Bank M & A: Predicting the Future

The "normal" merger and acquisition market for financial institutions receded 18 to 24 months ago and remains dormant except for a few one-off transactions. Banks and thrifts selling to one another for cash and stock may begin to bounce back by the fourth quarter of this year. Several factors will drive a return to the sale of whole-banks and branch offices in transactions that do not involve FDIC assistance. The signs of more normal activity are subtle at this stage, but the dots are starting to connect.

A More Realistic View of Credit Risk
After several quarters of severe commercial real estate loan problems, credit officers have gained increasing insight, through study and analytics, into the probable losses in their portfolios, and thus CEOs have, albeit painfully, begun to digest the further stress their capital ratios will be under as 2010 progresses. In response to the deeper insight into loss severity levels, banks' reserve levels have and will become more realistic, particularly as bank examiners use this greater transparency to urge higher allowance levels. As banks take a more realistic view of their probable losses and set appropriate reserves, potential bank buyers will slowly get more comfort concerning the quality of a target bank's balance sheet. At the same time, the reality of higher reserves and weaker capital levels will motivate sellers to find buyers for their institutions, a better solution than waiting to ride down the prompt corrective action "slide" into eventual receivership.

A "Tipping Point" is Coming
On the buyer's side, it has become increasingly apparent which banks have balance sheets strong enough to make acquisitions and access the capital markets to finance the transactions. There also is a realization that the market bottom in bank valuations offers the healthiest of banks great market share expansion opportunities. Potential buyers, however, will continue to measure the benefits of a bank acquisition in an FDIC receivership transaction against an acquisition without FDIC assistance. Even as that tension continues, a tipping point will emerge and an increasing number of acquisitions will be struck outside the scope of an assisted receivership transaction. While no one can predict the timing of the tipping point with any certainty, our best guess is that a trend toward more normal M & A activity will become evident in the fourth quarter of this year. For now, however, the merits of FDIC-assisted acquisitions continue to dominate the headlines and the market is very active.

FDIC Assistance — Advantages
FDIC-assisted acquisitions present significant benefits to buyers because of the credit-side protection through the FDIC loss-share arrangement. Buyers have snapped up failed banks in FDIC-assisted loss-share transactions because they offer the buyer significant value in the form of low-cost deposits and the target's franchise value, while protecting the buyer against credit losses. Indeed, a buyer who can work the target bank's portfolio effectively for the years after the acquisition stands to reap significant value in unanticipated recoveries that exceed the discount applied to the portfolio in the bid. In the final tally, approximately 140 institutions failed and were placed into receivership with the FDIC during 2009; most were sold to other institutions in FDIC-assisted sales, either with or without loss-sharing arrangements. The pace of failures and receivership activity is not likely to slow in 2010 and, consequently, there is a high level of interest in the potential benefits that a FDIC-assisted sale may provide.

See how Schiff Hardin assisted a bank with a FDIC assisted acquisition.

FDIC Assistance — Disadvantages
As a result of mounting political pressure, however, the FDIC has begun to wring some of the financial upside out of FDIC-assisted acquisitions through the use of equity appreciation instruments and unanticipated value claw-backs. Some potential buyers have, as a result, become increasingly apprehensive about participating in FDIC-assisted acquisitions, reflecting a concern over capped upside value and that the rules of the game may change further to the detriment of the buyer. In addition, as buyers in FDIC-assisted acquisitions know all too well, these are extremely complicated transactions to manage post-acquisition, with the loss-share office reporting requirements and the unusual integration issues they provoke. Indeed, the execution risk in an assisted acquisition is high, though manageable. To do these acquisitions right and maximize the value of the loss-share, a buyer has to devote considerable management time and attention post-acquisition to stabilization and integration issues.

In addition to the uncertainty creeping into FDIC-assisted acquisitions, buyers also have to take what they can get in these staged transactions; regulators decide when particular targets become available for bid and which targets are put into receivership. Thus, the timing and targets may not be an ideal fit for buyers eager to put their capital to use and expand their market share. Waiting to review target banks that fall into the FDIC's queue will eventually become less attractive to healthy buyers who want to seize the immediate market opportunity and ride the recovery in banking before the recovery is too far underway for an acquisition to make sense. As more banks become sophisticated with the bid process and understand the value of these transactions, the bidding process will become more competitive with more and more bidders participating in the auctions. Super competitive auctions reduce the chance for a successful bid for a particular buyer, yet the buyer has to spend significant time and money in due diligence and bid modeling. Negotiated acquisitions that avoid severe competition will become a more attractive alternative over time.

Buying Without FDIC Aid
With these trends in mind, buyers may be more interested in purchasing branches from distressed banks before FDIC receivership. For the buyer, it acquires good branches and likely leaves many of the bad loans behind, and it can grow its franchise without involving the U.S. government in the transaction. Likewise, banks will be motivated to sell branches to generate capital and forestall receivership if they are distressed. Whole-bank acquisitions outside the scope of FDIC assistance may increase in frequency as well, provided the problems in the target banks' credit portfolios have become more transparent and realistic valuations can be assigned to the portfolios. Buyers will increasingly feel the tension between waiting for the ideal FDIC-assisted acquisition and proceeding with a non-FDIC-assisted acquisition with good transparency on the credit portfolio, a low valuation, a motivated seller and an opportunity to expand the buyer's market share immediately. Quick, negotiated purchases avoid the increasingly competitive FDIC-bid process.

Demand is Building
Another driver in M & A activity is capital waiting on the sidelines to be deployed as the right opportunities are presented. Private equity firms and other institutional investors are waiting to see the bottom in banking and buy franchise value to take advantage of the inevitable upturn in valuations. This capital surplus is provoking investor groups to acquire platform banks that can receive huge capital injections from institutional sources of money and use the platform to acquire banks in FDIC-assisted acquisitions and non-FDIC-assisted acquisitions. Whenever there is so much capital waiting to get into the banking sector, and so many entrepreneurs ready to serve as the bridge between Wall Street and Main Street, demand for whole-banks will naturally increase. The sophisticated investors are now on the lookout for strong management teams and solid business plans, and they will finance acquisitive growth, increasing demand for bank franchises as an entry point for roll-ups.

Summary
There is still more clearing of the M & A market that has to happen through failed bank acquisitions, and that will take time. Yet we are starting to see signs of a return to a more normal M & A market for financial institutions as a result of increasing transparency of credit problems and more realistic reserve levels, a sorting out of the healthy acquirers from the not-so-healthy, and motivated sellers who see their survival as less likely than they did six or nine months ago. The universe of potential buyers will have to evaluate the merits of waiting for a target to go down before bidding versus taking the risk, without loss-share protection, of a negotiated acquisition to seize the market opportunity on its terms and timing. As the economy shows modest signs of improvement and credit losses become more predictable, capital will start flowing again and bargain hunters will take advantage of the distress of others. Banks will begin selling again and there is a real prospect that 2011 will see a remarkable surge in traditional bank M & A activity.

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