Divining Future Deals

GROWTH AND ACQUISITIONS

The resurgence of community bank mergers and acquisitions—fact or fiction?

By Thomas R. Mecredy

There has been much discussion among community bankers as to when merger and acquisition activity will heat up, and an increasing number of community banks are considering a strategic merger with another institution. Here are several reasons why we may or may not see a wave of bank merger transactions in the near future.

Reasons why

Many community bankers and their boards are deeply concerned about the following issues:

– difficult bank regulatory examination process and lower overall ratings;

– shifting demographic and economic trends in many community bank markets;

– diminishing customer loyalty;

– increased regulatory burden and increasing overhead expenses and efficiency ratios;

– possible lack of buyers for certain community banks;

– higher capital requirements and difficulty to raise capital without incurring significant dilution;

– management succession/family ownership and estate planning issues; and

– tax benefits of 10-year-old Subchapter S corporation banks for buyers and future changes in the long-term capital gain tax rate.

These may be reasons why we may see signs of life in merger and acquisition activity. Community banks may also be inclined to informally partner up with another community bank on a “book-to-book” or “adjusted book” basis to gain some efficiencies and some size in order to increase their ability to generate a reasonable return for their shareholders.

Reasons why not

Then again, other competing concerns may persuade community banks to avoid consolidations. Consider the following:

– Credit-quality issues remain for certain potential sellers, which makes it very difficult to determine “hard,” tangible book value and therefore accurately determine value.

– FAS 141R “Mark-to-Market” issues can significantly alter the premium paid for the selling organization. Buyers will need to mark loans, deposits, Federal Home Loan Bank borrowings, etc., to market, which in most cases will reduce the seller’s tangible equity at closing, increase the amount of goodwill booked by the buyer and thus reduce the buyer’s tangible equity.

– Buyers needing to finance all or a portion of the purchase price of a bank acquisition are facing funding challenges. Correspondent banks and bankers’ banks are much more conservative in their lending, and regulators are more conservative in their approval process.

– Buyers are more careful in their approach in acquiring community banks. Buyers perform a very thorough due diligence and are focused on pricing protection for downside credit risk. Buyers are worried about execution risk, capital preservation, economic uncertainty and, in general, making a mistake. These three factors will keep the pricing of community banks below the expectations of most banks considering selling in the short term.

– The stock price of many publicly traded banks makes it difficult to structure an attractively priced merger or acquisition that makes sense to a seller, since many of these buyers’ stocks are trading well below book value. It remains very difficult for community bank sellers to focus on the long-term upside potential of the buyer’s stock instead of the initial pricing.

– As community banks’ earnings performance continues to improve, a potential seller’s pricing expectations continue to increase. In today’s “buyers’ market,” many buyers, particularly those in certain regions of the country, cannot justify such higher expectations.

– There are still a large number of problem banks, which the FDIC will need to address in 2013 and beyond. These deals will continue to occupy the attention of a number of buyers.

As demonstrated in the chart below on the “Influence of Non-Performing Assets,” the pricing of community bank mergers and acquisitions has varied dramatically depending on the asset quality of the seller. Those sellers with non-performing assets below 2.00 percent of their bank’s total assets sold well below the pricing levels seen at the last merger and acquisition peaks in 1998 and 2006—selling on average at 2.72 and 2.41 times tangible book value, respectively, and at 21.1 percent and 19.9 percent premium on core deposits, respectively.

Given the current economic and regulatory environment, the limited number of buyers that are out there looking for deals will, in my opinion, proceed cautiously—and we will not see a significant resurgence of community bank mergers and acquisitions in the near term, but we will see a consistent number, between 200 and 250, of whole bank transactions per year.

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