A Better Way to Value Deposit-Driven Deals


deposits-4-1-19.pngThere’s no doubt that the focus these days on acquisitions centers around deposits. When surveyed at the 2019 Acquire or Be Acquired conference, 71 percent of attendees said that a target’s deposit base was the most important factor in making the decision to acquire. This suggests that targets with excess liquidity (low loan-to-deposit ratios) will be highly valued in the market going forward.

This strategic objective is out of whack with traditional deal valuation metrics.

The two primary traditional deal metrics are tangible book value (TBV) payback period and earnings per share (EPS) accretion. Investors expect every deal to meet the benchmarks of a low TBV payback period (ideally less than three years) and be accretive to EPS, according to a presentation from Keefe Bruyette & Woods President and CEO Tom Michaud.

These are earnings-based metrics, and targets with low loan-to-deposit ratios have lower earnings because they have larger securities portfolios relative to loans. Therefore, traditional consolidation modeling will undervalue those targets with longer payback periods and lower accretion. Potential acquirers will struggle to justify competitive prices for these highly valued targets.

Why are deals that clearly create shareholder value by strengthening the buyer’s deposit base not reflected by the deal metrics du jour? Because those metrics are flawed. How can you justify a deposit-driven deal to an investor base that is focused on TBV payback and EPS accretion? By abandoning traditional valuation methods and using forward-looking, common sense analytics that capture the true value of an acquisition.

Traditional consolidation methodology projects the buyer and seller independently, then combines them with some purchase accounting and cost savings adjustments. Maybe the analyst will increase consolidated loan growth generated from the excess deposits acquired. This methodology does not capture the true value of the acquired deposits.

The intelligent acquirer should first project its own financials under realistic scenarios, given current market trends. Industry deposit growth has already begun to slow, and the big banks are taking more and more market share. If the bank were to grow loans organically, it must be determined:

  • How much of the funding would come from core deposits and how much would require brokered deposits or other borrowings like Federal Home Loan Bank advances and repurchase agreements? This change in funding mix will drive up incremental interest expense.
  • How many of the bank’s existing depositors will shift their funds from low cost checking and savings accounts to higher cost CDs to capture higher market rates? This process will increase the bank’s existing cost of funds.
  • What will happen to my deposit rates when my competitors start advertising higher rates in a desperate play to attract deposits? This will put more pressure on the bank’s existing cost of funds.
  • How many of my existing loans will reprice at higher rates and help overcome increasing funding costs? Invictus’ BankGenome™ intelligence system suggests that, while the average fixed/floating mix for all banks in the US is 60/40, the percentage of floating rate loans actually repricing at higher rates in the next 12 months is much lower because the weighted average time between loan reset dates is more than six quarters.

Standalone projections for the buyer must adequately reflect the risks inherent in the current operating environment. These risks will affect a bank’s bottom line and, therefore, shareholder value. This process will create a true baseline against which to measure the impact of the acquisition. Management must educate its investors on the flaws in legacy analytics, so they can understand a deal’s true value.

In the acquisition scenario, the bank is acquiring loan growth with existing core deposit funding attached. And if the target has excess deposits, the acquirer can deploy those funds into additional loans grown organically without the funding risks due to current market trends. The cost differential between the organic growth and acquisition scenarios creates real, tangible savings. These savings translate to higher incremental earnings from the acquisition, which alleviate TBV payback periods and EPS accretion issues. Traditional deal metrics may be used as guideposts in evaluating an acquisition, but a misguided reliance on them can obscure the true strategic and financial shareholder value created in a transaction.

Every target should be analyzed in depth, with prices customized to the acquirer’s unique balance sheet and footprint. Don’t pass on a great deal because of flawed traditional methodologies.

Why Purchase Accounting Matters So Much During a Bank Deal


accounting-12-24-18.pngBank management must understand how purchase accounting works, how it can impact a transaction, and being involved can ensure all assumptions are complete and accurate. Here’s a specific look at interest rate mark and Core Deposit Intangible (“CDI”) purchase accounting analyses.

These analyses establish fair value of balance sheet assets and liabilities through a series of mark-to-market valuations. In addition to cost savings and transaction expenses, purchase accounting is one of the transaction adjustments that can have the largest impact on the metrics of a deal. Purchase accounting, however, is often seen as less straight-forward than other transaction adjustment components.

Overview of Mark-to-Market Impact of Assets and Liabilities
To evaluate and engage in discussions with a financial advisor, management must first understand the mechanics of interest rate mark adjustments. A premium on an asset marked-to-market will increase the value of the asset and in capital on day 1, which is then amortized through interest income over the remaining life of the asset. Conversely, a discount on an asset marked-to market will decrease the value of the asset and in capital on day 1, which is then accreted into interest income over the life of the asset. 

As an offsetting entry in purchase price allocation, the higher fair value of an asset the lower the amount of goodwill created. A premium on an asset will increase tangible book value per share (TBVS) but decrease forward earnings as the mark is amortized, while a discount on an asset will decrease TBVS on day 1 but increase forward earnings as the mark is accreted. Liabilities are intuitively the opposite of assets, with a premium resulting in a negative hit to capital on day 1, but lower forward interest expense over the life of the products. A discount will bolster capital on day 1 but will increase forward interest expense over time.

One item of note in the mark-to-market of loans is exit pricing. To represent additional risk assumed with a loan acquisition, an exit premium should be applied to each loan type and should capture a liquidity discount as well as an underwriting discount. Exit prices should vary by loan type. The liquidity and underwriting risk on a 1-4 family residential loan is very different than a speculative construction loan, and the different characteristics should be captured in market values and exit prices.

Publicly reporting institutions now have to to begin reporting the fair value of its loan portfolio under the “exit” price application, which illustrates the importance and proliferation of exit price methodology across the industry, not just in M&A transactions.

Land and buildings are assessed by comparing the net book value (with accumulated depreciation) against a third-party valuation. The mark on buildings will be accreted/amortized over the remaining life of the property.

The CDI takes into account the qualitative value of deposit relationships. There are multiple variables that can impact a CDI but the following provides an overview of major components: weighted average life of a product, cost of core deposit related activities, fee income on core deposits and alternative cost of funding and discount rates. The higher the values for any of these components, the higher the CDI. These variables may be offset by noninterest expense associated with core deposit related activities and the discount rate, for which higher values will reduce the CDI.

Management Involvement
Given the intricacies with mark-to-market purchase accounting, it is clear management should engage a financial advisor to explain the assumptions driving each adjustment and the impact. 

Mark-to-market purchase accounting is not something that should be approached only as a requirement of closing. The financial advisor in a transaction should also be conducting purchase accounting as part of due diligence.

If detailed purchase accounting is not occurring, there could be material marks not accounted for that can drastically affect the metrics of a transaction. Your financial advisors should on a regular basis explain the fair value assessment process and the methodologies.

Key Takeaways
Transaction adjustments are rarely detailed in pro forma analytics, which limits management’s ability to engage in meaningful conversation with its financial advisor. The best financial advisors provide a detailed breakout of all transaction adjustments to provide management with as much knowledge as possible. Without that, it is impossible for management to have the understanding required to ask important questions and actively participate in review of assumptions.

Always request full detail on all adjustments and to have management walked through each adjustment, along with the assumptions and methodologies used. Have calls throughout the process, and remember that fair value analyses are not reserved for closing. This should start early in due diligence. Interest rate marks and CDI can have a meaningful effect on the metrics of a transaction and, if not modeled properly, can create a misleading picture. It is crucial to first verify that the firm has the capacity to model with management and have a meaningful dialogue on critical assumptions.

These assumptions will make or break a deal and will continue drive the resultant entity’s accounting long after the transaction closes.

Are De Novos Making A Comeback?


de-novo-7-3-18.pngThere was a time, not long ago, when FDIC approved 237 applications in a single year. That was 2005. It’s unlikely there will be a return to similar activity levels, the de novo activity has grown from the post-recession single-digit levels to more than 20 open applications. That number that is anticipated to increase through 2018.

Among the de novos are geographically diverse groups involving non-traditional business models, online services, foreign nationals, ethnic/professional niches and minority ownership. Regulators have been open to applications that may have been deemed “non-starters” years ago.

Changes have been made to the FDIC application process that will benefit new community banks such as lessening the de novo period from seven to three years. The rescinding of the FDIC de novo period, the designation of de novo subject matter experts in the regional offices, and the issuance of supplemental guidance along with the FDIC’s “A Handbook for Organizer of De Novo Institutions” indicate a growing commitment by regulators to facilitate the process of establishing new community banks.

To ensure a smooth regulatory process and avoid significant cost outlays, groups should schedule and attend meetings with various regulatory agencies before pre-filing meetings to discuss the timeline and the likelihood of acceptance of an application. Federal and state regulators act in a timely manner, provide constructive feedback and can be easy to work with throughout the de novo process. Strong working relationship with the federal and state regulators, along with the collaboration between all parties highlight the importance of building the right team at the start.

The minimum opening capital requirement has been established at around $22 million. The caveat is that the capital must be in line with the risk profile of proposed bank, though more often than not $20 million or more of seed capital is almost always needed. Why is $22 million or more the magic number?

  • Start-up costs and initial operating losses of $1.5 to $3 million;
  • Profitability being achieved at between $175 to $225 million in assets;
  • Required Tier One Leverage ratio above 8 percent or more throughout the de novo period;
  • Creates an adequate loan-to-borrower limit.

Once the formation bank reaches the minimum capital requirement and gains approval it can open the doors. Once open, the bank can continue raising capital until a higher or maximum level is reached. Additionally, the ability to use 401k accounts for investors is a necessity.

De novo formations bring value to their communities, their markets, shareholders, and the banking industry by filling a void created by the consolidation. With the loss of many key banks, organizers and local businesses feel that larger banks are not providing the level of service and credit desired by small- to medium-sized business owners.

Since the Great Recession, select areas of the country have rebounded more strongly than others. Texas, the Dakotas, Florida, the Carolinas, Washington, D.C., Utah and Washington state are among leaders in job creation and population growth. Given the growth, along with the opportunities to serve growing ethnic and minority populations, many geographies across the country offer attractive opportunities for de novo banking.

Returns for de novo investors can be attractive. There is a risk associated with the initial start-up expenses and a resulting decline in tangible book value. A de novo raises initial capital at tangible book value. While building a franchise, reaching profitability and creating a successful bank allows for multiple expansions and strategic options which can provide attractive returns for initial investors.

Creating a well-connected and qualified board, management team and investor group is proven to be the best recipe for success. Having these individuals and businesses as deposit and lending customers increase, the community’s confidence in the bank facilitates the business generation, along with the marketing and word of mouth publicity.

The proper de novo team is comprised of the founder team, a strategic consultant with regulatory expertise and legal counsel. Business plans now routinely surpass 250 pages and legal requirements continue to expand. When choosing these partners, it is important they have experience in submitting de novo applications in recent years as nuances continue to evolve. Further, ensure all the fees paid are “success based,” so applicable expenses are aligned to the accomplishment of specific milestones.

Regulatory changes, market opportunities and industry consolidations have created an environment in which a de novo bank can form and flourish. With the right founding group and partners, now is the time to explore being part of the next wave of de novo banking.

Three Themes Are at the Top of Bankers’ Minds Right Now


risk-6-14-18.pngIf one looks at the bank industry as a whole, it’s easy to agree with Jamie Dimon, the chairman and CEO of JPMorgan Chase & Co., the nation’s biggest bank by assets, that we are in the midst of a “golden age of banking.”

This is true on multiple fronts. Dimon’s comments were directed specifically at the easing of the regulatory burden on banks, an evolution that has been going on since the change in administration at the beginning of last year. The lighter touch is most evident at the Consumer Financial Protection Bureau, which has taken a more passive approach to enforcement actions under its current acting director, Mick Mulvaney. The broadest base of regulatory relief culminated last month, when federal legislation was signed into law that eased the compliance burden on smaller banks in particular.

Banks are also reaping benefits from the cut last year in the corporate income tax rate from 35 percent down to 21 percent. The change led to a surge in profits and profitability.

These events highlight a trio of themes that emerged from this year’s Bank Audit & Risk Committees Conference hosted by Bank Director in Chicago. Each theme is unique, but the common denominator is that bank boards face an evolving landscape when it comes to the macroeconomic environment, cyber security threats and the means through which a bank can navigate this landscape.

Profitability is a point that Steve Hovde, chairman and CEO of Hovde Group, stressed in a presentation on the current and future state of banking. Banks earned a record $56 billion in the first quarter of the year, which amounted to 28 percent growth over the same quarter of 2017. And while the industry has yet to report a return on assets above 1 percent on an annual basis since the financial crisis a decade ago, the average bank eclipsed that figure in the first three months of the year.

And banks aren’t just more profitable, they’re also arguably safer, former Comptroller of the Currency Thomas Curry noted in a conversation with Bank Director magazine Editor in Chief Jack Milligan. Curry pointed to the fact that banks have more capital than they’ve had in decades.

Yet, as Hovde noted, many of these positive performance trends are not being experienced equally across the industry, with the lion’s share going to the biggest banks. The return on average assets of banks with between $10 billion and $50 billion in assets is 1.27 percent compared to 0.72 percent for banks with less than $1 billion in assets. This is also reflected in bank valuations, with big banks trading on average for more than two times tangible book value compared to 1.4 percent for smaller banks.

This gap is projected to grow with time, in part because of a second theme that coursed through conversations at this year’s Bank Audit & Risk Committees Conference: trends in technology and cyber threats, which large banks have deeper pockets to address. Of all the things that concern bank officers and directors right now, especially those tasked with audit- and risk-related duties, the need to defend against cyber threats is at the top of the list.

There are approximately 20 million hostile cyber events every day, with an estimated 200,000 of these targeted at financial institutions, noted Alex Hernandez, vice president of DefenseStorm, a cybersecurity defense firm. Seventy-three percent are perpetrated by people outside the organization compared to 28 percent by insiders. It isn’t just criminals who pose a threat, as nation-state actors are behind 12 percent of hostile cyber events, with their timing tending to coincide with elections.

The solution, Hernandez notes, is to double down on the fundamentals of cyber defense. “The most effective way to address cyber threats isn’t to focus on the latest shiny object like artificial intelligence, it’s about educating your staff and securing your network.” To this point, most threats come through unsophisticated channels, be it an email phishing scheme or malware delivered by way of a thumb drive.

One challenge in addressing these threats is simply recruiting the right expertise—not only on the bank level, but also on the board. Finding and retaining the right talent in not only information security but elsewhere was also a recurring theme. Most board members in attendance acknowledge they don’t know enough about technology to ask the right questions. But recruiting people who do is easier said than done, especially for banks in rural communities, who often try to tap into nearby metro areas for talent, or offer creative compensation plans to mitigate risk and retain younger officers.

There are certainly reasons to suggest big banks are experiencing a golden age, but smaller and mid-size banks shouldn’t use this recent change in fortune as an excuse to rest on their laurels. It remains incumbent on bank officers and directors to stay vigilant against ever-evolving cybersecurity risks and focused on recruiting the talent and designing effective governance structures to address them.

Sellers: Be Vigilant About Stock in a Deal


bank-stock-11-10-17.pngThrough the first nine months of 2017, the pace of bank merger and acquisitions has been up slightly from prior years in terms of the number of deals, and the strong performance of bank stocks since the U.S. Presidential election—the KBW Nasdaq Bank Index is up almost 40 percent—has led to an increase in deal prices for bank sellers in 2017. Price to tangible book value for all deals through Sept. 30, 2017, is up approximately 24 percent compared to the same nine-month period in 2016. Although sellers are happy about rising deal prices and bank stocks trading at high levels, they should consider how to protect the value of a deal in an all- or mostly-stock transaction negotiated in the period after the announcement and beyond the deal closing. Here are three considerations for boards and management teams.

1. Use a stock collar.
A stock collar allows the selling institution to walk away from the transaction without penalty, given a change in the buyer’s stock price. A double trigger often is required, meaning an agreed-upon decline in the buyer’s stock price along with a percentage deviation from a set market index. A 15 to 20 percent trigger often is used. The seller may require that a cap be used if a collar is requested. A cap would act in a similar manner as a collar and provide the buyer with the chance to walk away or renegotiate the number of shares should the buyer’s stock increase 15 or 20 percent from the announcement date. While collars and caps often are symmetrical, they do not need to be, and a higher cap percentage can be negotiated. The need for a collar tends to be driven by the buyer’s recent stock trends and financial performance.

2. Consider trading volumes and liquidity in your deliberations.
In an all-stock or a combination stock and cash deal, the seller makes a significant investment for their shareholders in the stock of the buyer. For many shareholders, this represents a significant opportunity for liquidity and wealth diversification. But these goals can be thwarted if the buyer’s stock is not liquid or doesn’t trade in enough daily volume to absorb the shares without detrimental impact. The table below indicates some of the volume and pricing differences between exchanges. The total number of shares to be issued in a transaction should be considered in comparison to the number of shares that trade on a weekly basis.

Exchange Avg Weekly Volume/Shares Outstanding (%) Number of Banks Median Price/LTM Core EPS (x) Median Price/Tangible Book (%) Median Dividend Yield (%)
Grey Mkt 0.00 8 13.60 92.38 2.07
OTC Pink 0.07 433 15.02 109.55 1.79
OTCQB 0.14 36 15.34 130.59 2.00
OTCQX 0.20 76 16.06 126.04 2.00
NASDAQ 1.18 344 19.35 184.02 1.69
NYSE MKT 0.98 6 18.88 197.00 2.10
NYSE 3.10 51 16.40 197.75 1.99

Source: S&P Global Market Intelligence as of Sept. 30, 2017
LTM: Last 12 months

3. Request reverse due diligence.
The larger a seller is in comparison to the buyer and the more stock a seller is asked to take, the more there is a need for reverse due diligence. Boards and management should require the opportunity to dig into the books and records of the buyer, when appropriate, to make sure the stock investment will provide the returns and values promised by the buyer. However, the request for reverse due diligence may be denied if the transaction is fairly small in scale for the buyer or only token amounts of stock are offered.

Reverse due diligence tends to be abbreviated compared to typical due diligence, and it’s more focused on the items that can materially affect stock price. Reverse due diligence tends to focus on items such as earnings and credit performance, regulatory issues that the risk committee is monitoring, pending litigation or other potential unrecorded liabilities, review of board and committee minutes, and dialogue around future performance and initiatives. Also, sellers should review a buyer’s stock characteristics, including reading equity analyst reports, transcripts of earnings calls, conference presentations and other public sources of information that could help to develop a holistic view of how the market might react to the transaction once it’s announced.

While no one can predict what will happen with stock prices over the next 12 months, it does seem that many believe the current run-up in bank stock prices is the result of the general election, the Federal Reserve’s increase in interest rates and expected additional rate increases. Stocks are trading at high levels, but bank sellers still need to be cautious about which stock they take in a deal.

Understanding Your Bank’s Capital Alternatives


capital-10-18-17.pngIt is crucial for executive management to engage their boards in practical conversations surrounding the raising of capital. Important questions include what form of capital is best from a strategic perspective, how much dilution to earnings per share (EPS) is acceptable and how soon can the dilution be earned back. To answer these questions, management must first have a solid understanding of each type of capital.

Common Equity
Common equity tends to receive the most favorable treatment from a regulatory perspective and is fully included in Tier 1 capital. This, however, comes at a cost beyond the 5 to 7 percent fee paid to your investment banker. A common equity raise increases the number of shares outstanding. This translates to dilution of earnings per share and existing ownership until the new capital is leveraged, or put to work.

When a bank undergoes a common equity raise, it also gives up ownership and voting rights. If the bank is unable to raise common equity at or above current tangible book value per share (TBVS), or is concerned with existing ownership dilution, it should seriously consider an alternative source of capital. Banks must have clearly defined parameters in place for raising capital, particularly its impact on TBVS and EPS.

When evaluating a common offering, two key considerations are: (1) whether to conduct a private offering or undergo an IPO, and (2) whether to raise capital internally or externally. Having a strategic plan in place is critical to ensure that the bank can execute on deploying capital and earning back the initial shareholder dilution.

IPO or No?
Not everyone needs to conduct an initial public offering (IPO), but for larger institutions or institutions seeking liquidity, it is an excellent option. An IPO provides liquidity for stockholders, generates capital to accelerate growth, and depending on trading volume establishes currency that can be utilized in acquisitions. Once an institution undergoes an IPO it has also created access to capital markets for follow-on offerings to continue to raise capital as needed. While IPOs provide a faster vehicle to raise capital, they also require more time from key management, detracting from their role in day-to-day operations.

Subchapter-S corporations must consider ramifications of increasing their shareholder base before triggering a requirement to convert to a stock corporation. Once an S-corporation exceeds 100 stockholders, it must convert to a C-corporation, which has immediate tax implications and changes in reporting requirements.

Private Placements
For smaller banks or institutions that are closely held, private placements may be preferable to an IPO. Although the timeframe for a private placement may be longer, less time is required from management. Private placements are limited to existing stockholders, accredited investors and qualified institutional buyers. While private placements are generally smaller and less dilutive to EPS, it can also may be difficult to raise larger amounts of capital using this vehicle. The bank will be able to remain private with less pressure to immediately leverage capital, allowing greater autonomy in strategic decisions.

Alternative Sources of Capital
Noncumulative perpetual preferred stock can be counted towards Tier 1 capital and can be used to increase tangible equity. Banks with a clean risk profile may be willing to operate with lower levels of tangible common equity and focus on bolstering tangible equity. Preferred stock is generally less expensive to raise, although there is a post-tax dividend that can range from 5 to 9 percent.

For banks with a holding company, another form of capital—debt—can be down-streamed in its entirety to common equity at the bank level. Debt is the least expensive form of capital, costing approximately 3 percent to raise with no dividends and tax-exempt interest expense.

Regardless of the approach used to raise capital, be realistic in how much you can effectively leverage. Excess capital may be viewed favorably from a regulatory perspective but can become a value detractor if not effectively deployed. This is particularly true for banks entertaining the possibility of a sale. Over-capitalized targets are likely to be priced on a leveraged capital approach, meaning that tangible common equity in excess of a certain percentage of average assets will be priced at 100 percent TBVS and only the leveraged portion of capital will receive a premium.

When raising capital in any form, proactively communicate with regulators and stockholders remembering that neither party likes surprises. Work with your financial advisor to run pro forma analyses on multiple scenarios and establish parameters for EPS and ownership dilution to maximize the impact of your capital raise.

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.

Bank M&A Update: Oil Prices and Low Interest Rates May Be Hurting Deals


The state of the bank merger and acquisition (M&A) market thus far in 2016 has been tepid compared to prior years. 2015 began the same way, but was helped by a tremendous fourth quarter in which the number of deals announced was more than 25 percent higher than the average of the first three quarters of the year. At the end of 2015, many bankers and industry experts hoped that the euphoria from the fourth quarter would carry over into 2016. Instead, the first quarter of 2016 saw M&A deals retreat to the moderate levels experienced in the first three quarters of 2015, with a modest increase in the second quarter giving way to a much lower third quarter. Year-to-date, announced deals are down a modest 5.6 percent compared to the same time period last year.

M&A Activity by Region

Quarter Mid Atlantic Midwest Northeast Southeast Southwest West Other* Total Deals
2015-Q1 7 26 2 12 10 8   65
2015-Q2 5 27 5 14 11 7   69
2015-Q3 9 24 3 9 12 6 1 64
2015-Q4 13 30 3 24 6 7   83
2016-Q1 4 38 1 10 5 5 1 63
2016-Q2 6 29 2 14 7 8   66
2016-Q3 4 25 1 14 6 7   57

*No geography listed
Source: SNL Financial, an offering of S&P Global Market Intelligence

The Midwest has been bolstering the modest numbers experienced year-to-date. This impact on the overall percent change in M&A activity for 2015 and the first three quarters of 2016 is apparent when compared to the other regions.

Indicators Affecting Bank M&A
Oil prices have had an impact on the number of deals in the Southwest. Credit quality does have an impact on deal volume, but between Jan. 1, 2015, and June 30, 2016, credit quality has been fairly good compared to the levels experienced in years 2008 to 2010.

The decline in longer-term interest rates could have an impact on buyers’ perceptions of banks’ future earnings prospects with already compressed net interest margins. The 10-year U.S. Treasury constant maturity rate has flattened in 2016, and this could be a contributing factor in the number of announced bank M&A deals.

As shown below, average deal pricing has declined, which also could be contributing to the decline in the number of M&A deals announced.

Pricing Over Time

Pricing ratios.PNG

Although not shown, a review of the trailing 12-month return on assets for the selling banks and also the level of tangible equity and tangible assets shows they are fairly consistent quarter to quarter, so these financial metrics are not responsible for the decline in either pricing ration.

An overrepresentation of the banks in the Midwest also has had an impact on why the median pricing ratios have declined. The sellers in this region tended to be smaller, and the size of the seller does affect the price realized:

Median Price/Tangible Book Value Jan. 1, 2015, through Sept. 30, 2016

Asset Size of Seller Mid Atlantic Midwest Northeast Southeast Southwest West Total
<$50 Million N/A 121.9% NA 96.9% 115.3% 50.1% 115.3%
$50M – $100M 129.1% 108.4% 146.7% 96.3% 132.7% 128.1% 114.4%
$100M – $500M 122.6% 126.2% 142.6% 136.2% 150.1% 133.5% 133.3%
$500M – $1B 161.5% 136.0% 125.7% 161.4% 165.8% 178.7% 157.7%
$1B – $5B 152.8% 179.3% 164.2% 194.9% 156.9% 222.1% 179.3%
$5B – $15B 219.4% 155.7% N/A 233.0% N/A N/A 219.4%
>$15B 159.8% 199.3% N/A 151.5% N/A 272.1% 171.4%

More than 80 percent of the transactions announced involve sellers with less than $500 million in assets, which explains the lower realized pricing ratios. The Midwest contains a significant number of bank charters with less than $500 million in assets and, as a result, if this region’s total deal volume is up and the rest of the regions are down or flat, the impact on the overall pricing still will trend down.

Looking Ahead
The big questions remaining are what will happen in the fourth quarter of 2016 and whether the industry’s experience this year will be a predictor for 2017.

None of the economic factors are expected to materially improve for the fourth quarter. The Federal Reserve is expected to increase interest rates modestly, but there are Fed governors who favor no interest rate increase this year. As a result, it appears unlikely that the compression of net interest margin will improve drastically over the next 15 months. What does seem likely to occur is consistent quarter-to-quarter deal totals, although a reduction in the number of deals in the Midwest region could lead to even lower M&A totals for 2017.