Stephen Nelson and Eugene Katz are among many dealmakers who have changed firms as investment banks seek an edge in the increasingly competitive bank mergers and acquisitions market.
They joined D.A. Davidson of Portland, Ore., in September from Hovde Financial, where Katz spent 15 years, and Nelson spent 18 years, handling Midwestern community bank mergers.
The two investment bankers, who are based in Chicago, say joining Davidson will enable them to build a new practice in middle of the country for an up-and-coming firm that can offer more services to clients than just M&A advice.
"Right firm, right time, right platform," Nelson says.
Bank M&A will increase slowly, and consolidation in the closely watched Chicago market is inevitable despite the obstacles to doing deals there, they said in a wide-ranging interview. The market disruption from Stifel Financial's (SF) agreement to buy KBW (KBW) will provide an opportunity to recruit new talent and clients, they also say.
Here is an edited transcript of the interview:
What is your take on Stifel's deal for KBW? How might it affect the bank M&A market?
EUGENE KATZ: Both organizations have been longtime competitors of ours. We have a lot of respect for people at both places. What I would say from a short-term perspective, is there will be some integration issues for them to get through. But from a long-term perspective this is going to be a very formidable organization for us to compete against, and I think for many other investment bankers as well. But from a strictly Davidson FIG [financial institutions group] perspective — you take two pretty good competitors out of the equation and consolidate them into one. And so for us I think it will open up a number of other opportunities here in the Midwest. And really, what I think you are going to see 12 to 18 months out is they are going to start going upstream with the type of relationships they are going to primarily allocate resources towards.
STEPHEN NELSON: Certainly, there are going to be some business opportunities from a personnel standpoint and a client standpoint that will come up. You also look at the histories of the two firms, and they've known each other for a long time. I have little doubt that they are going to integrate it properly. But whether they bat 100% on it, or 90% or 80%, it's hard to say. But they'll get it right in time. And Stifel has a long history of acquiring companies and making it work for their shareholders.
What is your outlook for community bank M&A?
NELSON: It's not sexy but our best guess is it will be more of the same. In our estimation in 2013 we'll likely see continued incremental improvement. We don't see any sort of hockey-stick type of recovery in terms of pricing or activity. Quarter to quarter there seems to be just about a 5% build each quarter in terms of pricing. Once you get two or three years out there we will see a significant difference than where we are at today, or where we were just two years ago.
One of the things that we track closely here in the Midwest is the frequently significant differences in pricing and activity in one market versus another. We see significant price pressures where there has been or continues to be meaningful FDIC activity. Where we're located here in Chicago, there has been a meaningful amount of FDIC activity that has occurred and likely will occur in the future and that depresses pricing. This is also the case in other larger metro markets in the Midwest. Minneapolis still has a little ways to go on that front, and Kansas City is still dealing with the ripple through of FDIC activity there. Conversely, in other parts of the Midwest the agricultural economy is helping some of these rural county-seat markets. They have not only done well, they've done fantastic over the past few years, with interest rates down and commodity prices high, and farmland pricing increasing over 25% a year over the past couple of years. And so the banks that operate in those types of markets have fared very well. Their asset quality is quite good. And the M&A pricing, interestingly enough, is at a stronger level than in many metro markets because buyers are not inheriting as many problems.
When you go back to 2007, the average bank in metro markets in the central U.S. sold for around 250% of tangible book. And that was consistent with the broader national markets. The rural markets in that time frame were a bit below 2 times tangible book. Today the average bank in the Midwest sells for around 110% of tangible book. In the Midwestern metro markets — and again it depends an awful lot on the market — pricing is probably closer to 100% or so of tangible book on average. However, the rural county-seat companies are outperforming these averages and are selling for around 125% to 130% of tangible book.
KATZ: You may see some of the larger players exiting some of their non-core markets, whether it is in the rural markets or metro markets where they are just not interested because they don't have the same penetration as they did in the past or it is just not as strategically significant as it once was. We haven't seen as much of that type of activity from some of the larger players as we've seen it for some of the companies in the $3 billion to $5 billion [in assets] range in the last four or five years. Really what you have to look at is who are the companies that have been aggressive acquirers over the last decade or two. And now is the time to start rationalizing those franchises. We all look at capital as an incredibly important component in the industry. And the easiest way to generate capital is by shrinking back and selling off pieces that are just not critical to your franchise going forward.
What about Chicago? Do we see deal activity picking up there?
KATZ: Chicago, Minneapolis and Atlanta have been three of the most troubled markets in the country. When you're looking at banks with Texas ratios that are above 100%, the central U.S. is getting cleaned up. In the state of Kansas there are two left. In the state of Oklahoma there's one. In Texas, there are seven. In the Chicago metro market there are still north of 30 banks with high Texas ratios above 100%.
In Chicago, one of the challenges is it is the most unconsolidated market in the country.
At one point we had almost 300 banks operating in the Chicago metro market, which is more than any other market in the U.S. I think it's more than many of the states out there. That number in Chicago is close to 200 today. And probably as you start seeing open-bank consolidation over the next five to seven years, that number probably will probably shrink to 100, maybe 130, or so when it is all said and done.
One of the challenges we've had for the last three or four years in Chicago, unlike some of the other markets, is there really hasn't been a reliable pricing benchmark when you talk about the bid and the ask [spread] in the bank M&A market. In some markets there is a pretty meaningful difference. In some markets it is relatively small. The trouble with Chicago for the last four years has been the fact there's been no bid. You're able to ask. But there's been no bid, period. And that's a serious problem in terms of getting open bank M&A done here. We have started to see a little bit of thawing on a couple of deals in the market but it has been pretty minimal. There have really been six open deals done in the last four years, since '08 in the Chicago market. Just six open-bank deals, versus pretty significant volume of FDIC transactions. What people have started to do is get some creative structures in place in terms of payouts and escrows and things of that nature to get through a deal. And that is going to continue.
NELSON: There are parts of the country where the bid/ask is a very real discussion. You can look up in New England, or the mid-Atlantic or certainly Texas and even in Oklahoma, areas where there has not been a lot of FDIC activity and there is not going to be. That is where you have the real bid-ask differentials occurring.
Will the results of the Nov. 6 elections affect M&A? Compel more deals? Deter them?
NELSON: I think you have to look more at the macro forces that are at work in the sector — asset quality, interest rates, regulation and capital. Whether it is a Republican or Democrat [in the White House], how much does that really impact a community bank? It does to a degree. What you have occurring with the Obama administration, and what will likely be a continuation of over the next four years, is just a lot of regulation. So regulation has increased since 2008 partially as a result of who is in the White House — but more as a result of the credit crisis the sector has gone through. How well our sector is able to educate lawmakers about how detrimental and inconsistent some of the regulation is and how unnecessary it is remains to be seen. I think it is a process that we need to go through, the sector needs to go through, our representatives in D.C. need to go through and the regulators have to listen and adapt to.
Does increased regulation in and of itself prompt more M&A activity? Look, it's a factor. The M&A activity in the space from '08 until today has been at reduced levels in an environment where regulation has been very high; but asset quality issues have been huge and pricing has been low. Banks looking to explore a potential transaction today are likely doing so for a variety of reasons. Maybe it is because of increased regulation. It could be because of changing tax policy. It could also just be management succession, or liquidity needs that a given company has. Profitability and margin compression also are factors. When you put it all together it does argue for more consolidation. But whether it was a Republican in there or a Democrat I really don't think that it is going to meaningfully impact the macro forces that are at work.
KATZ: What I would add on is there are some diehards out there. They are going to use this as an extra motivation to go get a deal done. Are there are lot of them? Probably not. Banks have bigger issues — some of the themes that Steve just laid out. Things we hear a lot about: Basel III, Dodd-Frank, a lack of sophistication at times on behalf of some of these boards and management teams and really an understanding of what these factors might lead to in terms of known and unknown risks for the bank.
Why make the move to D.A. Davidson right now?
NELSON: It's a great group of people here at Davidson. It's a conservatively run firm. They know the banking sector very well and have been operating in it for decades. They really haven't been active in developing too many Midwestern bank relationships from an investment banking perspective, and that is something that Gene and I are going to be bringing to the table.
KATZ: We had a great run at Hovde. We built some pretty good reputations — in the Midwest especially. We were known as the guys who got you a high price in good times and got hard deals done in tough times. It's been a great transition. We're excited that we're able to offer more than just the M&A side of the equation by leveraging Davidson's full-service platform.