Employee Benefits Agency Consolidation and Valuation

Lucas Parris, CFA, ASA-BV/IA, vice president, co-presented the session, “Employee Benefits Agency Consolidation and Valuation” with Mike Strakhov (Live Oak Bank) at the 2019 Workplace Benefits Renaissance Conference in Nashville, TN (February 20-22,2019).

A short description of the session can be found below.

Insurance agency merger and acquisition activity has been at historic levels for the past few years. Employee benefit agency transactions represent a significant number of these annually. This session will address the current state of agency consolidation including trends, who’s buying and who’s selling and the overall impact to employee benefits distribution. We’ll also identify and discuss the important characteristics that drive value of an employee benefits agency.

The Importance of Fairness Opinions in Transactions

It has been 34 years since the Delaware Supreme Court ruled in the landmark case Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985) and thereby made the issuance of fairness opinions de rigueur in M&A and other significant corporate transactions. The backstory of Trans Union is the board approved an LBO that was engineered by the CEO without hiring a financial advisor to vet a transaction that was presented to them without any supporting materials.

Why would the board approve a transaction without extensive review? Perhaps there were multiple reasons, but bad advice and price probably were driving factors.  An attorney told the board they could be sued if they did not approve a transaction that provided a hefty premium ($55 per share vs a trading range in the high $30s).

Although the Delaware Supreme Court found that the board acted in good faith, they had been grossly negligent in approving the offer. The Court expanded the concept of the Business Judgment Rule to include the duty of care in addition to the duties to act in good faith and loyalty.  The Trans Union board did not make an informed decision even though the takeover price was attractive. The process by which a board goes about reaching a decision can be just as important as the decision itself.

Directors are generally shielded from challenges to corporate actions the board approves under the Business Judgement Rule provided there is not a breach of one of the three duties; however, once any of the three duties is breached the burden of proof shifts from the plaintiffs to the directors.  In Trans Union the Court suggested had the board obtained a fairness opinion it would have been protected from liability for breach of the duty of care.

The suggestion was consequential.  Fairness opinions are now issued in significant corporate transactions for virtually all public companies and many private companies and banks with minority shareholders that are considering a take-over, material acquisition, or other significant transaction.

When to Get a Fairness Opinion

Although not as widely practiced, there has been a growing trend for fairness opinions to be issued by independent financial advisors who are hired to solely evaluate the transaction as opposed to the banker who is paid a success fee in addition to receiving a fee for issuing a fairness opinion.

While the following is not a complete list, consideration should be given to obtaining a fairness opinion if one or more of these situations are present:

  • There is only one offer for the bank and competing bids have not been solicited
  • Competing bids have been received that are different in price and structure (e.g., cash vs stock)
  • The shares to be received from the acquiring bank are not publicly traded and, therefore, the value ascribed to the shares is open to interpretation
  • Insiders negotiated the transaction or are proposing to acquire the bank
  • Shareholders face dilution from additional capital that will be provided by insiders
  • Varying offers are made to different classes of shareholders
  • There is concern that the shareholders fully understand that considerable efforts were expended to assure fairness to all parties

What’s Included (and What’s Not) in a Fairness Opinion

A fairness opinion involves a review of a transaction from a financial point of view that considers value (as a range concept) and the process the board followed. The financial advisor must look at pricing, terms, and consideration received in the context of the market for similar banks. The advisor then opines that the consideration to be received (sell-side) or paid (buy-side) is fair from a financial point of view of shareholders (particularly minority shareholders) provided the analysis leads to such a conclusion.

The fairness opinion is a short document, typically a letter.  The supporting work behind the fairness opinion letter is substantial, however, and is presented in a separate fairness memorandum or equivalent document.

A well-developed fairness opinion will be based upon the following considerations that are expounded upon in an analysis that accompanies the opinion:

  • A review of the proposed transaction, including terms and price and the process the board followed to reach an agreement
  • The subject company’s capital table/structure
  • Financial performance and factors impacting earnings
  • Management’s current year budget and multi-year forecast
  • Valuation analysis that considers multiple methods that provide the basis to develop a range of value to compare with the proposed transaction price
  • The investment characteristics of the shares to be received (or issued), including the pro-forma impact on the buyer’s capital structure, regulatory capital ratios, earnings capacity, accretion/dilution to EPS, TBVPS, DPS
  • Address the source of funds for the buyer and any risk funding may not be available

It is important to note what a fairness opinion does not prescribe, including:

  • What the highest obtainable price may be
  • The advisability of the action the board is taking versus an alternative
  • Where a company’s shares may trade in the future
  • How shareholders should vote a proxy
  • The reasonableness of compensation that may be paid to executives as a result of the transaction

Due diligence work is crucial to the development of the fairness opinion because there is no bright line test that consideration to be received or paid is fair or not.  Mercer Capital has nearly four decades of experience in assessing bank (and non-bank) transactions and the issuance of fairness opinions.  Please call if we can assist your board.

Originally appeared in Mercer Capital’s Bank Watch, April 2019

How to Value an Early-State FinTech Company

Jay D. Wilson, Jr., CFA, ASA, CBA, Vice President, presented “How to Value an Early-State FinTech Company” at the ICBA ThinkTech Accelerator on February 28th, 2019 in Little Rock, Arkansas.

Learning objectives include:

  • Pinpointing the external and internal factors that drive a FinTech company’s value
  • Recognizing how investor preferences can impact valuation 
  • Understanding when an early-stage FinTech company will need a valuation performed 
  • Identifying the basic valuation approaches for FinTech companies
  • Reviewing early-stage FinTech company case studies 

 

How to Value a Business & Situations That Give Rise to a Valuation

Karolina Calhoun, CPA/ABV/CFF, Vice President, presented “How to Value a Business & Situations That Give Rise to a Valuation” at the Tennessee Society of CPAs West Tennessee Chapter monthly meeting in Jackson, TN.

The valuation of a business can be a complex process, requiring accredited business valuation and forensic accounting professionals. This session will take a deep dive into the process and methodologies used in a valuation. Also covered will be the situations that give rise to valuation services such as estate/tax planning, ESOP annual valuation, M&A transactions, GAAP/ financial reporting, family law marital dissolution, buy-sell disputes, and corporate litigation.

Collaborative Divorce: An Alternative to Reduce Tension and Cost

In traditional divorces, each spouse engages a lawyer who fights hard to “win.” Their weapons can include bringing in their own financial professional to value financial assets. Naturally the neutrality of those valuations may be suspect in the other party’s eyes, even if the valuator follows all proper procedures. In collaborative divorce, each spouse still hires a lawyer, but the goal is to reach a settlement that satisfies each party. Neutral consultants, such as financial and mental health professionals, are also frequently involved. The model is “troubleshoot and problem-solve” rather than “fight and win.”

How Collaborative Divorce Works

The collaboration is carried out through a series of meetings in which the couples and their attorneys negotiate over issues such as property division, alimony, child support and custody. The meetings are quarterbacked by the mental health professional, who prioritizes the goals for each session, monitors the emotional climate, and keeps things on track. The attorneys each are responsible to look out for the interests of their clients, but rather than using the law to win, they are more focused on making sure their clients understand the legal issues involved and how a court might view them. The role of the financial professional, who is paid by both parties, is to provide an objective assessment of the financial issues involved. If one of the spouses has a business, the financial neutral provides an arm’s-length valuation and can also serve to educate the other spouse about the business, if needed. After several meetings, the financial neutral produces a marital balance sheet, laying out the couple’s financial landscape.

Advantages of Collaborative Divorce

While collaborative divorce is not for everyone, in the right settings it can have these advantages:

A Quicker Resolution

Divorces litigated through the court system can often take a year or more to reach a conclusion. The collaborative process can move faster because there is no waiting for motions to be filed and hearings to be held.

Lower Expense

Attorneys likely will have fewer billable hours since there is less engagement with the courts. There is only one financial consultant rather than two. In addition, because litigated cases tend to take more time, there may be a need for revised valuations as economic conditions change while the divorce makes its way through the process.

Less Acrimony

While there certainly can be tension between the two spouses during the collaborative process, the temperature tends to be lower when the working model is problem-solving rather than fighting. The addition of a mental health professional to the team also can serve to defuse tensions, and the neutrality of the financial professional can serve to reduce distrust.

More Control

When divorce cases reach the courtroom, subjective judgments by the judge can come into play. While Tennessee law spells out guidelines for judges in divorces, they still have latitude.

More Privacy

Divorce settlements litigated through the courts become public record. Settlements that result from the collaborative process do not. This can be of particular importance when one or both spouses are high-profile.

Conclusion

Collaborative divorce is not for everyone. Sometimes distrust between the parties has become so intense that litigation is the only way out. However, many divorcing spouses have found that a collaborative process can reduce tensions and cost and provide a result satisfactory to both parties. Attorneys can benefit from numerous services provided by financial professionals in litigated and collaborative divorce matters. At Mercer Capital, we have two professionals who are trained in the Collaborative Practice and provide assistance to attorneys in collaborative and litigated divorce matters. Please contact us if we can be of assistance to you and your clients.


Originally published in Mercer Capital’s Tennessee Family Law Newsletter, First Quarter 2019.

What Is a Lifestyle Analysis and Why Is it Important?

A lifestyle analysis is an analysis of each party’s sources of income and expenses. It is used in the divorce process to demonstrate the standard of living during the marriage and to determine the living expenses and spending habits of each spouse. It is typically a more in-depth analysis than the financial affidavits required in the divorce process and is prepared by a forensic accountant. The details in the analysis serve as verification of net worth and income, and expense statements submitted by both spouses can help a judge determine the equitable distribution of marital assets as well as alimony needs.

The lifestyle analysis pulls together all considerations and provides a visual of income and expenses over the remaining life expectancy. Through illustration of the aggregate sources of income(s) and expenses over time, one can discern what funds are actually required (and if these funds are available) to maintain standard of living, i.e., to fund expenses. The exercise then yields relative analyses (percentage comparisons and trend analyses), and ultimately, an illustration of net worth at a point in time, as well as net worth accumulation over time.

Factors Considered for Spousal Support

In Tennessee, the Decree for support of spouse is under § 36-5-121(i). Careful consideration must be given to the factors listed in the statute when determining historical lifestyle (standard of living) as well as reasonable need into the future. Twelve factors assist in determining whether the granting of an order for payment of support and maintenance to a party is appropriate, as well as determining the nature, amount, length of term, and manner of payment. Refer to § 36-5-121(i) for the full listing.

Although each of the factors must be considered when relevant to the parties’ circumstances, the first factor, “the relative earning capacity, obligations, needs, and financial resources of each party, including income from pension, profit sharing or retirement plans and all other sources,” has presented the two most important components: the disadvantaged spouse’s need and the obligor spouse’s ability to pay.

Hence arises the “pay & need analysis,” also known as the “lifestyle analysis.”

Sources of Financial Information Used in the Analysis

The following documentation provides financial information used in the analysis and is typically requested during the discovery process.

  • Tax returns
  • Brokerage accounts
  • Retirement, pension accounts
  • Bank, debit card, credit card statements
  • Personal financial statements
  • Loan applications
  • Insurance policies (cash surrender value)
  • Mortgage statements
  • Trusts, wills
  • Deeds to home, vehicles, motorboats, etc.
  • Annuity, stock certificates, deposit box
  • Business valuations
  • Appraisals of tangible items (artwork, collectibles, etc), among others

The Process: Building a Lifestyle Analysis

There are many moving pieces in constructing the lifestyle analysis, and the components can be quite different from case to case. During the preliminary stages, the financial expert/ forensic accountant will obtain pertinent documents from the aforementioned documentation in order to create the marital balance sheet (and potential separate property) and assess historical and current earnings and expenses/spending habits. Additionally, the expert may also assist in building a budget based on historical expenses. The expert will review retirement plans and annual contributions, brokerage accounts, cash & savings accounts, their respective average rates of return as well as varying tax obligations. The risk tolerance of the individuals can even be considered in relation to future rates of return. For example, a person with ample disposable cash may be willing to invest in riskier ventures where the return may be higher, than a person who chooses to invest conservatively due to limited disposable cash.

The investigative process may even lead the parties to establish the “true income” of a spouse who is suspecting of perpetrating fraud and determine any possible hidden assets or dissipation of marital assets.

Ultimately, the lifestyle analysis illustrates the sources of income, tax obligations, and disposable cash before and after expected expenses. This tool is valuable because it leads to further analyses such as relative analyses of gross earnings comparisons and after-tax disposable cash comparisons, among others. The analysis allows comparison on relative terms not just dollar amounts.

Another valuable result of the lifestyle analysis is the ability to assess the parties’ net worth at multiple points in time. The net worth accumulation analysis illustrates the differences of the division of net worth at the date of divorce, and the division of net worth at the date of death. Additionally, it illustrates the net worth accumulation between those two points in time. This process may highlight what appears to be reasonable at a point in time, may or may not be reasonable when extracted over time. When used as trial demonstratives, the illustration can assist the trier of facts in determining the disadvantaged spouse’s need and the obligor spouse’s ability to pay.

For a fact pattern and step-by-step illustration, refer to my Lifestyle / Pay & Need Analysis presentation from the 2018 AICPA Forensic & Business Valuation Conference.

Conclusion

In financial situations that may be scrutinized by regulators, courts, tax collectors, and a myriad of other lurking adversaries, the financial, economic, and accounting experience and skills of a financial expert are invaluable. The details in the lifestyle analysis can help determine the equitable distribution of marital assets as well as alimony needs.

Because no two cases are alike, all components of the analysis must be carefully assessed. Complexities that may need further consideration include, but are not limited to:

  • Earnings capacity: need for a vocational expert?
  • Differences in retirement plans (such as tax structure & penalties): qualified vs non-qualified, Roth vs Traditional, pensions, etc.
  • Investment risk profiles: risky vs risk averse (hence, annual returns may differ)
  • Alimony requested: duration, dollar amount, type
  • Business ownership: valuations, personal vs. enterprise goodwill, active vs. passive appreciation (i.e., marital vs. separate)
  • Deferred compensation:
  • Stock options and restricted stock (both vested and unvested) • Election 83(b): timing of tax on restricted stock
  • Short-term and long-term incentive plans (bonuses), among others

A competent financial expert will be able to define and quantify the financial aspects of a case and effectively communicate the conclusion. For more information or to discuss your matter, please don’t hesitate to contact us.


Originally published in Mercer Capital’s Tennessee Family Law Newsletter, First Quarter 2019.

Takeaways from AOBA 2019: “It was the best of times, it was the worst of times…”

I ventured into the Arizona desert again this year to Bank Director’s Acquire or Be Acquired Conference (“AOBA”) in Phoenix in late January. This year I was struck by the dichotomous outlook for the banking sector that reminded me of Dicken’s famous line: “It was the best of times, it was the worst of times…”

The Best of Times

The weather was lovely. Phoenix/Scottsdale is the place to be in late January, and this year did not disappoint with sunny weather and a high of around 70 each day. At the same time, much of the country was feeling the effects of a severe polar vortex that caused temperatures to plunge well below zero in the Upper Midwest and Great Plains. Many of the attendees from that area were forced to stay a day or two longer due to airline cancellations.

The operating environment for banks reflected a similar analogous dichotomy. Take the market for example. Most banks produced very good earnings in 2018, and many produced record earnings due to a good economy, the reduction in corporate tax rates, and margin relief as the Fed raised short-term interest rates four times further distancing itself from the zero interest rate policy (“ZIRP”) implemented in late 2008.

The Worst of Times

Nonetheless, bank stocks, along with most industry sectors, were crushed in the fourth quarter. The SNL Small Cap US and Large Cap US Bank Indices declined 16% and 17% respectively. Several AOBA sessions opined that valuations based on price-to-forward earnings multiples were at “financial crisis” levels as investors debated how much the economy could slow in 2019 and 2020 and thereby produce much lower earnings than Wall Street’s consensus estimates.

Within the industry the best of times vs. worst of times (or not as good of times) theme extended to size. Unlike past eras when small (to a point) was viewed as an advantage relative to large banks, the consensus has flipped. Large banks today are seen as having a net advantage in creating operating leverage, technology spending, better mobile products for the all-important millennials, and greater success in driving deposit growth.

Additionally, one presenter noted that larger publicly traded banks that are acquisitive have been able to acquire smaller targets at lower price/tangible book multiples than the multiple at which the shares issued for the target trade in the public market and thereby incur no or minimal dilution to tangible BVPS.

Technology

The most thought provoking sessions dealt with the intensifying impact of technology. Technology is not a new subject matter for AOBA, but the increasingly larger crowds that attended technology-focused sessions demonstrated this issue is on the minds of many bankers and directors. While technology is a tool to be used to deliver banking services, I think the unasked question most were thinking was: “What are implications of technology on the value of my bank?”

Several sessions noted big banks that once hemorrhaged market share are proving to be adept at deposit gathering in larger metro markets while community banks still perform relatively well in second-tier and small markets. Technology is helping drive this trend, especially among millennials who do not care much about brick-and-mortar but demand top-notch digital access. The efficiency and technology gap between large and small banks is widening according to the data, while both small and large banks are battling new FinTech entrants as well as each other.

Not all technology-related discussions were negative, however. Digital payment network Zelle (owned indirectly by Bank of America, BB&T, Capital One, JPMorgan Chase, PNC, US Bank, and Wells Fargo) has grown rapidly since it launched in 2017. Payment volume in dollar terms now exceeds millennial-favorite Venmo, which is owned by PayPal. Also, JPMorgan Chase rolled-out a new online brokerage offering that offers free trades for clients in an effort to add new brokerage and banking clients while also protecting its existing customer franchise.

Steps to Create Value

In addition to the best of times/worst of times theme, I picked up several ideas about what actions banks large and small can take to create value.

Create a Digital/FinTech Roadmap for Your Bank

There was a standing room only crowd for the day one FinXTech session: “The Next Wave of Innovation.” This stood in stark contrast to the first AOBA conference I attended which was during the financial crisis. Technology was hardly mentioned then and most sessions focused on failed bank acquisitions. Clearly, this year’s crowd proved that technology is top of mind for many bankers even if the roadmap is hazy. A key takeaway is that a digital technology roadmap must be weaved into the strategic plan so that an institution will be positioned to take advantage of the opportunity that technology creates to enhance customer service and lower costs. Further, emerging trends suggest that technology may help in assessing credit risk beyond credit scores. To assist banks in creating a FinTech roadmap, Bank Director recently unveiled a new project called FinXTech Connect that provides a tool bankers can use to consider and analyze potential FinTech partners.

Become a “Triple Threat” Bank

During our (Mercer Capital) session, Andy Gibbs and I argued for becoming a “triple threat” bank, noting that banks with higher fee income, superior efficiency ratios, and greater technology spending were being rewarded in the public market with better valuations all else equal (see table below). While we do not advocate for heavy tech spending as a means to an ill-defined objective, the evidence points to a superior valuation when technology is used to drive higher levels of fee income and greater operating leverage. For more information, view our slide deck.

Plan for the Good and Bad Times, Especially for the Bad Times

While there was a lot of discussion about an eventual slowdown in the economy and an inflection in the credit cycle, several sessions highlighted that a downturn will represent the best opportunity for those who are well prepared to grow. The key takeaway is to have a plan for both the good and the bad economic times to seize opportunity. Technology can play a role in a downturn by helping add customers at very low incremental costs.

Best Practices around Traditional M&A

On the M&A front, two M&A nuggets from attorneys stood out as well as a note about MOEs (mergers of equals):

  • Sullivan & Cromwell’s Rodgin Cohen suggested that buyers should determine what the counterparty wants and structure the transaction to achieve the counterparty’s objectives. Also, buyers need to “ride the circuit” to meet with potential acquisition candidates well before a decision to sell is made, while sellers need to know what they want to achieve before launching a sales process.
  • Howard & Howard’s Michael Bell, a leading attorney to credit unions, had an interesting session where he noted commercial bankers should actively court credit unions as potential acquirers in a marketing process because credit unions’ lower operating cost structures and tax-exempt status can produce a better cash price for the seller.
  • A few sessions discussed the potential for MOEs to create value for both banks’ shareholders through creating scale and by combining banks with different areas of strength. In addition, MOEs create an opportunity to upgrade technology while addressing costly legacy systems, including extensive branch networks. All three themes were addressed in two large MOEs announced in 2019 by TCF/Chemical and BB&T/SunTrust.

Conclusion

We will likely be back at AOBA next year and hope to see you there. In the meantime, if you have questions or wish to discuss a valuation or transaction need in confidence, don’t hesitate to contact us.

Tax Law Changes Affecting Family Law: 2019 Changes and Recap of 2018 Changes

2019 Changes

By now, many are familiar with the changes from the Tax Cuts and Jobs Act (TCJA), however, specific changes related to family law and alimony deductibility went into effect in 2019.

  • Alimony Payments. Effective January 1, 2019, alimony payments are no longer deductible to the payer spouse, and are no longer taxed to the recipient spouse. This applies to divorces finalized, by settlement agreement or court order, on or after January 1, 2019. Under the prior law, alimony was deductible to the payer, reducing income and basis for taxes, and taxed to the recipient, increasing income and basis for taxes. The change is permanent and will not sunset, like some of the TCJA amendments.
  • Income from Trusts. Also, under the prior law, income of a (alimony) trust paid to the ex-spouse was taxable to the recipient and not to the grantor. The TCJA eliminated that rule.
  • Existing Agreements and Modification Requests. Existing alimony or marital dissolution agreements, as well as any modification requests, are grandfathered to pre-January 1, 2019 rules as per existing agreements, unless both parties mutually consent and specifically opt to implement new rules. Alimony modification requests made January 1, 2019 and after will require recognition of the changes of the tax law.

Recap of 2018 Changes

We discussed many of these in a prior newsletter. The changes are as follows.

  • Personal Exemptions. Under the new tax law, personal exemptions are eliminated. Previously, personal exemptions were often used during divorce settlement negotiations with the parties splitting these deductions and sometimes one spouse compensating the other spouse to “purchase” the use of this exemption.
  • 529 Plans. The new tax law expands the use of 529 plans to include secondary education and other uses, whereas it was previously only available for college and higher education. Often, 529 plan accounts exist in a marital estate and become a topic discussed during settlement negotiations for how/when they will be used.
  • Business Valuation. TCJA reduced corporate income tax rate from 35% to 21%. The valuation of C corporations could be higher simply due to the mechanics of income approaches to value a business, all other factors held equal.
  • Child Tax Credit. The TCJA increased the credit to $2,000 and the income phase-out increased to $200,000 ($400,000 for joint filers).
  • Other Deductions. TCJA repealed legal and accounting fees related to taxable alimony, divorce-related tax planning, and related analysis. The TCJA suspends the miscellaneous deductions through Dec. 31, 2025. This also applies to professional fees related to splitting of Individual Retirement Accounts or ERISA plans (e.g., QDRO fees).

For more information, see this helpful reference.


Originally published in Mercer Capital’s Tennessee Family Law Newsletter, First Quarter 2019.

Leveraging FinTech to Survive & Thrive in the Digital Age

Andy Gibbs and Jay Wilson presented “Leveraging Fintech to Survive & Thrive in the Digital Age” at Bank Director’s 25th annual Acquire or Be Acquired (AOBA) Conference.

Developing a fintech strategy for your bank to enhance profitability, efficiency, shareholder value and customer satisfaction can be challenging. This session helps to navigate fintech and develop a fintech strategy; provides case studies of successful partnerships between community/regional banks and fintechs; and give an overview of fintech valuation and M&A trends.

 

How to Value an InsurTech Company

FinTech companies are the emerging and hyped sector of the financial services industry. Looking at FinTech’s recent activity, people can see that many of these companies begin as start-ups and a few exciting years later, are able to raise millions of dollars in hopes of becoming the next “unicorn” – an industry term describing a tech company valued at a billion dollars or more. While this business trajectory may seem simple and attractive, FinTech companies usually have a highly complex structure made up of many investors of different origins, including venture, corporate, and/or private equity, all with different preferences and capital structures.

Valuing a FinTech company can be very complicated and difficult, but carries important significance for employees, investors, and stakeholders for the company. While all Fin-Tech companies have large differences, including what niche (payments, solutions, technologies, etc.) they operate in or what stage of development the company is in, understanding the value of a FinTech company is critically important. More specifically, within the FinTech industry, an exciting niche termed InsurTech is emerging and threatening to change the traditional state of the insurance industry.

InsurTech Niche

InsurTech is a fast growing niche that operates in a massive global insurance industry with premium revenues of about $5 trillion annually. InsurTech is the term applied to many companies that are using technology to disrupt the traditional insurance industry landscape. InsurTech has high growth prospects and the potential for InsurTech to innovate and disrupt remains large. Funding for InsurTech companies in the recent years has spiked, especially for early-stage companies. Incumbents in the insurance industry have been slow to adopt disruptive, high-growth InsurTech, partly because insurance is so massive and has been around for such a long time. Additionally, many traditional insurance companies can benefit from InsurTech solutions that serve to enhance customer satisfaction and improve efficiency of operations by leveraging technology and enhancing the delivery of certain insurance offerings and solutions through digital channels.

Technology and innovation have disrupted many other long-established industries, such as the impact of medical technology in the healthcare industry. Insurance players, who maintain legacy systems believe that established customer connections will reduce the threat of InsurTech. However, this may not be the best strategy because insurance is often purchased begrudgingly. The historically strained relationship between customers and carriers is a rather vulnerable point along the insurance value chain. InsurTech companies can offer innovative technology that creates more touch points for customers and reduces many customer pain points.

Market Considerations

Understanding how well a given InsurTech company is doing within this FinTech niche is one of the most important factors in determining its value. Market dynamics such as market size, potential market available, and growth prospects are important to understand. A valuation will consider absolute market value, existing competitors, and existing incumbents.
The regulatory environment is another important consideration when valuing an InsurTech company. Financial services, such as banks and insurance companies, are heavily regulated, so understanding the rules and regulations is necessary for developing an accurate valuation.

Like other FinTech niches, certain solutions within InsurTech are relatively new and have the potential to disrupt the entire insurance industry. Since many industry incumbents have been slow to adopt this new technology, the range of this innovation has yet to be fully felt and rules/regulations have yet to change. While regulatory stability may seem favorable now, concrete rules and regulations are complex and can be hard to predict as regulators react to rising InsurTech involvement. Understanding these complexities is important to valuing InsurTech companies, as these regulations could help or hinder an InsurTech’s growth potential.

Company Considerations

When valuing a startup, quantitative information (financial and operating history) is limited; therefore, qualitative information can be extremely important in determining a company’s value. The quality and experience of the management team can be important. Knowledge of the insurance industry including understanding customer preferences, technology integration, the competitive and regulatory environments can enhance an InsurTech’s company value.

An InsurTech company’s ownership of intellectual property and other intangible assets, like strategic partnerships, all else equal, should be considered and could increase a company’s value, assuming they are in place and well documented. When in place and demonstrated, intangibles are an important qualitative consideration.

The stage of development of a FinTech company can also impact its value. Companies typically set milestones and track their own progress, and meeting these milestones might affect their valuation. Milestones usually include initial round financing, proof of concept, regulatory approval, obtaining a significant partner, and more.

Milestones are important to set and track as the more milestones a startup meets, the less uncertainty exists and the more value is created. For example, an InsurTech company with established technology, increased customer touch points, and the potential to increase revenues will be more valuable to a potential acquirer than a newer startup. In addition, meeting later stage milestones often provide greater value than meeting early stage milestones. When the valuation considers future funding rounds and the potential dilution from additional capital raises, a staged financing model is often prepared and the valuation will vary at different stages as shown below.

Valuation Approaches

As InsurTech companies enhance business operations and reduce costs, valuations for these companies will become more important. There are three common approaches to determining business value: asset approach, income approach, and market approach. Each valuation approach is typically considered and then weighted accordingly to provide an indicated value or a range of value for the company, and ultimately, the specific interest or share class of the company.

The Asset Approach

The asset approach determines the value of a business by examining the cost that would be incurred by the relevant party to reassemble the company’s assets and liabilities. This approach is generally inappropriate for technology startups as they are generally not capital intensive businesses until the company has completed funding rounds. However, it can be instructive to consider the potential costs and time that the company has undertaken in order to develop proprietary technology and other intangibles.

The Market Approach

The market approach determines the value of a company by utilizing valuation metrics from transactions in comparable companies or historical transactions in the company. Consideration of valuation metrics can provide meaningful indications for startups that have completed multiple funding rounds, but can be complicated by different preferences and rights with different share classes.

Regardless of complications, share prices can provide helpful valuation anchors to test the valuation range. Market data of publicly traded companies and acquisitions can be helpful in determining key valuation inputs for InsurTech companies. For early-stage companies, market metrics can provide valuable insight into potential valuations and financial performance once the InsurTech company matures. For already mature enterprises, recent financial performance can be compiled to serve as a valuable benchmarking tool.

Investors can discern how the market might value an InsurTech company based on pricing information from comparable InsurTech companies or recent acquisitions of comparable InsurTech companies.

The Income Approach

The income approach can also provide a meaningful indication of value for a FinTech company. This relies on considerations for the business’ expected cash flows, risk, and growth prospects.

The most common income approach method is the discount cash flow (DCF) method, which determines value based upon the present value of the expected cash flows for the enterprise. The DCF method projects the expected profitability of a company over a discrete period and prices the profitability using an expected rate of return, or a discount rate. The combination of present values of forecasted cash flows provides the indication of value for a specific set of assumptions.

For startup InsurTech companies, cash flow forecasts are often characterized by a period of operating losses, capital needs, and expected payoffs as profitability improves or some exit event, like an acquisition, occurs. Additionally, investors and analysts often consider multiple scenarios for early-stage companies both in terms of cash flows and exit outcomes (IPO, sale to a strategic or financial buyer, etc.), which can lead to the use of a probability weighted expected return model (PWERM) for valuation.

Putting it Together

Given their complexity, multiple valuation approaches and methods are often considered to provide lenses through which to assess value of InsurTech and FinTech companies and generate tests of reasonableness against which different indications of value can be evaluated.It is important to note that these different methods are not expected to align perfectly. Value indicators from the market approach can be rather volatile and investors often think longer-term. More enduring indicators from value can often come from income approaches, such as DCF models.

Valuation of an InsurTech company can be vital to measure realistic growth, to plan progression, and to secure employee and investor interest. Given the complexities in valuing privateFinTech and InsurTech companies and the ability for the market/regulatory environment to shift quickly, it is important to have a valuation expert who can adequately assess the value of the company and understand the prevalent market trends.

Credit Quality at a Crossroads

Last week, the Mercer Capital Bank Group headed south for a scenic trip through the fields of the Mississippi Delta, including the town of Clarksdale located about 90 miles from Memphis. Clarksdale’s musical heritage runs deep with such performers as Sam Cooke, John Lee Hooker, Son House, and Ike Turner born there, while Tennessee Williams spent much of his childhood there. Explaining the Delta’s prolific artistic output, Eudora Welty, a Mississippi writer, noted the landscape stretching to the horizon and the juxtaposition of societal elements – all these forces churning like the Mississippi river nearby.

Despite its gritty roots, Clarksdale now is experiencing its own hipster renaissance. It may not be Brooklyn, but the Bank Group noticed signs for last weekend’s Clarksdale Film Festival. Visitors can stay at a refurbished cotton gin, enjoying their Sweet Magnolia Gelato made from locally sourced ingredients. Presumably, craft cocktails are available as well, this being the Delta.

Beyond these recent additions to the tourist landscape, though, one attraction put Clarksdale on the map – the Crossroads. At the intersection of Highways 49 and 61, the bluesman Robert Johnson (who lived from 1911 to 1938), as the story goes, met the Devil at midnight who tuned his guitar and played a few songs. In exchange for his soul, Johnson realized his dream of blues mastery.

The point of this article is not that Lucifer lurked behind the revaluation of asset prices in the fourth quarter of 2018. Instead, the market gyrations laid bare the dichotomy between bank expectations regarding asset quality and the market’s view of mounting credit risk that was overlaid by a need to meet margin calls among some investors. Indeed, credit quality faces its own crossroads.

Highway 49

Along Hwy. 49 lies the town of Tutwiler, about 15 miles from Clarksdale. There, in 1903, the bandleader W.C. Handy heard a man playing slide guitar with a knife, singing “Goin’ where the Southern cross’ the Dog.” Handy adapted the song, which references the juncture of two railroads, thereby making it one of the first blues recordings.

From Call Report data, which includes 3,644 banks with total assets between $100 million and $5 billion, signs of credit quality deterioration remain virtually undetectable.

  • Loan growth continued apace in 2018, maintaining the community banking industry’s recent 10% annual growth rate (Figure 1, which shows the trailing twelve month change in loans). Notably, commercial real estate loan growth decelerated in 2018. Although this presumably pleases the regulatory agencies, competition from non-banks (e.g., insurance companies) and budding risks surrounding certain sectors (e.g., retail) likely explain the slowdown.
  • In absolute terms, nonperforming loans (nonaccrual loans plus loans more than 90 days past-due) declined in each year between 2014 and 2017 (Figure 2). As of September 30, 2018, however, NPLs increased by 4% over December 31, 2017, led by farmland NPLs (up 37%, or $258 million), agricultural production NPLs (up 32%, or $90 million), and commercial and industrial NPLs (up 8%, or $149 million). Given loan growth, though, the ratio of NPLs to loans continued to decline, falling slightly from 0.81% to 0.79% between December 31, 2017 and September 30, 2018.
  • Annualized charge-offs for the year-to-date period ended September 30, 2018 also compare favorably to the comparable prior year period, foreshadowing a possible post-recession low in the net charge-off ratio for fiscal 2018 (Figure 3).

    As they are wont to do, regulatory agencies noted some concerns regarding asset quality. However, consistent with our research into the community banking industry’s asset quality trends, the OCC also observed that “credit quality remains strong when measured by traditional performance metrics.”1 Despite its view of building credit risk, the OCC rated 95% of banks’ underwriting practices as satisfactory or strong in 2018, virtually unchanged from the 2017 level.2 Economic growth, corporate profits, and employment trends also support a sanguine view of credit quality.

    While also observing weaker underwriting – for example, covenant concessions – rating agencies predict better credit performance among leveraged loans and commercial mortgage backed securities in 2019. For 2019, Fitch Ratings projects a 1.5% leveraged loan default rate, down from 1.75% in 2018. Further, commercial mortgage-backed security delinquencies, which declined by 103 basis points to 2.19% between year-end 2017 and 2018, are expected to range between 1.75% and 2.00% in 2019. The Amazonification of the retail sector, which led to retail bankruptcies and defaults on loans secured by regional malls, contributed to higher delinquency and default rates in 2018 but may subside in 2019.

    The view from Hwy. 49, before reaching the Crossroads, looks favorable from the banking industry’s standpoint.

    Highway 61

    In the words of the writer David Cohn, the Mississippi Delta begins in the lobby of the Peabody Hotel (in Memphis) and ends on Catfish Row in Vicksburg, Mississippi.3 While his observation alludes to the economic as well as the geographic extremes of the Delta region, Highway 61 is the Delta’s spine connecting Cohn’s poles.

    One of the more concerning statistics is the level of corporate debt. Though household debt trended down following the Great Recession (see Figure 4), nonfinancial business debt has reached near record levels as a percentage of GDP.4 According to Morgan Stanley, BBB-rated corporate debt surged by 227% since 2009 to $2.5 trillion. This leaves approximately one-half of the investment grade corporate bond universe on the cusp of a high-yield rating. Moody’s migration data suggests that BBB-rated bonds have an 18% chance of being downgraded to non-investment grade within five years, which may overwhelm the high-yield bond market.5

    Regulatory agencies also observed looser underwriting. For new leveraged loans, the Federal Reserve noted that the share of highly leveraged large corporate loans – defined as more than 6x EBITDA – exceeds previous peak levels in 2007 and 2014, while issuers also are calculating EBITDA more liberally by making aggressive adjustments to reported EBITDA.6 From the OCC’s perspective, competitive pressures from banks and non-banks, along with plentiful investor liquidity, have led to weaker underwriting particularly among C&I and leveraged loans. According to the OCC, community banks are not immune. An example of weaker underwriting cited by the OCC is “general commercial loans, predominately in community banks” for which it compiles a list of shortcomings: “price concessions, inadequate credit analysis or loan-level stress testing, relaxed loan controls, noncompliance with internal credit policies, and weak risk assessments.”7

    Despite unemployment rates below 4% and some evidence of rising wages, consumer loan delinquency rates have risen in 2018 (Figure 5). Some lenders, such as Discover, already have begun reducing exposure to heated sectors like unsecured personal loans.

    Fears of a downturn crystallized in the fourth quarter of 2018 with the Federal Reserve’s December rate increase, trade friction with China, and signs of economic slowdowns in countries such as Germany. Option-adjusted spreads on corporate debt, after remaining quiescent through 2017 and most of 2018, widened suddenly, approaching levels last observed in 2016 when oil prices collapsed (Figure 6). According to Guggenheim, the fourth quarter spread widening implies a 3.2% high yield corporate debt default rate, up from 1.8% for 2018.8

    The perspective gleaned from Hwy. 61 is not necessarily alarming, but it does suggest that, directionally, risk is rising.

    The Crossroads

    Credit lies at a crossroads, consistent with a late cycle economic environment. Reported credit metrics are not improving significantly, nor are they worsening; conditions suggest continued low charge-offs and loan loss provisions in the nearterm. However, the market sniffs rising risks in various corners of the economy, most notably in corporate debt. Howlin’ Wolf sang, “Well I’m gonna get up in the morning // Hit the Highway 49.” Where are banks headed? Macroeconomic conditions ultimately will be determinative, but banks should avoid complacency in this environment marked by conflicting signals and aggressive competition. The poorest loans, in retrospect, often are originated in times such as these.

    End Notes

    1 OCC Semiannual Risk Perspective, Fall 2018, p. 1.

    2 OCC Semiannual Risk Perspective, Fall 2018, p. 22.

    3 Cohn, David, Where I Was Born and Raised, 1948.

    4 Federal Reserve, Financial Stability Report, November 2018, p. 18.

    5 Guggenheim Investments, Fixed Income Outlook, Fourth Quarter 2018, pp. 1 and 8.

    6 Federal Reserve, Financial Stability Report, November 2018, p. 20.

    7 OCC Semiannual Risk Perspective, Fall 2018, pp. 11 and 24.

    8 Guggenheim Investments, High Yield and Bank Loan Outlook, January 2019.

Creativity in Financial Elements of a Collaborative Divorce

This presentation was delivered by Scott A. Womack, ASA, MAFF and Cheryl C. Panther, CPA/PFS, ADFA/CDFA (Panther Financial Planning) 19th Annual Networking and Educational Forum hosted by the International Association of Collaborative Professionals.

This session, “Creativity in Financial Elements of a Collaborative Divorce,” is described below.

Financial creativity is not just for financial professionals. We will highlight actual case examples of how to strategically and efficiently use outside professionals and unique ways to utilize financial information. We’ll provide ideas that professionals from all disciplines can take back to their local practice groups.

Lifestyle / Pay & Need Analysis

This presentation was delivered by Karolina Calhoun, CPA/ABV/CFF at the AICPA 2018 Forensic & Valuation Services Conference.

Learning objectives include:

  • Identify and Classify Assets & Liabilities to include on marital and separate balance sheets:
    • Examine documentation and accuracy of the support
  • Assemble relevant information:
    • Current accounts (bank, brokerage) vs long-term compensation accounts (401k, pensions, etc.)
  • Evaluate monthly budget for each spouse:
    • Compare/contrast spouse’s budgets
  • Evaluate the payor’s ability to support and the payee’s need for support:
    • Lifestyle analysis comes into play here as the historical expenses may be used as a basis for monthly budget, however, depending on the finances, may or may not be supported post-divorce
    • Lifestyle analysis also provides the ability to measure the division of net worth at date of divorce and future net worth accumulation over time

2019 Outlook: Gasping for Air Replaces 2018’s Rainbow Chasing

What a difference a year makes. A year ago corporate tax reform had been enacted that lowered the top marginal tax rate to 21% from 35%. Banks were viewed as one of the primary beneficiaries through a reduction in tax rates and a pick-up in economic growth. Now investors are questioning whether bank stocks and other credit investments are canaries in the U.S. economic coalmine.

As 2018 draws to a close, bank fundamentals are very good; however, bank stock prices have tanked. SNL Financial’s small-, mid-, and large-cap bank indices have fallen by more than 20% since August 31, which meets the threshold definition of a bear market (i.e., down 20% vs. 10% for a correction).

Markets, of course, lead fundamentals, and corporate credit markets lead equity markets. Among industry groups, bank stocks are “early cyclicals”, meaning they turn down before the broader economy does and tend to turn up before other sectors when recessions bottom.

Large cap banks peaked in February while the balance of the industry peaked in the third quarter after having a fabulous run that dates to the national elections on November 8, 2016. The downturn in bank stock prices corresponds with weakening home sales, widening credit spreads in the leverage loan and high yield bond markets, a ~40% reduction in oil prices, and a nearly inverted Treasury yield curve.

To state the obvious: markets—but not fundamentals so far—are signaling 2019 (and maybe 2020) will be a more challenging year than was assumed a few months ago in which the economy slows and credit costs rise. The key question for 2019 then is: how much and is a slowdown fully priced into stocks?

Our next issue of Bank Watch will entail a deep dive into credit, but for this issue, we observe that a global unwind of leverage is underway as the Fed extracts liquidity from the system. Bond buying (QE) and ultra-low rates helped drive asset prices higher. The reverse is proving true, too.

Bank Fundamentals

Bank fundamentals are in good-to-great shape. During the third quarter all FDI-Cinsured institutions reported aggregate net income of $62 billion, up 29.3% from 3Q17. Excluding the impact of lower taxes, 3Q18 pro forma net income would have been about $55 billion, up 13.9% from 3Q17. The data is more nuanced once the industry is segregated by asset size, however.

As shown in Figure 3, ROA and ROE have nearly rebounded to the last pre-crisis year of 2006. Importantly, capital has increased significantly and, thereby, provides an additional buffer whenever the next downturn develops.

As it relates to 2019, bank fundamentals are not expected to change much other than credit costs are expected to increase from a very low level in which current loss rates in all loan categories are below long-term averages. Wall Street consensus EPS estimates project mid-single digit EPS growth for the largest banks, primarily as a result of share repurchases and a slightly higher full year NIM, while regional and community bank consensus estimates reflect upper single digit EPS growth from the same factors and somewhat better loan growth.

However, credit and equity markets imply the consensus is too high given the sharp widening in credit spreads and drop in bank stock prices the past several months. Although markets lead fundamentals, market signals about magnitude are less clear. Given continuing growth in the U.S. economy that on balance will be helped by lower oil prices, it seems reasonable that an increase in credit costs the market is forecasting will be modest, and as a result, bank profitability will not be meaningfully crimped in 2019.

The Fed: 2019 Rate Hikes Seem Unlikely

Whenever the Fed embarks on an extended rate hiking campaign, the saying goes the Fed hikes until something breaks. The market is signaling that the December rate hike—the ninth in the current cycle—that pushed the Fed Funds target from 2.25% to 2.50% when the yield on the 10-year UST bond was ~2.8% may be one of those moments. What’s unusual about the current tightening cycle is it represents an attempt by the Fed (but not the BOJ, ECB or SNB) to extract itself from radical monetary policies in which the Fed is raising short-term rates and shrinking its balance sheet at the same time.

Given the flat yield curve, it is hard to see how the Fed will hike the Fed Funds another couple of times as planned for 2019, unless the Fed wants to invert the yield curve or unless intermediate- and long-term rates reverse and trend higher. Presumably the $50 billion a month pace in the reduction of its US Treasury and Agency MBS portfolio will continue. Alternatively, perhaps the Fed will bow to the market and not raise rates in 2019 and slow or even halt the reduction in its balance sheet to stabilize markets.

As it relates to bank fundamentals, the impact on net interest margins will depend upon individual bank balance sheet compositions. Broadly, however, a scenario of no rate hikes implies less pressure to raise deposit rates, and rising wholesale borrowing rates should stabilize. The result, therefore, should be a little bit better NIMs than a slight reduction if the Fed continues to hike given that deposit rate betas for many institutions are well over 50% now. More important for banks if the Fed pauses vs continues to hike would be the impact on asset values (higher all else equal) and, therefore, credit costs.

Bank Valuations: Support but Never a Stand-Alone Catalyst

A synopsis of bank valuations is presented in Figure 4 in which current valuations for the market cap indices are compared to the approximate market top around August 31, November 8, 2016 when the national election occurred, and multi-year medians based upon daily observations. An important point is that valuation is not a catalyst to move a stock; rather, valuation provides a margin of safety (or lack thereof) and thereby can provide additional return over time as a catalyst such as upward (or downward) earnings revisions can cause a multiple to expand or contract.

Bank stocks—particularly mid-cap and large-cap banks—enter 2019 relatively inexpensive to history. The stocks are cheap relative to 2019 consensus earnings with large cap banks trading around 8x and small cap banks at 10x; however, the market’s message is that the estimates are too high. It is hard to envision that estimates are dramatically too high as proved to be the case in 2008 unless the economy is poised to roll-over hard, which seems unlikely. Assuming no recession or a shallow recession, then, the modest valuations may result in bank stocks having a good year even if fundamentals weaken and analysts cut estimates because the limited downside in earnings had been adequately priced into the stocks by late December.

Bank M&A: Slowing Activity for 2019 Likely

Outwardly, 2018 has been another good year for bank M&A even though activity slowed in the fourth quarter. There were few notable deals other than Fifth Third’s pending acquisition of Chicago-based MB Financial valued at $4.8 billion at announcement and Synovus Financial’s pending acquisition of Boca Raton-based FCB Financial Holding valued for $2.8 billion at announcement. Even before bank stocks rolled over the shares of both Fifth Third and Synovus severely underperformed peers as investors questioned the exchange ratios, cost saving assumptions, credit risk (especially at FCB), and whether the buyers could keep the franchises intact as key personnel defected elsewhere.

The national average price/tangible book multiple expanded to 173% from 166% in 2017 and about 140% in 2014, 2015 and 2016 before the sector was revalued in the wake of the national election. The median P/E of 25x was within the five-year range of 21x to 28x.

The total number of bank and thrift transactions through December 24 totaled 261, which equated to 4.4% of the commercial bank and thrift charters as of year-end 2017. During 2014–2018, the number of acquisitions exceeded 4% each year except for 2016 when activity at the beginning of the year was hampered by weak stock prices as a result of a slowing economy that was marked by a collapse in oil prices and sharply wider credit spreads.

Weak bank stock prices crimp the ability to negotiate deals because most sellers are focused on absolute price rather than relative value when taking the buyer’s shares as consideration; and, buyers usually are unwilling to increase the number of shares being offered given a limitation on minimum acceptable EPS accretion and maximum acceptable TBVPS dilution. A notable late year exception occurred when Cadence Bancorporation opted to increase the number of shares it will issue to State Bancorp by 9.6% because the double trigger in the merger agreement signed during May when Cadence’s share price was much higher came into play.

Although there is no change in the driver of consolidation such as succession issues, shareholder liquidity needs, and economies of scale, a slowdown in M&A activity in 2019 is likely because bank stocks will enter the year depressed. Deals that entail some amount of common share consideration will be tough to structure unless sellers will be willing to take less, which most will not do with operating fundamentals in good shape for now. All cash deals will be impacted less, but all cash deals are more prevalent among very small institutions in which pricing usually occurs at a discount to those that entail some proportion of common shares.

Summing It Up

The market is shouting fundamentals will weaken in 2019 after a long period of gradual improvement following the Great Financial Crisis, which most likely will be reflected in sluggish loan growth and modestly higher credit costs; however, bank stocks may surprise to the upside as they did to the downside in 2018 provided a) there is no recession or a shallow one; and, b) the Fed relents and does not hike further and potentially slows the run-off of its excess bonds (and liability reserves). For clients of Mercer Capital who obtain year-end valuations, rising stock prices since the presidential election may be reversed partially, given the compression in market price/earnings and price/tangible book value multiples that occurred in 2018.

Adjusted Earnings and Earning Power as the Base of the Valuation Pyramid

The extensive use of core versus reported earnings by public companies has been a widespread phenomenon for at least 25 years. During the past decade, the practice also has become widespread among companies (and their bankers who market deals) that are issuing debt in the leverage loan and high yield markets.

The practice is controversial. The SEC periodically will crack down on companies it thinks are pushing the envelope. Bank regulators have raised the issue of questionable adjustments to borrowers’ EBITDA for widely syndicated leverage loans.

Investors are aware of the issue, too, but have not demanded the practice to stop. In mid-2017, I attended a conference on private credit. One session dealt exclusively with adjusted EBITDA. One panelist offered that adjustments in the range of 5-10% of reported EBITDA were okay, but the consensus was the adjustments were out of control. Covenant Review reported that as of mid-2017 the average leverage for middle market LBOs over the prior two years was 5.5x based upon the target’s adjusted EBITDA compared to reported EBITDA of ~7x. The issue is no better, and perhaps worse, in 2018 judging from market sentiment.

If investors are solely relying upon company defined adjusted EBITDA, then they may be vacating their fiduciary duties when investing capital. That said, an analysis of core versus reported earnings is a critical element of any valuation or credit assessment of a non-early stage company with an established financial history.

Table 1 below provides a sample overview of the template we use at Mercer Capital. The process is not intended to create an alternate reality; rather, it is designed to shed light on core trends about where the company has been and where it may be headed.

Adjustments

Adjustments typically consist of items that are non-recurring, unusual, and infrequent. They also may entail elements for a change in business operations, such as the addition of a new product or the discontinuation of a division. This is where judgment is particularly important because we have noticed a trend among some investors to credit businesses with future earnings for initiatives such as stepped-up hiring of revenue producers in which a favorable outcome is highly uncertain.

Minority vs. Control

Adjustments considered should take into account whether the valuation is on a minority interest or controlling interest basis. An adjustment for an unusual litigation expense will not be impacted by the level-of-value; however, other potential adjustments—particularly synergies a buyer could reasonably be expected to realize would only apply in a control valuation.

Core Trends vs. Peers

The development of the adjusted earnings analysis should allow one to identify the source of revenue growth and the trend in margins through a business cycle. The process also will facilitate comparisons with peers both historically and currently to thereby make further qualitative judgments about how the business is performing.

Out Year Budget vs. Adjusted History

The adjusted earnings history should create a bridge to next year’s budget, and the budget a bridge to multi-year projections. The basic question should be addressed: Does the historical trend in adjusted earnings lead one to conclude that the budget and multi-year projections are reasonable with the underlying premise that the adjustments applied are reasonable?

Core Earnings vs. Ongoing Earning Power

Core earnings differ from earning power. Core earnings represent earnings after adjustments are made for non-recurring items and the like in a particular year. Earning power represents a base earning measure that is representative through the firm’s (or industry’s) business cycle and, therefore, requires examination of adjusted earnings ideally over an entire business cycle. If the company has grown such that adjusted earnings several years ago are less relevant, then earning power can be derived from the product of a representative revenue measure such as the latest 12 months or even the budget and an average EBITDA margin over the business cycle.

Platform Companies/Roll-Ups

Companies that are executing a roll-up strategy can be particularly nettlesome from a valuation perspective because there typically is a string of acquisitions that require multiple adjustments for transaction related expenses and the expected earnings contribution of the targets. The math of adding and subtracting is straightforward, but what is usually lacking is seasoning in which a several year period without acquisitions can be observed in order to discern if past acquisitions have been accretive to earnings. Public market investors struggle with this phenomenon, too, but often the high growth profile of roll-ups will trump questions about earning power and what is an appropriate multiple until growth slows.

Income and Market-Based Valuation Approaches

In addition to providing insight into how a business is performing, the adjusted earnings statement will “feed” multiple valuation methods. These include the Discounted Cash Flow and Single Period Earning Power Capitalization Methods that fall under the Income Approach, and the Guideline (Public) Company and Guideline (M&A) Transaction Methods that constitute Market Approaches.

It may be obvious, but we believe an analysis of adjusted (and reported) earnings statements for a subject company over a multi-year period is a critical, if not the critical element, in valuing securities that are held in private equity and credit portfolios. Mercer Capital has nearly 40 years of experience in which tens of thousands of adjusted earnings statements have been created. Please call if we can help you value investments held in your portfolio.


Originally published in Mercer Capital’s Portfolio Valuation Newsletter.

Value Drivers of a Store Valuation

Auto dealers, like most business owners, are constantly wondering about the value of their business. It’s easy to see how this issue moves to the forefront around certain events such as a transaction, buy-sell agreement, litigation, divorce, wealth-transfer event, etc. As our previous article “Six Different Ways to Look at a Dealership” points out, there are many other instances when a dealer can evaluate the condition, progress, or value of their store. Dealers can actually influence the value of their store prior to these obvious events by understanding the value drivers of a store valuation and addressing them on a consistent basis. So what are some of the value drivers of a store valuation?

Franchise

A store’s particular franchise affiliation has a major impact on value. Each franchise has a different reputation, selling strategy, target consumer demographic, etc. Public and value perception of franchises can be unique and are most easily illustrated through blue sky multiples. As the Haig Report and Kerrigan’s Blue Sky Report indicate, these blue sky multiples can vary over time and from period to period. Often stores and franchises are grouped into broader categories, such as: luxury franchises, mid-line franchises, domestic franchises, import franchises and/or high line franchises.

Real Estate/Quality of Facilities

Typically, most store locations and dealership operations are held in one entity, and the underlying real estate is held by a separate, often related, entity. Several issues with the real estate can affect a store valuation. First, an analysis of the rental rate and terms should be performed to establish a fair market value rental rate. Since the real estate is often owned by a related entity, the rent may be set higher or lower than market for tax or other motivations that would not reflect fair market value. Second, the quality and condition of the facilities are crucial to evaluate. Most manufacturers require facility and signage upgrades on a regular basis, often offering incentives to help mitigate these costs. It’s important to assess whether the store has regularly complied with these enhancements and is current with the condition of their facilities.

Employees/Management

The quality and depth of management can have a positive impact on a store valuation. Stores with greater management depth and less dependence on several key individuals will generally be viewed as less risky by an outside buyer. Also, a store’s CSI (Customer Service Index) and SSI (Service Satisfaction Index) rating can also influence incentives from the franchise and the overall perception of the consumer. A strong CSI and SSI are also a reflection of a strong service department and a commitment to quality customer service.

Recent Economic Performance

Like most industries, the auto industry is dependent on the national economy. We report later on the current SAAR (Seasonally Adjusted Annual Rate) which is an indicator of economic performance and future sales in the auto industry. Current conditions of rising interest rates and a leveling out of the SAAR compared to October 2017 could be predictors of stabilizing values and less activity in the M&A market in the months to come. In addition to monitoring and understanding the current month’s SAAR, the longer-term history of the SAAR and its trends also provide insight into the auto industry and a store valuation. Below is a long-term graph of the SAAR from 2000 to 2017.

This visual evidence demonstrates the cyclicality of the auto industry. Unlike some industries that may be seasonal or cyclical in a given year, the auto industry tends to be cyclical over a longer period of several years. For instance, it’s common for a store to have stronger volumes and profitability for a period of 4-5 years, before experiencing a sluggish year or two. Store valuations should consider the cyclicality of the industry and not overvalue a store during a strong year, or undervalue it during a sluggish year.

Another indicator of economic performance is an analysis of the auto cycle and where we are in that cycle based upon the average age of cars owned. The figure below illustrates the peak and trough of the auto cycle and where we sit today.

A store’s value and performance can be greatly influenced by the local economy as well as the national economy–sometimes more so. Certain markets are dominated by local economies of a certain trade or industry. Examples can be store locations near oil & gas refining areas, mining areas, or military bases. Each is probably more dependent on local economy conditions than national economy conditions.

Buyer Demand

Buyer demand in the transaction market can illustrate the value climate for store valuations. Typically, buyer demand is measured by the deal activity in the M&A market. The Haig Report indicated that the second quarter of 2018 transaction activity increased by 87% compared to second quarter of 2017. Further, the activity for the first six months of 2018 increased by 23% over the same six months of 2017. Similarly, Kerrigan’s figures reflect an increase in M&A activity of 13% in the first six months of 2018 compared to their data for the first six months of 2017.

Location/Market

The value of a store location can be more complex than urban vs. rural or major metropolitan city vs. minor metropolitan city. Each store location is assigned a certain area or group of zip codes referred to as an “area of responsibility” or “AoR”. Particularly, how does a location’s demographic characteristics line up with a certain franchise? For example, a high line store would perform better and seemingly be more valuable in a major metropolitan area with a high median income level, such as Beverly Hills or South Beach in Miami than in a mid western city. Conversely, mid-line stores would probably fare better in areas with more moderate median income levels.

Single-Point vs. Over-Franchised Market

The amount of competition in a store’s AoR, as well as the nearest location of a similar franchised store can also have an impact. It’s important to make the distinction that we are talking about a market and not a single-point store. A single-point market refers to a market where there is only one store of a particular franchise. An over-franchised market would be a larger market that may contain several stores of a particular franchise within a certain radius. Often, a store in a single-point market would be viewed as more valuable than one in an over-franchised market that would be competing with its own franchise for the same consumers. Additionally, the stores of the same franchise in the same market could be drastically different in size. One may be part of a larger auto group of stores, while the other may be a single-point dealership location, meaning its owner only owns that one location.

Conclusions/Observations

As we’ve discussed, the value of a store can be influenced by a variety of factors. Some of the factors are internal and can be affected by the owner, and some are external and are out of the control of the owner. To find out the value of your store, contact one of the automotive industry professionals at Mercer Capital.


Originally published in the Value Focus: Auto Dealer Industry Newsletter, Mid-Year 2018.

Six Different Ways to Look at a Dealership

Along the road to building the value of a dealership, it is necessary and appropriate to examine the dealership in a variety of ways. Each provides unique perspective and insight into how a dealer is proceeding along the path to grow the value of the dealership and if/when it may be ready to sell. Most dealers realize the obvious events that may require a formal valuation: potential sale/acquisition, shareholder dispute, death of a shareholder, gift/estate tax transfer of ownership, etc. A formal business valuation can also be very useful to a dealer when examining internal operations.

So, how does a dealer evaluate their dealership? And how can advisers or formal business valuations assist dealers examining their dealership? There are at least six ways and they are important, regardless of the size. All six of these should be contemplated within a formal business valuation.

  1. At a Point in Time.  The balance sheet and the current period (month or quarter) provide one reference point. If that is the only reference point, however, one never has any real perspective on what is happening to the dealership.
  2. Relative to Itself Over Time. Dealerships exhibit trends in performance that can only be discerned and understood if examined over a period of time, often years.
  3. Relative to Peer Group. Many dealers participate in 20 groups. Among other things, the 20 groups can provide statistics that offer a basis for comparing performance relative to other dealerships.
  4. Relative to Budget or Plan. Every dealer of any size should have a budget for the current year. The act of creating a budget forces management to make commitments about expected performance in light of a company’s position at the beginning of a year and its outlook in the context of its local economy, industry and/or the national economy. Setting a budget creates a commitment to achieve, which is critical to achievement. Most financial performance packages compare actual to budget for the current year.
  5. Relative to Your Unique Potential. Every dealer has prospects for “potential performance” if things go right and if management performs. If a dealership has grown at 5% per year in sales and earnings for the last five years, that sounds good on its face. But what if similar locations have been growing at 10% during that period?
  6. Relative to Requirements by Franchise. Increasingly, dealerships are subject to requirements by the franchise including facility enhancements, working capital levels, CSI and SSI ratings, sales volumes, profitability, etc.

Why is it important to evaluate a dealership in these ways? Together, these six ways provide a unique way for dealers and key managers to continuously reassess and adjust their performance to achieve optimal results. A formal business valuation can communicate the dealership’s current position in many of these areas. Successive, frequent business valuations allow dealers and key managers the opportunity to measure and track the performance and value of the dealership or over time against stated goals and objectives.


Originally published in the Value Focus: Auto Dealer Industry Newsletter, Mid-Year 2018.

Valuing an eSports Team

The value of a company is generally dependent on three factors: risk, growth, and cash flow. Esports teams have an abundance of risk as well as growth potential. Considering eSports is a relatively new industry, the growth potential is huge. At the same time, and for the same reason, there is significant risk in the industry – it is too early to know if there is a proven, sustainable, cash flow generating business model.

Risk

Sustainability is one of the key risk factors for eSports teams. Viewer interest in games changes rapidly as new games are released. For the week of September 4, 2017, PLAYERUNKNOWNS’S BATTLEGROUNDS (“PUBG”) was the most viewed game with 112,741 average Twitch viewers. League of Legends (94,940) and Hearthstone (58,427) completed the top three. One year later, for the week of September 3, 2018, Fortnite led the way with 163,303 viewers while Counter-Strike: Global Offensive (129,580), and League of Legends (109,210) completed the top three. Hearthstone dropped to 36,849 average Twitch viewers for the week and PUBG dropped to 33,877 average Twitch viewers. Tracking viewership trends and competing in games that are popular is an important skill for teams that want to maintain relevance. Team Liquid’s CEO, Steve Arhancet, indicated the team looks for multiplayer games that have a thriving competitive community and are enjoyable to watch and play. Game publishers are another source of risk for eSports teams. The soon to be started Overwatch League (“OWL”) has a total buy-in price of $20 million split among its 20 teams. The high up-front cost to participate in the league has made some teams avoid the league.

Esports teams also have risks related to their players. Since eSports is not yet an established industry, there is not a set protocol for player contracts that allows teams to keep players for a long period of time. In addition, eSports teams must consider team dynamics when assembling a roster much like other professional team sports such as basketball, football, or hockey. If an eSports team does not have chemistry, it is unlikely they will perform at a high level. Frisco, Texas based eSports team CompLexity cited roster instability as a reason they dropped their Overwatch team.

Growth

As shown in the chart below, the industry has been growing rapidly over recent years.

Esports industry research firm NewZoo projects 380 million total viewers in 2018, with 57% of those classified as frequent viewers/enthusiasts and 43% classified as occasional viewers. The compound annual growth rate of total viewers is projected to be 13.55% from 2017 to 2021.

Another area where growth can be observed is the prize pool for major eSports tournaments. For example, The International 8, held in 2018 set a record for the largest single tournament prize pool in eSports history for the fifth consecutive year at $25.5 million. Prior iterations of The International had prize pools as shown in Figure 2. The compound annual growth rate of the prize pool from 2014 to 2018 was 24%.

Newzoo defines industry revenue as the amount generated through the sale of sponsorships, media rights, advertising, publisher fees, tickets, and merchandising. Global eSports revenues are projected to reach $906 million in 2018. North America is projected to account for approximately 38% ($345 million) of global eSports revenue in 2018. As shown in Figure 3, global revenue for eSports is projected to reach $1.65 billion in 2021.

Cash Flow

Mercer Capital’s “eSports Business Models” shows how eSports teams make money and the costs of revenue associated with those income streams. Generally speaking, eSports teams have the following sources of revenue: sponsorships, broadcast revenue, merchandise sales, prize money, and naming rights. Costs of revenue include: player salaries, administrative personnel salaries, player housing expenses, training facility rent or operating expense, travel costs, and equipment/accessory expense. In broad terms, cash flow is calculated by subtracting operating expenses from total revenue.

Revenue can have different tiers of riskiness. For example, recurring revenue from sponsorships and subscriptions is less risky than merchandise sales or prize money. All else equal, teams with a higher ratio of recurring revenue to non-recurring revenue are considered less risky than a team with more non-recurring revenue than recurring revenue. Teams with lower risk cash flow are considered more valuable than teams with riskier cash flow.

Valuing an eSports Team

There are three approaches to value that are used or considered in any valuation. The three approaches to value are the cost approach, the income approach, and the market approach. This section walks through how an eSports team would be valued using each approach. Usually, valuation firms weight indications from each approach to arrive at a final conclusion of value.

Cost Approach

The cost approach is applied by adjusting the subject entity’s assets and liabilities to market value. Liabilities are then subtracted from assets to arrive at net asset value. A typical eSports team would have mostly intangible assets such as players. Tangible assets would be training facilities or team headquarters owned by the team. The cost approach, in many instances, would be weighted lightly, if at all, because it does not fully account for intangible assets.

Income Approach

The income approach is applied by calculating the cash flow either for a single period or for a projected multi-year period. At this stage, multi-year projections that account for potential growth will be the most common method employed. Capitalization at this point would be less likely to be used as growth has not stabilized within the industry. The risk and growth factors that would be considered for an eSports team will be the lynchpin to reasonably and properly measuring value. For an operating eSports team, the income approach would most likely be the heaviest weighted indication in a conclusion of value.

Market Approach

The market approach is similar to the income approach in that some element of cash flow is capitalized by some factor. However, in the market approach the capitalization factor is estimated using multiples indicated by public companies or transactions of private companies in the same or similar lines of business as the subject company. The market approach could be difficult to apply to an eSports team because, even though teams operate in the same general industry of eSports, there are many unique factors to each team. Within the market approach, cash flow, the capitalization factor(s)/multiple(s), or both may be adjusted based on how the subject team compares to the teams selected in the market approach. As the industry matures and more transactions occur, the market approach will develop alongside the industry.

Conclusion

In summary, eSports teams are valued using three methods: the cost approach, the market approach, and the income approach. Each of the methods considers three primary factors: risk, growth, and cash flow. Each eSports team is unique and there is no single formulaic way to value a team. However, in general, eSports teams will likely be valued using their historical and projected cash flows in the income approach. As the industry develops and matures there will be more transactions within the industry which will allow the market approach to become a more widely used tool.


Originally published in Mercer Capital’s Valuing an eSports Team whitepaper.

Control Issues in ESOP Purchase Transactions

Tim R. Lee, ASA delivered the presentation, “Control Issues in ESOP Purchase Transactions” at the 2018 Las Vegas ESOP Conference and Trade Show hosted by The ESOP Association (November 8-9, 2018).

A description of Tim’s session can be found below:

Many ESOP purchase transactions are made on a controlling interest valuation basis. However, as has been highlighted in DOL investigations and ESOP litigation, whether an ESOP has “control” is not always a crystal clear issue. In addition, the Appraisal Foundation has recently published its MPAP paper which addresses specific factors to consider, including but not limited to the company’s cash flows, when valuing a company on a controlling interest basis. This advanced session will explore several issues around the topic of control, including what “paying for control” really means, appropriate post transaction corporate governance and how control rights are reflected in an ESOP appraisal.

6 Ways to Look at a Business

Along the road to building the value of a business it is necessary, and indeed, appropriate, to examine the business in a variety of ways. Each provides unique perspective and insight into how a business owner is proceeding along the path to grow the value of the business and if/when it may be ready to sell. Most business owners realize the obvious events that may require a formal valuation: potential sale/acquisition, shareholder dispute, death of a shareholder, gift/estate tax transfer of ownership, etc. A formal business valuation can also be very useful to a business owner when examining internal operations.

So, how does a business owner evaluate their business? And how can advisers or formal business valuations assist owners examining their businesses? There are at least six ways and they are important, regardless of the size of the business. All six of these should be contemplated within a formal business valuation.

  1. At a Point in Time. The balance sheet and the current period (month or quarter) provide one reference point. If that is the only reference point, however, one never has any real perspective on what is happening to the business.
  2. Relative to Itself over Time. Businesses exhibit trends in performance that can only be discerned and understood if examined over a period of time, often years.
  3. Relative to Peer Groups. Many industries have associations or consulting groups that publish industry statistics. These statistics provide a basis for comparing performance relative to companies like the subject company.
  4. Relative to Budget or Plan. Every company of any size should have a budget for the current year. The act of creating a budget forces management to make commitments about expected performance in light of a company’s position at the beginning of a year and its outlook in the context of its local economy, industry and/or the national economy. Setting a budget creates a commitment to achieve, which is critical to achievement. Most financial performance packages compare actual to budget for the current year.
  5. Relative to your Unique Potential. Every company has prospects for “potential performance” if things go right and if management performs. If a company has grown at 5% per year in sales and earnings for the last five years, that sounds good on its face. But what if the industry niche has been growing at 10% during that period?
  6. Relative to Regulatory Expectations or Requirements. Increasingly, companies in many industries are subject to regulations that impact the way business can be done or its profitability.

Why is it important to evaluate a company in these ways? Together, these six ways of examining a company provide a unique way for business owners and key managers to continuously reassess and adjust their performance to achieve optimal results.

A formal business valuation can communicate the company’s current position in many of these areas. Successive, frequent business valuations allow business owners and key managers the opportunity to measure and track the performance and value of the company over time against stated goals and objectives.


Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Third Quarter 2018

How to Determine Whether an Asset and Its Appreciation is Marital or Separate Property

Under Tennessee law, marital property is subject to property division and separate property is excluded from property division in a divorce. The underlying factor in this distinction is whether the increase in value between the date of marriage and the date of divorce resulted from efforts by a spouse, known as active appreciation, or from external (economic, market, industry) forces, known as passive appreciation. While these concepts seem simple, the classifications are only part of the story.

Classification of Marital and Separate Property

Tennessee Code 36-4-121 defines marital property as “all real and personal property, both tangible and intangible, acquired by either or both spouses during the course of the marriage up to the date of the final divorce hearing.”

The same code section defines separate property as “all real and personal property owned by a spouse before marriage, property acquired in exchange for property acquired prior to marriage, property acquired by a spouse at any time by gift, bequest, devise or descent, etc.”

Can a Marital Asset Ever Become Separate or Can a Separate Asset Ever Become Martial?

Let’s examine this question in the context of a business or business interest as an example. If a couple or spouse starts a business or acquires a business interest during the marriage, then it would be classified as marital. Any appreciation or increase in value of the business or business interest would also be classified and remain a marital asset.

Conversely, if a spouse starts a business or business interest prior to the date of marriage or acquires it by gift, bequest, devise or descent, then initially that business or business interest would be classified as a separate asset. What happens to that business or business interest if the value changes during the marriage? The increased value or appreciation of a business or business interest could be classified as marital or separate. How is this possible?

If both spouses contribute to the preservation and appreciation of a separate property business or business interest and the contribution is “real” and “significant,” then the appreciation (increase in value) of the business or business interest would be determined to be a marital asset and subject to division. This is known as active appreciation.

If, on the other hand, both spouses do not contribute to the appreciation in value, there is no appreciation in value, or the appreciation is attributable to passive forces, such as inflation, then the separate property business or business interest would remain separate.

The following steps assist the financial analyst during the process:

  1.  Is the business, or business interests, marital or separate?
      1. a. Compare the formation or inheritance date(s) to date of marriage.
  2. If the answer to (1) concludes pre-marital, separate property, value the business as of the date of marriage as a starting point. Then, value the business as of the date of divorce (or as close to as possible).
  3. If the value has increased from the date of marriage to the date of divorce, a determination of active (marital) versus passive (separate) shall commence.

What Must Be Demonstrated

Tennessee code states that the substantial contribution of the non-business spouse “may include, but not be limited to, the direct or indirect contribution of the spouse as a homemaker, wage earner, parent or financial manager, together with such other factors as the court having jurisdiction thereof may determine.”

A non-business owner spouse must be able to demonstrate two things in order for appreciation of a separate property business or business interest to become a marital asset: substantial contribution of both spouses contributing to the appreciation,and actual appreciation in the value of the business or business interest during the marriage. Most often, a valuation of the business or business interest at the date of marriage and also the date of filing would be required among other things to try and support this claim.

This article has used a business or business interest to illustrate the concepts of martial vs. separate assets and also the appreciation in value. It should be noted that there could be potentially other considerations for these same issues with other assets, such as investment properties or passive assets (401Ks, etc.).

Conclusion

A financial expert, specifically one with expertise in business valuation, is vital in the determination of active appreciation (separate) versus passive appreciation (marital).

The professionals of Mercer Capital can assist in the process. For more information or discuss an engagement in confidence, please contact us.


Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Third Quarter 2018

Valuation Tax Panel

This presentation was delivered by Z. Christopher Mercer, FASA, CFA, ABAR at the AICPA 2018 Forensic & Valuation Services Conference.

A short description of the presentation can be found below:

How substantial is tax reform’s effect on business valuation? There has been a lot of discussion and interest in the new TCJA especially, but how has this changed the way we think about valuation. The panel will discuss different views on tax reform related to valuation modeling, forecasting, and subjective assumptions used when considering the TCJA.

Learning objectives include:

  • Understand the various implications of the TCJA on pass through entity valuations
  • Explore the effect on public company and transaction multiples post TCJA
  • Review best practices with model considerations in light of sunset provisions
  • Learn the effect of bonus depreciation and interest expense limitations

Active Passive Appreciation – Current Update

This presentation, delivered by Z. Christopher Mercer, FASA, CFA, ABAR at the AICPA 2018 Forensic & Valuation Services Conference, covers when and why an active passive analysis is needed, how these analyses are typically done, and the importance of working with engaging counsel for jurisdictional nuances.

Learning objectives include:

  • Understand the key elements involved in an active passive analysis
  • Update of current practice and understand how active passive analyses are typically done around the country
  • Discussion of jurisdictional nuances

Views from the Road: What Do Community Banks, FinTech, and Buffalo Have in Common?

In the last few weeks, I presented at two events geared towards helping community banks achieve better performance: the Moss Adams Community Banking Conference in Huntington Beach, California and the FI FinTech Unconference in Fredericksburg, Texas. The FI FinTech Unconference had a recurring visual theme of the buffalo, which struck me as an insightful image for a FinTech conference.

Much of the discussions at both conferences focused on the ability of community banks to adapt, survive, and thrive rather than thin out like the once massive North American buffalo herd. Both events had several presentations and discussions around FinTech and the need for community banks to evolve to meet customer expectations for improved digital interactions. Beyond thinking that I will miss the great views and weather I had for both trips, I came away with a few questions bankers should consider.

How Can Community Banks Compete with Larger Banks?

Larger banks are taking market share from smaller banks and have been gathering assets and deposits at a faster pace than community banks (defined as banks with less than $10 billion of assets) the last few decades. For example, banks with assets greater than $10 billion controlled around 85% of assets in mid-2018 compared to 50% in 1994. This is a significant trend illustrating how much market share community banks have ceded. Further, larger banks are producing higher ROEs, largely driven by higher levels of non-interest income (~0.90% of assets vs ~0.55%) and better operating leverage as measured by the efficiency ratio (~59% vs ~66%). The larger banks may widen their lead, too, given vast sums that are being spent on digital enhancements and other technology ventures to improve the client experience.

Can FinTech Serve as a Value Enhancer and Help Community Banks Close the Performance Gap with Larger Banks?

Most community banks are producing an ROE below 10%—an inadequate return for shareholders despite low credit costs. As a result, the critical role that a community bank fills as a lender to small business and agriculture is at risk if the board and/or shareholders decide to sell due to inadequate returns. Confronting this challenge requires the right team executing the right strategy to produce competitive returns for shareholders. FinTech solutions, rather than geographic expansion through branching and acquisitions, may be an option if FinTech products and processes can address areas where a bank falls short (e.g., wealth management).

Can Community Banks Hold Ground and Even Win the Fight for Retail Deposits?

Many community bank cost structures are wed to physical branches while customers— especially younger ones—are increasingly interacting with institutions first digitally and secondarily via a physical location. This transition is occurring at a time when core deposits are increasing in value to the industry as interest rates rise. In response, several larger banks, such as Citizens Financial, have increased their emphasis on digital delivery to drive incremental deposit growth. Additionally, as funding costs increase, some FinTech companies are being forced to consider partnerships with banks. Thus far, the digital banking push and the formal partnering of FinTech companies and banks are incremental in nature rather than reflective of a wholesale change in business models. Nonetheless, it will be interesting to see whether community banks can adapt and effectively use technology and FinTech partnerships to compete and win retail deposit relationships in a meaningful way.

How Can Community Banks Develop a FinTech Framework?

Against this backdrop, I see four primary steps to developing a FinTech framework:

  1. Identify attractive FinTech niches such as deposits, payments, digital lending, wealth management, insurance, or efficiency (i.e., tech initiatives designed to reduce costs)
  2. Identify attractive FinTech companies in those niches
  3. Develop a business case for different strategies (estimate the Internal Rates of Returns and IRRs)
  4. Compare the different strategies and execute the optimal strategy

What Are Some Immediate Steps that Banks Can Take Regarding FinTech?

The things that banks can do right now to explore FinTech opportunities are:

  • Get educated. There are an increasing number of events for community bankers incorporating FinTech into their agenda and we have a number of resources on the topic as well
  • Begin or continue to integrate FinTech into your strategic plan
  • Determine what your customers want/need/expect in terms of digital offerings
  • Seek out FinTech partners that provide solutions and begin due diligence discussions

How Mercer Capital Can Help

Mercer Capital can help your bank craft a comprehensive value creation strategy that properly aligns your business, financial, and investor strategies. Given the growing importance of FinTech solutions to the banking sector, a sound value creation strategy needs to incorporate FinTech.

We provide board/management retreats to educate you about the opportunities and challenges of FinTech for your institution. We can:

  • Help your bank identify which FinTech niches may be most appropriate for your bank given your existing market opportunities
  • Help your bank identify which FinTech companies may offer the greatest potential as partners for your bank
  • Help provide assistance with valuations should your bank elect to consider investments or acquisitions of FinTech companies

We are happy to help. Contact us at 901.685.2120 to discuss your needs.


Originally published in Bank Watch, October 2018.


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