Like many banks its size, Potomac Bank of Virginia in Fairfax has found the competition for loans and deposits to be especially fierce in recent quarters.
So instead of continuing to slug it out alone in the heavily banked Washington suburbs, the $247 million-asset bank announced in October that it would sell itself to Sandy Spring Bancorp Inc. in Olney, Md., and would operate as a division of the $2.6 billion-asset company.
Price certainly factored into the decision. Potomac shareholders are to get $65 million for the eight-year-old bank, or 2.65 times its book value and 41 times trailing earnings.
But G. Lawrence Warren, Potomac's chief executive, said that the deal was also driven by competitive pressures. Potomac would keep its name and its management team, but it would gain higher lending limits and could share marketing, compliance, and other costs with a much larger parent.
"For the first half of this decade, we really had the wind to our backs and had pretty smooth sailing," Mr. Warren said. "But frankly, we felt that the second half of this decade was going to be a bit more challenging because of the fight for deposits and yield-curve issues."
This is a familiar refrain among community bankers these days - and industry observers say it partially explains why most banks selling themselves these days are those with less than $1 billion of assets. It is also why many bankers, analysts, and investment bankers expect 2007 to be a particularly busy year for community bank deals, especially if prices come down.
"Buyers still have pretty strong currencies, but sellers' expectations are becoming a little bit more realistic as the earnings outlook for 2007 has more clarity," said Ben Plotkin, the chairman and chief executive of BankAtlantic Bancorp Inc.'s Ryan Beck & Co. Inc. "Everyone was holding out hope that there would be some relief with a positive yield curve and more organic deposit growth, but now they realize that 2007 is going to be a very challenging year - and that translates into more reasonable valuations."
An exception could be sellers with lots of core deposits, he said. These banks could be rewarded with higher deposit premiums.
Bankers and industry experts also expect to see more mergers of equals as smaller banks team up to get over the $1 billion-asset threshold and larger community banks merge with like-sized banks to gain even more scale.
This trend may already be emerging in the Midwest.
In June, Citizens Banking Corp. in Flint, Mich., said that it plans to combine with Republic Bancorp Inc. in Ann Arbor, Mich., to create a $14 billion-asset company that will be called Citizens Republic Bancorp. In July, Centrue Financial Corp. in Fairview Heights, Ill., and UnionBancorp Inc. in Ottawa, Ill., announced that they were teaming up to form a $1.3 billion-asset company. And in September, First Busey Corp. and Main Street Trust Inc. announced a merger-of-equals deal to create a dominant banking company in the Champaign-Urbana, Ill., market.
To be sure, 2006 was not a particularly active year for bank and thrift deals, when compared with some past years. Through Dec. 18, 257 deals had been announced, according to SNL Financial LC in Charlottesville, Va.
Worth noting, though, is that nearly 88% of those deals involved sellers with less than $1 billion of assets.
Of course, banks of all sizes are facing earnings pressure, but most agree that banks with assets of less than $1 billion are more vulnerable than their larger counterparts because they lack varied or large enough revenue streams to absorb hits to the bottom line.
Curtis Carpenter, the managing director at Sheshunoff & Co. Investment Banking in Austin, said that the climate is definitely getting tougher for the smallest banks.
"Larger banks have done a good job of integrating brokerage, insurance, wealth management, and trust services that generate fee income," he said. As a result, larger banks generally have ratios of noninterest revenue to average assets exceeding 2% and smaller banks generally have about 1%.
"So that's giving larger banks a competitive advantage," Mr. Carpenter said, "because they also can be more aggressive on their pricing on loans and deposits."
The quest for deposits is driving much of the merger-and-acquisition activity, Ryan Beck's Mr. Plotkin said.
Indeed, it is the main motive for the planned merger of $655 million-asset Assabet Valley Bancorp in Hudson, Mass., with the $300 million-asset Westborough Bancorp in Westborough, Mass. said Mark O'Connell, the president and CEO of Assabet's subsidiary, Hudson Savings Bank. (See related story
"It made all the sense in the world putting our two branch networks together," Mr. O'Connell said in an interview last week. "If we didn't do this, we both would have had to open more branches to get more deposit growth."
Not all small community banks are struggling with these pressures, says Edward Carpenter, an Irvine, Calif., investment banker (and no relation to Sheshunoff's Curtis Carpenter), and this is particularly true in California. Banks in the Golden State tend to be much more asset-sensitive that their counterparts in other parts of the country, so they can better mitigate yield-curve issues by repricing loans faster than deposits, Edward Carpenter said. Moreover, banks there generally have more business customers than retail customers and, consequently, a higher percentage of low-cost deposits.
California banks thus are under less pressure to sell, Mr. Carpenter said. Still, he said, merger-and-acquisition activity is likely to rise in the state next year because "more out-of-state banks that have experienced interest rate squeezes want to come to California to lower their cost of funds."
Another factor that could drive activity in 2007 is the 600 banks nationwide that will reach their 10th anniversary as Subchapter S banks and become eligible to be bought on what amounts to a tax-advantaged basis for the buyer, said Joe Ford, a lawyer at DLA Piper Rudnick Gray Cary LLP in Austin. Some experts believe buyers will pay as much as 15% more to enjoy this tax advantage, he said, and this should generate deals.
Then there are regulatory costs. Such costs are fixed, but larger banks can more readily cover them with revenue increases, as well as better economies of scale, than smaller banks can achieve, said Rick D. Weiss, an analyst at Janney Montgomery Scott LLC in Philadelphia.
"That's a big reason why M&A will pick up next year," Mr. Weiss said. "Increased regulatory burdens just add to the cost, as well as the 'time and hassle' factor, and many banks would rather just be doing their jobs of making money" and sell to a larger bank that could better handle compliance.
Though many believe that deal prices will moderate, banker Glenn E. Moyer was not so sure. The president of $5.4 billion-asset National Penn Bancshares Inc. in Boyertown, Pa., said he thinks asking prices could remain high, prompting some banking companies - including his - to consider mergers of equals.
"Embedded in the merger-of-equals concept is that there is a fairly low premium paid up-front," he said, as a tradeoff "for the potential that there might be significant shareholder value in the future" from a combination. "With a very challenging yield curve and a very competitive marketplace, we need to consider finding more efficiencies by combining organizations. The combined capital base would also enable us to manage larger lending limits."
Mr. Ford said that some bigger companies would be better off in mergers of equals because they would gain more efficient access to capital markets - for example, getting better prices on trust-preferred securities.
But hammering out a merger-of-equals deal can be daunting, Mr. Moyer and Mr. Ford said.
"You have to have somebody running the place, and both sides have to agree on which side that person is going to come from - and that's sometimes difficult to do," Mr. Ford said. "Banks who otherwise are doing quite well and are not up against a wall quite yet may look at other alternatives."
An outright sale could be the better alternative, said Ryan Beck's Mr. Plotkin.
"There will always be acquirers who will pay a premium," he said, "so the shareholders of the lesser of the 'equals' are generally better off selling" outright instead, he said.
