As banking consolidation continues apace, directors and bank managers essentially face three strategic options: acquire, sell, or do nothing.
The decision whether to sell or remain independent is one of the most difficult directors can face. Very few boards have ever had to consider even an informal acquisition overture. But the likelihood of getting a formal offer increases each year as active acquirers pursue a dwindling supply of potential sellers.
Once a decision is made to sell, then directors must act to maximize shareholder value. Some courts have interpreted this to mean conducting an auction, but others simply require the exercise of good faith and sound business judgment.
If a board is entertaining the prospect of selling the institution, shareholder value is most likely to be maximized when multiple offers are solicited. The highest offer, however, may not necessarily maximize shareholder value. A number of factors should be considered.
Estimated value of the institution. Directors and managers should be able to compare any acquisition offer with a recent valuation of the institution. Periodic valuation analyses offer an initial benchmark against which offers can be compared. However, updated analyses should be obtained to illuminate offers that a board expects to pursue.
The purchase price. Obviously, a key datum is the proposed purchase price. However, a proposed price is only the starting point for analyzing an offer. Not all offers are necessarily equal even if the prices may be comparable.
In analyzing an offer, directors should not be fixated on price-book ratios and other such yardsticks. Many boards are simply not informed; they may reject legitimate offers simply for failing a "two-times book" or other arbitrary standard. Directors whose decision isn't based upon informed judgment may violate the "business judgment rule," leaving the board vulnerable to charges that it had failed its fiduciary duty to shareholders.
Cash purchases. A cash price probably can be accepted at face value, provided that financing is available to the buyer. If the potential acquirer is significantly larger than the target, then obtaining financing should not be a problem. If the institutions are similar in size, then directors are well advised to explore fully the likelihood of the buyer's obtaining the necessary financing.
A secondary concern relates to capital adequacy of the combined institution, including whether a cash purchase financed with debt and/or excess capital would result in inadequate capital on a pro forma basis. Such an outcome might lead to regulatory authorities' rejecting the merger application.
Cash versus stock. One of the largest drawbacks of cash purchases, excluding the accounting requirement for the acquiring institution, is the capital gains liability they create. Stock swaps which are properly structured do not create a tax liability for selling shareholders, while the payment of cash for the sellers' shares is taxable.
The current federal capital gains tax rate stands at 28%. If the rate were reduced, then cash transactions would become more attractive. One benefit of cash transactions is the ability to diversify one's portfolio. By contrast, stock swaps entail converting the seller's shares into the buyer's shares.
Stock purchases. An exchange of shares is the predominant means by which acquisitions occur in the industry. Stock swaps are preferred by sellers because capital gains taxes are avoided. Also, the greed factor leads some to prefer swapping stock with institutions that are themselves takeover candidates, raising the chance of a "double dip."
Buyers prefer stock transactions because they can be accounted for as a pooling of interests. Under this method of accounting, pro forma capital levels generally do not become an issue since the balance sheets are merged without creating goodwill. Stock swaps raise a number of issues, including the offer's real value.
The exchange ratio. Although the exchange of shares may appear fairly simple, the calculation method can be complex and have a significant effect on the amount of consideration received. Exchanges may be based upon fixed ratios or floating ratios.
Fixed ratios allow sellers to lock into the buyer's stock based upon the stated ratio. As a result, the seller assumes the risk that the purchase value will fall if the buyer's stock price weakens before closing, whereas an appreciated stock would produce higher purchase value.
A floating exchange ratio establishes a dollar value for the seller, and the number of shares issued for the purchase is adjusted based upon the buyer's market price during a calculation period. A weak stock price during this period works in the seller's favor since more shares are issued, resulting in a larger pro forma increase in dividends, earnings, and book value per share. An appreciating stock price works against the seller and for the buyer since fewer shares are issued.
"Cuffs" and "collars" are often used in floating mechanisms to lock in an exchange ratio if the buyer's shares fall below or exceed specific prices.
Pro forma per share changes for the seller. Any proposed stock transaction should be analyzed for the pro forma changes in dividends, earnings, and book value per share from the perspective of the selling shareholders after the exchange. Also, the seller's collective ownership position in the merged institution should be analyzed. For the seller, the most important pro forma calculation generally is the change in dividend per share.
Pro forma per share changes for the buyer. The same pro forma calculations should be analyzed from the perspective of the acquiring institution. Particular attention should be paid to the amount, if any, of earnings dilution the buyer is incurring. If the offer is not dilutive or even accretive to pro forma earnings per share before considering any merger economies, then the buyer likely has the ability to increase the offer without damaging its stock price. Offers that appear dilutive of earnings per share are likely top dollar, unless significant merger economies can be achieved. Offers that appear too good to be true may be just that.
Investment characteristics of the acquirer's shares. Analyzing the investment outlook for the acquiring bank's shares is a highly subjective, but necessary, exercise. Particular attention should be paid to the shares' liquidity, the stock price performance relative to a peer group, analysts' outlook for the stock, and the shares' pricing in relation to a peer group.
If the acquiring institution is trading at an unusually high multiple of earnings and book value relative to its peers, the seller may be acquiring a stock with greater downside than upside potential. An analysis should seek to determine why the acquirer is trading at a high value, for example, merger speculation. Likewise, an unusually low stock price should be analyzed to ensure that the acquirer is not troubled.
Financial position of the acquirer. A full analysis of the acquirer's financial history and prospects should be done to gauge, among other things, earnings capacity and growth potential, quality of reported earnings, dividend-paying capacity, capital adequacy, interest rate and credit risk profiles, and the like.
Soft issues. The soft issues should be explored, too. These generally encompass operating strategies and management and staffing plans after the acquisition.
Terms of the merger agreement. Merger agreements should be scrutinized for onerous requirements. Also, agreements should give each party a walk- away option if certain conditions are not met, including a weak stock price for the buyer that is not adjusted by renegotiating the exchange ratio.
Fairness considerations. Merger agreements should require the seller to obtain a fairness opinion from a competent adviser, stating that the deal is fair to the selling shareholders from a financial point of view. Fairness opinions give directors a potential safe harbor from a charge that they violated their fiduciary duties to shareholders.
Mr. Davis is vice president at Mercer Capital Management Inc., Memphis.