By John S. Carusone
The outlook for bank mergers & acquisitions has changed dramatically from the frenetic pace during the past decade. Moreover, the future is difficult to predict due to conflicting economic, competitive and regulatory signals.
What can be said about the future outlook for banking consolidation? What are the new developments based on available data and what are the more durable issues for banks seeking to buy or sell?
The frantic pace of consolidation has slowed dramatically. Through mid-June of 2009 the pace of consolidation as measured by the volume of announced mergers/acquisitions has declined by almost 65 percent since 2007 – the most recent year of normal activity. This is true nationally and for the nine Northeast states. [Editor’s Note: please visit www.bankingny.com to see tables reflecting merger activity nationally and in the 9 Northeast states].
Pricing has declined by about the same order of magnitude. The most common bank takeover metrics have always been (1) price as a percentage of book value (tangible or nominal) and (2) price as a multiple of earnings (usually “latest twelve months” or current period annualized). Both of these metrics indicate that pricing has declined considerably from the recent past when 220 percent of book value and 25 times latest earnings were generally regarded as “median” values. In the nine Northeast states during the first six months of 2009 the median book value takeover price was 118 percent for the eight announced transactions; down roughly 50 percent from historical standards. Because bank profits were either scarce or negative, the multiple of earnings is not applicable. The same description applies to the US national statistics: median price as a percentage of book value was 82 percent for the 57 transactions announced since the beginning of 2009 and the PE multiple was again meaningless because of the lack overall earnings in the collection of target institutions.
With activity levels and pricing benchmarks at their lowest levels in almost 20 years, what is next for the consolidation sweepstakes in American banking? In my view, signals are mixed. Here is a listing of factors that should help you organize your thoughts.
In the near term and on balance, I believe the present recessionary economy will dampen consolidation activity in the banking industry.
Many institutions carry non-performing assets or investment securities with an uncertain market value; somehave both. This complicates valuation issues and lowers pricing, heightening risk and resulting in lower takeover premiums.
Other banks – although free of problematic assets – have seen their stock price punished simply by association with the financial services sector, curtailing their ability to make acquisitions on desirable terms.
Nonetheless, a minority of institutions who remain well-capitalized and well reserved to non-performing assets may view the present environment as an opportunity. Takeover prices are deeply discounted, presenting opportunities to enlarge franchise on acceptable terms to stakeholders.
Regulation and Re-regulation
I believe the net effect of the prospect of more regulation will likely help accelerate consolidation.
Smaller banks have been laboring for years under the added compliance cost burden of Sarbannes Oxley, The Patriot Act, The Bank Secrecy Act, The Community Reinvestment Act, among others. The cost of bank compliance has increased exponentially in the last decade. Some small-to-medium size banks may simply determine that they may lack the size and scale to absorb new regulatory costs. They’ll look to be acquired or merge with a larger sister institution.
Many previously unregulated or “lightly” regulated financial services entities – hedge funds, mortgage banking entities; private equity firms – will come under some form of regulation. Their world is going to change. For these entities, the prospect of owning or investing in a bank may be viewed as a safe harbor; perhaps a way to legitimize their activities. Our firm, Bank Analysis Center, has been approached by numerous non-bank entities like these seeking entrée into the banking system. Look to this group to help accelerate the momentum of bank consolidation.
For mid-size or regional institutions, the prospect of higher capital and/or liquidity requirements expected to be imposed on larger money center institutions (which have typically operated with thinner capital ratios) may be viewed as helping to level the competitive playing field. These institutions may see re-regulation as a boon for smaller institutions relative to larger banks and may seek to enlarge their franchise through external growth involving mergers and acquisitions.
The luster and patina of industry stalwarts has been tarnished. The public now questions the relationship between size and safety. Smaller banks have a new-found sense of public acceptance and respectability, and may seek to exploit the change in customer sentiment. If they have the capital and vision they may choose to enlarge their franchise through bank purchases, or to diversify their revenue sources through selective non-bank acquisitions in areas such as insurance and investment management. For this group of banks, the present environment represents strategic opportunity. They will hasten the pace of consolidation activity.
Each of these motivating factors – the economy, regulation and competitive strategy – are influential in the decision to acquire or be acquired. The recent deal list of New York banking transactions (see page 19) typifies this process.
The process of buying and selling banks will remain complex. But enduring and time tested principals remain regarding the decision to buy or sell a bank. In this regard, the following represents some important issues you should consider:
Be Prepared: Don’t back yourself into a corner when it comes to mergers or acquisitions. Don’t put yourself in a position to have to react to events that are thrust upon you because you will be at a disadvantage. Know how much you are willing to pay and how you are willing to pay (i.e. in stock or cash or combination). If you are looking to be acquired know what your bank is worth in today’s merger/acquisition market.
Lack of Strategic Focus: Many boards of directors and managements pay lip service to strategic planning. They treat it as an exercise in long-range budgeting rather than a process of self evaluation and resource allocation The issues of strategy – how to compete, across what product lines, with what technology, with what merger/acquisition strategy, will help you determine whether you are destined to be a buyer of other banks, a seller of your own bank, a merger partner or an independent.
Unrealistic Expectation of Bank’s Future: Be honest with yourself about your bank’s future prospects. It will be difficult for you to be a survivor unless you can answer affirmatively to most of the following questions:
Your market share is at least approximately as great as your largest competitor in your designated primary market (definition is important here), and that you have a long-term sustainable competitive position.
You are profitable, and have a record of profitability.
You are well capitalized and/or can access capital on favorable terms.
You are well reserved to non-performing loans.
You are able to utilize and exploit technology well.
You have depth of management in all the major functional areas of banking.
If you can’t answer most of these questions affirmatively then recognize that the best choice for your institution, and for you personally as a professional, may be to affiliate with another institution.
Unrealistic Expectations of Price When Selling: If you are selling your bank, remember that value lies in the eye of the beholder. You may think you are worth three times book value and twenty five times earnings but the marketplace is the true arbiter of your value. Bank M & A pricing is a function of many complex variables. If you can honestly conclude that the present pricing for your institution doesn’t recognize true value, then do not start the process of being acquired because you will do yourself harm in the long run.
Overpaying for an Acquisition: If you are proposing to purchase a bank, do not overpay. Overpaying can cause dysfunctional behavior after the deal is completed, and can cause unacceptable EPS dilution, book value dilution, or both.
Poorly Planned Due Diligence: Make sure that your offer to purchase an institution is conditional upon your ability to go in and “kick the tires.” If the bank is not forthcoming with the appropriate information, just walk away. If you are selling your bank you also need to perform due diligence and “kick the other guy’s tires.” Even if you are accepting cash, you need to consider what risks the buyer may present in terms of non-consummation factors. If you are accepting stock as all or as a portion of the consideration, you need to perform considerable due diligence on the quality and the value of the security you are accepting.
The Role of Advisors: Everyone wants to play dealmaker. It’s a heady experience and creates a certain mystique. However, the best deal makers are always represented in important transactions. Why? Because it gives them a buffer for flexibility, provides an independent reality check and allows the principal to break ties and act statesman-like when necessary. Make sure that your investment banker is impartial and acting in your best interest. Don’t hire anyone who may be conflicted now or possibly in the future with an eye on deals to come.
Tying Management’s Future to Shareholders’ Future: Bank managers are like any other human being: they are self-preservationists. To assure that you are getting unbiased objective information, be sure that the personal interests of your management are congruent with the interests of your stakeholders.
Managing the Combined Institution: After the deal is completed the operations of the combined bank must be streamlined in order to earn back the premium paid and obtain a satisfactory return on investment. Establish a plan for operating the combined institution by examining all aspects of the operations of each bank. Execute the plan of joint operations as soon as practical. Delaying not only incurs redundant expenses but also postpones important personnel decisions regarding the organization of the combined banks.
Make sure you have thought about employee relations and communications. Buyer institutions would do well to have a very carefully thought-out employee communications program at the start of, and during, the integration process.
In addition, personnel not scheduled to remain with the combined organization will need to make their own personal plans sooner rather than later. Wise managers will conduct this process under the rules of meritocracy, recognizing that acquired employees may be superior performers to certain of the acquiror’s own employees.
The concept of “mergers of equals” is appealing because it allows us to remember the innocence of our childhood. Except in very rare situations, there are no mergers of equals: it is a contradiction in terms.
In bank mergers, one of the cardinal rules is that the higher the price paid for the acquiree, the less autonomy from the acquiror. The preeminent bank will have the choice of operating the new acquiree under conditions of either (1) affiliation (autonomy), (2) coordination (semi-autonomy) or (3) integration (no autonomy). The timing and pacing of these stages is a function of corporate culture, management style, and politicking.
Fairness Opinions: It is wise to have one. A fairness opinion is a certification from an investment banker that the terms of the deal for the buyer or the seller are “fair from a financial point of view.” A fairness opinion protects the Board of Directors from shareholders that wish to second-guess the deal. It can also provide a rationale for declining a deal. Thirdly, in some cases, it can be used to “adjust” the terms of the deal.
The investment banker that advises you on the deal itself may not necessarily be the same advisor that provides the fairness opinion. You should obtain from your investment banker (1) a formal letter to the Board for inclusion in your proxy materials to shareholders; as well as (2) a detailed set of back-up material for the investment banker’s conclusion. You need both. The process should be rigorous, thorough and comprehensible both to the average shareholder as well as a judge.
Presently the pace of bank consolidation has slowed but is unlikely to remain so. How you choose to participate in the next wave of the industry’s consolidation sweepstakes will be determined by how well you understand the motivational forces and the subtleties of the process.
John S. Carusone is president and managing principal of Bank Analysis Center Inc., an investment banking and bank consulting concern. He has been involved in more than 50 bank mergers and acquisitions. Prior to becoming BAC president in 1987, he was affiliated with Bank of New England Corporation and Connecticut Bank and Trust, subsequently acquired by Fleet Financial Corporation of Providence, Rhode Island. He can be reached at 860-275-6050 or via email at email@example.com.