Not every community bank can or should expand. In the aftermath of the financial crisis, many smaller banks are in weakened competitive positions. Growing organically or through acquisitions is a high-risk strategy that involves potentially dilutive capital raises with uncertain payoffs.
For some community banks that lack a viable long-term business model and face limited revenue and profit opportunities, the best option may be to sell to a market consolidator. But many banks have a hard time reaching this decision because of seller's reluctance.
Performing institutions that have at least $1 billion in assets and operate in stable markets are the best sale candidates, given their franchise value. Perhaps no more than a few hundred banks nationwide fit these characteristics. These candidates can capitalize on their scarcity value in an improving community bank M&A market. Furthermore, they can exploit the winners curse by getting buyers to overpay as the market heats up.
Making this move can be tough decision. Bankers may believe that, having survived the financial crisis, the worst is behind them. The owners of some closely held, family-owned banks can readily acknowledge the difficult economic and regulatory environment, illiquid nature of their stock, limited capital market access and looming succession issues. Yet they understandably resist relinquishing their banks because of emotional attachments. Many banks that display seller's reluctance are prone to the endowment effect: the value they ascribe to what they already own is greater than the amount they would be willing to pay to acquire it.
In this way, sellers develop unrealistic expectations and price themselves out of the market. This is an especially common problem for inexperienced first-time sellers.
Community banks in this position must develop a disciplined process that allows them to determine if they have reached their sell-by date. This requires comparing the retained value of holding onto the bank with the bank's private market price in the M&A market. Retained valuethe floor below which the bank should not be soldis the potential seller's expected equity cash flows discounted at its cost of equity capital. A bank's private market value is based on comparable transactions.
If the private market value is greater than the retained value, the bank is worth more to someone else than to its current owners. Even if banks in that position opt not to sell, they know the opportunity cost of that decision.
Bankers can also work to overcome sellers reluctance by commissioning an external review of the bank well before any actual exit opportunity. This will help ensure objectivity in the decision-making process. An annual appraisal can help banks determine whether to sell and at what price, providing the basis for beginning discussions with qualified buyers. These processes also help bankers view selling as a valid aspect of strategy rather than as a last resort.
Knowing when to sell, and at what price, is just as important as knowing when to buy. Bankers must learn that it's better to sell when you can, and not when you must.
J.V. Rizzi is a banking industry consultant and investor. He is also an instructor at DePaul University Chicago.