There’s no doubt that the community bank market is in the midst of an M&A sea change. Here are some of the common questions bankers have been asking in this new environment.
Q1. We want to acquire banks, but the biggest problem we have in our market right now is a lack of sellers. Until that changes, how are acquisitions a practical option?
A. Several reasons account for the apparent shortage of sellers:
• Rather go on than sell. It goes against the grain for non-ownership management to choose to sell their banks. In fact, it is far more common for management to resist, even if the investors want to sell.
• Crossing the one-way border. Banks want to avoid the disruption to operations, customers, and management, coupled with the occasional stigma that accompanies the divestiture of a bank. Equally importantly, once a bank is up for sale, its eventual disposition is preordained—irrespective of final price.
• What’s my price? Bankers want to avoid the uncertainty regarding the bank’s transaction value in the market.
• Bad end to musical chairs. Executives worry about job security.
These disincentives can be overcome. Doing so requires an acquirer with a proactive approach and the right analytics. Bankers who use proper analytics can identify targets, determine a reasonable and attractive price, and facilitate a confidential transaction—without the negative attention and exposure drawn by traditional auctions.
Q2. The asking price for some banks seems outrageous. When do you think the valuation expectations of selling banks will come back to earth?
A. “Outrageous price” implies its measurement against a certain standard. Let’s consider that.
The choice of standard—historical book values, multiples, tangible book value dilution, etc.—is fraught with danger. That’s where many banks/buyers miss potential opportunities.
In every industry, when organic growth prospects are poor, multiples tend to rise, and the reverse is also true. You cannot look to historic multiples without looking at the economic context.
This is a serious and common mistake that many would-be acquirer banks are making. The post-recession environment, with its drastically changed capital adequacy requirements, low interest rate monetary policy, and highly competitive loan demand, remains in flux.
You can’t compare it to the pre-recession banking environment. These radical changes demand an equally radical change in the approach to M&A valuation in banking.
The new and evolving environment present several wrinkles that affect how a buyer can properly assess the true value of a target. Consider:
• The buyer’s own profile. The same target has substantially different values based on the potential acquirer’s unique loan mix, risk profile, profitability, and capital structure.
• No vacuum: Economic and monetary conditions matter. The same target will also have substantially different values to the buyer based upon current and anticipated economic conditions and monetary policy.
• Filtering with outdated screens. Analyzing publicly available financial data using traditional metrics is extremely misleading in quantifying a potential opportunity. Due diligence techniques based on pre-recession practice cannot accurately evaluate the pro forma implications of the transaction.
• Historical statistics mean nothing. This applies even when evaluating similar institutions in overlapping geographic territories. This is one of the most common and serious mistakes made in M&A across all industries.
The statistics’ only value is to an intelligent acquirer who can gain an edge by estimating the competing bidding ranges of the acquirers who are still relying on historical statistics based on legacy analytics.
Bottom line: There is no such thing as an outrageous price. You could be paying an outrageous price, but the same “outrageous price” could be very reasonable for an acquiring bank that has done its homework with the proper analytics.
Q3. I feel like I know and have talked to most of the other players in my market. In some cases, I think I know them better than they know themselves. How could I possibly still gain some kind of edge with analytics?
A. The probability of a CEO or investor acknowledging the possibility of selling his or her bank should be evaluated in the context of the probability of you acknowledging to the same party the availability for sale of your bank.
There is always a price at which your bank would be for sale.
Unfortunately, acknowledging that fact in a social setting to an outsider, no matter how friendly, is fraught with serious operating and legal issues.
There is inevitably a personal consideration for the selling management. This consideration cannot be addressed and/or taken seriously by the seller until the potential buyer has indicated a reasonable transaction structure based on the proper pre-due diligence analytics.
Every CEO, board member, and investor has formed a mental estimate of the approximate selling value of their bank in the existing marketplace. This estimate is based on a subjective evaluation of recent transactions, investment banker and board member conversations, press articles, etc.
Such mental evaluations and expectations don’t prove conducive to a selling decision, generally. Unfortunately, these self-inflicted “mental evaluations” do a disservice to the target bank, which could command a substantially higher price to the right buyer.
On the other hand, this “mental estimate” that is in the mind of every seller opens up a unique opportunity for those buyers who can identify targets that are not officially for sale. This can create substantial value for the savvy buyer. In the right situation the perceived “substantial value” could translate into a price discussion that is above the “mental estimate” of the potentially selling CEO or investor, too.
Q4. That sounds interesting, but does this really happen very often?
A. A surprisingly large number of transactions have occurred after such conversations—conversations between a buyer and a target that wasn’t originally in play. The confidentiality associated with such potential transactions often leads to subsequent discussions without the negatives associated with auctions.
Also keep in mind that “shareholder fatigue” is beginning to settle in at many of these targets. Many bank stockholders have been feeling the pain of reduced or eliminated dividends over a prolonged period of time. Their patience relative to achieving a return on investment is beginning to wane.
Many of the CEOs at these institutions will want to take control of the process, if they sense that the sale of the bank is inevitable.
You want to be in front of them when that happens, so you want to be talking to them a year earlier, not a day later. If an investment banker is engaged to manage the sale of the bank via an auction, management is no longer in control. At that point you just become a stalking horse for their investment banker to exploit. All you’ll do is help the investment banker drive up the price.
Q5. Pundits have been predicting a massive consolidation in banking for years. Will it ever happen? If so, what will be the tipping point?
A. The community banking market has long been conservative and traditional. Community banks are not typically owned by investors looking for a quick turnaround. This has created an investor base that is not likely to react knee-jerk fashion to economic downturns.
On the other hand, there are some very unique and unusual factors that are silently putting enormous pressure on the same investors. Certain institutional investors have already started using their weight with bank management.
These pressures will continue to ramp up and build to a crescendo before the market tips. Consider:
• Fewer new banking investors coming on the scene. The Russell 3000 is a good indicator that investors may be shying away from community banks. Given the psychology of the typical community bank investor and their long-term orientation, there remains some comfort that existing investors will not abandon ship. However, the loss of appetite for investment in banking institutions has significance in that it will certainly discourage the entry of new investors into the sector.
• Trouble lurking beneath banks’ surface. There is an insidious change going on in the community banking market that is masked by traditional accounting and asset-liability management systems and ignored by market analysts and investment bankers. Inevitably community bank investor perspectives and behavior will change as a result.
The prolonged period of low interest rates has slowly but steadily poisoned bank loan portfolios with ever-increasing percentages of low interest loans created in the period of post-recession monetary policy.
The impact of these low interest loans is to some extent negated by the accompanying low cost of funds—creating complacency that has no business in the community banking market.
What is different about low rates now? Pre-recession low interest-rate periods were short in duration, with reasonably high interest rate troughs. These fluctuations did not have enough time to impact significant portions of loan portfolios.
Not so what we are in now. The prolonged low interest rate environment does not bode well for future earnings, as higher rate and spread loans continue to run off balance sheets. Increased competition for loans and aggressive pricing by banks continues to aggravate the situation.
• Financial leverage continues to decline in the community banking system as capital adequacy requirements continue to rise. More capital is going to be required to support the same amount of assets, assets that have substantially lower earnings power. This trend of increasing capital adequacy requirements shows no sign of abating.
Now, put it all together: Investors will start to see consistently decreasing earnings and a lack of liquidity that will increasingly test their patience. These operating and financial trends are already happening, but they have yet to be recognized due to the limitations of legacy analytics and reporting systems. The rate of transformation of loan portfolios, toward increasing percentages of lower interest rate yield loans, is accelerating at an alarming rate.
These issues will rise to the surface once we see a change in the business cycle. That shift will likely be driven by a change in monetary policy or an economic downturn.
Q6. We have been thinking about acquisitions, but we are in the process of a core systems conversion and have several other internal projects on the horizon that are tying up resources. What do you think the M&A environment will be like in, say, nine to twelve months from now, when we think we may be ready?
A. Every industry in the U.S. has come under financial and operating pressure at some point, resulting in an inevitable decline in investor ROI. The survivors are the institutions that consolidated aggressively through acquisition.
Early adopters have always survived the downturns and prospered in the recoveries. Institutions that delay, due to timidity or excessive introspection, often disappear from the landscape.
This scenario is built into the DNA of capitalism. In banking, the top 20 banks built up their present positions through acquisitions. Many of their peers of the 1990s exist only in history books. This pattern has and will continue to repeat itself.
Q7. Are you suggesting we have to make a strategic adjustment?
A. A bank that is focused only on the coming year needs to take a step back from its annual business plan and consider:
• Realistic projection of growth. Any business plan in the community banking market will reflect, at best, low double-digit growth. Growth in assets means inherently low yields and increasing risk. In the meantime, higher rate loans will continue to run off the bank’s books.
Even in the best of circumstances, given the existing operating environment, most banks will be worse off at the end of the year. And to achieve their year-end targets, they will have to deal with the accompanying challenges, stresses, and operating costs of running their bank.
• Planning without M&A component misses key opportunity. One small M&A transaction, properly analyzed and structured, can in the space of months result in better earnings and a far more robust yielding asset base than the eventual successful completion of the proposed annual business plan. The opportunity time lost during this year can never be recovered.
• Waiting until tomorrow may be too late. The odds of the appropriate transaction being available 12 months down the road will continue to decline at a rapid rate.
It is very easy for management to delay focusing on a perceived “non-essential” process like M&A while getting the “house in order.” After all, that’s an essential and fundamental responsibility of management. Unfortunately, economic conditions, monetary policy, and the competitive environment have created a slow but steadily burning fire outside the house that has to be addressed.
• Lead time is critical to remember. A proactive approach to M&A—which results in the best transactions—already requires patience. There is a courtship and dating period that occurs before there is a wedding. If you are thinking about a transaction 9-12 months from now, you need to start the courtship period now.
Q8. Do I have to work with an investment banker if I want to acquire banks? They seem to be the “connectors” between buyers and sellers in the market.
A. Investment bankers will continue to play a key role in the M&A market. However, it becomes extremely important for the community banker to properly define and compartmentalize the role of the investment banker.
From an investment banker’s perspective, advising the seller is the equivalent to a “bird in the hand,” whereas buyers are just birds in the bush. In most situations, buyers are becoming aware of banks for sale through the seller’s investment banker, not their own.
Long story short—if you are a buyer and your investment banker is not bringing you deals, then their value to you is more limited and the analytics and deal advisory they bring to the table becomes more of a commodity.
About the author
Invictus Consulting Group Chairman Kamal Mustafa is the former head of global M&A at Citibank.