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.

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