The financial crisis and its aftermath have profoundly altered banking. Curtailed growth and increased regulatory costs from Dodd-Frank are among the many resultant structural changes. These changes, however, create opportunities for strong community banks to enhance their market positions through thoughtful M&A.
The end result of this consolidation will be the creation of a new class of regional bank champions in the depleted $10 billion to $50 billion market segment. This is similar to the consolidation wave following the Riegle-Neal bill, which permitted nationwide branching, and the repeal of Glass-Steagall in the 1990s. These legislative shocks triggered the M&A wave creating the megabanks.
It is understandably difficult to create shareholder value buying publicly held banks at a premium. Nonetheless, the right buyers at the right time can succeed by targeting smaller, undervalued banks … provided they can generate synergies exceeding the acquisition premium.
Bank M&A currently remains tepid, despite a recovery in capital positions and resolution of legacy asset quality problems. Bank stock prices, while improved, still trail pre-crisis multiples. The lag reflects a weak economy. Additionally, it reflects regulatory changes in the industry's cost structure especially at the community bank level. The changes affect the economic viability of the community banking model for institutions lacking sufficient scale. Banks able to consolidate sub-scale institutions in attractive markets at reasonable prices can create substantial valve.
One of the factors inhibiting this development is the belief that M&A is a loser's game with most acquisitions failing to add value for the acquirer's shareholders. Hubris or overconfidence is frequently given as the explanation for this phenomenon. This explanation is troubling as it assumes those managers continuing to acquire are collectively and consistently irrational.
An alternative explanation is that most acquisitions do not fail. Rather, they have been miscalculated. Academic event studies examining the value impact of mergers focus on the bidder's stock price performance relative to an index following the bid announcement. The period studied is usually three days – the day before the bid, the announcement day and the day following the bid. This approach may understate the full merger wealth effect if the market anticipates the bid.
Recent studies show the returns to bidders, including the anticipation effects 30 days before the announcement, are positive. Good managers intuitively understand this fact. This is why they continue to acquire despite folklore to the contrary. Bottom line, M&A is no money machine, but it also isn't a black hole.
Furthermore, caution against making a possibly over-priced acquisition (a Type I false positive error) fails to consider the impact of making a Type II false negative error by passing on a value-adding strategic acquisition. Smart bankers recognize the importance of capitalizing on once-in-a-career opportunities presented by the financial crisis. They understand the adverse competitive consequences of passing on potentially market-shaping transactions. Pre-emptive or defensive aspects of M&A are difficult to measure and frequently ignored. Recent positive market reactions to announced bids, even ignoring possible anticipation effects, highlight the importance of strategic transactions to investors.
M&A is a high risk activity and many things can go wrong. Each deal must be evaluated on its merits. You can improve your chances by focusing on three key questions. First, are you the best owner of the target? This means you are capable of extracting the most improvements through strategy and execution changes. Weak buyers gambling for redemption rarely succeed.
Next, is your bid premium less than credible cost savings as opposed to incredible revenue synergies? Absent that, no value creation is possible. Finally, have you adequately considered integration risks? Buyer M&A experience, smaller targets and limiting the number of post-acquisition changes reduce integration risk.
Post-crisis structural changes will trigger a wave of community bank M&A, creating new regional bank powerhouses. Investors will pressure management to do something – acquire, sell or return capital through dividends or repurchases. There will be no runners-up in the coming consolidation wave. Those failing to act risk falling further behind. In this environment, being too cautious is just as dangerous as being too aggressive.
All bid winners are not cursed, but those who hesitate to bid may be.
J.V. Rizzi is a banking industry consultant and investor. He is also an instructor at DePaul University Chicago.