Understanding the merger acquisition cycle
Understanding the cycle can help your bank choose the best course in times of market uncertainty.
Until recently, it was thought that the US economy was on the road to recovery and that competitive conditions for community banks would soon be returning to the normalcy of the pre-2008 period. Instead, the economic growth spurt has slowed and new concerns about Asian growth and the European financial crisis have emerged. In the community banking arena, the model in place prior to 2008 is struggling and no new model has successfully taken its place. Given these events, it appears that community banks will not be returning to profitability any time soon, and there is no consensus as to when financial markets will stabilize.
Opportunity amid uncertainty
Yet there is still much that banks can do in late 2012 to strengthen their operations, bottom line performance and shareholder value. By no means should current market uncertainties be seen as justification for waiting out the markets. For example, many banks are choosing to focus on internal cost containment programs. Others are spending their time developing capital plans and establishing efficient service delivery channels for their customers. Still other community banks are recognizing that the best way to shore up shareholder value is to join ranks with a larger organization. These banks are using the current period to analyze acquisition targets, perhaps as a way to set the stage for mergers and acquisitions (M&A) in the near future or when market conditions permit.
During the past three years, the troubled economic environment has prompted bank acquirers to change the way they evaluate potential acquisition targets. For example, they are using different methods for assessing the core earnings of a target institution. These methods are looking at how banks address the write-downs of assets, deal with regulations that result in decreased fee income, deal with a loan pipeline that has little flow and finally, how banks can address the incremental costs of complying with the regulations that have grown out of the Dodd-Frank Act (Dodd-Frank).
Recent indicators and what they mean
Some recent indicators have already prompted a renewed sense of investor confidence. According to the FDIC Quarterly Banking Profile for the fourth quarter of 2011, core bank earnings were up for the period. Banks earned $26.3 billion in the fourth quarter, with net income for the entire 2011 year surpassing $100 billion for the first time since 2006. These results were driven primarily by lower loan loss provisions. Asset quality continued to improve with noncurrent loan levels declining in most major loan categories, according to the profile. These positive indicators appear to have buoyed investor interest in mergers and acquisitions, and will likely continue to do so.
While the core earnings indicator is probably the most important factor driving the M&A market, there are other significant drivers of business consolidation, including:
- The fragmented banking industry - There are 6,700 banks and thrifts with assets less than $1 billion and with low performance numbers.
- Asset growth - Presently, asset growth is slow and organic, but M&A activity could speed it up.
- Repayment of TARP - Three out of four banks still have not repaid TARP funds. Since 274 of them are distressed, small or nonpublic, repayment will probably be an issue.
- More stringent capital requirement - Today, well capitalized means having 5 percent leverage capital, 6 percent Tier 1 capital and 10 percent total capital. If the new definition of well-capitalized is 8, 10 and 12 percent, then many banks are going to need capital.
Mergers & acquisitions follow a cycle
Clearly, M&A activity is beginning to show signs of change. To understand this trend, it's necessary to understand the changes as part of a larger pattern. M&A activity, like most economic and business trends, follows predictable cycles. Business consolidations tend to bottom out during periods of economic downturn and low bank valuations. When bank valuations are low, acquirers have little interest in using stock that is trading at a discount as currency for a deal; consequently, they conserve their cash. This explains the drop in M&A activity we have seen since 2009.
The economic downturn is then followed by a period of FDIC-assisted transactions where regulators contend with problem banks. This in turn leads to a prolonged period of bank closures, as occurred in the 2008-2011 period. During the bank closure stage, M&A activity tends to focus on banks that have credit problems; this in turn, leads regulators to a bid process to attract potential acquirers, offering the opportunity to consolidate assets and have a bargain purchase gain at the end of the deal.
According to the FDIC, there were more than 400 bank failures nation-wide from 2008 to 2011. In 2012, there have been only 31 bank closures to date (through June 15), a clear sign that the banking industry is beginning to stabilize, if not recover.
Also, the volume of FDIC-assisted transactions is continuing to dwindle, as shown by the following table:
|Large hedge fund advisers||31||90||157||140|
The FDIC-assisted transaction stage is usually followed by a phase in which the transactions take on a creative perspective. The latter term is defined as the period wherein transactions that feature earn outs, good bank or bad bank strategies and holding company bankruptcies are prevalent. Also during this part of the cycle, acquirers tend to be focused on the quality of the assets being acquired, as well as the risk management of the acquired entity and the creation of long term value for stockholders.
In the 2008-2011 period, buyers were not confident in their ability to estimate credit losses in a loan portfolio; consequently, discounts on asset values were extremely high. Now, in 2012, it appears that buyers have more confidence in their ability to assess the quality of a loan portfolio. With lower fair value marks on the loan portfolio, valuations are beginning to improve. But banks located in slow growth markets and with only marginal earnings are going to be below and at a discount to tangible book value.
As the economy and capital markets continue to recover, the final stage of the M&A cycle takes on the appearance of a more traditional market with values based on traditional M&A metrics and higher stock valuations predicated on normalized loan loss assessments.
Further signs from bank industry data
To understand the direction of bank consolidation activity, we need look only as far as the FDIC Quarterly Banking Profile. As of Dec. 31, 2011, there were 7, 357 insured banks and thrift institutions. Within that group, 2,416 institutions had assets of less than $100 million, and 6,700 of them had assets of less than $1 billion. The latter group of banks controls less than 10 percent of the total deposits in the bank marketplace. While bank net income improved in 2011, the group of 6,700 banks generated a return on assets of less than 60 basis points and a return on equity of less than 560 basis points. The industry as a whole generated a return on assets of 88 basis points and a return on equity of 786 basis points. The smaller financial institutions with less than $100 million in assets are finding it more and more difficult to generate net interest income and noninterest income.
As small banks struggle to improve operating revenues, they must also contend with the increased cost of compliance resulting from the regulations created by Dodd-Frank. While an argument can be made that Dodd-Frank does not focus on smaller community banks, the cascading of best practices from large to small banks will clearly influence the cost of doing business for community banks as a whole.
Other drivers of merger activity
The key drivers of profitability in a bank are loan growth, net interest margin, loan loss expense, fee income and noninterest expense. All of these drivers have been negatively affected by recent economic and regulatory trends. When you consider other factors influencing the community banking industry, it is likely that this sector will see the largest movement in M&A activity in the near future. Other factors that may come into play include:
- High average age of board members
- Lack of management succession plans
- Competitive environment
- Challenges posed by new and emerging technology
For community bank acquisitions, buyers will strive to develop a prominent market footprint and attain economies of scale that will reward bank shareholders. The selling bank's shareholders will have the opportunity to exit, hopefully at a premium, but with more opportunities to create value in a stronger organization.
The decision to stay independent
Not all financial institutions with assets under $1 billion are going to disappear. Some of them will decide to remain independent. The phrase being independent used to mean simply that a bank would not acquire or merge with another entity. In today's banking environment, the phrase has a totally different connotation. It means that bank management and its board of directors, rather than selling the bank, must take decisive and well-defined steps to insure superior returns for their shareholders. Among those actions are:
- Focusing on improvement of core earnings. Without core earnings, the bank will not be able to invest either in technology or the human skills necessary to develop strong customer relationships. And without these earnings, shareholders will not receive the dividend checks they expect.
- Ensuring that bank ownership structure is appropriate. Banks must consider other possible ownership structures. For example, one of the strongest drivers of value for community banks is conversion to an S corporation, which keeps the value generated in the hands of the shareholders. This and other options should be evaluated.
- Creating liquidity for shareholders. Banks should consider new ways to create liquidity, including, for example, a stock repurchase program that could help utilize capital and create value for shareholders. This means that the bank may need a valuation mechanism for determining the value of its shares.
- Developing strong relationships with regulators. Not only should banks have ongoing discussions with regulators about potential issues of concern, they should take preemptive steps to avoid regulatory attention by taking responsibility for bank operations and capital structure.
- Developing a strong capital plan. Banks should share capital plans with regulators and be prepared to explain how the strategic risks taken by the bank will not pose a risk to its capital levels.
- Having a management succession plan in place. Developing and retaining high quality management personnel will play a significant role in the success of an independent community bank.
Preparing for a new banking environment
Bank managers need to prepare themselves for the new normal that is coming to their industry. Even though the banking industry is just starting to show improvement, there are already major signs of changing practices in how the industry creates value. These new practices will create new opportunities for maximizing the value of banks, as well as fresh ways to capitalize on the strengths of the overall organization and its management.