Sellers: Be Vigilant About Stock in a Deal

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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

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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?

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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

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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

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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.

Small Bank Deals Dominate 2016 M&A Transactions

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merger-10-14-16.pngThere is a growing likelihood that the bank M&A market in 2016 will see declines in both deal volume and pricing compared to the previous two years, even as the industry’s underlying fundamentals remain relatively unchanged. “The operating environment is tough,” said Rory McKinney, the co-head of investment banking at D.A. Davidson Companies, during a presentation at S&P Global Market Intelligence’s 8th annual M&A Symposium in Washington, D.C., late last month. “We think there should be more activity. There’s a lot of pressure to build earnings per share and M&A is one of the ways you can do that.”

There were 181 announced healthy banks deals through September 30, which is well off the pace set in 2015 and 2014 when there were 278 and 282 deals, respectively, according to S&P. To match even the 2015 total, there would have to be 97 announced deals between now and the end of the year, which is probably unlikely. Pricing was also off through the first nine months of the year, with an average price-to-tangible-book-value ratio of 133 compared to 143 last year and 142 in 2014. Pricing was also lower on a price-to-earnings basis for four trailing quarters, coming in at 22 times earnings through September 30, compared to 25 last year and 26 in 2014.

So what gives? In a subsequent interview, McKinney reiterated his surprise that there hadn’t been more deal volume at the three-quarter post this year. “My personal opinion is that there should be more M&A just given the challenges from a financial perspective,” he says. “But banks are sold, not bought.” One factor might be that many potential sellers aren’t sure if this is the best time to sell if they want to maximize their bank’s value, he explains. If the economic expansion still has a few more years left before hitting the recessionary brick wall that most experts assume is out there, then perhaps the best thing to do is to wait for pricing to improve.

Of course, many of those potential sellers might have an unreasonably optimistic expectation for what their bank is worth in today’s market. “We get the question all the time—when can I sell my bank for two times book [value]?” says McKinney. There was a time in the early 2000s when banks did fetch that kind of valuation, but generally they don’t today. “We’ve only seen six deals this year at two times book,” he says.

Another factor is that after several decades of consolidation, the banking industry is much smaller than it used to be. “When you look at the number of deals this year compared to last year, keep in mind there’s also fewer banks as well,” he says. “We’ve got a shrinking universe.”

The decline in pricing might have less to do with the industry’s underlying fundamentals than the types of deals that are getting done in 2016. After all, the fundamentals are pretty similar. “If you look at where bank stock trading multiples are today—and that’s a pretty big driver of M&A pricing—they are pretty similar to where they were a year ago,” McKinney says. “I would say that most banks have the same currency [valuation today] they had a year ago from an earnings multiple or price-to-book [basis].”

However, what is different is the size of banks that dominated the deal volume through the first nine months of 2016. According to S&P, well over 60 percent of all deals this year have been for banks under $250 million in assets, where the average price-to-tangible-book-value ratio has been approximately 117, and the price-to-earnings-multiple has been about 17 times earnings. By contrast, the highest valuations have been for banks with $1 billion in assets and above, where price-to-tangible-book value ratios have ranged from 160 to 180 depending on the size of the bank. Generally, large banks sell for more than small banks, demonstrating a clear buyer preference for scale.

McKinney says that for small banks, it’s a buyer’s market. “The buyer is in the position to drive pricing [down] on those deals because they know they’re only one of maybe two or three [prospective] buyers for those franchises,” he says. “Where we see pricing stabilizing or maybe even slightly higher is [for banks with] good long-term demographics [in] metro areas, and also with $1 billion dollars and above in assets.”

Private Banks Can Get Deals Done

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The vast majority of the banking industry is composed of privately owned stock banks. Of the 794 non-FDIC assisted bank M&A deals that were announced in 2013 through 2015, almost two-thirds involved a non-exchange traded buyer. Non-publicly traded banks are clearly getting deals done. There are several key facets that FinPro Capital Advisors (FCA) works on with its non-exchange traded bank clients in order to get an M&A transaction done.

1. Know Your Value
Value for a bank is driven by earnings per share (EPS) and tangible book value per share (TBVS). A bank’s stock price is equal to TBVS multiplied by a TBVS market multiple and EPS multiplied by an EPS market multiple. Those market multiples are the market’s perception of the risk profile of the bank, and a bank can influence that market multiple by changing its risk profile and communicating the appropriate risk profile to the public. As seen below in the table, a lower risk profile bank will likely have a higher TBVS market multiple, resulting in a much higher value.

Tangible Book Value Per Share – Range of Market Multiples 2016Q1
    High Risk Average Risk Low Risk
A Tangible Common Equity $150,000 $150,000 $150,000
B Common Shares Outstanding $5,000 $5,000 $5,000
C=A/B Tangible Book Value Per Share $30.00 $30.00 $30.00
D Price/TBVS Multiple 80.00% 100.00% 120.00%
C x D Stock Price $24.00 $30.00 $36.00

Value is measured primarily by stock price, which means that for both potential nonpublic buyers and sellers it is critical to conduct a quarterly valuation. A private bank can actually have more control over its valuation and the communication around the bank’s value proposition. A private bank controls its message, whereas a publicly traded bank’s message is heavily influenced by the market. FCA believes banks must continue to fix their risk profile, enhance value creators and reduce value detractors in order to increase inherent value. Then, this inherent value must be conveyed to the potential partner involved in the transaction.

2. Know Your Opportunities
In order to reflect all strategic options available, FCA periodically analyzes for each of its clients a full range of buy-side and sell-side options to reflect the full universe of options available to the institution. The detailed process includes:

  1. Comprehensive screening based on strategy
  2. Prioritizing the initial screen to approximately 10 potential targets (or buyers/strategic partners)
  3. Modeling to ensure appropriate assumptions with pro forma financials
  4. Rankings reflecting long-term strategy and multiple pro forma analyses

Once this preliminary list is established, further refinement and prioritization of both buyers and targets can be conducted based on M&A parameters, strategic rationale, and market knowledge as established by your institution’s board of directors. Once you have a prioritized list of strategic partners, be active in staying in contact with those institutions. You can never be sure when another institution on your list will seek a strategic partner.

3. Model Transactions Based On Quantitative and Qualitative Factors
After a short-list is established, comprehensive pro forma financials can be modeled. A buy-side institution needs defined parameters before modeling to maintain discipline. Exceptions to parameters require a strong qualitative rationale behind the deal. Whether you are a buyer or target, a more sophisticated understanding of modeling assumptions directly relates to unlocking greater value in the transaction and recognizing synergies. Regardless of whether you are a buyer or a seller, remember that banking is a people business so make sure to lock up key people as part of the transaction.

M&A-Guidelines.png

4. Understand Key Issues for Consideration
Though a deal must work financially, it is not just about the numbers. FCA spends a great deal of time working with its clients on nonfinancial aspects of the deal:

  • Choosing the correct legal, corporate and operating structure
  • Maintaining or reducing the risk profile of the combined entity
  • Understanding the regulatory view of the transaction
  • Understanding synergies (not just financial synergies) for the combined entity
  • Establishing the branding and marketing of the combined entity
  • Recruiting and retaining key talent is vital to any transaction
  • Establishing the corporate culture going forward
  • Effectively integrating the target to ensure future value

Just because an institution doesn’t trade on a national exchange, doesn’t mean it can’t be involved in M&A. Know your value, know your opportunities and understand the process. Whether you engage in a transaction or not, the organizations which move the quickest to capitalize on these opportunities are the ones which follow these four steps on a regular basis. Just make sure to choose your strategic M&A partner based upon the long term value of the combined entity.

Midyear Update: Current Trends in Bank M&A

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Bank mergers and acquisitions (M&A) in the first half of 2015 can be summed up with a single word: consistency. Each of the first seven months of the year has seen the announcement of approximately 25 deals per month with the exception of January, when only 20 deals were announced. The results have been a robust M&A market consistent with the one experienced in 2014.

How well 2015 turns out will depend on consistency in the remaining months. As shown below, 2014 deal volume was influenced substantially by the very strong fourth quarter. That quarter was fairly weak, though, until the last two weeks of December, when numerous unexpected deal announcements resulted in the strongest fourth quarter in years.

Based on the current pace for bank acquisitions, 2015 should end just slightly below 2014’s totals. To quantify that, the chart below shows the rate of consolidation based on the number of bank charters in use at the beginning of a period and then shows the number of announced bank deals for that period divided by the charters. The average rate of consolidation over time has been approximately 3.41 percent.

In 2014 and so far in 2015, the consolidation rate has been above 4.5 percent, which is another indication of how strong the bank M&A market is.

Credit Drives M&A Volume
So where is all of the consolidation coming from, and what are the drivers of the strong M&A volume?

Credit has been a significant driver, and last year saw credit improve enough at target banks to spur an increase in deal volume. The other drivers have been the size of the banks sold and an improvement in pricing.

Over the past five and a half years, deals have been dominated by smaller community banks (those with less than $250 million in assets), as shown below.

The median size of sellers has not fluctuated significantly over this time frame. What has changed are the levels of nonperforming assets and the profitability of the sellers. In 2010-2011 these deals were affected by high levels of nonperforming assets, which drove losses at many of the sellers. Nonperforming asset levels currently are down, and profits are up. As a result, the price/tangible book value realized increased from the lower levels of five-plus years ago and is spurring deal flow.

While deal pricing has improved, it’s interesting to look at the stratification of the number of deals in each band of price/tangible book value. Even with improved pricing, no clear pattern of where pricing is being clustered is emerging. Several bands at both the low and high ends of the pricing spectrum indicate that the deals are varied and include banks that still suffer from credit and earnings issues as well as banks in desirable markets with strong credit quality and strong earnings prospects.

All Regions Show Improvement
As shown below, all regions in the U.S. have fared well during the 18 months ending June 30, 2015. Compared to two years ago, the improvement is marked.

The highest deal volume occurred in the Midwest region, which is consistent with the fact that the Midwest has the most bank charters. However, the median size of the seller is the lowest, and this translated into the lowest price/tangible book value ratios of any region. After the initial impact of plummeting oil prices on deal volume and values, the Southwest rebounded to have the most robust pricing. The other two compelling regions are the Southeast and the West. Both regions were hit hard by declines in land values during the credit crisis and now, having weathered that storm, are experiencing strong activity and rising prices. New England continues to be strong, although the deal volume there is the lowest of any region.

Future for Bank M&A Is Consistent
2015 should shape up to be another strong year in bank M&A. The buyers are smaller in asset size than in the pre-crisis years, but they are active and looking to increase their franchise footprint. Many of the buyers are facing challenges to earnings growth, whether from a lack of organic growth in loans and deposits or because of the Federal Reserve’s prolonged low interest rates negatively affecting bank net interest margins. At the same time, many sellers have expressed concerns over the cost of regulatory burdens on their income statement, and some sellers are finding it difficult to replace retiring board members and upper management, leading them to look for a partner for the future. Whatever the impetus, the data clearly shows that bank M&A should remain consistent for some time into the future.

Don’t Sell the Bank

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2-18-15-Al.pngI recently read a report from FIG Partners, an investment bank, that says “M&A pricing is actually much stronger than investors realize given the fact the capital levels are twice—or at least significantly higher—than the past cycle and now price-to-tangible book values are rising.” So if pricing is, in general, improving from a seller’s perspective, it is easy to see why a bank’s board of directors would consider putting the bank up for sale.

But my question is: Why sell now when better times might be ahead?

True, addressing this issue largely depends on how the institution is positioned, geographically, by product line and yes, asset size. Further, I realize a bird in hand is worth two in the bush, and this wait-and-see approach is one that a number of advisers warn boards from taking. However, while the pool of potential buyers is larger than previous years, I don’t see it as aggressive as some would lead you to think.

Still, figuring out when a bank should be a buyer—or a seller—has been on my mind since the Royal Bank of Canada announced a deal for “Hollywood’s bank,” City National Corp., for $5.4 billion. This is the most expensive large U.S. bank deal announced since the financial crisis, based on a price-to-tangible book value of 262 percent. Since that announcement, various media outlets have speculated that buyers will pay a premium for trophy properties like City National. Many anticipate banks that cater to the wealthy will be front and center. But I’m not so sure that institutions with a similar clientele, like San Francisco-based First Republic Bank, should sell, even if approached with a huge multiple.

If you’re not familiar with First Republic, I find the bank’s story fascinating. Jim Herbert founded the bank in 1985, sold it to Merrill in 2007 for 360 percent of book value, took it private through a management-led buyout in July 2010 after Merrill was acquired by Bank of America, then took it public again in December through an initial public offering. A few years ago I sat down with Jim in their New York City offices and came away impressed: not only is the bank solely focused on organic growth, it’s also focused solely on private banking.

So I wonder. Members of First Republic’s board have a fiduciary responsibility to shareholders; however, does a short-term premium trump sustained long-term potential?  For a bank that caters to the wealthy, business executives and owners, I’m sure the U.S. Department of Labor’s announcement that the U.S. economy created 257,000 jobs in January—making this the longest stretch of sustained monthly growth since the early 1990s—was well received. While the unemployment rate ticked back up to 5.7 percent, from 5.6 percent in December, The Wall Street Journal reports that the climb was likely because more Americans said they were looking for jobs, a sign of growing confidence.  As the tide begins to rise, why sell the proverbial boat?

Moreover, a recent report from Deloitte’s Center for Financial Services says that, “the encouraging M&A activity seen in 2014 is likely to continue through 2015, driven by a number of factors: stronger balance sheets, the pursuit of stable deposit franchises, improving loan origination, revenue growth challenges, and limits to cost efficiencies.” However, their 2015 Banking Outlook also acknowledged that “as banks move from a defensive to an offensive position to seek growth and scale, they should view M&A targets with a sharper focus on factors such as efficiencies, growth prospects, funding profile, technology, and compliance.”

So rather than consider an exit, isn’t now the time to double down on your growth efforts?

Drivers of Bank Valuation, Part I: Defining Value

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3-4-13_Commerce_Street.pngWhen looking at a bank’s value, whether as a going concern or through the merger process, the headline is the price.  This can be expressed as a dollar value per-share or as a multiple of earnings or tangible book value (“TBV”).  Either way, price is the critical metric for boards to assess management’s performance, for shareholders who must approve merger transactions, or for financial advisory firms who must opine on a transaction’s fairness.

It follows, then, that boards should spend time during the strategic planning process evaluating what drives bank value and what steps they and the bank’s management can take now to improve the organization’s overall valuation and worth in the marketplace. This process pays dividends in growing share value, improving the bank’s perception in the marketplace (especially important for banks with publicly listed stock), and ultimately receiving a satisfactory price in a merger or sale transaction.

Defining Value

The baseline for valuation is the net worth or book value of the company.  Typically, buyers and investors look to the bank’s TBV—or the bank’s net worth after all intangibles and hybrid capital instruments are netted out.  After TBV, the most critical factor in assessing value is earnings. Earnings grow TBV and they allow boards flexibility in providing benefits to shareholders through stock buybacks and dividends. Plus, they allow management the flexibility to invest in people, processes and new lines of business.  Also, in a sale of the company, buyers rely on the acquired company’s earnings to repay them for the dilution they take as a result of paying a control premium.  More earnings, more premium—and more benefit to shareholders.  

In the first of a three part series, we will examine some of the attributes that drive tangible book value and are perceived as valuable to prospective acquirers and merger partners.  In this issue’s installment, we will look at the TBV metric in detail and how focusing on TBV is critical to driving shareholder value.

Growing Tangible Book Value

Since the financial crisis in 2008, regulators, investors and prospective purchasers have all migrated toward discounting the capital benefits of so-called Tier 2 capital and other intangibles that make up a bank’s “book value.”  The use of TBV as the standard metric for assessing a bank’s equity and pricing deals should drive boards toward placing a premium on growing TBV through organic growth.  This isn’t necessarily an argument not to do deals, but deals involve premiums and thus are dilutive—even if only for a time—to the organization’s TBV. If boards are eyeing an exit in the short-to-medium term, growing TBV should be an overriding priority.  

Consider a simplistic example.  If a bank organizes and raises capital at $10 per share and runs a five-year business plan that yields growth in TBV of 15 percent per year, the share value at the end of the business plan will be approximately $20 per share.  Assuming an exit at 2 times TBV, the bank’s investors will realize a 4 times return on their original investment of $10. Fair enough. Now, take that same bank and grow the TBV at 20 percent instead of 15 percent and the investor will exit at $50—moving the return from 4 times cash-on-cash to 5 times.  

The point here is that incremental changes in TBV over the life of a bank’s business plan can have a significant beneficial impact on the bank’s shareholders.  Likewise, poor capital planning—including raising capital at significant premiums or poor M&A strategy—can erode TBV and significantly erode the return to shareholders.  

So, how to grow TBV?  This is certainly a challenge given the compressed margins and lower earnings in the current banking market.  But running the bank efficiently, allocating capital to higher margin businesses, controlling cost of funds, expanding fee income opportunities and careful pricing in the M&A markets can all help push more of the bank’s earnings capacity into the company’s net worth—and yield a better price for the bank’s shares in the open market or in an outright sale.  

In the next article in this series, we will explore several operating metrics that assist in TBV growth and drive higher valuations in open market stock sales and the merger markets.

Lee’s comments are strictly his views and opinions and do not constitute investment advice.