Banks have raised billions since the market crisis began. Their immediate future is thereby ensured. Nonetheless, survival alone is not enough.
Investors, new and legacy, who supplied capital, expect a return on their investment. An anemic economic environment coupled with high regulatory costs makes achieving appropriate returns problematic. This is reflected in depressed stock prices, which highlight the absence of growth value. Consequently, institutions are exploring acquisitions to grow and produce the required returns. The focus is shifting from Federal Deposit Insurance Corp.-assisted transactions to open-bank deals, given the declining economics of assisted transactions.
Acquisitions, however, can be hazardous to shareholder wealth. Most acquisitions produce a transfer of wealth from the buyer to the seller's shareholders. Acquirers can succeed despite these odds. The key is a disciplined process to achieve the success required to maintain the trust of regulators, boards and investors.
The first step in the process is having a clearly defined and justified strategic basis for making the purchase. Acquisitions should flow from strategy; they are not a substitute for strategy.
In the current market environment, consolidation strategies can be attractive, given the large number of inefficient small institutions. For example, about 600 of the nation's 8,000 banks have assets exceeding $1 billion.
Many banks with assets below that mark are too small to succeed. Trying to grow organically in such a market can be an unprofitable zero-sum game. It can be more efficient to buy growth through acquisitions. This works, provided the acquirer does not overpay.
Determining an offer price begins with estimating the target's stand-alone, discounted cash-flow value, plus improvements or synergies. This is then compared to the value paid. The value paid is the target's prebid price, plus a premium. Stand-alone value and prebid price are usually equal. Thus, the acquirer's shareholder value added equals the premium paid, less synergies. In-market purchases offer the greatest synergy potential; 30% to 40% cost savings are common.
Premiums can be estimated by referring to market comparables expressed as multiples of earnings and tangible book value. Less favorable industry growth prospects suggest the multiples will be closer to the 1990s levels of 15 times earnings and 1.5 times tangible book value than to the 25 and 2.5 multiples common in 2003-7.
Furthermore, the multiples are lower earlier in an M&A cycle due to less competition. Earn-outs tied to asset-quality performance can be used to bridge gaps between the offer and seller expectations. These expectations may fall for many potential sellers when compared against an alternative dilutive capital raise.
Synergy estimates are complicated by managerial overconfidence. Protection against overbidding requires establishing a clear price range before the process begins, based on realistic estimates of achievable cash flow. Next, an estimate is needed of the acquirer's shareholder value at risk. SVAR is the premium offered as a share of the buyer's market capitalization. It measures the effect on the buyer's shareholders of failing to achieve the projected synergies.
SVAR highlights how much a bank's management is wagering on the deal. It is an indicator to regulators, directors and shareholders of management overconfidence.
Next, adequate due diligence is needed to ensure that the buyer gets the deal it expects. This is especially true regarding asset quality. Effective due diligence requires thinking more like an investor than a compliance officer.
A particularly useful due diligence-related provision is to let the buyer walk away, to terminate the deal, if credit deteriorates or purchase accounting adjustments rise above a threshold before the closing.
It is both frustrating and expensive to lose a deal to a competitor after signing but before the purchase closes. An example is Citibank's 2008 loss of Wachovia to Wells Fargo. This risk increases as competition for deals grows. Mechanisms to enforce no-shop, breakup and transaction fee provisions are crucial.
Finally, doing a deal is one thing; making it work is another. A detailed integration plan covering systems, severance, expected synergies and due diligence is required.
The key is to start early, move quickly and act through a program management officer to achieve a seamless post-merger transition.
Bank merger activity is showing signs of resurgence after years of lying relatively dormant. Well-managed, financially strong institutions can capitalize on this development.
Mergers are, however, complex, and sophistication is a competitive advantage. Buyers lacking the required skills become bad bidders.
Bad bidders make good targets. So let the buyers beware.