Acquire or Be Acquired Perspectives: Two Banking Megatrends to Watch For


megatrends-4-27-18.png	Bronstein_Gary.pngThis is the fourth in a five-part series that examines the bank M&A market from the perspective of five attendees at Bank Director’s Acquire or Be Acquired conference, which occurred in late January at the Arizona Biltmore resort in Phoenix.

Read the perspectives of other industry leaders:
John Asbury, president and CEO of Union Bankshares
Eugene Ludwig, founder and CEO of Promontory Financial Group
Kirk Wycoff, managing partner of Patriot Financial Partners, L.P.


There were two industry trends at the forefront of attendees’ minds at the 2018 Acquire or Be Acquired conference hosted earlier this year by Bank Director at the Biltmore resort in Phoenix: the heating up of technology and the cooling down of M&A.

This was echoed in a conversation that Bank Director had at the conference with Gary Bronstein, a partner at Kilpatrick Townsend & Stockton LLP, who presented at the event and said that his biggest takeaways came from conversations about technology.

Bronstein is one of five perspectives Bank Director cultivated about M&A following its annual conference in late January.
The bank industry is no stranger to changes, many of which have led commentators and industry observers in the past to proclaim the death of traditional banks. Yet, there was a palatable sense among bankers in Phoenix that the evolution in technology happening right now could indeed be different.

“What does all of this actually mean?” asked Bronstein. “It’s pretty general at this point, but the demographics are changing. There’s a recognition that, once you get below a certain age range, people stop going into branches.”

The impact of this is starting to be reflected by trends in deposit growth. “I thought it was interesting to learn that, historically, the community banks typically increased their deposit bases by taking customers away from larger banks, but it appears that this trend has reversed itself,” says Bronstein. “The largest banks in the United States are now organically growing deposits even though they pay rates that are considerably lower than what community banks pay.”

Bronstein notes that brand recognition is one explanation for this. “When a young person moves to a new place and they need to open a bank account, they pick a bank with a household name,” says Bronstein. But he also believes that it could be driven by the ability of large banks to afford better technology that better appeals to younger generations.

One consequence is that banks should prioritize efforts to recruit directors with technology experience. “It’s important to have the right kind of expertise on your board,” says Bronstein. “Banks have been good about having accounting expertise on their board because, particularly for public companies, you are essentially required to have that for your audit committee. But I think equally as important today is technology expertise. It is important to make the effort to try to find it.”

Whether a bank is successful at recruiting the right expertise depends in part on location. “In rural areas this can be more difficult,” says Bronstein. “In urban areas or around urban areas, there are plenty of prospects with technology experience out there. It’s just a question of picking the right person.”

In addition to conversations about technology, Bronstein also noticed at the 2018 Acquire or Be Acquired conference that bankers seem more optimistic than at any time over the past decade. But interestingly, that optimism does not appear to be filtering through to M&A activity.

What’s causing this juxtaposition? There are few likely culprits, Bronstein notes.

The first is that there are not as many buyers in the market. “A theme at the conference was recognition on the part of people involved in bank M&A on a daily basis, including myself, that in many markets there is a limited number of buyers,” says Bronstein.

Underlying this is the perception that it is safer and simpler to grow organically. “There are some banks that have come to the conclusion that they do not want to be buyers,” says Bronstein. “They do not want to take on the risk. They do not want to do the work because it is not an effective use of their management capital.”

Another reason Bronstein offers for the underwhelming M&A market is that only a limited number of banks have currencies that are potent enough to make highly accretive acquisitions.

Many banks are trading for high multiples to their earnings, of course, but the problem is that much of the industry is in the same boat. This leaves few opportunities for banks with high valuations to realize earnings and book value accretion from the acquisition of banks with low valuations.

There’s also the simple matter of arithmetic. As the bank industry consolidates, with an average of 4 percent of banks disappearing by way of merger or acquisition each year, the number of prospective targets shrinks. And to Bronstein’s earlier point, this is a trend that is only likely to continue as community and regional banks seek the scale needed to compete against the technology offerings of the big banks.

No Time for Complacency


valuation-1-31-18.pngThe bank industry is no stranger to change. In just the past few decades, deregulation, telephone banking, ATMs, the internet and mobile phones have all caused banks and bankers to adjust how they approach their trade. But while the fundamentals of banking have remained the same throughout all of this, with the changes confined largely to the way banking products are delivered, one gets a palatable sense from attendees at Bank Director’s Acquire or Be Acquired conference this year that the industry is on the verge of a more transformational realignment.

In the short-term, bankers are upbeat about last year’s historic tax cut. You have to go back to World War II to find the last time the corporate income tax rate was as low as 21 percent. Few industries will benefit more than banks from this reduction, as three out of the four biggest taxpayers on the S&P 500 are banks. The net result is that profitability in the industry, measured by return on assets, is expected to increase by 20 basis points in one fell swoop.

The benefit to banks from the tax cut won’t just be on the expense side. In an audience poll on the second day of the conference, 84 percent of attendees said that they expect small businesses to recycle tax savings into new investments, be it better technology or higher wages for their employees. If this comes to fruition, it would pour fuel on the economy, pushing up wages and accelerating inflation. The desire to keep price increases in check, would incentivize the Federal Reserve to raise rates more aggressively, thereby pushing up net interest margins and thus revenue and profits throughout the bank industry.

This is one of the reasons that bankers are so optimistic about 2018. Bank stocks have soared over the past 14 months, pushing valuations up to the highest level in a decade. Bankers who own stock in their banks have seen their balance sheets respond in kind. For banks that have considered a sale, this presents a previously unexpected opportunity to cash in by drawing a markedly higher price for their shareholders from a merger or acquisition.

Yet, there are two underlying currents of concern. The first is that the improved outlook will lull bankers into complacency. With profits up and shareholders feeling rich, investors fear that bankers will feel less urgency to change. But as Tom Brown, CEO of hedge fund Second Curve Capital, reminded attendees earlier in the conference, bankers should be careful not to confuse a bull market with brains.

Banks have survived countless innovations that have washed over the industry in the past by adapting to them and incorporating them into their existing business models, but the changes afoot now, be it big data or mobile banking, strike at the very heart of those business models themselves. In a separate poll of audience members at this year’s conference, 83.5 percent of attendees said that big data is the new oil. The implication is that it could usher in changes as significant as the industrial revolution.

This is a point that Dennis Hudson III, the chairman and CEO of Seacoast Bank, a $5.8 billion bank based in Stuart, Florida, drove home in an interview with Bank Director. Customers are becoming less sticky. Many customers no longer walk into branches and younger generations in particular now value banks less for the ability to store money and more as the means to facilitate secure, real-time payments. Banks that don’t adapt to these realities could find themselves in the same situation as horse buggy drivers who dismissed the automobile as a toy for hobbyists.

When you also factor in the maturity of the consolidation cycle, which could leave under-performing banks with few suitors and competing against bigger and more sophisticated rivals, this may be one of the worst times in the history of banking to grow complacent. Consistently throughout the conference there was talk of the haves and have nots. The haves are banks that earn industry-leading returns and thereby serve as attractive acquisition targets or are in a position to be serial acquirers in their own right. The have nots, on the other hand, are banks that lag the performance of their peers, lack the resources to devote to innovation and could thus find themselves standing alone when the proverbial music stops playing.

Further underlining this point is that, for the first time, the nation’s biggest banks are growing customers organically, attracting them with simple and sophisticated mobile banking offerings and competing aggressively for consumer deposits as they comply with new liquidity requirements. This is a meaningful inflection point. Previously, community and regional banks benefited from the acquisitive ways of the biggest players in the industry, which shed customers as the banking behemoths worked to digest their acquisition targets. But now, with the three biggest banks in the country locked out of the acquisition game as a result of the 10 percent cap on deposits, they are focused inward, bringing them into more direct competition with smaller banks.

The overarching takeaways from this year’s gathering of over 1,000 bankers are accordingly twofold. The near-term looks promising for banks, with more money hitting the bottom line from the recent historic tax cut. But banks should use this to accelerate their transformation into the financial institutions of the future, not as an excuse to rest on their laurels and buy back stock.

Cautious Optimism for Bank M&A


industry-1-29-18.pngThere is a general sense of optimism about the state of deal-making in the banking industry at Bank Director’s Acquire or Be Acquired conference in Phoenix, Arizona. Bankers and industry observers pointed repeatedly throughout the first day to the fact that bank stock valuations have soared in the 14 months since the 2016 presidential election, opening up new possibilities for interested buyers and sellers.

Bank stocks faced an uncertain if not bleak future two years ago, a point that Thomas Michaud, president and CEO of Keefe, Bruyette & Woods, used to set the scene for the state of banking in 2018. Oil prices had dropped to below $30 a barrel, economic growth in China seemed to be tempering and the United Kingdom was lurching towards a nationwide referendum on quitting the European Union. This trifecta of bad news led bank stocks to drop, producing a dour outlook for prospective sellers.

Yet, you only had to flash forward to the end of 2016 to find a dramatically altered landscape. Stocks soared following the presidential election. And no industry benefited more than banks, where share prices rose by nearly a third over the next four months. Since the beginning of 2016, large-cap bank stocks have climbed 55 percent while regional bank stocks have gained 44 percent—both having bettered the S&P 500’s 36 percent advance over the same stretch.

This has resulted in meaningfully higher valuations, a core driver of deal activity. Prior to the presidential election, banks were valued below their 15-year median of 15.2 times forward earnings per share estimates. After peaking at 18.8 times forward earnings in the immediate wake of the election, they have settled at 15.4. But even though bank valuations are up, which makes deals more attractive to buyers and sellers with higher multiples, they are nowhere near euphoric levels, given the mere 20 basis point premium over the long-run average.

Virtually everyone you talk to at this year’s gathering of more than 1,000 bankers from across the country believes there is still room for these valuations to climb even higher. This was a point made in a session on the drivers of a bank’s value by Curtis Carpenter, principal and head of investment banking at Sheshunoff & Co. Investment Banking. In just the last five weeks of 2017, six deals priced for more than two times tangible book value were announced, creating strong momentum for 2018.

Underlying all of this is an improved outlook for bank profitability, the primary determinate of valuation. In the immediate wake of the financial crisis, it was common to hear people say that banks would be lucky to return 1 percent on their assets. Now, a combination of factors is leading people like Michaud to forecast that the average bank will generate a 1.2 percent return on assets.

Multiple factors are playing into this, beginning with the pristine state of the industry’s asset quality. You have to go back to the 1970s to find the last time the current credit outlook for banks was this good, says Michaud. This has some industry observers watching closely. One of them is Tim Johnson, who leads KPMG LLP’s deal advisory financial services sector. Johnson commented in a panel discussion on deal-making that he believes the consumer credit cycle could take a turn for the worse this year. But there are others, like Tom Brown, founder and chief executive officer of the hedge fund Second Curve Capital, who doesn’t see any reason to be worried about consumer credit trends in light of the low unemployment rate and high consumer confidence.

The expected changing of the guard atop the regulatory agencies is a second factor fueling optimism that profitability will improve this year. Former banker Joseph Otting is the new comptroller of the currency, while Jerome Powell has been confirmed as the new chair of the Federal Reserve Board. Jelena McWilliams awaits confirmation by the U.S. Senate as the new chairman of the Federal Deposit Insurance Corp., and President Donald Trump is expected to nominate a new director to lead the Consumer Financial Protection Bureau. While there are few signs of tangible benefits in terms of a lower compliance burden from the new administration, this should eventually change once new leaders are in place at the top of all of the agencies.

Last but not least, the biggest boost to profitability in the industry will come from the recently enacted corporate tax cuts, which lower the corporate income tax rate from 35 percent down to 21 percent. The drop is so significant that it caused KBW to raise its earnings estimates for banks by 14 percent in 2018 and 12 percent in 2019. And when you factor in the likelihood that many banks will use the savings to buy back stock, KBW projects that earnings per share in the industry will climb this year by 25.6 percent over 2017.

The atmosphere on the first day of the conference was thus upbeat, with presenters and attendees projecting a sense of cautious optimism over the improved outlook for the industry. At the same time, there is recognition that the longer-term macro consolidation cycle that shifted into high gear following the elimination of laws against interstate banking in the mid-1990s could soon reach critical mass. If that were to happen, banks that don’t capitalize on today’s improved outlook by seeking a partner could be left standing alone at the merger alter.

A Witness to M&A History


merger-1-28-18.pngWhen Bank Director hosted its first Acquire or Be Acquired conference in 1994, there were 12,604 banks and thrifts in the U.S., according to the Federal Deposit Insurance Corp. As of the third quarter of 2017, which is the FDIC’s most recent tally, there were 5,737 banks and thrifts—a 54.5 percent decrease. That is a stunning reduction in the number of depository institutions over this period of nearly two and a half decades, and the Acquire or Be Acquired conference has been a witness—and a chronicler—of it all.

This year’s event will kick off on Sunday, January 28 at the Arizona Biltmore Resort in Phoenix. By my count, I have attended 18 of these conferences, and the things we have discussed while we were there have changed over time and are always a reflection of the times. In the early 2000s, when the U.S. economy was strong and big banks were still in the game, we focused on the dealmakers who were building banking empires and taught the fundamentals of putting together a successful M&A transaction. During the depths of the financial crisis, when there wasn’t much M&A activity going on as many banks were more focused on shoring up their shaky balance sheets, and some were taking money from the Treasury Department’s Troubled Asset Relief Program, we talked a lot about strategies for raising capital. And since the few transactions during that period tended to be government-assisted deals with the FDIC, we offered advice on how to do those successfully.

More recently, as the industry’s financial health has returned, capital levels have improved and there are no longer many broken banks to buy, we have focused on the mechanics of buying and selling healthy banks. For many banks today, M&A has once again become the centerpiece of their strategic growth plans. However, we have also expanded the conference’s focus in recent years by adding general sessions and workshops on a broad array of topics including financial technology, lending, data, interest rates and deposits. The decision to buy or sell a bank is rarely made on the strength of the deal price alone, but is driven by these and other critical business considerations. We have tried to account for that broader perspective.

An issue that has been an underpinning to Acquire or Be Acquired from its very beginning has been the banking industry’s consolidation, a trend that dates back to at least the early 1980s. Last year there were 261 healthy bank acquisitions, according to S&P Global Market Intelligence, compared to 240 in 2016 and 278 in 2015. The outlook for 2018 is good, based on the rise in bank stock valuations following the enactment of a tax reform law that drastically cuts the corporate tax rate. With a stronger currency in the form of a higher stock price, acquirers should have an easier time putting together deals that are attractive to their own shareholders. It’s a fool’s game to predict the number of transactions in any given year (and a game that I have played, foolishly and without much success, in years past), but I would expect to see deal volume this year somewhere in that 240 to 278 range, which has come to represent a normalized bank M&A market in recent years.

Whatever the deal count in 2018 turns out to be, the banking industry’s consolidation rolls on, and the Acquire or Be Acquired conference will continue to be a witness to history.

Three Ways to Increase Shareholder Value


shareholder-5-3-17.pngWith the Federal Reserve due to raise interest rates again this year and an administration focused on domestic issues and reducing regulation, community bank stocks are in high demand. The OTCQX Banks Index, a benchmark for community banks traded on the OTCQX market, gained 30 percent in the past 12 months, compared to 15 percent for the S&P 500. How can community banks leverage this positive trend and deliver greater value to their shareholders?

First, achieve a fair valuation for your shares. Fair market value is the price at which a person is willing to buy a company’s stock on the open market. Determining fair market value for a publicly traded stock is relatively straightforward and can be done by, for example, taking the average of the highest and lowest selling prices for the stock that day.

Figuring out fair market value for a stock that is not traded on a public market is a little more complex. For privately held community banks, this typically requires the chief financial officer to call around to multiple investors to negotiate prices in bilateral transactions. Not only is this process opaque and inefficient, but it generally doesn’t yield the highest value for shareholders.

For a publicly traded community bank, achieving fair market value is also a factor of the market on which it is traded and how much information it makes available to investors. A bank that trades on an established public market like OTCQX or OTCQB is helping maximize the value of its shares by providing transparent pricing, access to liquidity and convenient access to its news and financial disclosure.

Second, reduce the risk of owning your securities. Community banks can also maximize shareholder value by reducing the risk of trading their securities. A privately-held bank that trades its stock out of a desk drawer opens itself up to additional risks related to pricing, holding and clearing its securities. In contrast, a bank that trades on an established public market reduces risk for shareholders by allowing them to freely get into and out of its stock.

Public market standards can also help lower shareholder risks. In the OTC markets, the top two markets—OTCQX and OTCQB—have verification processes which allow banks to demonstrate to shareholders that they have met certain standards and that there are risk controls around their securities. In contrast, there is no such verification process for companies on the bottom Pink market, which increases the risks—and costs—of owning these securities.

Third, embrace technology. As community banks struggle to replace an aging shareholder base, technology will play a key role in attracting and retaining a new generation of millennial investors. Millennials, aged 18 to 34 years old, get most of their news online and on their phones, so banks need to embrace technology to make sure their financials and news are widely disseminated.

Trading on an established public market like OTCQX and OTCQB can help community banks ensure their news and disclosure is seen by broker-dealers and investors wherever they analyze, value or trade its securities. OTC Markets Group also works with Edgar Online to provide non-Securities and Exchange Commission reporting banks conversion and distribution of their fundamental data in XBRL format, so it can be more easily consumed and analyzed by investors.

With community bank stocks receiving positive attention, now is the time for banks to capitalize on market demand. Think about your shareholders and what’s important to them. Whether your bank has $100 million in assets or $3 billion, your shareholders should be treated like customers and you need to put their needs first.

Risk Versus Return in M&A Transactions


transactions-2-20-17.pngMergers and acquisition (M&A) transactions need to be looked at from a risk versus return perspective. Participants in deals, both the buyer and seller, should understand the value proposition of the transaction and determine whether it is better to continue to grow and thrive organically or execute on a deal. Understanding value drivers and how to optimize value is the key to prospering in the future.

1. Know your value and what drives it.
There are both value creators and value detractors that exist for every company. It might be weak internal controls, a consent order or a multimillion-dollar, unfunded pension that weakens your deal prospects. On the other hand, you may have strong core deposits, strong profitability metrics or an experienced and actively engaged management team with deep client relationships that drive growth and value.

Value detractors specific to each company can be corrected over time. As the risk profile of the company improves, it is shown that valuation multiples will also improve. A company that has many value detractors can improve its risk profile over time. By improving its risk profile, the company increases the market’s perception of the value of the company, leading to higher valuation multiples. As your institution’s comparative value to the market changes over time, you must conduct periodic valuations to understand what the company’s current value is and what is driving it.

2. Understand your bank’s strategic paths, value and the execution risks of each path.
Once a company has a better understanding of its current value, it must understand the different decision tree paths available. Each of these paths will have a resultant present value of the company based upon executing on each path into the future. The risks and return associated with each path needs to be assessed. Below is an example of a strategic decision tree with five different paths. Each of these future strategic paths is modeled to determine the resultant present value resulting from each scenario path.

community-bank-chart.png

Not only is a present value calculated for each path, but the key risks and value drivers for each path need to be determined as well. For instance, if the company remains independent (path A), a key risk is that it may not be able to attract and retain key talent necessary for the company to thrive in the future.

In addition to the execution risks associated with each path, the financial value of the company under each scenario is also based upon a set of assumptions. Those assumptions must be reviewed carefully and the management team and the board of directors must critically review and sign off on those assumptions. More specific to M&A transactions, here are some of the major factors that impact an M&A deal:

  • Price: A stronger buyer currency shortens the work-back period of tangible book value dilution in a stock transaction.
  • Form of Consideration: Cash may decrease the work-back period of dilution in a transaction relative to utilizing stock consideration, due to higher earnings per share accretion, but utilizing cash will reduce the amount of capital at the combined entity.
  • Cost Savings: Acquisition of smaller banks and in-market deals will generally have higher savings (30-50 percent), while market or business line expansions generally have somewhat lower savings (25-35 percent).
  • Synergies: Deals can provide many synergies such as higher legal lending limit, greater franchise, new combined customer base, new sources of fee income, complementary loan and deposit products, or additional management bench depth for the combined entity.
  • Transaction Expenses: These are nonrecurring expense items and therefore should not be included in the pro forma combined income statement going forward but will impact tangible book value per share (TBVS) dilution and work-back period. Transaction expenses should generally be 7-12 percent for community bank deals and levels outside the range should be reviewed.
  • Mark-to-Market Assumptions: The target gets marked-to-market in a deal and these marks will initially impact TBVS upward or downward. The marks will be amortized/accreted through earnings over time. The marks generally have a bigger initial impact on TBVS and the earnings impact will be taken over a longer time period.

3. Recognize that a good deal on paper does not translate to a successful resultant entity.
Even with an extensive review of the assumptions, modeling and financial aspects of a transaction, a good deal on paper does not necessarily translate into a successful entity. Merger integration will make or break an institution’s ability to realize value in a transaction. Practical issues including vendor selection, branding and employee retention impact restructuring expenses. Social issues, such as corporate culture and leadership structure, define the bank moving forward.

Remember that there is an inherent risk versus return tradeoff in every M&A transaction. Understanding your institution’s risk profile, corporate culture, and all possible strategic paths will mitigate risk and maximize return.

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


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

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

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

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

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

Rising Stock Prices Could Impact Deal Market


stock-prices-1-19-17.pngThe year 2016 was filled with tumult and that had a negative impact on activity in the bank mergers and acquisitions (M&A) market, while higher bank stock prices are adding to the uncertainty. Will higher stock prices last? Will they lead to higher valuations in the months ahead? This article takes a look at M&A activity in 2016 with an eye toward how the environment could impact pricing and trends in 2017.

After posting 285 healthy bank acquisitions in 2014 and 279 deals in 2015, the market slipped back to 241 last year, according to data provided by S&P Global Market Intelligence. There are several reasons for this, but they can all be summed up in a single word—uncertainty. And bankers hate uncertainty like dirt hates a bar of soap.

In the first quarter of 2016, the sharp decline in the price of oil and economic softness in China and in Europe led to concerns about how that might impact the U.S. economy. There was even some talk that economic weakness abroad could result in a recession here in the United States by the end of 2016. “When oil fell off, combined with the China thing, it really took the bloom off of the rose,” says Dory Wiley, president and chief executive officer at Commerce Street Holdings, a Dallas-based investment bank. The Southwest, where Wiley works, saw a drop off in deal-making following the fall-off in oil prices. “It kind of froze all the buyers and a lot of deals, and of course sellers are always very reluctant to change their price expectations, so it slowed the amount of deals.”

The U.S. economy did not in fact slip into a recession in the second half of 2016, growing 2.9 percent in the third quarter, according to the U.S. Commerce Department. (Data for the fourth quarter was not available when this article was written.) But there was still plenty of uncertainty entering the second half of the year, which perhaps had an even more paralyzing effect on the M&A market. Once the presidential election campaign between Democrat Hillary Clinton and Republican Donald Trump had gone into full swing (both parties held their nominating conventions in July), it seems that some bank boards decided to hold off on a possible acquisition or sale in hopes that a Trump victory would create a better economic environment for banks, and have a positive impact on bank stocks.

Stocks, indeed, rose. The KBW Nasdaq Bank Index, a compilation of large U.S. national money center and regional bank stocks, expanded from 63.24 on January 19, 2016, to 75.42 on November 7, for an increase of 16 percent. However, immediately following the presidential election the index shot up from 75.42 on November 7 to 92.31 as of January 12 of this year, an increase of 22 percent. While Donald Trump’s election victory might have been received as good news by many bankers, it seems to have brought about a slowdown in M&A activity precisely because bank stock prices were going up. With valuations on the rise, some boards were reluctant to sell out if their franchise could fetch a higher price later on by waiting.

Johnathan Hightower, a partner at the law firm Bryan Cave LLP, supports this theory with data that shows a noticeable slowdown in deal flow in the fourth quarter of 2016. There were 88 announced deals in the fourth quarter of 2014 and 82 in the fourth quarter of 2015. In the final quarter of last year, the number of announced deals dropped off to 62. “I think a good bit of that can be attributed to uncertainty on the political scene,” says Hightower.

As we head into 2017, the biggest question might be how high bank stock prices will go, because continued increases may discourage M&A activity as buyers and sellers alike try to work out how deals should be valued, and what kind of structure should be used. “I think whenever you see a sharp change in valuation like we’ve seen over the past eight weeks or so, it does cause some complication in working out exchange math and exchange mechanics,” says Hightower. For example, does the seller want to lock in a fixed exchange ratio or opt for a structure that would allow the deal price to float higher if its stock price continues to rise? “The seller is doing that same sort of math on its end, so it can be hard to reach agreement, or at least require some creativity in structuring a deal,” he says.

How much higher can bank stock prices go? Jim McAlpin, who heads up the financial services practice at Bryan Cave, says he recently led a strategic planning session for the board of a Texas bank. “I was talking to the CEO about where the board was on a possible sale,” McAlpin recalls. “He said that given the recent changes [in the bank’s stock price], they’re now thinking that three times book value is possible. A year ago I would have laughed hard at that. I only chuckled this time because he said there was a bank across the street that went for 2.3 times book value. We just recently saw a bank in Georgia go for almost 2.7 [times book value] in part because of rising valuations.”

For an industry that has been dogged by low interest rates, margin pressures and economic sluggishness for several years now, the future suddenly seems very bright. But will it last? “The interesting question that no one can answer right now is, will we see a real shift in economic growth that would support an overall lift in those valuations?” asks Hightower. “Can we expect banks to have healthy, sustainable growth because we’ve got healthy, sustainable growth in the overall economy?”

Prices remained fairly steady from 2014 through 2016. According to S&P, average deal pricing was 1.42 times tangible book value in 2014, then went up slightly to 1.43 in 2015 before dipping back down to 1.35 in 2016, despite the steady run up in stock prices through the year. But we’ve now entered a period where, as the mutual fund industry likes to say, past performance may not be indicative of future results. “When you look at what the market has done in the last three to four months, with the election behind us … I don’t know that past pricing is going to be as relevant as it was,” says Wiley.

Other factors that impacted the M&A market last year include a kind of speed control that bank regulators exercise over the pace of deals. While the regulators are generally more receptive to acquisitions than they were in the years immediately after the financial crisis, and are approving deals much faster now, they still limit the frequency of deals for even experienced acquirers. “You’d be lucky to get somewhere between one and three [deals a year now],” according to Wiley. And that has added a layer of complexity to the M&A process, particularly for investment bankers. “So a guy calls you up and says, ‘Hey, run some comps, figure out what I’m worth.’ That’s not enough,” he says. “The investment banker running the deal has to know who’s in the market, who isn’t in the market and when they’re going to be in the market because it’s not an easy answer anymore.”

And because they are limited as to the pace they can string deals together, many acquirers have become more selective in what they are willing to buy. “Even with stock prices rallying like they have the last three or four months … it doesn’t mean that the acquirer can run around and just give his stock away because he’s got to be picky,” says Wiley. “He’s like, ‘Hey, I only get a couple shots at this because the regulators aren’t going to let me do anything.’’’

Does that mean it is now a buyer’s market? “I thought it was a buyer’s market for the last eight years,” says Wiley. “The only thing now is that the buyers are starting to realize it. They’ve got a big stock price now and they’re feeling good about themselves. Somebody told them they were pretty.”

Small Bank Deals Dominate 2016 M&A Transactions


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.”

Stock Considerations When Doing An M&A Deal



Most M&A transactions include stock, which provides a liquid currency for the selling bank while helping the acquirer manage its capital levels. What does this mean for privately held acquirers? In this video, Jeff Jones, managing director at Stephens Inc., explains the challenges private banks face, and when deals between two private banks make sense.

  • What is the value of a public currency vs. privately held shares in an acquisition?
  • Is there a time when a buyer might sacrifice liquidity?
  • How should buyers and sellers determine valuation when both parties are private?