into at least some of them. Some banks (but not most) should offer a proprietary wallet, but only if it fits into their larger strategy. Add the wallet to fit your strategy; don’t change your strategy to fit the wallet. Focus on your strategic differentiator and ensure that most of your future effort and investment are focused on the differentiator and not spread across all the possible initiatives in which you could invest (including wallets).

What’s More Important—Size or Profitability?

scale-12-9-15.pngDoes size matter in banking? Many senior bank executives and directors plainly think that it does, based on the results of Bank Director’s 2016 Bank M&A Survey. Sixty-seven percent of the survey respondents said they believe their banks need to grow significantly larger to stay competitive in today’s more highly concentrated marketplace, and about a third of them say their institutions need to get to at least $1 billion in assets.

I struggle with this logic because there is nothing that is necessarily magical about size per se—and particularly a specific number like $1 billion—that makes it more likely that a bank will be able to attain an acceptable level of profitability. The argument you frequently hear is that scale helps you spread your compliance costs—which have gone up precipitously in recent years—over a larger base. It also makes it easier to afford the kind of technological investments that are necessary to stay competitive in a marketplace where consumers and small businesses are using digital and mobile channels in increasing numbers. Both rationales have some basis in fact, but I wonder how many boards of directors have actually put their banks up for sale solely because they couldn’t afford the costs of regulatory compliance and/or technology upgrades. I think not very many.

One of banking’s most persistent problems in recent years has been a low interest rate environment that has compressed net interest margins across the industry and made it difficult to grow both top line revenue and bottom line profits. And herein, I believe, lays the rationale for many of the acquisitions that we have seen in recent years. Perhaps by getting bigger, many CEOs and their boards think they can become more profitable—but that doesn’t just happen ipso facto. Almost always, there’s vital post-acquisition work that needs to be done, such as cutting duplicate administrative costs, rationalizing overlapping branch networks, or deploying one of the merger partners’ expertise in a particular area to the other partners’ untapped market.

Gaining scale can increase a bank’s profits in an absolute sense, but not necessarily its profitability. Profit is the actual amount of earnings that a bank makes for a particular reporting period, while its profitability is what it makes relative to its asset base (return on assets) or market capitalization (return on equity). I believe that profitability is the better yardstick with which to judge the effectiveness of a management team and board of directors because it measures how well they did with what they had to work with. And behind every successful acquisition is, I believe, a strategy for how to increase the combined bank’s profitability rather than its absolute profits.

I really don’t consider doing an acquisition to be a “strategy” per se. An M&A transaction is exactly that—a transaction. This might seem like an overly nuanced point, but “strategy” is what the acquirer intends to do with its prize after the deal closes. How does the acquirer use its new, larger platform to increase its profitability? In fact, I would go so far as to say that if the acquirer’s ROA and (if it is a public company) ROE don’t improve materially within 18 months of the deal’s closing date, than the acquisition has probably failed to live up to its potential even if the bank’s net income is higher. 

Strategy is so important, in fact, that many highly successful banks avoid the M&A game altogether and focus all of their efforts on organic growth, which is rarely achieved and sustained without a well-conceived plan for how to make it happen. I don’t discount the fact that regulatory compliance and technology costs have gone up significantly in recent years, but growth through acquisition needs to be done with a larger purpose behind it than just getting bigger.

How to Set Performance Metrics that Drive Success

incentive-pay-10-12-15.pngGenerally bank incentive programs reward team members for the achievement of bank-wide financial results. However, important goals which actually build value, such as customer retention, operational improvements and talent management, are often overlooked. Strategy-based compensation marries a bank’s compensation programs with its business strategy, rewarding team players for performance which results in the achievement of strategic objectives. A helpful tool in designing a program that works is a strategic road map, which clearly identifies activities and players needed to achieve results and create value for your organization.

Creating Your Strategic Road Map
The foundation of strategy-based compensation is an understanding at all levels of the organization as to which activities are required to achieve the stated objectives. A road map to execution will identify the focal points—financial/capital requirements, customer consideration, technology needs and the alignment of talent—as well as the value drivers to push success. Laying out your strategy demonstrates team placement and individual responsibilities within the broad scheme. The illustration below is a hypothetical strategic map for a community bank. Efforts in talent management, operation process, and customer satisfaction ultimately drive the desired financial outcome: growth in income and shareholder value.

Incentive Design Considerations
Among banks, executive incentive plans typically measure bank-wide performance across three buckets:

  • Balance sheet goals (e.g. growth in loans and deposits);
  • Earnings (e.g. return on assets and/or equity); and
  • Portfolio quality (e.g. regulatory ratings, non-performing assets, and/or net charge-offs).

As demonstrated in the strategic map above, these financial metrics are outcome-based and generally reflect the results of efforts. Limiting the overall focus of incentive plans to financial objectives potentially limits the program’s ability to reward and motivate the actions required to realize the success of the business strategy. Forward-looking organizations support differentiating their incentive programs beyond the typical financial focus.

From an executive perspective, incentive plans can incorporate value-driving performance metrics such as:

  • Growth in deposits from new accounts;
  • Expansion of lending activities specifically tied to new markets;
  • Identification of acquisitions;
  • Increases in operating efficiencies, new technology platforms;
  • Demonstration of robust succession planning efforts beyond; and
  • Customer satisfaction and usage.

Below the executive level, team members should be rewarded for areas within the strategic map that they can directly impact. For example, branch managers or operation officers are instrumental in increasing efficiencies and improving customer experiences. However, these individuals have limited line of sight and impact on loan growth or capital requirements. Linkage of incentives to particular elements of the strategy map drives towards the stated strategic outcome.

Goal Setting
Equally as important in the incentive design process is setting performance goals. Designing an incentive plan to drive performance beyond the day-to-day requires setting goals with sufficient stretch to push superior market performance. Testing where your target performance goals sit relative to your bank’s and your peers’ past performance, as well as market expectations, demonstrates the rigor of your goals. For example, from a financial perspective, is the achievement of your loan growth target a walk in the park or a more difficult and dramatic home run?

In addition, setting performance goals requires an understanding of the timelines for execution. The strategic map should illustrate the milestones required to execute your objectives and your short- and long-term incentive programs should align accordingly. For example, entry into a new market may require the identification of a branch to acquire or new construction, as well as staffing. The time frame required to complete these activities and their successful deployment is likely to vary and may not be easily compartmentalized in a typical incentive plan performance period of one or three years. The most successful incentive program designs will demonstrate a level of flexibility.

Driving Performance Beyond the Day-to-Day
Incentive programs are powerful tools when designed properly. The program’s design should dovetail with your business objectives, timeframes, and lines of sight among participants. Further, these programs should be frequently monitored, reviewed, and revised as appropriate to ensure they support your bank’s evolving strategic objectives, thereby driving performance beyond the day-to-day.

Getting to Strong: Should Your Bank Acquire?

2-28-14-KPMG.pngWith the number of bank mergers thus far in 2014 marginally ahead of the pace set in the same period last year, it is tempting to think that this could be the year when the much-anticipated mergers and acquisitions (M&A) wave finally materializes. SNL Financial reported that 14 deals were announced in January, two more than the 12 in the same period last year, and—perhaps more interestingly—the median price-to-tangible book ratio of the deals had risen 43 basis points to 140.86 percent, compared to January 2013.

As encouraging as that report might be, no one at this point can say with any confidence that the M&A engine is primed to roar. Nevertheless, KPMG LLP’s view of the marketplace allows us to suggest that, if nothing else, it makes sense for hundreds of banks and thrifts to merge, acquire or form strategic alliances. Let’s list a handful of factors we believe auger well for the M&A pace to pick up:

Not a week has gone by in the past several months, it seems, without any of us hearing about the growing popularity of a “merger of equals’’ in the industry as a way for the smaller-asset banks to combine strengths to compete with bigger, stronger banks. After all, that “if-you-can’t-beat-‘em-join-‘em’’ posture fits with one of the key findings of KPMG LLP’s 2013 Community Banking Outlook Survey. A hefty 77 percent of respondents in the November 2013 survey said they believe a bank must achieve an asset level of at least $1 billion or more to remain independent in today’s market.

Then, there are the other reasons in the litany of drivers arguing that smaller banks join with peers or sell to bigger brethren in more deals: the escalating costs associated with staying in compliance with regulatory demands, the attractiveness of spreading into new geographies where specific demographics would make sense for expansion, and the attractiveness of acquiring a competitor that holds rich talent to drive new sources of revenue or to enhance technological capabilities.

On the flip side, it’s always prudent to be aware of “deal fever,’’ a desire to do a deal just to do a deal— which can be brought on by a sometimes poorly thought out plan to buy or sell just because others around you are doing deals. Our belief is that the chances of a successful deal are enhanced when the board and management team maintain a rigorous target-selection process that strictly focuses on strategic alignment. There must be a fit, a focus, and a follow through—without shortcuts.

As part of our panel discussion at Bank Director’s recent Acquire or Be Acquired conference, Roberto Herencia, chairman at FirstBancorp and FirstBank Puerto Rico, also reminded us that, because banks are sold, and not bought, acquirers will need to sharpen their business cases. An acquirer, therefore, must frequently convince a reluctant target that a sale make sense for both parties, and equally must respect the emotions of the sellers as much as dollar and cents, because of the role that smaller banks play in the fabric of smaller communities.

That said, we also believe that deals today must be game changers, given that so much time and effort is required in the current highly regulated environment, and that many targets may still struggle with possible toxic assets on the books. Such realities, in our view, mean most of the sellers will be in the $500-million to $2.5-billion asset range, which encompasses about 1,000 banks.

Through it all, we would argue that bank directors must have comfort that management presents the board with documentation that a target is aligned with the bank’s strategic objectives, that the deal has passed through the critical pre-signing phase where significant value drivers have been vetted, and that there has been an aggressive focus on risk and synergy implications. Further, no deal can be successful without the board having evidence that an effective governance structure— complete with realistic processes—has been established.