Current M&A Trends and Implications

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Bank and thrift merger and acquisition strength continued in the first quarter of 2015, with transaction volume essentially the same as the first quarter of 2014. A notable trend was the continued strengthening of transaction pricing, with 2015 transaction multiples at the highest levels since 2008.

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Source: SNL Financial; transaction data through March 31, 2015

What is Driving Transactions?
Many of the factors driving the current M&A cycle have been well documented and remain largely unchanged—improving industry fundamentals, increased regulatory costs, net interest margin compression in a low rate environment, industry overcapacity, and economies of scale. While those themes have been playing out in various forms for several years, some additional themes are emerging that are significantly impacting the M&A environment:

The advantages of scale are translating to a significant currency premium. For years we have seen a significant correlation between size, operating performance and currency strength. Lately, that trend has become a significant currency advantage for institutions with greater than $1 billion in assets and resulted in smaller institutions being constrained in their ability to compete for acquisition partners because of a weaker valuation. The chart below details current price to book and price to earnings multiples for publicly traded banks and thrifts based on asset sizes.

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Source: SNL Financial; market data as of April 10, 2015

Net interest margin revenue challenges and uncertainty about the timing and magnitude of a Federal Reserve rate increase have placed pressure on bank stock performance. After recovering from the depths of the Great Recession, the banking industry experienced significant improvement in asset quality, capital levels, operating performance and earnings growth from 2011 to 2014. This translated to significant stock price performance, evidenced by banking stocks outperforming the overall market by nearly 30 percent on a cumulative basis during 2012 to 2014. However, beginning in early 2014, bank stocks have largely underperformed, mainly as a result of decelerating revenue and earnings growth and an uncertain outlook for Fed rate hikes. The result has been an alignment of buyers and sellers as buyers have utilized acquisitions to continue to increase revenues and sellers (smaller banks in particular) have concluded that a strategic partnership with a larger institution is the best method of delivering shareholder value.

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Source: SNL Financial

Increasing M&A multiples have contributed to increased capital issuance. Increased transaction multiples is resulting in more goodwill creation, a higher likelihood of tangible book value dilution and a reduction in regulatory capital ratios. Acquirers are responding by issuing capital in what has been a favorable capital raising environment over the past several years due to a combination of strong price/earnings multiples and low interest rates. The banking industry has taken advantage of the favorable environment by issuing common and preferred equity and senior and subordinated debt. While some of the issuance has been focused on redeeming the government’s TARP/SBLF money, refinancing debt, and general corporate purposes, recent issuances have clearly been focused on merger activity. In reviewing offering documents, over half of issuers since the beginning of 2014 have indicated acquisition funding as a potential use of proceeds.

Conclusion
Merger and acquisition multiples have been increasing and 2015 will continue to be a favorable environment for M&A activity as the industry weighs the impact of potential rate increases and buyer and seller interests continue to align. Forward looking institutions have been raising capital to position themselves to be opportunistic buyers when strategic opportunities become available and sellers are taking advantage of a more favorable pricing environment.

Higher Salaries, Tougher Performance Metrics Mark Pay Trends for 2015

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12-19-14-Pearl.pngAs banks look ahead to 2015, compensation committees are entrusted with the task of determining executive pay for the upcoming year. The goal is to ensure an optimal balance between providing fair compensation for the job and motivation to meet and exceed business objectives.

Based on Pearl Meyer & Partners’ recent survey, Looking Ahead to Executive Pay Practices in 2015 – Banking Edition, there are five trends that compensation committees should consider as they make decisions for the upcoming year.

Banks of all sizes are facing the same pay challenges.
Regardless of size, the study indicates that banks are facing the same top three pressing issues:

  1. Alignment of incentives with business strategy and objectives;
  2. Assuring compensation plans ultimately result in pay/performance alignment; and
  3. Attraction and retention of key executives.

Implications: The ongoing quest to align pay programs with business strategies requires specificity. Boards should define “what is success?” in enough detail that incentive plan metrics can be chosen that have a direct linkage to realizing that success.

Compensation committees should also consider the definition of pay being used as they analyze pay-for-performance. Pay realized or realizable by the executive may offer the best insight into the relationship between compensation and financial results.

More banks are increasing CEO and direct report base salaries.
The overall number of institutions in 2015 that expect to increase CEO base pay between 2 percent and 4 percent is 41 percent, up from 26 percent in 2014. Increases in the 4 percent to 6 percent range are also on the rise versus the previous year.

CEO direct report base salaries are also rising modestly with 59 percent of banks anticipating increases between 2 percent and 4 percent, an improvement of 9 percentage points over the previous year.

Implications: As banks return to profitability, more are reinstituting modest base salary increases. Significant gains in executive compensation are more likely to come through incentive compensation and in particular, long-term awards as compensation committees seek to strengthen the pay-for-performance relationship.

Annual incentive program payout levels are expected to be strong.
Thirty-three percent of banks anticipate that bonuses will be somewhat higher for 2014 performance, with 32 percent expecting bonuses to exceed 100 percent of target. In particular, larger banks with more than $3 billion in assets expect strong payouts, with 47 percent indicating bonuses above 100 percent of target. Another 33 percent expect bonus payouts similar to the prior year.

Implications: Annual incentive plan payouts are an indication that many banks have recovered from the worst of the financial crisis. Compensation committees should align payout levels with strengthening bank financials and the economy as our next trend suggests.

Incentive program performance goals are expected to get tougher.
Perhaps as a sign of continued economic recovery and greater scrutiny on pay-for-performance, 48 percent of banks are planning to increase the difficulty of their performance goals in 2015. This again is most pronounced among institutions with more than $3 billion in assets, where 67 percent expect to increase goal difficulty.

Implications: Goal difficulty should be tested using both internal and external benchmarks to ensure performance levels employ an appropriate level of stretch goals while being realistic and achievable. Comparisons to historical performance, budget, analyst forecasts and peer group performance may prove useful.

Long-term incentive values are steady and growing. Performance shares are gaining in prevalence.
As banks consider shareholder alignment and regulator encouragement to link rewards to the time horizon for risk, 44 percent of banks predict equity award values will remain at current levels, while 38 percent of all respondents are expecting either somewhat or considerably higher value in 2015.

Banks continue to adopt performance shares, which are prevalent in other industries. Currently, only 18 percent of banks use performance-based vesting versus 33 percent in other industries; however, more than 15 percent of bank participants are planning to use performance-based awards for the first time in 2015.

Implications: The data indicates that banks may be shifting the executive compensation mix to be more long-term through the use of equity awards. As stock option usage declines and there is greater pressure to link pay and financial performance, banks often are adding performance vesting to restricted stock (or restricted stock units) in order to achieve the objectives of shareholder alignment, stock ownership and executive retention.

Conclusion
As banks address the same pay challenges across asset sizes, compensation committees are seeking ways in which to improve the pay-for-performance relationship. Based on the results of the study, boards are doing this by increasing the difficulty of annual incentive plan goals, placing emphasis on long-term incentive compensation and granting performance-based equity. Combining these actions with a review of performance to realized/realizable pay and testing incentive plan goal difficulty can assist the committee in making appropriate compensations decisions for 2015.