Risk Assets and Loan Vintages Emerge as Key M&A Analytics

February 2014

Risk Assets and Loan Vintages Emerge as Key M&A Analytics

Bank acquisitions that ignore the regulatory capital requirements of their targets and instead focus solely on earnings and market or book value can be considerably flawed. This analytical error is amplified by the fact that many target banks with higher earnings have a greater than average dependence on higher risk, regulatory capital-intensive assets.

Regulatory capital calculations are tied to the levels of risk associated with different loan categories. Post-recession, it is important to evaluate this risk under extreme conditions best described as a “hypothetical severe recession scenario.” The impact of individual risk characteristics associated with different loan categories and subcategories is magnified, which raises the importance of specific asset risk on the capital adequacy calculation.

Two banks with identical total assets could have substantially different regulatory capital requirements based on their loan mix. Even if their return on total assets were identical, their “return on required regulatory capital” would be radically different. Given this, it becomes clear that Return On Assets is no longer a valid measure in acquisition analysis.

The proper measure of value in an acquisition is now found by taking the Gross Asset Return divided by the Regulatory Capital Required to Support the Assets, (which we call the Invictus Return on Required Capital Ratio). Obviously, the impact of cost of funds and operating efficiency and the all-important franchise value must be applied once this return is calculated.

The Invictus approach reveals some disturbing insights into the use of accretive-to-earnings as justification for deals. Many recent acquisitions tagged with this label were indeed accretive-to-earnings, but primarily because of two essentially negative factors:

  1. First, they had a portfolio mix of high return and high-risk assets that required more capital relative to other loans.
  2. Second, they tended to have higher proportion of loans with pre-recession vintages. These loans tended to have higher margins and far greater risks associated with them.

These accretive-to-earnings transactions not only required a disproportional amount of regulatory capital, but they will also rapidly lose their inherent net profitability when their pre-recession loans roll off their books.

These factors highlight the absolute necessity for acquisitive banks to stress test their target banks. They must review in detail the target bank’s regulatory capital requirements, as well as the impact on the capital requirements of the consolidated entity.

To properly estimate a Bank’s Regulatory Capital Required to Support its Assets, Invictus performs a CCAR-like test and uses publicly available Call Report data as well as Invictus proprietary analytics to stress test all but the largest U.S. banks. This process provides a reasonable estimate and a fairly accurate relative calculation of each bank’s regulatory capital requirement, based on its unique portfolio distribution. Because we stress test almost every U.S. bank, we can look at relative capital requirements in the country, in a region, or in a categorization of banks.

Targeting Acquisitions

M&A clients can use the Invictus Acquisition Gauge to get an early-stage assessment of potential targets or merger partners. We  produce a graph similar to the one above (an example for a theoretical client bank).  Banks in the lower right corner of the graph inhabit the “sweet spot” for acquisitions. (Banks to the left of that corner would have to be purchased at discounts-to-book to achieve similar benefits). For instance, a Should Buy bank should prioritize any bank in the Sweet Spot box above subject to regional, size and other attribute screening.