The M&A market looks as strong as ever in 2007 as buyers seeking revenue growth look for strategic expansion as well as cost-saving opportunities.
Summary of Discssions between
EMMETT J. DALY, Principal, Sandler O’Neill & Partners, L.P.
JOHN DUFFY, Chairman & CEO, Keefe Bruyette & Woods
STEVEN D. HOVDE, President & CEO, Hovde Financial LLC
MICHAEL R. MCCLINTOCK, Managing Director, Friedman Billings Ramsey & Co.
About deal activity that occurred in 2006 and likely scenario in in the next 12 months
Pricing levels have stayed high in 2006 and there were a fair number of potential transactions that didn’t get announced because pricing expectations weren’t met. There are certain markets where sellers’ expectations are either too high or there’s a paucity of wellheeled buyers. For 2007, there are still certain pockets in the country—Florida,Texas, the high-growth markets—where there’s greater-than-average interest on the part of potential buyers in accessing those markets. Companies like National City Corp. (NatCity) that have gone into Florida, and other banks entering new geographic areas, are being forced to pay high prices.That will continue as long as valuations and trading markets stay where they are now, or go higher.There are other markets where potential sellers are under increasing pressure to figure out how to grow the revenue stream, and if they can’t figure that out, they’re probably going to wind up selling. In those cases, they’ll probably take multiples quite a bit below those that were seen in the high-growth markets.
Buyers using acquisitions to supplement weak organic revenue growth are paying high prices.
It looked like things were cooling off a little mid-summer, as far as pricing, perhaps softening the market a bit, but then it picked up again at the end of 2006, and it’s continuing strong in 2007. Obviously there are markets that are very pricey—Florida is one,Texas is another. M&A may stay pretty active throughout 2007, at least until late summer depending upon what happens elsewhere. But all indications are that, if anything, 2007 will be as busy as 2006, with pricing differences persisting among regions.
The need for revenue growth - Driving M&A's?
Banks are pursuing growth and they’re willing to pay for it. Another factor is there are still a fair number of market entrants that are willing to “pay up” to get into markets, and they’re offering more than existing banks in those markets are willing to pay. NatCity is a prime example of a bank that paid up to enter Florida and, quite frankly, paid more than anybody else would have.
We thought last year (2006) that M&A market has reached a high-water mark, and it’s bound to go down with margin pressures.This year, we could probably say the exact same thing. 2006 was more active than we originally thought it would be.
A study found out that high-performing banks get clearly superior multiples: 3 times book and 28 times earnings, something like that. But guess what? Mediocre banks in Florida also get clearly superior multiples! There’s no differentiation right now between good management and bad management in Florida. Some correction may happen there. But looking elsewhere, other than the big market centers, like Chicago, that aren’t already consolidated, going may be pretty dry for rural areas—there’s really nothing going on in slow-growth states. So as for M&A there, one is not sure what the trigger will be, except for earnings pressure.
Most banks, whether they’re large or small, are facing the same revenue challenges.The exceptions are the small banks in the high-growth markets—they’re the ones trading at the highest multiples today. So if they decide to sell because they can get an extraordinary multiple, then yes, they’re willing to do deals.
The basic issue today is the challenge to grow revenues and profitable business.That’s really what causes M&A dynamics. More deal activity my take place —the big guys are challenged just as much as the small guys.They’re back to looking at cost saves. In some earlier deals, people kept pushing the envelope in terms of how much they thought they could take out of a combination, and some expense-save numbers that were well north of 30% in some examples. While those acquirers ultimately may have gotten to those cost-save numbers, many of them lost 30% of the revenue due to their preoccupation with achievement of planned cost reductions. Buyers today are generally smarter, but still, some of the bigger banks are willing to push a bit on some of the cost-save numbers.
The averages look high today, although the mid-20 P/Es are a bit misleading.That kind of pricing is coming from the smaller deals where there is less scrutiny by the analyst community and where the buyers are using their own very highly priced stocks.The bigger acquirers that were hammered in years past for overpaying and underdelivering have shown more pricing restraint. So today, you have many of the bigger banks reentering the M&A scene, but they’re doing deals at levels closer to 18 times to 20 times earnings.
The multiples are going to moderate. A lot of buyers have used up their financial flexibility so they’re going to have to use stock more, which will moderate the pricing issue. Everybody has put as much trust-preferred as they can into capital structures. All the rabbits have been pulled out of the hat, so to speak, so the pricing matrix will be driven by where the multiples of the acquirers are trading.To some extent, they may be getting a little bit more aggressive on the cost-save numbers, That doesn’t mean we won’t see banks in Florida going for 25 times earnings, but that’s going to be the exception, rather than the norm.
Regarding the future of revenue growth for banks.The vast majority of a regional bank’s product set has been commoditized–mortgage banking, credit cards, and now even deposit products are being poached by nonbank competitors. Banks express concern with the flat yield curve, but in fact, an even more critical problem is the compression of their profit margin from product commoditization.
The construction and development business is a niche where you can get a point, or point and a half, with an 18-month turnover and still make good money. But as that slows down, it’s going to be difficult. With a weak housing market, mortgage bankers aren’t going to develop as much pipeline as they’ve had, so that could be problematic.
The insurance business has really been the panacea. But there are very few banks that can make money on it.
Banks have to be very careful with those acquisitions. Yes, as a revenue line item, it looks great. But on a bottom-line basis, it often looks terrible.The bulk of the revenue is being paid in commissions to the agent.There is generally very little falling to the bank’s bottom line.
There is still a belief among some of the bigger players that you need to gather market share within a market. If banks can get that market share, margins will widen, so they’ll want to continue acquiring in certain markets to gather more market share. So there is a demand for acquisition from players who want to grow their market share.
The scope for the consolidation to increase market share
There are too many banks today, plain and simple—too much competition.
And the barrier to entry these days isn’t very high. It almost seems for every two that are purchased, we’re seeing another one created. There were 191 de novo charters in 2006.
Private equity firms and hedge funds are investing in large de novo banks.The money needed to start de novos is much greater these days. $60 million to $100 million each were raised recentlt by two start-ups in Orlando, Florida and Durham, North Carolina. For these banks to compete, they needed critical mass to attract talent and make larger loans. Raising only $5 million to $15 million will not give you that capacity.
why denovos are booming? The reason is because existing franchises are trading at 15 times or 16 times earnings. So if you can lift out a management team and build some scale, it’s not too hard to get a decent IRR. For example, if you take an existing management team and, in three to four years, build a billion-dollar institution and get it up near 1% ROA, even with a 10% capital ratio (which is where the regulators make you keep it for the first three years), you could still get some pretty decent returns.
If you can make it profitable in the second year (so you don’t have three years of cumulative losses where you’re eating up a quarter of the book value) and then get it near 1% by the fourth year, the numbers will work. But it’s a question of having that management team in place. Is there enough management talent available to make that formula work?
There are a fair number of frustrated bankers at the big banks. Many times, these guys reach a point in their careers where they long for a more entrepreneurial environment. So if you come along with the right model and enough capital, you can get the right talent.
Wii credit become a significant challenge in 2007?
There are signs that it’s weakening right now.
Credit quality is starting to weaken in certain markets. A couple of Florida banks, for example, announced meaningful credit-quality deterioration earlier this year.This very well could be a significant theme in ’07. And it could actually slow down the M&A activity in markets where credit quality is difficult to measure.
changes in regulatory and accounting practices?Have they helped M&A in any meaningful way by increasing the transparency of transactions?
Sarbanes-Oxley and other Enron-induced regulation had less of an impact on the banking industry than it did on other industries.The banking industry was already well regulated, and bankers were accustomed to strict oversight.While it created some added costs, the banks have managed it quite well.
I don’t think Sarbanes-Oxley added much value, but it did add a lot of cost. So for most banks, it was nothing more than an expense structure that really didn’t produce any value to the industry as a whole.
For most banks, compliance costs doubled after Sarbanes-Oxley.
advice to directors about planning strategically for M&A this year
if you’re thinking about selling in the next few years, sooner is probably better than later. A couple things could happen by waiting.To start, we’ve got a 15% capital gains tax rate. That has been extended to 2010, but what Congress giveth Congress can taketh away.We now have a Democratic-controlled Congress, and if a Democratic president is elected in November of ’08, we may see tax rates rise. If you are a seller, that will mean a big chunk out of the money that stays in your pocket.That also could create a rush of people selling equities who will be looking to take advantage of the 15% capital gains before the rate goes any higher.
The yield curve is going to kill earnings, and to your point, Emmett, revenue growth is pretty tough.
In considering advice for directors, there are two messages that I would give directors. For acquirers, you need to do your due diligence really well.Turn over a few stones—you might find some dicey credits out there. I think some banks, in order to keep the earnings game going, have been stretching themselves. Pricing has been very competitive but in certain markets there has also been some liberalization of underwriting, and, in the end, the only thing that ever really breaks down a bank is credit. You can have margin squeeze, you can have slow earnings growth, but the only thing that really gets you in trouble is bad underwriting. So that advice holds true whether you’re a bank with shaky credit, or you’re looking to buy a bank that might have sacrificed some underwriting standards.That’s the biggest risk when you acquire. Luckily, there may not be a lot of examples of that because, for the most part, buyers have been disciplined.
On the other side of the table, for sellers, deals are going to have a larger stock component than perhaps they’ve had in the past, because acquirers have used up a lot of their capital flexibility. So if you’re going to trade paper, unless you’re going to sell it in the short run to beat the bump in the capital gains tax, you really want to be concerned about the quality of the paper you’re taking. It’s not just a number and a multiple. If you’re going to hold the stock for a while, you’re really making an investment in the acquirer, and you’d better know what you’re getting.
Comments of a client taking stock in a deal - “I’m thinking of three things: I’m selling, so I want the best price. I’m taking a job, so I want to make sure I have a good employment contract. And I’m also making an investment.” He owns 100% of this nonbank financial company. He got a good price, but he wants to make sure he’s making a good investment. It’s a fascinating way to look at it.
There have been a fair number of deals done in the past six months more for strategic merits than just for short-term financial gain. Huntington Bancshares/Sky Financial, for example, was more of a merger of equals where the best of both companies will be drawn upon.The Mellon Financial/Bank of New York deal was a very intelligent market share play. Equally strategic, PNC Financial Services reviewed all its business lines, resulting in a landmark deal between its subsidiary, Black Rock, and Merrill Lynch Asset Management. In all three examples, the market traded up upon the announcements. So for sellers, pricing may be on the top of the list, but it’s not the only thing. Don’t focus solely on the last nickel. Be just as concerned with the quality of the paper and the strategic merits of the deal.
For the full article