Monday, July 29, 2013

Bank M&A: A Wake Up Call-Finally?

Bank M&A, like M&A in general, has been depressed since the 2007 financial crisis. Deal volume for 1H13 was below 2012 anemic levels with just 76 deals. The deals done were primarily small fill-in transactions involving motivated (i.e. troubled) sellers. Low pricing multiples reflected the buyers’ market nature of the environment. A variety of factors were responsible for the depressed volume. These include:

1)     Post crisis malaise: confidence fell following the crisis. Banks were focused on surviving and resolving asset quality issues than growth. Investors also supported a cautious view regarding acquisitions-buyer share prices would fall for the few deals that were announced.

2)     Weak stock prices: buyers were reluctant to incur significant dilution by funding acquisitions with under valued stock. Sellers were unlikely to sell at depressed prices unless forced to do so by regulators.

3)     Regulatory uncertainty: regulators were likely to encourage banks to solve their own capital problems before approving significant acquisitions.

4)     Purchase accounting: the adoption of purchase accounting in June 2001 had a larger than anticipated negative impact on bank M&A. Any goodwill created reduced a key regulatory ratio concerning tangible book value (TBV) to assets. This pressured acquirers to consider larger equity issues to offset TBV reductions. Combined with depressed stock prices this would produce larger levels of earnings dilution. Dilution is dismissed as an accounting measure. Nonetheless, it serves as a useful buyer pricing constraint.

Despite the above, the case for M&A has been growing for years ( see M&A May be Best Path Available to Profit Growth). Stock prices for both buyers and sellers have risen substantially this year. Buyer confidence has returned as operating performance has recovered. Investors have signaled greater openness towards acquisitions that make strategic sense and are appropriately priced. Added to this is the growing frustration of many banks regarding weak loan demand (reflected in low loan to deposit ratios) and rising cost levels as a percentage of revenues.

In July, two large transactions were announced. The first was a July 15 $680MM deal involving MB Financial’s ($9.B assets-MB) acquisition of Cole Taylor Bank ($5.9B assets-TAYL) in suburban Chicago MB Taylor. The price was relatively full at 1.8X TBV (to book value) -sufficient enough to entice the seller to accept. The following week PacWest ($5.3B assets-PACW) announced the largest banking deal of year with a $2.3B deal PACW CSE to acquire Capital Source ($9.2B assets-CSE) an industrial loan company. The CSE price was 1.66X TBV. The market response to the less well covered Taylor transaction was muted with MB’s price falling 3% on announcement. Some investors have expressed concern regarding the price given Taylor’s mortgage reliance in a rising rate market. PACW’s price jumped 7% on its planned acquisition. This reflects the tighter pricing relative to expected synergies.

The transactions share some common features as follow:

1)    The driving force was strategic: the buyers had substantial low cost deposit bases and depressed loan to deposit ratios highlighting their difficulty in making loans. The sellers were 'demand deposit constrained' but had national asset origination capabilities in asset based finance, equipment leasing and mortgages reflected in high loan to deposit ratios. The buyers hoped to utilize the sellers’ national origination platforms to distribute credit products funded by their excess low cost deposits.

2)    Substantial identified cost savings.

3)    Tax free transaction involving use of the buyers’ appreciated stock limited TBV and EPS dilution. MB was trading near its 52 week high of $29 p/s as was PACW compared to its 52 week high of 33. Thus, fewer new shares needed to be issued.

4)    Relatively large transformational acquisitions involving significant integration risk. This  is offset by the experienced teams at MB and PACW. The business profile and risk of both acquirers will be altered by the transactions. How this impacts their pricing multiples is yet to be determined.
The transactions offer insight into possible future deals. First, buyers are unlikely to be big banks ($250B+ assets) due to regulatory concerns regarding too- big- to- fail. Rather, buyers will likely be in the $5-10B asset size institutions looking to achieve scale and national lending platforms. Banks with assets exceeding $10B appear to have economies of scale reflected in higher ROEs compared to smaller institutions. Targets will likely either be lower priced smaller (less than $1B assets) deals, or larger fully priced $5B+ assets institutions. There are a limited number of the larger targets which offer scale. Hence, a scarcity value for these banks may exist.  The thousands of banks below $1B assets are likely facing a more difficult selling process. Non bank finance companies may also become more popular bank targets.

These two transactions could serve as a wake-up call to other banks which have been reluctant to consider acquisitions. This will be driven by investors growing frustration with low bank ROEs due rising costs and weak loan demand. My guess is we will see the formation of more regional ($10-20B assets) and super regional ($20-50B assets) combinations. Keep in mind that of the 7000+ domestic banks there are only 100+ with assets above $10B. Going forward,  small banks will need to get bigger, while the too-big-to-fail will need to shrink. The keys to implementing this strategy will be the patience to wait for the right target, discipline to avoid over paying and the ability to execute.


p.s. disclosure-I am a PACW shareholder.

Thursday, July 25, 2013

Utility Mergers, Synergy or Collusion?

Mergers of utilities face increased scrutiny by governmental regulators seeking to avoid collusion and monopolistic pricing.  Traditional research on mergers often neglect this industry due to it's unique characteristics.  In an article published in the Journal of Financial and Quantitative Analysis  we test for the existence and source of gains in utility mergers and distinguish between collusion and synergy as motives for mergers in this industry.  The abstract is below.  The complete article can be downloaded here.

Sources of Gains in Corporate Mergers: Refined Tests from a Neglected Industry
David A. Becher
Drexel University - Department of Finance 
University of Georgia - Department of Banking and Finance 
Drexel University - Lebow College of Business

Journal of Financial and Quantitative Analysis (JFQA), Forthcoming

Our work provides refined tests of the existence and source of merger gains in a neglected industry: utilities. While excluded from traditional analyses, utilities offer fertile ground for a detailed analysis of the traditional theories of synergy, collusion, hubris and anticipation. The analysis of utilities provides methodological advantages and is important for public policy reasons. We find that utility mergers create wealth for the combined bidder and target. These positive wealth effects are consistent with both the synergy hypothesis and the collusion hypothesis. To distinguish between the hypotheses, we study the stock price returns to industry rivals across several dimensions specifically related to collusion: deregulation, horizontal mergers, geography, and withdrawn deals. We also examine the impact of mergers on consumer prices. The results are consistent with synergy and inconsistent with collusion. Analysis of industry rivals that subsequently become targets also rejects the collusion hypothesis and is consistent with the anticipation hypothesis.

Monday, July 22, 2013

Big Banks, Leverage and the Smell Test

Federal Regulator's recently proposed tougher regulations for eight banks.  Will it hurt the economy?  Lobbyists for these banks think so.  My colleague, Joe Rizzi, says 'Not so fast'.  Read his interesting article that appeared in  the American Banker last week regarding Big Banks, Leverage and the Smell Test.

Thursday, July 18, 2013

Corporate Governance, A View from the Top

Last Spring Raj Gupta, Richard Jaffe and I sat down with Joe DiStefano, a leading reporter for the Philadelphia Inquirer.  Richard chairs the advisory board of our governance center of which I am executive director.  Raj, as you will see, is an important member of our center and was Chairman of Rohm and Haas leading it to a spectacular merger with Dow Chemical (spectacular for Rohm and Haas shareholders at least).   The article describes some of Raj's philosophies on governance, philosophies learned through important work on the boards of companies like Rohm and Haas, Tyco, Vanguard, Dephi and Hewlett Packard.  It is well worth reading.

The entire article can be downloaded here.

All the best,


Monday, July 15, 2013

Robbing Peter to Pay Paul

They are at it again. There is another muddled attack on shareholder value Shareholder Primacy. Ordinarily, I ignore these, but this one sounded so smug that I could not let it pass. The separation of ownership from management in large public firms makes having a clear measurable managerial objective critical to govern a firm. That objective should be to maximize shareholder value, which is the value of the firm less debt claims. A firm’s value is the present value of its long-term cash flows discounted for their risk. Capital goes where it is welcome and stays where it is treated well. The shareholder value objective satisfies both requirements.

Shareholder value is especially important in M&A. For example, target management frequently alleges in a hostile takeover that the offer price does not reflect the target’s long term value (e.g. Jerry Yang resisting Microsoft’s offer for Yahoo). Another example is an acquirer’s management trying to justify an over-priced empire building acquisition as not being fully appreciated by the market (e.g. First Niagara’s HSBC branch purchase).

Shareholder value is usually attacked by management and their lawyers (e.g. M. Lipton) on the following grounds:

1)     Shareholder value is short term orientated. They mistakenly characterize shareholder value as myopically focusing on increasing current earnings - in particular earnings per share(EPS). It is true that some managers have twisted shareholder value towards such short term measures to maximize their bonuses ( e.g. Robert Nardelli at Home Depot). This more a governance - incentive compensation lapse by an ill informed board than a problem with shareholder value. Evidence clearly shows that capital markets reward firms that invest for the long term (e.g. Amazon), and penalize short term accounting-EPS orientated firms like the old Home Depot. Managers may be myopic, but markets are not.

2)     Capital markets cannot properly value strategies and managerial vision. Strategies and visions have financial implications and results, which sometimes differ from what was anticipated or promised. Ignoring stock market responses is like flying blind - it leads to crashes. Clearly share price does not always equal value. Rather, it represents investor consensus of value, not value itself. When the consensus differs from management’s value belief it reflects either an investor relations communication problem or that investors do not share management’s beliefs. Either way, management should react rather than ignore financial market responses just as they would react to product market customer input. This is required to protect against managerial visions becoming delusional.

3)     Shareholder value does not properly reflect the interests of other stakeholders. While shareholder value can be measured, I know of no way to meaningful measure stakeholder value. Furthermore, it is difficult to increase shareholder value if you are exploiting other stakeholders. Usually, when stakeholders are mentioned, management is trying to justify robbing Peter(shareholders) to pay Paul (themselves). In such circumstances you can always count on the support of the Paul’s and their lawyers. Allowing stakeholders coequal control over capital supplied by other is equivalent to letting one group risk another’s capital. This will impair future capital formation and depress share prices and shareholder wealth.

Bottom line, shareholder value attacks are really efforts to weaken governance by deflecting criticism of underperformance. Understandably, managers do not like having their actions questioned, but that is precisely the meaning of governance. In M&A, governance is critical to offset the impact of the winner’s curse, unless, of course, you are Paul.


Thursday, July 11, 2013

Delaware, Lawsuits and Firm Value

In a previous post we noted "Doing a Large Deal:  Expect to Get Sued".  Suing corporations just got a little tougher recently.  Chancellor Leo Strine of the Delaware Court of Chancery ruled that boards can adopt bylaws that require most lawsuits to be filed in Delaware.  This restricts lawsuits filed in multiple courts and also gives corporations headquartered in Delaware what some experts have called a 'home field advantage'.  A Thomson Reuters version of this story can be read here.

Delaware is known to be pro-business and it's rapid litigation schedule and fairly low fee awards.

Yet I am reminded of empirical studies that show firms relocating to Delaware are met with increased stock returns at the announcement of the move and of this study by Robert Daines that shows firms incorporated in Delaware have increased value.

"Does Delaware Law Improve Firm Value?"

by Robert Daines

November 1999

I present evidence that Delaware corporate law improves firm value and facilitates the sale of public firms. Using Tobin?s Q as an estimate of firm value, I find Delaware firms are worth significantly more than similar firms incorporated elsewhere. The result is robust to controls for firm size, diversification, profitability, investment opportunity and industry. Delaware firms also receive significantly more takeover bids and are significantly more likely to be acquired. Firms with strong incentives to choose valuable legal regimes are likely to incorporate in Delaware when they go public. These results suggest that corporate law affects firm value.

The complete article can be downloaded here.

All the best,


Monday, July 8, 2013

Change of Seasons

I have always believed markets have seasons. The seasons themselves are not as interesting as the change among seasons. We appear to be currently undergoing one of the more interesting changes in years. The June Federal Reserve (Fed) announcement concerning the beginning of the end of its QE3 (quantitative easing) bond buying program this September promises to have major corporate finance implications. The Fed seems concerned that QE was creating market distortions, and was no longer needed.

The market response to the announcement was dramatic. It triggered a substantial stock market correction. More importantly, however, it produced a major bond market rout. The bell-weather 10 year Treasury (T10) jumped by 80bps almost overnight to 2.5% a level not seen since 2011. Credit spreads on other private debt instruments jumped even more. For example BB bonds credit spreads widened by almost 140bps. As a rough rule of thumb, bond prices drop by 1% for each year of a bond’s duration for every 1% increase in rates. Duration (Duration) is in effect a bond’s beta. Investors had been reaching for yield by going further out on the yield curve (i.e. taking increased duration exposure) for the past year to offset artificially low interest rates due to the QE3. Hence,  duration for many investors and bond funds exceeded 5 years. Thus they suffered massive June market value losses of more than 4% - even more for leveraged bond funds. Investor withdrawals from bond funds were large. PIMCO, a major bond fund sponsor for example, suffered billions of withdrawals in June as the market re-priced. The severity of this re-pricing rivaled the 1994 Fed surprise rate adjustment. Furthermore, the expectation for rates is a continued rise as markets adjust to a world without QE. Rates could increase to a more normal 3.5-4% pre-crisis level over the next year.

Consequently, investor bond appetite has declined, and issuers are curtailing bond offerings as the market adjusts. Some implications of these developments are as follows:

1)    Debt financed stock repurchases and recaps will slow as the relative cost of debt rises compared to equity. The impact on pending deals like Dell should be interesting.

2)    Decline in use of aggressive debt features such as PIK, covenant lite and second lien. Issuers will focus on more investor friendly straight debt instruments.

3)    Increased funding risk for debt-financed cash acquisitions involving non investment grade buyers. This will favor better financed strategic buyers over financial buyers.

4)    Debt capacity will decline as rates increase. This will depress purchase price and funded debt multiples.

5)    PE fund raising and exits will decline from near record 2Q13 levels.

6)    IPO and M&A volumes will suffer.

The abrupt market change highlights again the value of financial slack -“excess” capital and liquidity. Firms with slack will weather the adjustment process without any major disruptions. Additionally, they will have the capacity to engage in opportunistic transactions to capitalize on market mispricing.

Firms need to recognize the end of the multiyear QE based bond bull market. The means adjusting to new investor demands when designing instruments and transactions. It was great while it lasted, but he bull market bond summer season is over. This is not necessarily bad - it just means things will be different. These changes are what good corporate finance professionals are paid to recognize, improvise on, adapt to and overcome.