Banks and the Clustering of Mergers and Acquisitions Activity

Industry structural changes are a major M&A catalyst. The changes inhibit incumbent firms’ ability to create shareholder value. This is reflected in the current clustering of M&A activity in the healthcare, technology and oil and gas industries. Banking has also seen increased activity in the number of deals. The deals have been primarily in the smaller community and regional bank segments. Hence, dollar volume is still off pre crisis levels. Larger Too-Big-To-Fail banks are still reluctant to seek regulatory approval. Nonetheless, banking has structurally changed since the financial crisis as reflected in weaker operating performance. Many bank, however, have yet to adjust to the changes.

This is reflected in lower economic returns, ROE less cost of equity, and consequently lower pricing multiples like price to book.  Pricing multiples reflect underlying operating performance. Pressure is building, primarily from activists, to improve returns. Banks who “get it” will enjoy improved returns and values e.g. Warren Buffet’s favorite bank Wells Fargo. They will likely force changes upon weaker banks that “don’t get it” like Bank of America which trades below book value. This will spur increased banking M&A-initially smaller transactions until a larger deal is pushed thru the regulatory log jam. My thoughts on this matter are outlined in my attached American Banker BankThink comment.

J

Curb Your Enthusiasm: The Valuation Impact of Interest Rate Increases

Banks are suffering from low net interest margins (NIM) and net income growth since the 2008 Great Recession. Some believe the Federal Reserve’s low interest rate policy is responsible for this situation. In fact, the two favorite excuses provided by banks for performance issues are regulation and low rates. This post focuses on the bogus interest rate excuse. Bankers are awaiting the long expected Fed rate hike now hoped for this fall. They believe NIM, net income and hopefully stock prices will benefit from the hike. NIM and net income may initially and temporarily improve but bank stock prices are unlikely to improve.

All intrinsic valuation models capitalize expected future earnings or cash flows and their timing at a discount rate. The rate reflects two factors. The first is the time value of money (i.e. present value factor) usually represented by the risk free (Rf) rate of return. The second factor is the riskiness of the cash flows. Keeping risk, earnings and the timing of the earnings constant, rate increases will impact the time value of money thru changes in Rf. Simply stated expected earnings discounted at a higher rate have a lower (present) value.

It gets a little more complicated for banks because there may be an initial temporary increase in bank earnings when rates rise. This depends on the shape of the yield curve and how the bank’s balance sheet is positioned (asset sensitivity). Over time, the liabilities will re price and the benefit disappears.

All other things equal, rate increase are not good for stocks, banks included. Simple valuation fundamentals may be forgotten, but do not disappear.

J

M&A Catalyst: Shareholder Activists

The linked article from the American banker on banking shareholder Activists highlights some important M&A points. First activists provide an important function in keeping banks on their toes. Activist activity has become the 21^st century version of the hostile takeover. Activists are raising important questions over valuation and who is the best owner and manager of a bank’s assets-especially in a rapidly evolving industry. Second activists are drawn to firms with weak governance. Everything an activist is suggesting could be done by existing management if prodded by the board. M&A and its mirror image, divestment, will likely result from activist activity.

j

Leveraged Finance: Best of Times?

Regulators are concerned with the state of credit markets, in general, and the leveraged loan (LL) market, in particular (see Regulators). Market states are driven by changes in investor risk appetite. Rising wealth from the post crisis bull market is fueling increased risk appetite. This, combined with a search for yield in a low interest rate environment, underlies the resurgence of leveraged financing.

This is especially notable in the return of the collateralized loan obligation CLO market. This market shut down during the crisis due to unexpected losses from step market price declines. The activity returned in 2012. CLO investors are the major LL investor base. Their return underlies the spike in 2013 leveraged activity. Note the following:

1)        LBO activity has ballooned this year.

2)        Funded debt multiples of EBITDA have returned to near pre-crisis levels 5.5X v 6.2X.

3)        Purchase price multiples are increasing.

4)        Percentage of contributed equity in LBOs is falling to 32% - near the pre-crisis low.

5)        Financing structures have changed. Balloon based term loan B’s have replaced amortizing term loan A’s.

6)        Loan spreads have fallen to pre-crisis levels. They fell 100BP alone from 2012 levels.

7)        Return of aggressive pre-crisis instruments like Payment-in-Kind-Toggle PIK-T and covenant-lite   loans Cov-lite. In fact, cov-lite now represents a record 52% of LL  issuance.

8)        Surge in higher risk transactions including Public-to-Private (PTP) and Leveraged Recapitalizations (LevR). PTP is at its highest level since the pre-crisis 2007 peak, while LevR have reached record levels.

9)        CLOs issuance for 9 months 2013 is  $57B v $30B for same period 2013.

For issuers it is the return of the good times in terms of funding availability, structure and flexibility. Just because you can do something, however, does not mean you should do it. We are likely to see to higher priced and over leveraged transactions going forward. Yield chasing investors are likely to suffer disappointing pro forma returns once risk appetite peaks and market liquidity falls. We cannot predict when this correction occurs. We can, however, predict that it is closer than where it was at the beginning of 2013.

j

PS We are approaching the next offering of our Acquisition Finance Course in Amsterdam and that also means approaching the deadline to sign up. Hope to see you in Amsterdam - one of our favorite cities!