Banks for sale! Buyer beware!

By Robert M. Lallo, managing director, Darling Consulting Group 

The economy has been in a lengthy expansion cycle that began after the Great Recession of 2008. As long as the expansion part of the cycle has been underway, it has not been as robust nor fruitful as expected, from a banker’s perspective.

In fact, bankers found it one of the more difficult periods in decades. Consider: rates, at historically low levels for an extended time; tepid economic activity and growth; and a new mountain of regulations—combined, enough to make the most courageous banker ponder the meaning of life.

Loan growth has been a mandate for financial success in this cycle. Low risk/return on investments has given banks nowhere to run or hide. How soon things will improve now that the Federal Reserve has definitively committed to raising rates remains to be seen.

In the early part of this cycle, we saw a good deal of M&A activity among smaller-sized banks (generally $150 million and under). Typically these were banks with one branch where the CEO was the driving force behind all of the bank’s critical activity and operations. Over the past year, it seems that the asset size of the predominant acquisition activity has climbed to the $500 million size range or larger. These are likely being driven again by the difficult operating environment noted above and perhaps the looming specter that we may not see a substantially easier growth environment for a while longer.

Having spoken with bankers, we can tell you that there are a number of institutions looking to be buyers and/or sellers in the current market. Many of these institutions are testing waters that they have not been in before, or at least not for a while.

The pursuit of an acquisition or sale can be very emotional for the buyer or the seller. On one hand, a deal can present a great opportunity for shareholder value or strategic improvement. On the other, they can be very risky if a clear and level head is not maintained.

The point of this article is to shine some light on both the opportunities and the perils that could confront you if you are considering engaging in an acquisition. Keep your head, and stress facts and analysis over emotion.

Reasons and opportunities

Over the years, we have seen some very successful mergers and acquisitions. Here is a brief description of some of the reasoning behind these mergers for sellers and/or buyers.

• Current operating environment. As alluded to earlier, some banks just seemed to run out of the desire to continue as an independently run institution.

We believe that given the current economic outlook, there will be more potential acquisition targets in this category. Another potential driver behind the number of willing sellers may be that many lack a special niche to exploit.

Alternatively, or even additionally, these banks may be running out of capacity to do the type of lending that had been successful for them. The cause could be regulatory or due to concentration constraints. Commercial rate estate loans are one such area.

• Regulatory burden. For many the onslaught of regulatory requirements (e.g. CFPB) have made them gun-shy about lending to certain customers to whom they have always made loans. All of the requirements along with a lack of scale have pushed them to consider joining with another institution.

• Economies of scale. There are certain fixed costs related to specific business activities. Also, the investment required to support those functions or systems at a level competitive with larger institutions is not always proportional to bank size.

• Acquiring a complimentary niche or strength. This type of acquisition is not limited to banks. A transaction could also entail the acquisition of non-banking finance companies such as mortgage companies, finance companies, leasing companies, etc.

• Blocking competition. In some cases, a bank may not be inspired by the merits and added value of a potential acquisition. Yet management may be loathe to allow a deal to go to another bank who is or will become a competitor.

This is a real issue. Management may be considering the potential business lost by not doing the deal. However, this can be very difficult to put a price on.

• Expanding the capital base, and thus the ability to serve larger customers. A larger capital base allows for more loans to one borrower and also supports larger loans under legal lending limits. We have seen this happen with a larger acquirer bringing stronger lending capacity into a smaller market where the target bank was in the right market but lacked lending capacity.

• Expansion into new markets. Simply put, looking for new or better opportunities to expand business, with the feeling that current markets are too saturated and perhaps showing decreasing returns and margins. With today’s growing ability to use technology to operate, this may not necessarily be a contiguous market for a given acquirer.

• Access to a deposit base/liquidity. Over the past eight years many institutions just haven’t been able to keep or grow loans. That said, they may offer a solid deposit base to a bank that is stretched from a liquidity perspective (i.e. growing loans and short on deposits to fund them).

Such deals can offer the potential for a quick balance sheet fix—if done for the right price. One would assume the under-loaned bank is not a top earnings performer and that its performance trends have likely been declining.

Does faulty reasoning underlie some strategies?

We often hear banks talk about a need to be bigger or to expand their footprint. These terms are often mentioned in acquiring banks’ presentations to shareholders.

But there is a big difference to be considered here. On the one hand, a deal may be proposed for several strategic reasons, and it also happens to make the acquirer bigger and/or expand its map.

On the other hand, there are deals that are pursued strictly for the purposes of increasing in size or footprint.

But bigger is not always better.

With size comes scale. But other issues may arise—outgrowing staff, systems, and other customer platforms. Organic growth is one thing. Acquiring just to grow may be another. Expansion of markets and footprint can be a great opportunity given an evaluation of potential positive factors. Without these factors, an expansion of market footprint can equate to a higher level of overhead and diminished profitability.

Common mistakes buyers make

In the “heat of battle” or the excitement of deal making the reasons for getting involved in a deal are sometimes overshadowed by the very human desire to “win.”

Maintaining objectivity throughout the deal is essential. Otherwise, you could make an acquisition for the wrong reasons.

Here are a few of the pitfalls that buyers miss:

• Dying markets. Considering local economic and population trends in the prospective new markets is critical. If the markets are contracting or at the mercy of one or two larger employers, do you want to take on such risks? Is the likelihood that you will be able to grow in these markets enough to justify the premium that you will pay?

There is nothing better as a seller than to get a top-of-the-market premium on branches in dying communities. Sellers obtain such benefits when a buyer’s desire to “increase map coverage” overshadows a realistic assessment of opportunities.

• Culture clash. The effort that it takes to transition cultures can be severely underestimated. Clashing cultures can be difficult to overcome.

Most high-performing banks today have been actively refining their own cultures to become more proficient in one aspect of their practices—such as deposit gathering.

Imagine doing all this work to make your bank better and then paying a large premium for an institution where a sales culture may be lacking.

Better think through your strategies to get everyone on the same team and thinking the same as soon as possible. It might even require removal of some players who are likely to remain obstacles well into the post-acquisition period.

This issue can be even worse with a “merger of equals.” More than one legacy institutions’ leaders calling the shots can produce confusion.

• Strain on competencies and resources. Certain members of management who are solid players at a $400 million bank may not be up to the task for the degree of risks and complexities that come with that position at a $1 billion bank.

This is not a deal breaker, per se, but it can place an unanticipated strain on meeting the post-acquisition objectives. Other matters coming under this risk are in the area of technology resources, although often such issues receive proper consideration in the due diligence process.

• Credit administration deficiencies. Every due diligence team on a whole-bank acquisition is going to spend some time studying the key credits and practices of the target organization.

The reason I put this on the list is that on occasion—particularly for a less-healthy target—there may be extensive risks embedded because the bank did a poor job of perfecting liens or performing credit evaluations.

Can you bet that all the performing loans will keep performing, and not create a credit nightmare in workout later on?

This is not a frequent issue. But we have seen it come up from time to time. The” sickness” is not just in the largest credits or even the perceived riskiest part of the portfolio.

• “White elephant.” Many deals will have what I call a “white elephant.” Usually this is something that centers on real estate, an operations center, or a main branch/headquarters building. Inevitably, they seem to get too much attention (weight) and serve as a distraction to properly evaluate the value of the rest of the institution.

So the issue isn’t whether or not you have a white elephant in your deal or not but rather to approach it objectively and keep it in proper context.

Treat it more as an intangible to the deal when you adjust that final price and don’t let it become the centerpiece of the contemplated transaction.

• Plain old overpaying. Particularly in competitive bidding situations, even with the advice of investment bankers, the rival offers spiral up and up based on where competition was in the prior stage—or maybe because someone marketing the target is just doing a fine job.

When we are deep into the due diligence process, do we ever stop to reconcile the amount of premium we are paying to the tangible benefit that we are acquiring?

For example, let’s say the prospective buyer is attracted to the target because of a lending team or some key players specifically. (This can be particularly so for a smaller target.) At what point would it be better to overpay the team itself via a “lift out” versus paying a higher premium to get the team and maybe the one or two branches it comes with?

A good practice that can help: Apply a return on investment calculation to the projected earnings enhancements and the potential growth of the target.

Beyond that, as a learning or evaluation exercise, a buyer should go back to see how well the target has done on an internal rate of return basis. This might yield some interesting information that helps with the next deal.

Enter the fray informed and prepared

Understand, my purpose has not been to dissuade you from taking a look at potential deals, nor to make you turn and run. Acquisitions can be fantastic opportunities for meeting strategic objectives or becoming a better overall franchise.

It all comes down to the question: “At what price?”

Keeping a focus on the positive aspects of the deal and remaining objective in breaking down its value, as well as being open-minded about the drawbacks is really what is essential.

We have seen the pitfalls and patterns noted above happen with some of the most intelligent bankers. Emotions run high.

Don’t let the drive to win and matters of ego outstrip your common sense and objective view.

About the author

Robert Lallo has an extensive 25-year background in community banking. Prior to joining Darling Consulting Group, he served as executive vice-president and CFO for a publicly traded savings bank as well as several years as an audit manager at a worldwide public accounting firm.