M&A Economics:  Navigating the Trade-off between EPS Accretion and TBV Dilution

By Adam Mustafa

Although bank M&A deals are essentially flat versus last year, if there were a metric that measured the amount of M&A chatter in the market, it would likely be at an all-time high.  Our clients are looking at more deals at a more rapid pace than ever before, and that trend will only increase as the business cycle changes. 

But then why aren’t more deals getting done?  The short answer is because too large a spread still exists between the “bid” and the “ask.” 

On the “ask” front, many investment bankers are creating unreasonable expectations in the board room with respect to the pricing and valuation a selling bank could fetch in the market.  As far as the “bid” side goes, buyers are perhaps overly focused on dilution to tangible book value and the corresponding payback period. Buyers are essentially struggling with weighing the boost to earnings from a deal against the dilution to tangible book value and how long it takes to recoup the dilution.  Community banks tend to shy away from a deal if the payback period is longer than four years.

However, the better way to think about M&A is from a risk / reward perspective.  The analyses that buyers should focus on should be guided by the following questions:

• How much capital are we deploying based on the risk profile of the target and the structure of the transaction? 
• What is the return on capital we are getting as measured by increased earnings? 
• How does that ROI compare to other viable alternatives such as organic growth? 
• What is the time value of money relative to organic growth, which is a much slower and frankly more uncertain process?

Banks armed with the necessary array of analytical tools should be able to quantify the answers to these questions very quickly when assessing a given deal.  Absent a change in economic conditions and the low interest rate environment, M&A becomes a very attractive way to deploy capital, perhaps by default.  This is because the risk / reward characteristics of making new loans in this environment continues to rapidly erode.  Banks that analyze a given deal in a vacuum and are unable to quantify the return on capital of pursuing organic growth or other strategic actions (including returning capital to shareholders) will fall into the trap of overly focusing on TBV dilution and its corresponding payback period. 

In summary, buyers tend to focus too much on TBV dilution and the pay-back period for the dilution.  Instead, the emphasis should be on return on capital.  However, in order to measure capital and the return on capital properly, forward-looking analytical tools are required.

Management teams will need to be able to educate their boards and shareholders on this critical distinction.  Those who are able to do so will find themselves with a massive competitive edge in the M&A market.