The following is the fourth installment in our series “What Keeps Family Business Owners Awake at Night”
Our multi-generation family business clients ask us about dividend policy more often than any other topic. This should not be unexpected, since returns to family business shareholders come in only two forms: current income from distributions and capital appreciation. For many shareholders, capital appreciation is what makes them wealthy, but current income is what makes them feel wealthy.
In other words, distributions are the most transparent expression of what the family business means to the family economically. Knowing what the business “means” to the family is essential for promoting positive shareholder engagement, family harmony, and sustainability. The business may “mean” different things to the family at different times (or, to different members of the family at the same time). In our experience, there are four broad “meanings” that a family business can have. These “meanings” are not mutually exclusive, but one will usually predominate at a given time. As discussed below, the “meaning” of the business has implications for the role of distributions.
From a textbook perspective, distributions are treated as a residual: once attractive reinvestment opportunities have been exhausted, the remaining cash flow should be distributed to the shareholders. However, at a practical level, the different potential “meanings” assigned to the business by the family will, to some degree, circumscribe the distribution policy alternatives available to the directors. For example, eliminating distributions in favor of increased reinvestment is not a practical alternative for family businesses in the third or fourth categories above, regardless of how abundant attractive investment opportunities may be.
The following table illustrates the relationship between “meaning” and distribution policy:
The textbook perspective on distribution policy is valid, but can be adhered to only within the context of the “meaning” assigned to the family business. In contrast to public companies or those owned by private equity funds, “meaning” will generally trump dispassionate analysis of available investment opportunities. If family business leaders conclude that the “meaning” assigned to the business by the family does not align with the optimal distribution policy, the priority should be given to changing what the business “means” to the family. Once the change in “meaning” has been embraced by the family, the change in distribution policy will more naturally follow.
A distribution policy describes how the family business determines distributions on a year-to-year basis. A consistent distribution policy helps family shareholders understand, predict, and evaluate distribution decisions made by the board of directors. Potential family business distribution policies can be arrayed on a spectrum that ranges from maximum shareholder certainty to maximum board discretion.
Family shareholders should know what the company’s current distribution policy is. As evident from the preceding table, knowing the distribution policy does not necessarily mean that one will know the dividend for that year. However, a consistently-communicated and understandable distribution policy contributes greatly to developing positive shareholder engagement.
So what should your family business’s distribution policy be? Answering that question requires looking inward and outward. Looking inward, what does the business “mean” to the family? Looking outward, are attractive investment opportunities abundant or scarce? Once the inward and outward perspectives are properly aligned, the distribution policy that is appropriate to the company can be determined by the board and communicated to shareholders.
Through our family business advisory services practice, we work with successful families facing issues like these every day. Give us a call to discuss your needs in confidence.
The following is the third installment in our series “What Keeps Family Business Owners Awake at Night”
Communication determines the success of any relationship, and the relationships among shareholders of multi-generation family businesses are no exception. In the early years of a family business, communication is generally informal (and continual), since the dining room often doubles as the board room. As the business and family grow, the shareholder relationships become more complicated, and formal communication becomes more important.
For a multi-generation family business, communication is not optional. A failure to communicate is a communication failure. When communication is lacking, the default assumption of shareholders – especially those not actively involved in the business – will be that management is hiding something. Suspicion breeds discontent; prolonged discontent solidifies into rancor and, in some cases, litigation.
In light of the dire consequences of poor communication, how can family business leaders develop effective and sustainable communication programs? We suggest that public companies can provide a great template for multi-generation family businesses. It is perhaps ironic that public companies – to whom their shareholder bases are largely anonymous – are typically more diligent in their shareholder communications than family businesses, whose shareholders are literally flesh and blood. While public companies’ shareholder communications are legally mandated, forward-thinking public companies view the required shareholder communications not as regulatory requirements to be met, but as opportunities to tell their story in a compelling way.
There are probably only a handful of family businesses for which shareholder communication needs to be as frequent and detailed as that required by the SEC. The structure and discipline of SEC reporting is what needs to be emulated. For family businesses, the goal is to communicate, not inundate. At some point, too much information can simply turn into noise. Family business leaders should tailor a shareholder communication program along the following dimensions:
Shareholder communication is an investment, but one that in our experience has an attractive return. To get the most out of the investment, family business leaders must provide the necessary training and education to shareholders so that they will be able confidently to assess and interpret the information communicated. With that foundation in place, a structured communication program can go a long way to ensuring that family shareholders are positively engaged with the business.
Through our family business advisory services practice, we work with successful families facing issues like these every day. Give us a call to discuss your needs in confidence.
A Memphis establishment long has used the slogan, “It’s Tax Time (… Baby),” in their low budget television advertising. After listening to early fourth quarter earnings calls, banks – and especially their investors – appear to be embracing this slogan as well. Four investment theses undergirded the revaluation of bank stocks after the 2016 presidential election: regulatory reform, higher interest rates, faster economic growth, and tax reform. One year later, regulatory reform is stymied in Congress, and legislative efforts appear likely to yield limited benefits. Short-term rates have risen, but the benefit for many banks has been squashed by a flatter yield curve and competition for deposits. Economic growth has not yet translated into rising loan demand.
Fortunately for bank stock valuations, the tax reform plank materialized in the Tax Cuts and Jobs Act of 2017 (the “Act”).1 The Act has sweeping implications for banks, influencing more than their effective tax rates. This article explores these lesser known ramifications of the Act.2
In 2017, the total effective tax rate on C corporation earnings – at the corporate level and, assuming a 100% dividend payout ratio, at the shareholder level – was 50.5%. Under the Act, this rate will decline to 39.8%, reflecting the new 21% corporate rate and no change in individual taxes on dividends. For a hypothetical bank currently facing the highest corporate tax rate, the Act will cause a 40% reduction in tax expense, a 22% increase in after-tax earnings, and a 269bp enhancement to return on equity (Table 1).
The benefit reduces, however, for banks with lower effective tax rates resulting from, among other items, tax-exempt interest income. Continuing the example in Table 1, which assumed a 35% effective tax rate, Table 2 illustrates the effect on banks with 30%, 25%, and 20% effective tax rates.
Since investors in bank stocks value after-tax earnings, not surprisingly banks with the highest effective 2016 tax rates experienced the greatest share price appreciation in 2017. Table 3 analyzes share price changes for publicly-traded banks with assets between $1 and $10 billion.
The preceding tax examples distill a nuanced subject into one number, namely an effective tax rate. The implications of the Act for banks, though, spread far beyond mathematical tax calculations. We classify the broader implications of the Act into the following categories:
We know for certain that the tax savings resulting from the Act will be allocated among three stakeholder groups – customers, employees, and shareholders.3 The allocation between these groups remains unknown, though.
Jamie Dimon had a succinct explication of the effect of the Act on customers:
And just on the tax side, so these people understand, generally, yes, if you reduce the tax rates, all things being equal, to 20% or something, eventually, that increased return will be competed away.4
The logic is straightforward. The after-tax return on lending and deposit-taking now has increased; higher after-tax returns attract competition; the new competitors then eliminate the higher after-tax returns. Rinse and repeat. One assumption underlying Mr. Dimon’s statement, though, is that prospective after-tax returns will exceed banks’ theoretical cost of capital. If not, loan and deposit pricing may not budge, relative to the former tax rate regime. Supporting the expectation that customers will benefit from the Act is the level of capital in the banking industry searching for lending opportunities.
Renasant Corporation has noted already potential pressure on its net interest margin.
Not sure [net interest margin expansion is] going to hold. We’ll need a quarter or 2 to see what competitive reaction is to say that we’ll have margin expansion. But we do think that margin at a minimum will be flat and would be variable upon competitive pressures around what’s down with the tax increase.5
An early winner of tax reform was employees of numerous banks, who received one-time bonuses, higher compensation, and upgraded benefits packages. With falling unemployment rates, economists will debate whether employers would have made such compensation adjustments absent the Act. Nevertheless, the public nature of these announcements, with local newspapers often covering such promises, will create pressure on other banks to follow suit.
Generally, bank compensation adjustments have emphasized entry level positions. An open question is whether such benefits will spread to more highly compensated positions, thereby placing more pressure on bank earnings. For example, consider a relationship manager who in 2017 netted the bank $100 thousand after considering the employee’s compensation and the cost of funding, servicing, and provisioning her portfolio. Assuming that customers do not capture the benefit, the officer’s portfolio suddenly generates after-tax net income of $122 thousand. The loan officer could well expect to capture a share of this benefit, or take her services to a competitor more amenable to splitting the benefit of tax reform.
Mr. Market clearly views shareholders as the biggest winner of tax reform, and we have no reason to doubt this – at least in the short-run. Worth watching is the form this capital return to shareholders takes. With bank stocks trading at healthy P/Es, even adjusted for tax reform, banks may hesitate to be significant buyers of their own stock. Instead, some public banks have suggested higher dividends are in the offing. Meanwhile, Signature Bank (New York), which has not paid dividends historically, indicated it may initiate a dividend in 2018. In the two days after the CEO’s announcement, Signature’s stock price climbed 8%.
Table 4 compiles announced expenditures by certain banks on employees, philanthropy, and capital investments. Click to view Table 4.
Some public market analysts have “allocated” 60% to 80% of the tax savings to shareholders, with the remainder flowing to other stakeholders. Time will tell, but banks will face pressure from numerous constituencies to share the benefits.
The Act potentially affects loan volume with future possible effects on credit quality.
Looked at most favorably, higher economic growth resulting from the Act, as well as accelerated capital expenditures due to the Act’s depreciation provisions, may provide a tailwind to loan growth. However, some headwinds exist too. Businesses may use their tax savings to pay down debt or fund investments with internal resources. The Act eliminates the deductibility of interest on home equity loans and lines of credit, potentially impairing their attractiveness to consumers. Last, the Act disqualifies non-real estate assets from obtaining favorable like-kind exchange treatment, potentially affecting some types of equipment finance.
While we do not expect the Act to cause any immediate negative effects on credit quality, certain provisions “reallocate” a business’ cash flow between the Treasury and other stakeholders (e.g., creditors) in certain circumstances:
Banks should also prepare for reorganizations among business borrowers currently taxed as pass-through entities, especially in certain service businesses not qualifying for the 20% deduction described subsequently. From a tax planning standpoint, it may be advisable for some business clients to reorganize with certain activities conducted under a C corporation and others under a pass-through structure.
Additional considerations include:
Table 5 presents, for publicly traded banks with assets between $1 billion and $5 billion, their net deferred tax asset or liability positions as a percentage of tangible common equity. Table 5 also presents the number of banks reporting net DTAs or DTLs.
From a valuation standpoint, we do not expect DTA write-downs to cause significant consternation among investors. If Citigroup’s $22 billion DTA revaluation did not scare investors, we doubt other banks will experience a significant negative reaction. In Citigroup’s case, the impairment has the salutary effect of boosting its future ROE, as Citigroup’s regulatory capital excluded a large portion of the DTAs anyway.
The Basel III capital regulations limit the inclusion of DTAs related to temporary differences in regulatory capital, but DTAs that could be realized through using NOL carrybacks are not subject to exclusion from regulatory capital. As noted previously, though, the Act eliminates NOL carrybacks. Therefore, certain banks may face disallowances (or greater disallowances) of portions of their DTAs when computing common equity Tier 1 regulatory capital.8
An emerging issue facing community banks is their relevance among technology savvy consumers and businesses. Via its “bonus” depreciation provisions, the Act provides tax-advantaged options for banks to address technological weaknesses. For qualifying assets – generally, assets other than real estate and, under the Act, even used assets – are eligible for 100% bonus depreciation through 2022. The bonus depreciation phases out to 0% for assets placed in service after 2026.9
Our understanding is that the Act will not materially change the existing motivations for structuring a transaction as non-taxable or taxable. With banks accumulating capital at a faster pace given a reduced tax rate, it will be interesting to observe whether cash increases as a proportion of the overall consideration mix offered to sellers.
One parting thought concerns the longevity of the recent tax reforms. The Act passed via reconciliation with no bipartisan support, unlike the Tax Reform Act of 1986. As exhibited recently by the CFPB, the regulatory winds can shift suddenly. Like the CFPB, is tax reform built on a foundation of sand?
At the risk of exhausting our readership, we will detour briefly through the Act’s provisions affecting S corporations (§199A). While the Act’s authors purportedly intended to simplify the Code, the smattering of “lesser of the greater of” tests throughout §199A suggests that this goal went unfulfilled.
Briefly, the Act provides that shareholders of S corporations can deduct 20% of their pro rata share of the entity’s Qualified Business Income (“QBI”), assuming that the entity is a Qualified Trade or Business (“QTB”) but not a Specified Service Trade or Business (“SSTB”).10 That is, shareholders of QTBs that are not SSTBs can deduct 20% of their pro rata share of the entity’s QBI.11 Simple.
The 20% QBI deduction causes an S corporation’s prospective tax rate to fall to 33.4%, versus the 44.6% total rate applicable in 2017, thereby remaining below the comparable total C corporation tax rate (Table 6).
S corporations should review closely the impact of the Act on their tax structure. The 2013 increase in the top marginal personal rate to 39.6% and the imposition of the Net Investment Income Tax on passive shareholders previously diminished the benefit of S corporation status. The Act implements a $10 thousand limit on the deductibility of state and local taxes, which may further diminish the remaining benefit of S corporation status. While we understand this limitation will not affect the deductibility of taxes paid by the S corporation itself (such as real estate taxes on its properties), it may reduce shareholders’ ability to deduct state-level taxes paid by a shareholder on his or her pro rata share of the S corporation’s earnings. S corporations also should evaluate their projected shareholder distributions, as S corporations distributing only sufficient amounts to cover shareholders’ tax liability may see fewer benefits from maintaining an S corporation election.12
For banks, the provisions of the Act intertwine throughout their activities. Calculating the effect of a lower tax rate on a bank’s corporate tax liability represents a math exercise; predicting its effect on other constituencies is fraught with uncertainty.13 We look forward to discussing with clients how the far reaching provisions of the Act will affect their banks, clients, and the economy at large. It will be Tax Time for quite some time. As always, Mercer Capital is available to discuss the valuation implications of the Act.
This article originally appeared in Mercer Capital’s Bank Watch, January 2018.
Corporate valuations are a function of expected cash flows, risk, and growth. While the reduction in tax rates triggers the most obvious revision to expected cash flows, other provisions of the bill may also significantly influence cash flows for individual companies.
Corporate tax rate reduced to 21% from 35%
Deductibility of Capital Investment
Through 2022, companies will be able to deduct capital investment as made rather than over time through depreciation charges
Deductibility of Interest
Interest expense deduction limited to 30% of EBITDA through 2021, and 30% of EBIT thereafter
U.S. taxes due only on U.S. income, with one-time tax to allow repatriation of existing foreign retained earnings
NOL Carryforward Limitations
Max out at 80% of taxable income for year, no expiration
Changes to availability
Does a lower corporate tax rate make corporations more valuable, all else equal? Yes. Will all else always be equal? No. Appraisers will need to carefully consider the effect of the new tax law not just on rates, but on growth expectations, reinvestment decisions, the use of leverage, operating margins, and the like for individual companies.
What effect does the new tax law have on the value of minority interests in pass-through entities, all else equal? It depends. The resulting differential between corporate and personal rates and the availability of the QBI deduction may cause some business owners to re-evaluate the merits of the S election. The ultimate effect on valuation will depend on the subject company’s distribution policy, the length of the expected holding period, and the perceived risk associated with the S election.
These significant changes should be evaluated on a company-by-company basis to determine what effect, if any, the changes will have on expected cash flows. Appraisers with deep experience in the relevant industry are best positioned to evaluate the potential effects.
Download the full presentation here.
Based on discussions with family business leaders from across the country at the most recent Transitions conference, we wrote an article addressing themes among attendees, and we continue the discussion in this article. One challenge noted by leaders of multi-generation family businesses was how to promote positive shareholder engagement.
As family businesses mature into the third and subsequent generations, it becomes less and less likely that extended family members will be both shareholders and active participants in the business. As families grow numerically, they tend to become more geographically dispersed. Lack of professional involvement in the business, combined with geographic separation, can result in family shareholders feeling disconnected and becoming disengaged from the family business. A successful multi-generation family business can promote healthy family cohesion, but when shareholders are not positively engaged, the business can quickly turn into a source of stress and family strife.
Some families choose to eliminate the existence of disengaged shareholders by limiting share ownership to those members that are actively involved in the business. While this may be an appropriate solution for some families, it can have the unintended consequence of creating distinct classes of economic haves and have-nots within the family. When that occurs, the business quickly ceases to be a center of family unity.
For most businesses, there simply is no necessary link between share ownership and active involvement in the company. If public companies can function well with non-employee owners, surely it is possible for family businesses to do so as well. But to do so, family businesses will need to be diligent to promote positive shareholder engagement.
It might be tempting to label non-employee shareholders as “passive”, but we suspect that term does not do justice to the ideal relationship between the company and such shareholders. “Actively non-controlling” hits closer to the mark but doesn’t exactly trip off the tongue. If “passive” is not the ideal, the following characteristics can be used to identify positively engaged shareholders.
The family business leaders we spoke with at the conference were eager to share and learn best practices around promoting shareholder engagement. The “how” of shareholder engagement is closely related to the characteristics of engaged shareholders noted above.
Most of the intra-family shareholder disputes we have seen (and we have witnessed too many) are ultimately traceable to shareholders that over time became disengaged from the business. Family business leaders who focus on positive shareholder engagement today can prevent a lot of grief tomorrow.
Through our family business advisory services practice, we work with successful families facing issues like these every day. Give us a call to discuss your needs in confidence.
We recently attended the Transitions West conference hosted by Family Business Magazine. The event brought together representatives from nearly 100 family businesses of all sizes. Through the educational sessions and informal conversations during breaks, we came away with a better appreciation of the joys, stresses, privileges, and responsibilities which come with stewarding a multi-generation family business.
While every family is unique, a few common themes and/or concerns stood out among the attendees we met:
The question for most financial institutions is not if a valuation is necessary, but when it will be required. Valuation issues that may arise include merger and acquisition activity, an employee stock ownership plan, capital planning, litigation, or financial planning, among others. Thus, an understanding of some of drivers impacting your bank’s value is an important component in preparing for these eventualities.
Determining the value of your bank is more complicated than simply taking a financial metric from one of your many financial reports and multiplying it by the relevant market multiple. However, examination of current and long term public pricing trends can shed some light on how certain quantitative factors may affect the value of your bank.
To analyze trends, we focus our discussion on P/TBV ratios since this is one of the most commonly cited metrics for bankers. While all banks can be affected by overall macroeconomic trends like inflation rates, employment rates, the regulatory environment, and the like, we explore relative value in light of three factors we consider in all appraisals – size, profitability, and asset quality.
Size differentials generally encompass a range of underlying considerations regarding financial and market diversity. A larger asset base generally implies a broader economic reach and oftentimes a more diverse revenue stream which can help to mitigate harmful effects of unforeseen events that may adversely affect a certain geographic market or industry. Furthermore, larger banks tend to have access to more metropolitan markets which have better growth prospects relative to more rural markets. Figures 1 and 2 on the next page illustrate that, to a point, larger size typically plays a role in value, as measured by price / tangible book value multiples. The sweet spot for asset size seems to be between $5 and $10 billion in total assets. Banks in this category traded at the highest P/TBV multiple as of September 30, 2017 and have generally outperformed all other asset size groups over the long term.
To examine how profitability affects the value of your bank, we compare median P/TBV multiples for four groups of banks segmented by return on average tangible equity (Figures 3 and 4 on the prior page). A bank’s return on equity can be measured as the product of the asset base’s profitability (or return on assets) and balance sheet leverage. Balancing these two inputs in order to maximize returns to shareholders is one goal of bank management. A bank’s return on equity measures how productively the bank invests its capital, and as one would expect, the banks with the highest returns on equity trade at the highest P/TBV multiple.
Inferior asset quality increases risk relative to companies with more stable asset quality and may limit future growth potential, both of which may negatively impact returns to shareholders. In addition, it makes sense that a bank with high levels of non-performing assets might trade below book value. Book value of the loans (or other non-performing assets) may not reflect the true market value of the assets given the potential for greater losses than those accounted for in the loan loss reserve and the negative impact on earning potential. Figure 5 illustrates how pricing is affected by higher levels of non-performing assets. As shown in Figure 6, P/TBV multiples plummeted at the start of the economic recession and have yet to recover to pre-crisis levels.
Size, profitability, and asset quality are factors to consider in your bank’s valuation. From an investor’s perspective, your bank’s worth is based on its potential for future shareholder returns. This, in turn, requires evaluating qualitative and quantitative factors bearing on the bank’s current performance, growth potential, and risk attributes.
Mercer Capital offers comprehensive valuation services. Contact us to discuss your valuation needs in confidence.
This article originally appeared in Mercer Capital’s Bank Watch, November 2017.
Webinar Recording Price: $79
With recording, receive a complimentary copy of Jay Wilson’s recent book, Creating Strategic Value Through Financial Technology (regularly priced at $65).
Do you have a clear picture of your company’s value and do you know if you are creating value in your early-stage FinTech company?
Hidden behind the veil of the private market, an early-stage FinTech company’s value can seem complex and obscure. However, it doesn’t have to be that way. Entrepreneurs and investors benefit from a clear picture of company value. Measuring value creation over time is vital for planning purposes, and an awareness of valuation drivers can propel the company to higher growth.
The knowledge gleaned from the valuation process provides insights and identifies key risk and growth opportunities that can improve the company’s strategic planning process–a process that might build to a successful liquidity event (sale or IPO) or the development of a stable company that can operate independently for a long time.
For investors, entrepreneurs, and potential partners, this webinar identifies the key value drivers for an early-stage FinTech company.
The weighted average cost of capital is a critical component of any business valuation. While there is wide agreement regarding the basic building blocks of the WACC, there is much less agreement regarding how to estimate those components. Much appraiser ink has been spilled over the past two decades describing how to estimate specific components, sometimes in excruciating detail. But has increasing precision done anything to promote accuracy?
In the webinar, Travis explored ways to bring market evidence to bear in evaluating the reasonableness of WACC estimates. Topics of discussion included, but were not limited to:
An explanation of Travis’ presentation, Valuing Investments in Start-Ups, is available below:
For many early-stage companies, traditional valuation metrics such as revenue and profit may not exist, and earnings projections can seem quite speculative. Yet, venture capital firms regularly value interests in such firms. In this session, Travis explains the vocabulary and concepts that valuation specialists need to master to value such investments.
- How early-stage companies are financed
- Understand key valuation methods for estimating the value of early-stage companies
- Obtain techniques for valuing individual components of early-stage capital structures
When Z. Christopher Mercer, FASA, CFA, ABAR began testifying as an expert witness in the early 1980s, he didn’t have a clue about what to do or how to do it. Since then, Mercer has testified scores of times and learned some important lessons the hard way. As he shares his experiences with you, gain insights on how to prepare for and conduct yourself in depositions. From acceptance to final billing, understand how to organize expert witness engagements. Plus, learn how to be an effective witness on the stand by providing impactful testimony.
Unless your client has had their buy-sell agreement reviewed from a valuation perspective, they don’t know what it says. This comes as a surprise to many – an often unpleasant surprise as too many find themselves caught up in unexpected and costly legal wrangles or personal turmoil.
Originally presented by Z. Christopher Mercer, FASA, CFA, ABAR at the 2017 Southern Federal Tax Institute, this session provides you with information from a valuation perspective that will help ensure that your clients’ buy-sell, shareholder, or joint venture agreement results in a reasonable resolution and is not a ticking time bomb set to explode upon a triggering event. In other words, you will leave this session understanding how your clients’ buy-sell agreement will work – before a trigger event occurs.
Timothy R. Lee, ASA, Managing Director, moderated an educational session on the importance of due diligence regarding financial projections at the ESOP Association’s 2017 Las Vegas ESOP Conference & Trade Show. Phillip Chou, managing director at AmbroseAdvisors, and Erin Hollis, ASA, CDBV, director of Dispute Resolution & Litigation Support at Marshall & Stevens, Inc., were co-presenters alongside Tim.
A description of the session is below:
Management’s financial projections are a key input into the analyses underlying ESOP fairness opinions and annual appraisal reports. Furthermore, the DOL Process Agreement highlighted the importance of thoroughly evaluating management’s financial projections. This session will review methods and procedures that fiduciaries and valuation professionals can use to evaluate the reasonableness of projections as part of the valuation process. Furthermore, the panel will address the importance of obtaining sufficient industry-related information and/or employing outside experts when dealing with industry-specific nuances. Finally, panel will address the feasibility of a quality of earning (Q of E) report, and what alternatives may be available in connection with the financial due diligence process.
In 2016, Mercer Capital published an article on core deposit trends through November 1 just before the presidential election. At that time, core deposit intangible (CDI) values remained near historical lows. Following the financial crisis, CDI values decreased as deposits have less worth, so to speak, in a very low rate environment than in a “normal” environment as existed before the crisis.
Despite a rate increase by the FOMC in December 2015, the costs of alternative funds such as FHLB advances had not materially increased and were not expected to increase more than the gradual pace the Fed had targeted for short-term interest rates since late 2015. The persistent low rate environment limited both deposit premiums paid in acquisitions and CDI values booked.
A week later, the presidential election defied market expectations and drove bond yields higher almost immediately on expectations of stronger economic growth and rising inflation. Three more rate increases by the FOMC followed in December 2016, March 2017, and June 2017. Since the post-election run-up, the yield curve has flattened, but overall yields remain well above pre-election levels (Chart 1).
Using data compiled by S&P Global Market Intelligence, we analyzed trends in CDI assets recorded in whole bank acquisitions completed from 2008 through the third quarter of 2017, and we compared CDIs recorded as a percentage of core deposits acquired to 5-year FHLB rates over the same period. CDI values generally have followed interest rate trends. Prior to the start of the financial crisis, CDIs recorded in acquisitions averaged 1.5%–2.0%, but post-crisis CDIs stabilized at approximately 1.0%–1.25% in the 2014 to 2016 period. Since the November 2016 election, CDI values have risen through mid-2017 as yields rose, before declining in the third quarter as the yield curve flattened. CDIs represent the benefit of having a low-cost, stable funding source, and in times when alternative sources of funds have higher rates, core deposits have greater “worth” to an acquirer (see Chart 2).
Although CDI values have increased since the post-crisis lows, CDI values remain well below long-term historical average levels. CDI values have averaged approximately 1.5% in 2017, compared to averages in the 2.5%–3.0% range in the early 2000s. Even as CDI values remained largely stagnant through 2016, deposit premiums paid in whole bank acquisitions have shown more volatility, driven by improved deal values that have pushed deposit premiums up at a quicker pace from their 2009 lows, a trend that has continued through 2017.1 The flattening yield curve that pushed CDI values lower in the third quarter of 2017 did not have the same effect on deposit premiums, but for deals closed in the third quarter deposit premiums largely reflected transaction values determined earlier in the year when the yield curve was steeper, and this lagged effect could push deposit premiums back down in upcoming quarters. Regardless of the near-term outlook, current deposit premiums in the range of 10% remain well below pre-financial crisis levels when premiums for whole bank acquisitions averaged closer to 20%.
Deposit premiums paid in branch transactions, defined as the value paid in excess of deposits acquired, have generally been less volatile than tangible book value premiums paid in whole bank acquisitions. Branch transaction deposit premiums are up some from the lows observed in the financial crisis but have remained in the 4%–5% range for the last 12 months.
For our analysis of industry trends in CDI values, we defined core deposits as total deposits, less accounts with balances over $100,000. In analyzing core deposit intangible assets for individual acquisitions, however, a more detailed analysis of the deposit base would consider the relative stability of various account types. In general, CDs tend to be more rate sensitive and less stable. Even in cases where a CD base is considered a stable customer base, given their relatively higher cost compared to non-time deposits, CDs often do not contribute to the core deposit intangible asset recorded. Furthermore, account types such as brokered or Qwickrate accounts and certain public funds that may be subject to a competitive bidding process are generally excluded from core deposits when determining the value of a CDI.
Based on the data for acquisitions for which core deposit intangible detail was reported, a majority of banks selected a ten-year amortization term for the CDI values booked. Less than 10% of transactions for which data was available selected amortization terms longer than ten years. Amortization methods were somewhat more varied, but the accelerated amortization method was selected in approximately half of these transactions.
For more information about Mercer Capital’s core deposit services, please contact us.
Originally presented at the ASA’s 2017 Advanced Business Valuation Conference.
In his session, Jeff reviewed the business model for banks and other financial institutions and how the model differs from that of non-financial institutions. He reviewed various valuation methodologies for financial institutions and what pitfalls valuation professionals may grapple with vis-a-vis non-financial institutions. Overlaid will be a perspective on factors that matter for stock selection and why these factors can differ somewhat from valuation factors. Further, Jeff reviewed issues related to valuing securities issued by financial institutions that are in the capital stack above common equity.
Originally presented at the ASA’s 2017 Advanced Business Valuation Conference.
Through a case study approach, Travis W. Harms, Senior Vice President, helped attendees develop a greater understanding of the iterative nature of the cost of capital and the firm’s capital structure, how to assess and interpret the marginal cost of capital, and how to infer the cost of capital for guideline public companies and develop appropriate adjustments for subject entities.
Complying with the revised disclosure requirements of ASU 2016-01 may necessitate that banks adopt new methodologies to determine the fair value of the bank’s loan portfolio.
In listening to presenters at the recent AICPA National Conference on Banks & Savings Institutions, we gathered that some banks are taking their first fitful steps toward implementing the pending accounting rule governing credit impairment. Bankers should not lose sight, however, of another FASB pronouncement that becomes effective, for most banks, in the first quarter of 2018. Accounting Standards Update No. 2016-01 addresses the recognition and measurement of financial assets and liabilities.
A long and winding history preceded the issuance of ASU 2016-01. In 2010, the FASB drafted a predecessor to ASU 2016-01, which required that financial statement issuers carry most financial instruments at fair value. As a result, assets and liabilities presently reported by banks at amortized cost, such as loans, would be marked periodically to fair value. This proposal was almost universally scorned, satisfying neither financial statement issuers nor investors. The FASB followed with a revised exposure draft in 2013, which maintained amortized cost as the measurement methodology for many financial instruments. Stakeholders objected, however, to a new framework in the 2013 exposure draft that linked the measurement method (fair value or amortized cost) to the nature of the investment and the issuer’s anticipated exit strategy. The FASB agreed with these concerns, eliminating this framework from the final rule on cost/benefit grounds.
The final pronouncement issued in January 2016 generally maintains existing GAAP for debt instruments, including loans and debt securities. However, the standard modifies current GAAP for equity investments, generally requiring issuers to carry such investments at fair value. Restricted equity securities commonly held by banks, such as stock in the Federal Reserve or Federal Home Loan Bank, are excluded from the scope of ASU 2016-01; therefore, no change in accounting for these investments will occur. Excluding these restricted investments, community banks typically do not hold equity securities, and we do not discuss the accounting for equity investments in this article. Interested readers may wish to review a previous Mercer Capital article summarizing certain changes that ASU 2016-01 makes to equity investment accounting.
While ASU 2016-01 maintains current accounting for debt instruments, it does contain several revisions to the fair value disclosures presented in financial statement footnotes. Originally issued via SFAS 107, these requirements were codified in ASC Topic 825, Financial Instruments. Although ASU 2016-01 makes several changes to the qualitative and quantitative disclosures that are beyond the scope of this article, the most significant revisions are as follows:
Current GAAP is ambiguous regarding whether the fair value of financial instruments measured at amortized cost should embrace an “entry” or “exit” price notion. According to the FASB, this has led to inconsistent disclosures between issuers holding otherwise similar financial instruments. Certain sections of ASC Topic 825, which carried over from SFAS 107, could be construed as permitting an “entry price” measurement. For example, existing GAAP provides an illustrative footnote disclosure describing an entity’s fair value estimate for loans receivable:
The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. [ASC 825-10-55-3, which is superseded by ASU 2016-01]
By referencing “current rates” on “similar loans,” the guidance implicitly suggests an “entry” price notion, which represents the price paid to acquire an asset. Instead, ASC Topic 820, Fair Value Measurement, which was issued subsequent to SFAS 107, clearly defines fair value as an exit price; that is, the price that would be received upon selling an asset.
In our experience, banks often use fair value estimates derived from their asset/liability management models in completing the fair value footnote disclosures for loan portfolios. Reliance on ALCO models suffers from several weaknesses when viewed from the perspective of achieving an exit price measurement:
Complying with the revised disclosure requirements of ASU 2016-01, therefore, may necessitate that banks adopt new methodologies to determine the fair value of the bank’s loan portfolio. Mercer Capital has significant experience in determining the fair value of loan portfolios from which we offer the following guidance:
Mercer Capital has developed fair value estimates for a wide variety of loan portfolios, on an exit price basis, ranging in size from under $100 million to over $1 billion, covering numerous lending niches, and possessing insignificant to severe asset quality deterioration. We have the resources, expertise, and experience to assist banks in complying with the new requirements in ASU 2016-01.
This article originally appeared in Mercer Capital’s Bank Watch, September 2017.
1 The definition of a “public business entity” is broader than the term may suggest. A registrant with the SEC is clearly a PBE, but the definition also includes issuers with securities “traded, listed, or quoted on an exchange or an over-the-counter market” (emphasis added). A number of banks “trade” on an over-the-counter market and therefore would appear to be deemed PBEs, even if they are not an SEC registrant. The following entities are also deemed PBEs:
In 2012, Chris Mercer, CEO, wrote about a recent appellate level case in Kentucky addressing the question of statutory fair value in Kentucky. Given several recent conversations with Kentucky clients, a revisit of that case is appropriate.
For further information about statutory fair value, see this e-book by Chris Mercer.
In the case, Shawnee Telecom Resources, Inc. v. Kathy Brown, the Kentucky Supreme Court provides a number of interesting insights into the evolution of statutory fair value in the various states, and, in this matter, in Kentucky.
Kentucky has had an interesting history regarding statutory fair value. For many years, the leading case on the issue was a Court of Appeals decision in Ford v. Courier-Journal Job Printing Co., 639 S.W.2d 553 (Ky App. 1982). This case allowed the application of a 25% marketability discount, and was the reigning precedent for nearly thirty years.
The Ford case was overruled by another Court of Appeals decision in Brooks v. Brooks Furniture Mfgrs., Inc. 325 S.W.3d 904 (Ky. App. 2010). The Court of Appeals explicitly overruled Ford with respect to the application of the marketability discount. However, the Court of Appeals also rejected the use of the net asset value method. Enter the Kentucky Supreme Court:
The case before us presents squarely the broad issue of “fair value” and the more specific issues of the continuing viability of a marketability discount in a dissenters’ rights appraisal action and the appropriateness of valuing closely held corporate stock under the net asset method. Having thoroughly considered the statute [Subtitle 13 of the Kentucky Business Corporation act, Kentucky Revised Statutes (KRS) Chapter 271B] and its underlying purpose, we conclude that “fair value” is the shareholder’s proportionate interest in the value of the company as a whole and as a going concern. Any valuation method generally recognized in the business appraisal field, including the net asset and the capitalization of earnings methods employed in this case can be appropriate in valuing a given business….[emphasis added]
What is fascinating about this case is that the Kentucky Supreme Court seems not only to have understood the concepts underlying what we in the business appraisal profession call the levels of value, but also reflected that understanding in clearly written prose. The levels of value charts are shown below:
The traditional, three-level chart is shown on the left. The chart that is generally recognized by most writers in the field now is the four-level chart on the right. The levels at (or) above that of the marketable minority level are referred to as enterprise or entity levels of value. Values at the enterprise levels are developed based on the expected cash flows, risks and expected growth of the enterprises, or as noted above, “the value of the company as a whole and as a going concern.”
The level below that of marketable minority is the nonmarketable minority level of value. This is the shareholder level of value. Value at this level is based on the expected cash flows, risks and expected growth pertaining to a particular shareholder’s interest in the business. Intuitively, most people recognize that the value of an illiquid minority interest in a business is most often worth less than that interest’s proportionate share of enterprise value.
The Kentucky Supreme Court understands the distinction, as is clear in the following:
As for applying a marketability discount when valuing the dissenter’s shares, we join the majority of jurisdictions which, as a matter of law, reject this shareholder-level discount because it is premised on fair market value principles which overlook the primary purpose of the dissenters’ appraisal right — the right to receive the value of their stock in the company as a going concern, not its value in a hypothetical sale to a corporate outsider. However, generally recognized entity-level discounts, where justified by the evidence are appropriate because these are factors that affect the intrinsic value of the corporate entity as a whole. [emphasis added]
This language regarding entity level valuation is consistent with the recent case I wrote about from the South Dakota Supreme Court. The post was titled Statutory Fair Value (South Dakota): Customer Risk Consideration is not a Valuation Discount. The point of that case was that it is inappropriate to lump entity-level adjustments into so-called valuation discounts like the minority interest discount or the marketability discount.
The Kentucky Supreme Court reviewed a good bit of history pertaining to statutory fair value. In so doing, a number of important points were made to clarify the meaning of fair value in Kentucky.
Because an award of anything less than a fully proportionate share would have the effect of transferring a portion of the minority interest to the majority, and because it is the company being valued and not the minority shares themselves as a commodity, shareholder level discounts for lack of control or lack of marketability have also been widely disallowed.
Fair value should be determined using the customary valuation concepts and techniques generally employed in the relevant securities and financial markets for similar businesses in the context of the transaction giving rise to appraisal (quoting Principles of Corporate Governance: Analysis and Recommendations § 7.22(a) (ALI 1994))
…[W]e find a broad consensus among courts, commentators, and the drafters of the Model Act that “fair value” in this context is best understood, not as a hypothetical price at which the dissenting shareholder might sell his or her particular shares, but rather as the dissenter’s proportionate interest in the company as a going concern.
Because a hypothetical market price for the dissenter’s particular shares as a commodity is thus not the value being sought, market adjustments to arrive at such a price, such as discounts for lack of control or lack of marketability, are inappropriate.
An Amicus Brief was filed by the Kentucky Chamber of Commerce that suggested that dissenting shareholders might obtain a windfall in an appraisal proceeding if the typical valuation discounts were not applied. The logic was that there would be a likelihood that the minority shareholder purchased his or her shares at a discounted level and that if they were bought out at undiscounted levels, there could be a windfall to them. This logic was dismissed by the court. Dissenters are not voluntary participants in transactions, and therefore need to be protected.
The court also found that the net asset value method, appropriately considered in the value of an enterprise, was an appropriate valuation method.
The Kentucky Supreme Court was specific that entity-level discounts, where supported by the evidence, are acceptable. Shawnee argued that, if a marketability discount was not allowable at the shareholder level, one should be available at the entity level. The court was wary of this argument, stating:
We agree [that a marketability discount at the entity level could be applicable] but with the strong caveat, that any entity level discount must be based on particular facts and authority germane to the specific company being valued, i.e., there can be no automatic 15-25% discount of the whole entity’s value simply because it is closely held and not publicly traded.
The court listed a number of “recognized entity-level discounts” that could be appropriate in specific circumstances, including a key manager discount, a limited customer [see the South Dakota Supreme Court’s analysis of this one] or supplier base discount, a built-in capital gains discount, a “portfolio” discount, a small size discount or a privately held company discount.The court referred to Shannon Pratt’s book, Business Valuation Discounts and Premiums when discussing this list of discounts.
Immediately following this list of entity-level discounts, the court emphasized the distinction between entity-level and shareholder-level discounts, which I quote because of the importance of the discussion:
As noted above, the distinction between entity-level and shareholder-level discounts is recognized in the business valuation literature, Shannon P. Pratt, Business Valuation Discounts and Premiums, p. 3 (2001) [linked above], and was referred to in Cavalier, where the Court observed that shareholder-level discounts, such as those for lack of control and lack of marketability, tend to defeat the protective purpose of the appraisal remedy by transferring a portion of the dissenter’s interest in the company to the majority. Entity-level discounts, on the other hand, take into account those factors, such as a company’s reliance on a key manager, that affect the value of the company as a whole…”Cavalier authorized corporate level discounting as a means of establishing the intrinsic value of the enterprise.” Where such entity-level adjustments are proper, they should be incorporated into the valuation technique employed, and the appraiser should be able to cite the relevant facts and authority for making the adjustment. (emphasis added)
The Court then discussed the Delaware Chancery Court’s rejection of “the sort of marketability discount that the court applied.” Borruso v. Communications Telesystems International, 753 A.2d 451 (Del. Ch. 1999). While holding that an appraiser might properly support a discount based on privately held companies selling at lower multiples than publicly traded companies, the court found that there was insufficient evidence to support the discount applied. The court cited, among other things, my article “Should Marketability Discounts Be Applied to Controlling Interests in Companies?” in the June 1994 edition of Business Valuation Review [subscription required. Email me if you’d like a copy].
As if to hammer the point home, the Court stated:
On remand, Shawnee is free to present evidence tending to show that its going concern value is lessened by such factors as its small size and its private nature, but otherwise it is not entitled to a discount based simply on the generally perceived lack of marketability of closely held corporate shares.
The conclusion of Shawnee is instructive:
In sum, we agree with the Court of Appeals that Ford [applying a marketability discount] has outlived its usefulness and does not provide a suitable interpretation of the appraisal remedy currently available under KRS Subchapter 271B.13. under that subchapter, a properly dissenting shareholder is entitled to the “fair value” of his or her shares, which is the shareholder’s proportionate interest in the value of the company as a whole as a going concern. Going concern value is to be determined in accord with the concepts and techniques generally recognized and employed in the business and financial community. Although the parties may, and indeed are encouraged to, offer estimates of value derived by more than one technique, the trial court is not obliged to assign a weight to or to average the various estimates, but may combine or choose among them as it believes appropriate given the evidence. If the particular technique allows for them, adequately supported entity-level adjustments may be appropriate to reflect aspects of the company bearing positively or negatively on its value. Once the entire company has been valued as a going concern, however, by applying an appraisal technique that passes judicial muster, the dissenting shareholder’s interest may not be discounted to reflect either a lack of control or a lack of marketability….
A careful reading of this case indicates that the Kentucky Supreme Court warns courts (and appraisers) that shareholder-level discounts disguised as entity-level adjustments are not appropriate.
In terms of the levels of value chart above, fair value in Kentucky could be interpreted to be the functional equivalent of fair market value at the entity-, or enterprise level. What is not clear, however, is whether the Kentucky Supreme Court would embrace valuation in dissenters’ rights matters at the strategic control level. The case addressed protections afforded by the Kentucky statute to dissenting, generally minority, shareholders. There was no discussion of taking into account any potential synergies that might occur in a strategic or synergistic sale of the business.
Perhaps, the answer lies in the language used in a conclusory statement noted above:
… we conclude that “fair value” is the shareholder’s proportionate interest in the value of the Company as a whole and as a going concern.
If a company is valued “as a whole” and as a “going concern,” it may be difficult to argue that the implied combination with another entity in a strategic valuation is appropriate.
The Court is clear that there can be no downward bias from entity-level valuation to the shareholder level of valuation in Shawnee. However, the issue of any upward bias in statutory fair value determinations was not addressed in the case.
Originally published on ChrisMercer.net | October 19, 2017
Below is the transcript of the above video, Corporate Finance Basics for Directors and Shareholders. In this video, Travis W. Harms, CFA, CPA/ABV, senior vice president of Mercer Capital, offers a short, yet thorough, overview of corporate finance fundamentals for closely held and family business directors and shareholders.
Hi, my name is Travis Harms, and I lead Mercer Capital’s Family Business Advisory practice. I welcome and thank you for taking a few minutes to listen to our discussion, “Corporate Finance Basics for Directors and Shareholders.”
Corporate finance does not need to be a mystery. In this short presentation, I will give you the tools and vocabulary to help you think about some of the most important long-term decisions facing your company.
To do this, we review the foundational concepts of finance, identify the three key questions of corporate finance, and then leverage those three questions to help think strategically about the future of your company.
Let’s start with the fundamentals of finance: return and risk.
Return measures the reward for making an investment. Investment returns come in two different forms: the first, distribution yield, is a measure of the annual distributions generated by an investment. The second, capital appreciation, measures the change in the value of an investment over time. Total return is the sum of these two components.
This is important because two investments may generate the same total return, although in very different forms. Some investments, like bonds, emphasize current income, while others, like venture capital, are all about capital appreciation. Many investments promise a mix of current income and future upside.
The most basic law of corporate finance is that return follows risk.
The above chart compares the expected return required by investors and the risk of different investments. Since investment markets are generally efficient, higher returns are available only by accepting greater risk.
But what is risk?
Simply put, risk is the fact that future investment outcomes are unknown. The wider the distribution of potential outcomes, the greater the risk.
While both investments represented above are risky, the dispersion of outcomes for the investment on the right is wider than that on the left, so the investment on the right is riskier. Because it is riskier, it will have a higher expected return. Now, whether that higher return actually materializes is unknown when the investment is made – that’s what makes it risky.
For a particular company, the expected return is referred to as the company’s cost of capital. From a corporate finance perspective, the company stands between investors (who are potential providers of capital) and investment projects (which are potential uses of the capital provided by investors). The cost of capital is the price paid to attract capital from investors to fund investment projects.
When evaluating potential investment projects, corporate managers use the cost of capital as the hurdle rate to measure the attractiveness of the project.
Next, we will move on to the three essential questions of corporate finance.
Corporate managers and directors should always be thinking about three fundamental corporate finance questions:
Let’s start with the first question: what is the most efficient mix of capital?
You can think of the company’s assets as a portfolio of individual capital projects – that is the left side of the balance sheet. The right side of the balance sheet tells us how the company has paid for those investments. The only two funding options are debt and equity. Because debt holders are promised a contractual return and have a priority claim on the assets and cash flows of the company, debt is less expensive than equity, which has only a residual claim on the company.
You can think of the company’s assets as a portfolio of individual capital projects – that is the left side of the balance sheet. The right side of the balance sheet tells us how the company has paid for those investments. The only two funding options are debt and equity. Because debt holders are promised a contractual return and have a priority claim on the assets and cash flows of the company, debt is less expensive than equity, which has only a residual claim on the company.
If debt is cheaper than equity, you might assume that a company could reduce its cost of capital by simply issuing more and more debt. That is not the case, however. As the company uses more debt, the risk of both the debt and the equity increase. And, as we said earlier, greater risk will cause both debt and equity investors to demand higher returns.
Eventually, because the cost of both components is increasing, the overall blended (or weighted average) cost of capital increases with increasing reliance on debt. The goal of capital structure analysis is to identify the optimal capital structure, or the mix of debt and equity that minimizes the company’s cost of capital.
Now let’s move on to the second question: what investment projects should the company devote capital to? At the strategic level, management’s job is to survey the landscape of potential investment projects, choosing those that are strategically compelling and financially favorable.
From a financial perspective, a potential investment project is attractive if the return from the expected cash flows meets or exceeds the hurdle rate, which is the cost of capital.
The appropriate pace of investment for a company is therefore related to the availability of attractive investment projects.
If attractive investment projects are abundant, the company should reinvest earnings into new projects, and, if yet more attractive projects are available, borrow money and/or issue new equity to fund the investment. If attractive investment projects are scarce, however, the company should return capital to investors through debt repayment, distribution of earnings, or share repurchase. We can now begin to see how the three questions are related to one another. Capital structure decisions are always made relative to the need for investment capital.
This inter-relationship is illustrated above within the context of the two components of total return we discussed earlier. Distribution yield provides a current return to shareholders from cash flow not reinvested in the business, while the cumulative impact of reinvested cash flows is manifest in the capital appreciation component of total return.
This leads us to the final corporate finance question, which relates to distribution policy: what mix of returns do shareholders desire?
While the operating performance of the business ultimately determines total return, the board can tailor the components of that return to fit shareholder preferences better.
We’ve primarily been looking through the rearview mirror to assess what the company has done in the past; now it’s time to look through the windshield and think prospectively about capital structure, capital budgeting, and distribution policy going forward.
First, capital structure. In the long-run, the optimal capital structure will balance the cost of funds, flexibility, availability, and the risk preferences of the shareholders. Now, that last factor – shareholder preferences – should not be overlooked. Family businesses should not be managed for some abstract textbook shareholder, but rather for the actual family members that own the business.
For example, while an under-leveraged capital structure reduces potential return on equity, it also reduces the risk of bankruptcy. Some shareholders may view this tradeoff favorably even if it can be demonstrated to be “sub-optimal” from a textbook standpoint.
Second, capital budgeting. The attractiveness of investment opportunities should be evaluated with reference to future – and not past – returns. Beyond the threshold question of whether such opportunities are in fact available, managers and directors should also consider financial and management constraints under which the company is operating and the desire of shareholders for diversification.
Since family business shareholders lack ready liquidity for their shares, they may have a greater desire to diversify their investment holdings away from the family business. In other words, they may favor foregoing some otherwise attractive investment opportunities in order to increase distributions that would help shareholders diversify.
Third, distribution policy. The appropriate form and amount of distributions should reflect shareholder preferences within the context of capital budgeting and capital structure decisions. Perhaps most importantly, a clearly communicated distribution policy enhances predictability for shareholders, and shareholders like predictability.
Family business shareholders should know which of the four basic options describes their company’s distribution policy.
Finally, to recap, each of the three questions relates to one another.
The company’s capital structure influences the cost of capital, which serves as the hurdle rate in capital budgeting decisions. The availability of attractive investment projects, in turn, determines whether earnings should be retained or distributed. Lastly, distribution policy affects, and is affected by, the cost and availability of marginal financing sources.
For a deeper dive into some of the topics we talked about, we have several whitepapers and other resources that you can download from our website.
The good news is that you do not have to have an advanced degree in finance to be an informed director or shareholder. With the concepts from this presentation, you can make relevant and meaningful contributions to your company’s strategic financial decisions. In fact, we suspect that a roomful of finance “experts” can actually be an obstacle to the sort of multi-disciplinary, collaborative decision-making that promotes the long-term health and sustainability of the company. Our family business advisory practice gives directors and shareholders a vocabulary and conceptual framework for thinking about and making strategic corporate finance decisions.
Again, my name is Travis Harms and I thank you for listening. If you’d like to continue the discussion further or have any questions about how we may help you, please give us a call.
As summer came to an end, the U.S. was treated with a historic event as the first total solar eclipse crossed the country since 1918. The timing of the event had social media and news outlets buzzing in a traditionally sleepy news month. For many, the event exceeded all expectations; for others, it was a dud that didn’t live up to the hype. My personal experience was a bit of both. The minutes of darkened skies were definitely memorable, but things returned to normal quickly as the sun shone brightly only minutes after.
Community bank M&A trends also seem mixed. Rising regulatory burdens, weak margins from a historically low interest rate environment and heightened competition have crimped ROEs for years. Many pundits have predicted a rapid wave of consolidation and the demise of community banks in the years since the financial crisis. However, the pace of consolidation the last few years is consistent with the past three decades in which roughly 3-4% of the industry’s banks are absorbed through M&A yearly. The result is many fewer banks—5,787 at June 30 compared to about 15,000 in the mid-1980s when meaningful industry consolidation got underway.
Somewhat surprisingly, the spike in bank stock prices following the November 2016 national elections did not cause M&A to accelerate. As would be expected, acquisition multiples increased in 2017 because publicly traded acquirers could “pay-up” with appreciated shares. As seen in the table on the next page, the median P/E and P/TBV multiples and the median core deposit premium increased for the latest twelve months (LTM) ended July 31, 2017 compared to the year ago LTM period. The ability of buyers—at least the publicly traded ones—to more easily meet sellers’ price expectations seemingly would lead more banks to sell. However, that has not happened as the pace of consolidation declined slightly to 132 transactions in the most recent LTM period compared to 140 in the year ago LTM time frame.
Another emerging M&A trend is the presence of non-traditional bank acquirers, which include private investor groups, non-bank specialty lenders, and credit unions. While a FinTech company has not yet announced an acquisition of a U.S. bank this year, several FinTechs have announced they are applying for a bank charter (SoFi, VaroMoney), and in the U.K., Tandem has agreed to acquire Harrods Bank.
So far, FinTech acquisitions of banks have been limited to a few acquisitions by online brokers and Green Dot Corporation’s acquisition of a bank in 2011. While FinTech companies have yet to emerge as active buyers, there have been some predictions that could change if regulatory hurdles can be navigated. Some FinTech companies are well-funded or have access to additional funding that could be tapped for a bank acquisition. In addition, an overlay of enhancing financial inclusion for the under-banked could mean bank transactions may not be as far-fetched as some may think.
Beyond serving as potential acquirers, FinTech continues to emerge as an important piece of the community banking puzzle of how to engage customers through digital channels as the costly branch banking model sees usage decline year-after-year. Many FinTechs are eager to partner with banks to scale their operations for greater profitability, thereby better positioning themselves for a successful exit down the road.
Consistent with this trend, we have also seen some acquirers (and analysts) comment on FinTech as a benefit of a transaction, as opposed to (or at least in addition to) the historical focus on geographic location, credit quality, asset size, and profitability. We will be watching to see if FinTech initiatives, whether internally developed or acquired, become a bigger driving force in bank M&A. If so, acquisitions of FinTech companies by traditional banks may increase (as discussed more fully in this article).
As these trends grow in importance, buyers and sellers will have to grapple with unique valuation and transaction issues that require each to fully understand the value of the seller and the buyer, assuming a portion of the consideration consists of the buyer’s shares. Whether that buyer includes a traditional bank whose stock is private or a non-bank buyer, such as a specialty lender or FinTech company, we have significant valuation and transaction expertise to help your bank understand the deal landscape and the strategic options available to it.
If we can be of assistance, give us a call to discuss your needs in confidence.
This article originally appeared in Mercer Capital’s Bank Watch, August 2017.
Sometimes deals can go horribly wrong between the signing of a merger agreement and closing. Buyers can fail to obtain financing that seemed assured; sellers can see their financial position materially deteriorate; and a host of other “bad” things can occur. Most of these lapses will be covered in the merger agreement through reps and warranties, conditions to close, and if necessary, the nuclear trigger that can be pushed if negotiations do not produce a resolution: the material adverse event clause (MAEC). And MAEC = litigation.
Bank of America’s (BAC) 2008 acquisition of Countrywide Financial Corporation will probably be remembered as one of the worst transactions in U.S. history, given the losses and massive fines that were attributed to Countrywide. BAC management regretted the follow-on acquisition of Merrill Lynch so much that the government held CEO Ken Lewis’ feet to the fire when he threatened to trigger MAEC in late 2008 when large swaths of Merrill’s assets were subjected to draconian losses. BAC shareholders bore the losses and were diluted via vast amounts of common equity that were subsequently raised at very low prices.
Another less well-known situation from the early crisis years is the acquisition of Charlotte-based Frist Charter Corporation (FCTR) by Fifth Third Bancorp (FITB). The transaction was announced on August 16, 2007 and consummated on June 6, 2008. The deal called for FITB to pay $1.1 billion for FCTR, consisting 30% of cash and 70% FITB shares with the exchange ratio to be set based upon the five day closing price for FITB the day before the effective date. At the time of the announcement FITB expected to issue ~20 million common shares; however, 45 million shares were issued because FITB shares fell from the high $30s immediately before the merger agreement was signed to the high teens when it was consummated. (The shares would fall to a closing low of $1.03 per share on February 20, 2009; the shares closed at $25.93 per share on July 14, 2017.) The additional shares were material because FITB then had about 535 million shares outstanding. Eagerness to get a deal in the Carolinas may have caused FITB and its advisors to agree to a fixed price / floating exchange ratio structure without any downside protection.
A more recent example of a deal that may entail both buyer and seller regrets is Canadian Imperial Bank of Commerce’s (CIBC) now closed acquisition of Chicago-based Private Bancorp Inc. (PVTB). A more detailed account of the history of the transaction can be found here. The gist of the transaction is that PVTB entered into an agreement to be acquired by CIBC on June 29, 2016 for 0.3657 CIBC shares that trade in Toronto (C$) and New York (US$), and $18.80 per share of cash. At announcement the transaction was valued at $3.7 billion, or $46.20 per share. As U.S. bank stocks rapidly appreciated after the November 8 national elections, institutional investors began to express dismay because Canadian stocks did not advance. In early December, proxy firms recommended shareholders vote against the deal. A mid-December shareholder vote was then postponed.
CIBC subsequently upped the consideration two times. On March 31, 2017, it proposed to acquire PVTB for 0.4176 CIBC shares and $24.20 per share of cash. On May 4, CIBC further increased the cash consideration by $3.00 to $27.20 per share because its shares had trended lower since March as concerns intensified about the health of Canada’s housing market. On May 12, shareholders representing 66% of PVTB’s shares approved the acquisition.
Figure 1 highlights the trouble with the deal from PVTB shareholders’ perspective. While the original deal entailed a modest premium, the performance of CIBC’s shares and the sizable cash consideration resulted in little change in the deal value based upon the original terms. On March 30 the deal equivalent price for PVTB was $50.10 per share, while the market price was $59.00 per share. The following day when PVTB upped the consideration the offer was valued at $60.11 per share; however, the revised offer would have been worth nearly $69 per share had CIBC’s shares tracked the SNL U.S. Bank Index since the agreement was announced on June 29. On May 11 immediately before the shareholder vote the additional $3.00 per share of cash offset the reduction in CIBC’s share price such that transaction was worth ~$60 per share, while the “yes-but” value was over $71 per share had CIBC’s shares tracked the U.S. index since late June.
Fairness opinions do not cover regret, but there are some interesting issues raised when evaluating fairness from a financial point of view of both PVTB and CIBC shareholders. (Note: Goldman Sachs & Co. and Sandler O’Neill & Partners provided fairness opinions to PVTB as of June 29 and March 30. The registration statement does not disclose if J.P. Morgan Securities provided a fairness opinion as the lead financial advisor to CIBC. The value of the transaction on March 30 when the offer was upped the second time was $4.9 billion compared to CIBC’s then market cap of US$34 billion.)
Some transactions are not fair, some are reasonable, and others are very fair. The qualitative aspect of fairness is not expressed in the opinion itself, but the financial advisor conveys his or her view to management and a board that is considering a significant transaction. When the PVTB deal was announced on June 29, it equated to $46.35 per share, which represented premiums of 29% and 14% to the prior day close and 20-day average closing price. The price/tangible book value multiple was 220%, while the P/E based upon the then 2016 consensus estimate was 18.4x. As the world existed prior to November 8, the multiples appeared reasonable but not spectacular.
Fairness opinions are qualified based upon prevailing economic conditions; forecasts provided by management and the like and are issued as of a specific date. The opinion is not explicitly forward looking, while merger agreements today rarely require an affirmation of the initial opinion immediately prior to closing as a condition to close. That is understandable in the context that the parties cut a deal that was deemed fair to shareholders from a financial point of view when signed. In the case of PVTB, the future operating environment (allegedly) changed with the outcome of the national election. Banks were seen as the industry that would benefit from a combination of lower corporate tax rates, less regulation, faster economic growth, and higher rates as part of the “reflation trade.” A reasonable deal became not so reasonable if not regrettable when the post November 8 narrative excluded Canadian banks. Time will tell if PVTB’s earning power really will improve, or whether the move in bank stocks was purely speculative.
Although not a major factor in the underperformance of CIBC’s shares vis-à-vis U.S. banks, the Canadian dollar weakened from about C$1.30 when the merger was announced on June 29 to C$1.33 in early December when the shareholder meeting was postponed. When shareholders voted to approve the deal on May 12 the Canadian dollar had eased further to C$1.37. The weakness occurred after the merger agreement was signed and the initial fairness opinions were delivered on June 29. Sometimes seemingly small financial issues can matter in the broad fairness mosaic, but only with the clarity of hindsight.
Although a board will consider the business case for a transaction and strategic alternatives, a fairness opinion does not address these issues. The original registration statement noted that Private was not formally shopped. The deal was negotiated with CIBC exclusively, which twice upped its initial offer before the merger agreement was signed in June. It was noted that the likely potential acquirers of PVTB were unable to transact for various reasons. The turn of events raises an interesting look-back question: should the board have waited for a better competitive situation to develop? We will never know; however, the board is given the benefit of the doubt because it made an informed decision given what was then known.
Institutional shareholders had implicitly rejected what became an unfair deal by early December when PVTB’s shares traded well above the deal price. The market combined with the “no” recommendation of three proxy firms forced PVTB to delay the special meeting. The increase in the consideration in late March pushed the deal price to a slight premium to PVTB’s market price. CIBC increased the cash consideration an additional $3.00 per share in early May to offset a decline in CIBC’s shares that had occurred since the consideration was increased in March. The market had in effect established its view of a fair price. While CIBC could have declined to up its offer yet again, it chose to offset the decline.
What appeared to be a reasonable deal from CIBC’s perspective in June became exceptionally fair by early December, if the market is correct that the earning power of U.S. commercial banks will materially improve as a result of the November 8 election. CIBC’s financial advisors can easily change assumptions in Excel spreadsheets to justify a higher price based upon better future earnings than originally projected, but would doing so be “fair” to CIBC shareholders whether expressed euphemistically or formally in a written opinion? So far the evidence of higher earning power is indirect via the market placing a higher multiple on current bank earnings in expectation of much better earnings that will not be observable until 2018 or 2019. That as a stand-alone proposition is an interesting valuation attribute to consider as part of a fairness analysis both from PVTB’s and CIBC’s perspective.
Hindsight is easy; predicting the future is a fool’s errand. Fairness opinions do not opine where securities will trade in the future. Some PVTB shareholders may have regrets that CIBC was not a U.S. commercial bank whose shares would have
out-performed CIBC’s after November 8. CIBC shareholders may regret the PVTB acquisition even though U.S. expansion has been a top priority. The key, as always in any M&A transaction, will be execution over the next several years rather than the PowerPoint presentation. Higher rates, a faster growing U.S. economy and the like will help, too, if they occur.
We at Mercer Capital cannot predict the future, but we have over three decades of experience in helping boards assess transactions as financial advisors. Sometimes paths and fairness from a financial point of view seem clear; other times they do not. Please call if we can assist your company in evaluating a transaction.
This article originally appeared in Mercer Capital’s Bank Watch, July 2017.
This discussion is adapted from Section III of the new book Creating Strategic Value Through Financial Technology by Jay D. Wilson, Jr., CFA, ASA, CBA.
I enjoyed some interesting discussions between bankers, FinTech executives, and consultants at the FinXTech event in NYC in late April. One dominant theme at the event was a growing desire of both banks and FinTech companies to find ways to work together. Whether through partnerships or potential investments and acquisitions, both banks and FinTech companies are coming to the conclusion that they need each other. Banks control the majority of customer relationships, have a stark funding advantage and know how to navigate the maze of regulations, while FinTechs represent a means to achieve low-cost scaling of new and traditional bank services. So one key question emerging from these discussions is: Who will survive and thrive in the digital age? As one recent Tearsheet article that I was quoted in asked: Should fintech startups buy banks? Or as another article discussed: Will banks be able to compete against an army of Fintech startups?
Banks face a conundrum of whether they should build their own FinTech applications, partner, or acquire. FinTech companies face similar questions, though the questions are viewed through the prism of customer acquisition rather than applications. Non-control investments of FinTech companies by banks represent a hybrid strategy. Regulatory hurdles limit the ability of FinTech companies to make anything more than a modest investment in banks absent bypassing voting common stock for non-voting common and/or convertible preferred.
While these strategic decisions will vary from company to company, the stakes are incredibly high for all. We can help both sides navigate the decision process.
As I noted in my recently published book, community banks collectively remain the largest lenders to both small business and agricultural businesses, and individually, they are often the lifeblood for economic development within their local communities. Yet the number of community banks declines each year through M&A, while some risk loosened deposit relationships as children who no longer reside in a community where the bank is located inherit the financial assets of deceased parents. FinTech can loosen those bonds further, or it can be used to strengthen relationships while providing a means to deliver services at a lower cost.
In my view, it is increasingly important for bankers to develop a FinTech framework and be able to adequately assess potential returns from FinTech partnerships. Similar to other business endeavors, the difference between success and failure in the FinTech realm is often not found in the ideas themselves, but rather, in the execution.
Banks face a conundrum of whether they should build their own FinTech applications, partner, or acquire.
While a bank’s FinTech framework may evolve over time, it will be important to provide a strategic roadmap for the bank to optimize chances of success. Within this framework, there are a number of important steps:
For a number of banks, the use of FinTech and other enhanced digital offerings represents a potential investment that uses capital but may be deemed to have more attractive returns than other traditional bank growth strategies. Community banks typically underperform their larger brethren (as measured by ROE and ROA) because fee income is lower and expenses are higher as measured by efficiency ratios. Both areas can be enhanced through deployment of a number of FinTech offerings/solutions.
The decision process for whether to build, partner, or acquire requires the bank to establish a rate of return threshold, which arguably may be higher than the institution’s base cost of capital given the risk that can be associated with FinTech investments. The range of returns for each strategy (build, partner, or acquire) for a targeted niche (such as payments or wealth management) provides a framework to help answer the question how to proceed just as is the case with the question of how to deploy capital for organic growth, acquisitions, and shareholder distributions. The same applies for FinTech companies, though often the decision is in the context of whether to accept dilutive equity capital.
A detailed analysis, including an IRR analysis, helps a bank determine the financial impact of each strategic decision and informs the optimal course.
While each option presents a unique set of considerations and execution issues/risks, a detailed analysis, including an IRR analysis, helps a bank determine the financial impact of each strategic decision and informs the optimal course. A detailed analysis also allows the bank to compare its FinTech strategy to the bank’s more traditional growth strategies, strategic plan, and cost of capital. See the table to the right for an example of a traditional community bank compared to a bank who has partnered with a FinTech company.
Beyond the strategic decisions and return analyses, some additional questions remain for community banks that consider FinTech partners, including:
Should the community bank ultimately decide to invest in a FinTech partner a number of other key questions emerge, such as:
To help both banks and FinTech companies execute their optimal strategies and create maximum value for their shareholders, we have a number of solutions here at Mercer Capital. We have a book that provides greater detail on the history and outlook for the FinTech industry, as well as containing targeted information to help bankers answer some of the key questions discussed here.
Mercer Capital has a long history of working with banks. We are aware of the challenges facing community banks. With ROEs for the majority below 10% and their cost of capital, it has become increasingly difficult for many banks to deliver adequate returns to shareholders even though credit costs today, are low. Being both a great company that delivers benefits to your local community, as well as one that delivers strong returns to shareholders is a difficult challenge. Confronting the challenge requires a solid mix of the right strategy as well as the right team to execute that strategy.
No one understands community banks and FinTech as well as Mercer Capital.
Mercer Capital can help your bank craft a comprehensive value creation strategy that properly aligns your business, financial, and investor strategy. Given the growing importance of FinTech solutions to the banking sector, a sound value creation strategy needs to incorporate FinTech into it and Mercer Capital can help.
No one understands community banks and FinTech as well as Mercer Capital. We are happy to help. Contact me to discuss your needs.
This article first appeared in Mercer Capital’s Bank Watch, June 2017.
Of all the well-worn clichés that should be retired, “maximizing shareholder value” is surely toward the top of the list. Since private companies don’t have constant public market feedback, attempts to “maximize” shareholder “value” are destined to end in frustration. While private company managers are not able to gauge instantaneous market reaction to their performance, they do know who their shareholders are. Wouldn’t it be better to make corporate decisions based on the characteristics and preferences of actual flesh-and-blood shareholders than the assumed preferences of generic shareholders that exist only in textbooks? If so, there is no substitute for simply asking. Here’s a quick list of five good reasons for conducting a survey of your shareholders.
For more information about conducting a shareholder survey, check out the article “5 Reasons to Conduct a Shareholder Survey.”
To discuss how a shareholder survey or ongoing investor relations program might benefit your company, learn more about our Corporate Finance Consulting or give us a call.
To craft an effective corporate strategy, management and directors must answer the three fundamental questions of corporate finance.
These questions should not be viewed as the special preserve of the finance team. To maintain a healthy governance culture, all directors and shareholders need to have a voice in how these long-term decisions are made. This presentation is an example of the topics that we cover in education sessions with directors and shareholders. The purpose of the presentation is to provide directors and shareholders with a conceptual framework and vocabulary to help contribute to answering the three fundamental questions.