Many banks frustrated by elusive loan and revenue growth are exploring the mergers and acquisitions market — however tentatively — in the hope of improving earnings through cost savings. The pivotal question is how to avoid overpaying for the savings.
Despite banks' eagerness to return to robust growth, M&A activity has been muted. Some blame regulators and purchase accounting barriers, but the real issue is lack of confidence. An uncertain economy and weak stock prices have made many well-capitalized would-be acquirers hesitant. Rather, some are returning excess capital to shareholders through increased dividends and share repurchases. Others are retaining excess capital to build an acquisition worksheet.
M&A demand is cyclical and positively related to the performance of the bidder's stock price, which is frequently used as acquisition currency. Transaction valuation multiples, while improving, have yet to normalize. The current multiples are heavily weighted toward lower-priced struggling institutions being sold that have dominated the acquisition market to date.
The return of sales of stronger banks has yet to occur. Historically, M&A volume recovers quickly once government-assisted transactions have peaked. They appear to have done so this year, though the number of troubled institutions remains high.
Eventually confidence will return, probably in 2012, and M&A volume will increase. Stronger, highly rated institutions with deep capital markets access will lead the way. They will seek to exploit cost synergies by buying and consolidating smaller, less efficient banks. Unfortunately, the projected buyer gains are largely illusory, with actual realized values likely to be meager.
Most acquisitions fail to create value for the acquirer; the benefits go largely to the seller given the heavily competitive nature of the M&A market. That the banking industry had more than $45 billion of acquisition-related goodwill charges in 2008 and 2009 alone for previous overpriced transactions highlights this fact.
This reflects the large, concentrated investments at premium prices and the nature of the acquisitions. Buyers in effect are prepaying for uncertain future synergies. Banks of all sizes suffered by overpaying for expected synergies prior to crisis. So it's understandable that the buyer's shareholders react negatively to acquisition announcements.
On average, the acquirer's share price falls 3%-4% once the transaction is announced. This is known as the winner's curse: when the winning bid in an auction exceeds the value of the entity being acquired. This is a result of managerial overconfidence and the urge to beat competing bidders.
The key to avoiding this problem is to make accurate assessment of the target's value and to have the discipline not to bid more than that value. This requires establishing a walk-away, or reservation, price before making a bid. The opening bid would be set at a fraction of that price based on competitive considerations.
Ultimately, it is not just what you buy, but what you pay that determines an acquisition's success. Overpaying for the benefits received destroys shareholder value. Distinguishing between cheap and frugal is needed when pricing an acquisition. Cheap refers to low value. Frugal, however, represents efficiency. You usually get what you pay for. Equally important is to avoid paying more for what you get.
Complicating the matter is that price is a fact and represents what you give up now. Value, however, is an opinion concerning what you expect to receive in the future.
A target's price has two components. The first is the stand-alone, pre-bid minority ownership price. This reflects the status quo value of its cash flow under the current strategy and management. The second is the premium required to persuade the shareholders to sell a control position. This premium is estimated from recent comparable transactions based on earnings, tangible book value and deposit premium measures. The premiums vary over time, reflecting the seller's bargaining position and competing bidders. They tend to widen later in the economic cycle.
Expected value includes the target's status quo value plus potential earnings improvements from cost and revenue improvements or synergies. Value varies by owner depending on strategies pursued and how they manage the assets. Stand-alone price equals the status quo value subject to due diligence verification.
The acquirer's net value added equals the difference between the expected synergies less the premium paid to acquire them. This illustrates the iron law of mergers: buyers lose when the transaction premium exceeds expected synergies. Thus, the buyer's maximum price is the seller's status quo value plus expected synergies.
Projected synergies can represent a form of valuation Viagra used to justify excessive premiums. As Warren Buffett notes, while deals often fail in practice, they never fail in projections. Avoiding this trap requires strong board of director oversight. Banks with weak governance and dominated by a forceful chief executive are prone to value-destructive acquisitions.
The board needs to consider the reasonableness of the projected synergies. This depends on the type and size of planned synergies. Cost synergies are more achievable than revenue gains, which are frequently frustrated by competitor responses. The synergies should be based on unique factors allowing the buyer to bid and win while still adding value. For example, in-market bidders should have an advantage over more remote competitors.
Additionally, a detailed integration plan on how the synergies will be achieved tied to incentive compensation is required.
Finally, the board should consider the risk of acquisitions represented by shareholder value at risk, which is the premium offered relative to the buyer's market capitalization. It measures the impact of failing to achieve the projected synergies. Larger, more competitively priced acquisitions exhibit high SVAR, and should receive additional oversight.
Also, how the acquisition is funded influences its success. Cash transactions have a higher likelihood of success than stock transactions. This is especially true when the acquirer shares being offered as the acquisition currency are trading below their intrinsic value, which is the case for many institutions right now.
Surprisingly, many banks that believe their shares are undervalued are all too willing to issue them to acquire another institution. They mistakenly measure the price paid relative to the market price of the shares offered instead of their higher intrinsic value. You cannot exchange undervalued shares for a fully valued target without hurting your shareholders.
Cash transactions avoid this risk.
Value-adding acquisitions are difficult. Growth is not free. Alternatives including organic growth, divestment, shareholder distributions and putting yourself up for sale to capitalize on market overvaluation should also be considered.
The M&A paradox is that the industry benefits from the transfer of assets to higher-value owners. Yet, acquirers tend to overpay thereby transferring most of the transaction's benefits to the seller. The keys to succeeding include pricing discipline reflected in moderate premiums, cash funding, smaller deals, strong governance and going early in the cycle.
Acquirers possessing these skills are likely to avoid meager results from aggressively priced acquisitions.
Keep in mind there is no right way to do the wrong thing. Overpaying for synergies with an excessive premium is the wrong thing. Bid wisely to avoid the winner's curse by using caution to temper desire.
Joseph V. Rizzi is a senior strategist at CapGen Financial Group, a private-equity firm. He spent 24 years at ABN Amro Group and LaSalle Bank.
