When an economy pulls itself out of a recession, consumers are not the only ones who open their wallets — corporate dealmakers also return from the sidelines to invest in mergers and acquisitions to drive growth.
Analysts ambitiously predicted that 30 to 40 percent of U.S. banks would consolidate in the wake of the financial crisis, but, so far, the water has remained calm. Since 2008, the industry has only seen about 460 banks close nationwide and a similar number be acquired — a far cry from the analysts’ steep predictions. However, with mounting costs, revenue pressures, succession issues and capital-raising challenges, community banks are expected to have a harder time growing the balance sheet and, ultimately, the income statement in the foreseeable future. As such, many experts re-affirmed their predictions, claiming that 2013 would be poised for an M&A boom.
Yet, five months into 2013, the industry has seen fewer than 100 transactions close or reach definitive agreement (according to SNL Financial), again weighing in far below industry expectations. If this trend holds, we may see a mere 270 transactions by year’s end.
Before analyzing why this seemingly inevitable consolidation has not come to pass, let’s take a look at the elements that led to these predictions in the first place.
The Polarizing Effect of the Financial Crisis on Banks
The financial crisis left banks in one of two groups: 1) the well-capitalized and stable institutions that have learned how to adjust to the changing marketplace and increased level of regulation; and 2) those still suffering from regulatory and economic symptoms, who still face the insurmountable challenges of managing problem loans, rising expenses and growth obstacles. And with the slow uptick in economic activity, the disparity between these two groups continues to increase, leaving many community banks still struggling. These conditions, however, have opened the door for the strongest banks to pick up market share by merging or acquiring those that can no longer thrive on their own.
At the beginning of 2013, there were still more than 200 banks that had not repaid TARP money. The U.S. Treasury is divesting the outstanding balances in these banks by auctioning the investment as well as converting the initial investments into bond-like instruments at premium rates of 9 percent. Banks that have not been able to raise new capital to retire this debt should consider becoming acquisition targets as the cost of carrying this debt becomes even more expensive.
Small Banks Bow Under Stricter Regulations
Since the financial crisis, there has been an avalanche of new regulations in the banking industry. While the legislation has mostly been targeted at large institutions, the trickle-down effect of this legislation is hurting small banks. Changes to capital requirements and accounting treatments will continue to put pressure on balance sheets — potentially setting off another wave of failed banks.
As more regulations continue to emerge and reporting requirements become increasingly complex, smaller banks may struggle under the increased compliance burdens. The potential additional $300,000 to $500,000 of annual compliance expense is prohibitive for a bank with less than $100 million in assets, and could quickly cut its profit in half. Larger institutions have the critical mass to absorb these stricter regulations and the costs that accompany them, but community organizations often do not.
Organic Growth Is No Longer the Answer
In the banking industry, an industry that has reached maturity and continues to consolidate, competition to increase market share is more fierce than ever. As the market begins to rebound and banks start looking for new expansion opportunities, many are realizing that the once tried and true ways of boosting revenue are no longer sufficient. With flat to minimal increases in interest rates for the foreseeable future, less lending activity and undiversified revenue streams, the pressure on bank income statements is increasing while overall earnings are depressed. Consequently, institutions may be forced to consider external activity, like mergers and acquisitions, for continued growth and revenue diversification opportunities.
Market Valuations Are Back on Track
When comparing historical transactions to recent activity, buyers and sellers seem to have had misaligned perceptions of value, creating a gap that has limited potential M&A transactions. Instead of setting a realistic valuation expectation, many community banks looking to sell have held out for pre-Great Recession prices of 2 to 2.5 times book value. But with multiple recent announcements of unassisted transactions, a defined market valuation standard and comparative price point is beginning to emerge around 1.5 times book. As more of these deals take place, and expectations begin to temper, banks will likely open their doors to more merger and acquisition activity.
With all of these factors in place, why have not we seen the M&A surge everyone expected?
The truth may be that all of the necessary elements have not fallen into place. For one, there is still a gap between the market’s supply and demand. Buyers and sellers have yet to work out a reasonable price precedent, giving unstable banks reason to hold out for better offers. From an executive standpoint, bank management is primarily focused on new regulatory and compliance concerns – leaving little time to discuss growth through M&A.
To get M&A back on banks’ radars, the industry as a whole needs to adjust its expectations. Many institutions will need to come to terms with the reality of today’s economy, the regulatory landscape and the health of their own portfolios, and understand that today’s offers are going to be under historical deal averages.
As shareholder value continues to diminish due to lean interest margins and compliance costs, banks’ only exit strategy may be a merger or divestiture. And given the short supply of banks to acquire, buyers will need to approach M&A with a clearer idea of what target institution traits merit a premium offer.
Although the industry has not experienced the robust consolidation originally predicted, there is one key takeaway: Banks of all sizes must first adjust their expectations to welcome merger and acquisition activity, and create necessary, healthy change.
Neil Hartman is a director and leader of West Monroe Partners’ Midwest banking practice. He can be reached at nhartman(at)westmonroepartners.com.
Copyright (c) July 2013 by BankNews Media