M&A Primetime | By Peter Weinstock
Bankers are increasingly discussing M&A in light of the brutal net interest margins, compliance costs and tepid growth in lending. But it’s not just the big banks that are doing so.
Before your bank’s board and management place the bank on the market, they must see that the bank is ready to be sold. Doing so maximizes returns (both price and other considerations). Here are the steps:
Define the selling horizon. Management and the board must determine when they intend to sell the bank. Certain actions that are sensible if a bank will be sold quickly may become counterproductive over a longer selling period.
Maximize earnings. A bank, as the selling bank, should take all reasonable steps to maximize earnings. Banks are bought and sold based on earnings more than on prospects for earnings. So any reasonable steps that increase earnings increase the purchase price. Attack sacred cows.
Put in place gold, silver and tin parachutes/severance policies. What is in place gets paid. Banks that wait until an acquirer has been identified will have difficulty developing such employee protections without a trade-off on the bank’s sales price.
Avoid capital investments, branching and new activities. There are specific reasons for avoiding these three activities:
Capital investments. Your bank should take the approach of homeowners who are preparing to sell: They would avoid adding a swimming pool because they will not get their money out of the investment; but, they would paint the house because it increases the value of the house by more than the cost of the paint. In the same way, your bank should avoid capital investments unless such investments have an almost immediate payoff.
Branching and new activities: You should avoid engaging in new activities or establishing new branches because these activities tend not to become a net contributor to your bank’s profitability for some time. A typical branch does not become profitable for 12 to 18 months after it has been established. Even then, it takes additional time for your bank to recoup the opportunity costs associated with devoting funds to establishing the branch instead of investing them in earning assets. Engaging in new activities usually has the same effect.
Negotiate data processing agreements with a sale in mind. Investments in new technologies or lengthy data processing agreements almost always reduce the purchase price. The prospective purchaser and acquisition target seem never to use the same data processing system. So any systems or equipment the selling bank purchases reduces its earnings and provides little, if any, value to the prospective purchaser.
Selling banks also must avoid long-term data processing services agreements. These agreements often include extremely high liquidated damages provisions in case there is a change in control of the selling bank. A selling bank’s board and management should try to keep services agreements relatively short-term. If they are unable to do so, they should insist on eliminating the liquidated damages provision in determining the price to be paid for the selling bank.
Reduce unproductive and employment expenses. If the selling horizon is short, the selling bank should reduce its level of employee expenses. It often can accomplish this simply through attrition, although sometimes a more aggressive approach might be in order.
For example: If a bank employee’s performance is unacceptable, it makes sense to terminate that employee sooner rather than later to achieve higher short-term earnings and a higher purchase price for the selling bank’s shareholders. If the prospective purchaser dismisses the employee, then the purchaser’s shareholders benefit.
Defer expenses. To the extent possible, the selling bank’s management and board should defer expenses, if not actually cut them. For example, if a bulk order of bank forms provides absolutely no benefit to a prospective purchaser. You generally also can decrease advertising and public relations and consulting services without any short-term negative ramifications.
Of course, if the selling horizon is longer term, management and the board should be more judicious in deciding what to cut.
Enhance the quality of the bank’s documentation. Homeowners might paint their house to improve the prospective purchaser’s impression of the house; similarly, the selling bank’s board should insist on superb documentation to make a good impression. Management should review loan files and should take a concerted approach to reducing documentation exceptions. There are few issues that concern a prospective purchaser more than poor documentation and files. Such concerns can cause a prospective purchaser to reduce the price it is willing to pay so that it has some reserve for contingencies.
Identify problem loans. The selling bank’s management and board should be able to advise the prospective purchaser of all problem loans in the bank. Again, nothing causes a prospective purchaser more lingering concerns than to discover unrecognized problems in the bank’s loan portfolio.
Sell other assets. The selling bank should liquidate all of its parcels of other real-estate owned (OREO) and other assets to the extent it can do so at reasonable prices. Prospective purchasers typically discount the value of OREO significantly.
If the selling bank can sell a parcel of OREO at 10 percent less than the price it believes the property is worth, its shareholders still will benefit. It would not be uncommon for a prospective purchaser to value that same parcel of OREO at 25-50 percent of book value. So the selling bank’s shareholders achieve a net gain equal to 15 percent of the book value of the property.
Manage the investment portfolio to avoid risk. Management and the board should require that investment portfolio managers focus mainly on short-term maturities and that they avoid particularly risky investments. This way, unexpected changes in market conditions (e.g., fluctuations in interest rates) will have less of a negative impact on the purchase price.
Consider corporate governance issues. For instance, consider making mandatory, rather than just permissive, indemnification provisions under the articles or certificate of incorporation; moreover, if there are outstanding ownership issues such as whether prior stock issuances were consistent with corporate law (were shares duly authorized and issued).
Address compliance issues. Regulators are raising the selling bank’s compliance issues during the buyer’s regulatory application process. Depending upon the nature and extent of such issues, buyer’s applications are being bogged down. In some cases deals are being derailed if the regulators do not believe such issues are able to be addressed by buyers.
Whether and how to hire a broker. Once a bank has decided to sell, it will need to address how to orchestrate the sale and the actual selling process. As part of such efforts, the board will want to evaluate whether to hire a broker and, if so, how to maximize the benefits of such decision.■
Peter G. Weinstock is the practice group leader of the financial institutions corporate and regulatory practice group at Hunton & Williams LLP. He may be reached at (214) 468-3395 or firstname.lastname@example.org.