As Consolidation Looms, Once-Reluctant Banks Begin M&A Conversations

September 2015

As Consolidation Looms, Once-Reluctant Banks Begin M&A Conversations

By Lisa Getter and Kamal Mustafa

Even community banks that haven’t contemplated a merger or acquisition in the past are now having frank M&A discussions in the boardroom. In an economic environment with artificially low interest rates and low yields, an M&A deal may be a better strategic option than organic growth for many overcapitalized banks.

Regulators are even giving banks an incentive to acquire. Under the Federal Deposit Insurance Corp.’s proposed small bank assessment rule, banks that grow significantly in a year may face a higher assessment rate, unless that growth is ‘through merger or by acquiring failed banks.” 

So once a bank board decides it wants to embark on the M&A path, what should it do? How does a bank evaluate a deal and know when the price is right?  How does it pick a target? And how does it evaluate the impact of an acquisition going forward?

Many banks still rely on legacy M&A analytics to answer these questions. But three things in recent years have rendered those analytics essentially obsolete: We are in a never-before-seen economic environment. U.S. monetary policy, with its near-zero interest rates, is also unique in this country. And banks are operating under a new set of regulatory restrictions since the 2008 recession.  M&A analytics that do not take these three things into consideration will not accurately quantify a merger or acquisition.

New forward-looking risk analytics, which incorporate stress testing, regulatory capital and loan level vintage analysis, give banks a competitive edge in this new environment. Here, for instance, are six ways that appropriate strategic analytics can quantify the value of an M&A deal:

The same target has a substantially different value for each individual bidder based on the bidding bank’s unique balance sheet and P&L, with a substantial focus on the risk reward structure of their individual loan portfolios. Multiples-of-book have zero value in this analysis and should never be used to establish a target price. They can be used to help in a “proceed/not proceed to bid” decision, assuming the balance of bidders are relying on these misleading analytics.

Since valuation is a function of each bank’s condition, the value of a potential acquisition for two different buyers should not be the same. An acquisition is literally a compressed period of organic growth that must be measured. Banks must establish a baseline of what a target is worth to them before proceeding.

Targets must be evaluated, not in a vacuum, but in the context of market alternatives (primarily organic growth and secondarily, alternative transactions) to establish their true value to the bidder.

Subjective factors, which typically are difficult to quantify, should have the proper price/cost allocation applied to them to help management make an appropriate decision. These include the geographical footprint of the target, its deposit base composition, its regulatory capital and even its management resources.

Due diligence should not be limited to loan review, loan classification and ALLL.

The “to bid or not to bid” decision must be made early, before time and costs begin to mount.  Nine out of 10 bidders end up on the losing side of a transaction. That’s an awful lot of time and resources deployed for naught. (Except for the advisers, lawyers, investment bankers and accountants, who get paid regardless).  Proper analytics can let a bank know whether to stay in the game. If a deal is borderline, and there are better opportunities in your region, don’t jump into the bidding arena.

Editor’s Note: Invictus has developed a unique M&A analytical system built from proprietary forward-looking risk analytics linked to economic conditions. The system evaluates a potential target based on the capital structure, timing needs, product line, geography and yields of the acquirer. It allows banks to understand at what ceiling price a deal is worth, and what strategic options exist for the bank if it decides not to buy. The system also quantifies the hidden risks a target might present. It allows a bank CEO to explain this to a board: To win this deal, we must pay X, and the value to us is Y.  Once a bank understands that equation, it can bid competitively, but will never overpay.