08 Oct M&A Hunting Season: Why the Pandemic is a Perfect Time to Target Acquisitions
By Adam Mustafa, Invictus Group CEO
As crazy as it sounds, now is an ideal time to be on the M&A hunt for community banks. It comes down to supply and demand. The supply of willing sellers is likely to increase as management teams and boards grapple with the long-term prospects for the industry in the wake of the pandemic. Meanwhile, many acquirers are on the sidelines, paralyzed by their fear of acquiring a loan portfolio that could blow up in their faces, while crippled by their cratering stock prices, which has destroyed their primary currency.
More significantly, the importance of an M&A-driven strategy has increased since the period immediately prior to the pandemic.
The Value of M&A: Pre-Pandemic vs Today
M&A is first and foremost a growth strategy. Therefore, its ultimate value is a function of how it benchmarks against organic growth. In good times, when organic growth is strong, the value of M&A decreases. The “Buy versus Build” question swings in favor of build because it’s more predictable. The supply of banking expands to meet demand.
When organic growth stagnates and margins compress, the value of M&A increases by default. That is exactly the situation we find ourselves in today. The pandemic has rapidly accelerated these trends, but make no mistake about it, they were occurring prior to the pandemic.
What about Valuations?
Over the last several years acquirers in the banking space grew accustomed to using their stock as the primary form of currency to fund acquisitions. However, banks stocks are volatile. The decline in M&A transactions in recent months is due in part to the would-be-buyers’ tumbling stock prices.
To neutralize this volatility, let’s look at M&A through the lens of an all-cash transaction. Certain targets will have a balance sheet construct that will position them to better absorb the post-pandemic economy. The cash value of these targets has likely increased since the pandemic, not the other way around.
But not all targets are created equal. Many will struggle to maintain growth and earnings in the post-pandemic world. The cash value of these targets has decreased since the pandemic. Net net, some targets are worth a lot more and some are worth much less.
Many banks simply do not have enough excess cash/capital on hand right now to pay for a material acquisition. A combination of foresight and creativity can be used to overcome a depressed stock price to fund a transaction. Those who pursue this path will reap the rewards because they will see fewer competitors for transactions.
More Willing Sellers?
Targets are gradually being conditioned to the new realities of the M&A market. They are discovering the trend of declining valuations, both in the stock market for public banks, and in announced M&A transactions. Like any market that experiences a decline in prices, it will take time to fully manifest.
But an increase in willing sellers at lower prices is inevitable. Many bankers and boards no longer have the “fire in the belly” to navigate through a highly uncertain environment with an upside that is difficult to see. Some likely regret not monetizing their bank prior to the pandemic, increasing their fear of missing out the next time an offer comes around.
Meanwhile, customary selling reasons such as an aging shareholder base, succession planning issues, and rising technology costs gradually exacerbate. Bankers, directors, and stakeholders are nervous right now, and rightfully so. Nervousness also means more willingness to have conversations.
If you are a buyer, you have a tremendous opportunity because you can potentially pay less for something that is worth more. That same bank that may have told you $100M was too low a year ago might be happy to take $90M today. That situation represents the best of both worlds for the right targets: The value of the target has increased to you AND the price you may need to pay has decreased simultaneously.
What about Credit Risk?
We are not even close to being out of the woods as far as the impact of the pandemic on loan losses goes. This is a real concern and must be addressed to protect the buyer in any contemplated deal.
Nobody wants to buy a pig in a poke. This is where stress testing becomes the right tool for the job. However, stress testing can no longer be a check-the-box /mindless due diligence exercise. It needs to be a loan-level analysis properly tailored for the unique aspects of the pandemic.
Most importantly, the results of the loan-level pandemic stress tests should be a critical input into the final valuation and structuring of the transaction. There are creative ways to do this to mitigate the risk to the buyer and/or provide upside to the seller in the event the credit risks do not materialize as anticipated.
What Should You be Doing Now?
A unique window of opportunity is open now. The lethargic post-pandemic prospects for the economy will translate to an increase in willing sellers, but this will be occurring far more on a covert basis. Negotiated transactions will increase at the expense of bidding processes. This means that as a prospective buyer, you must be proactive.
Now is the time to develop a target list and customize the valuation of each target to how it fits with your bank. While the pandemic has strengthened the case for M&A, it also creates a massive divergence between good targets and bad ones. In other words, M&A will bring you greater rewards, but there is also more risk. Your customized valuations and analysis of each target must reflect this volatility.
You must also tailor a strategy for approaching and engaging each target into exploratory discussions. In some instances, it might make sense to approach the CEO directly. In other instances, it may make more sense to approach a shareholder or director. Do your homework and take action. It’s better to be talking to a target six months early than a day late.
A first-mover advantage is required. Negotiated transactions take time. The process needs to start now to close deals in 6 to 18 months. The beauty of this runway is it provides more visibility into the fate of the economy. You can always walk away from a deal in progress if it becomes clear that the economy is headed off a cliff.
You have an opportunity to zig while the majority of banks zag. The convergence of an increase in willing sellers, adjusted valuation expectations, increased internal valuations of certain targets, and a decrease in potential buyers too busy bemoaning their depressed stock prices presents a highly unique opportunity that we may not see again for a long time.
Adam Mustafa is the CEO and Co-Founder of Invictus Group. Invictus helps acquisitive banks target, create, structure, and execute negotiated transactions.