M&A in 2013: Activity up, values down

While most other industries debate healthcare reform, the banking industry continues to deal with the uncertainties surrounding the implementation of Dodd-Frank and Basel III. However, it will also, we predict, spend 2013 immersed in a very different discussion: mergers and acquisitions.

This year will be a buyers’ market for bank acquisitions, and strategic mergers may be the only way for many community banks to survive.

Tough new capital regulations and stockholder pressure will force many banks—particularly smaller banks—to sell or merge. The bad news for sellers: selling prices compared to book values have plummeted over the last few years, dropping from 3-4x book value to 1-1.5x.

Why do we expect M&A activity to pick up in 2013? Several reasons:

  • A number of banks survived the financial and regulatory challenges of 2008-2010 by changing their operating model, but now find it difficult to achieve meaningful returns on assets or attain historical levels of profitability.
  • Many banks were forced during the last few years to sell some of their most profitable operations to raise capital or to avoid making investments in growing business segments, making them less competitive in the marketplace.
  • New compliance rules and capital requirements will especially strain smaller institutions, forcing them to merge or to be acquired to survive in any form.
  • Bank owners are more inclined to entertain offers and contemplate transactions compared to prior years (for the reasons cited above).

Similarly, banks that would have been rejected as possible acquisition targets two or three years ago are now much more attractive candidates, as a result of improved balance sheets or continued investment in systems and infrastructure.

In short, Dodd-Frank and the Volcker Rule, the heavy capital requirements, and the necessary investments in systems and processes bode well for increased M&A activity in 2013.

Merger targets

Many smaller institutions, particularly community banks, may have solid balance sheets, but they will need to merge with larger or similarly sized institutions to meet the operational and compliance requirements of Dodd-Frank and leverage a larger or combined platform. However, larger institutions are not likely to merely acquire branches in smaller communities (towns of less than 5,000) without a strategic fit. What is more likely is that neighboring community banks with a similar culture and philosophy will combine to better serve a larger yet similar customer base and capture the economies of scale.

The majority of these community banks are closely held—often by a local family. That family may hold executive positions in the bank, as well as the majority of board seats. Therefore, family disagreements about the direction of the institution and other closely held business issues could present hurdles to a transaction. The same is true with respect to an unrealistic view of current valuation (compared to values prior to the financial collapse).

Tax issues and opportunities

There are various tax issues and planning opportunities that should be considered as part of the due diligence process. Considerations should include items such as:

  • Deferred tax asset (valuation allowance) recognition after the transaction
  • Accounting methods of the purchaser and seller
  • Whether a stock or an asset acquisition is preferred for tax purposes
  • Whether a taxable or a tax-free transaction is preferred
  • Advantages and disadvantages of purchase price allocation options to the various assets

TARP

Another driver of increased M&A activity this year will be TARP (Troubled Asset Relief Program). Many institutions received TARP money and have yet to pay it all back. In 2014, the interest rate on that money will almost double, from 5% to 9%. Institutions that expect to have difficulty paying back those funds when the interest rate doubles have little choice but to merge or be acquired in 2013.

Values in the market

How has the market responded? Primarily by slashing values. For example, Citicorp is currently trading at approximately 0.67 of book value. If Citicorp liquidated tomorrow, its assets would be worth almost 50% more than its market capitalization. This is an ultraconservative valuation, and one that affects many institutions, not just Citicorp. Part of the reason is that making money in the banking business has become more difficult, and regulations have forced banks to divest themselves of ancillary, profitable lines of business.

What to consider when considering M&A

Before beginning any M&A activity, whether as a buyer, seller, or merger partner, talk with an experienced advisor. It will be key to understand and agree on your goal, and the goal of shareholders. Is it an exit strategy for the present management team and large stockholders? Is it survival of the institution in a different form? Is it banding together with like-minded institutions to meet the competition from larger institutions? Is it to strengthen a balance sheet?

These considerations will drive every institution’s activity in 2013, and we expect to see a significantly different banking landscape over the next year and beyond.