After five or six years of strong bank M&A activity, 2020 slowed drastically following the onset of COVID-19. Eventually, we expect M&A activity will rebound once buyers have more confidence in the economy and the COVID-19 medical outlook. In that case, there will be greater certainty around seller’s earnings outlook and credit quality, particularly for those loan segments more exposed in the post-COVID-19 economic environment.
The factors that drive consolidation such as buyers’ needs to obtain scale,
improve profitability, and support growth will remain as will seller desires to exit due to shareholder needs for liquidity and management succession among others.
One emerging trend prior to the bank M&A slowdown in March 2020 was credit unions (“CUs”) acquiring small community banks. Since January 1, 2015, there have been 36 acquisitions of banks by CUs of which 15 were announced in 2019.
In addition to the factors favoring consolidation noted above, credit unions can benefit from diversifying their loan portfolio away from a heavy reliance on consumers and into new geographic markets. In addition to diversification benefits, bank acquisitions can also enhance the growth profile of the acquiring CU.
From the first quarter of 2015 through the second quarter of 2019, CU bank buyers grew their membership by ~23% compared to ~15% for other CUs according to S&P Global Market Intelligence. A positive for community bank sellers is that CUs pay cash and often acquire small community banks located in small communities or even rural areas, that do not interest most large community and regional bank acquirers.
There are, of course, unique valuation issues to consider when a credit union buys (or is bidding for) a commercial bank.
Based upon our experience of working as the financial advisor to credit unions that are contemplating an acquisition of a bank, we see three broad factors CUs should consider.
Developing a reasonable valuation for a bank target is important in any economic environment but particularly so in the post-COVID-19 environment. Generally, the guideline M&A comparable transactions and discounted cash flow (“DCF”) valuation methods are relied upon.
In the pre-COVID-19 environment, transaction data was more readily available so that one could tailor one or more M&A comp groups that closely reflected the target’s geographic location, asset size, financial performance, and the like. Until sufficient M&A activity resumes, timely and relevant market data is limited. Even when M&A activity resumes, inferences from historical data for CU deals should be made with caution because it is a small sample set of ~35 pre-COVID-19 deals where only 75% of announced deals since 2015 included pricing data with a wide P/TBV range of ~0.5x to ~1.7x (with a median of ~1.3x).
While deal values are often reported and compared based upon multiples of tangible book value, CU acquirers are like most bank acquirers in which value is a function of projected cash flow estimates that they believe the bank target can produce in the future once merged with their CU.
A key question to consider is: What factors drive the cash flow forecast and ultimately value? No two valuations or cash flow estimates are alike and determining the value for a bank or its branches requires evaluating both qualitative and quantitative factors bearing on the target bank’s current performance, outlook, growth potential, and risk attributes.
The primary factors driving value in our experience include considering both qualitative and quantitative factors. In a post-COVID-19 valuation, a CU may have a high degree of confidence in expense savings, but less so in other aspects of the forecast—especially related to growth potential, credit losses, and the net interest margin (“NIM”).
It is important for CUs to develop reasonable and accurate fair value estimates as these estimates will impact the pro forma net worth of the CU at closing as well as their future earnings and net worth. In the initial accounting for a bank acquisition by a CU, acquired assets and liabilities are marked to their fair values, with the most significant marks typically for the loan portfolio followed by depositor customer relationship (core deposit) intangible assets.
Once a valuation range is determined and the pro forma balance sheet is prepared, the CU can then begin to model certain deal metrics to assess the strength and weaknesses of the transaction. Many of the traditional metrics that banks utilize when assessing bank targets are also commonplace for CUs to evaluate and consider, including net worth (or book value) dilution and the earnback period, earnings accretion/dilution, and an IRR analysis. These and other measures usually are meaningfully impacted by the opportunity cost of cash allocated to the purchase and retention estimates for accounts and lines of business that may have an uncertain future as part of a CU.
One deal metric that often gets a lot of focus from CUs is the estimated internal rate of return (“IRR”) for the transaction based upon the following key items: the cash price for the acquisitions, the opportunity cost of the cash, and the forecast cash flows/valuation for the target inclusive of any expense savings and growth/attrition over time in lines of business. This IRR estimate can then be compared to the CU’s historical and/or projected return on equity or net worth to assess whether the transaction offers the potential to enhance pro forma cash flow and provide a reasonable return to the CU and its members. In our experience, an IRR estimate 200-500 basis points (2-5%) above the CUs historical return on equity (net worth) implies an attractive acquisition candidate.
Mercer Capital has significant experience providing valuation, due diligence, and advisory services to credit unions and community banks across each phase of a potential transaction. Our services for CUs include providing initial valuation ranges to CUs for bank targets, performing due diligence on targets during the negotiation phase, providing fairness opinions and presentations related to the acquisition to the CU’s management and/or Board, and providing valuations for fair value estimates of loans and core deposit prior to or at closing.
We also provide valuation and advisory services to community banks considering strategic options and can assist with developing a process to maximize valuation upon exit by including a credit union in the transaction process. Feel free to reach out to us to discuss your community bank or credit union’s unique situation in confidence.
Originally published in Bank Watch, May 2020.
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