The focus on the EBITDA of private companies is almost ubiquitous among business appraisers. This session addresses the relationship between depreciation (and amortization) and EBIT as one measure of relative capital intensity. This relationship, “the EBITDA Depreciation Factor,” is then used to convert debt-free pre-tax (i.e., EBIT) multiples into corresponding multiples of EBITDA. Mercer presents analysis that illustrates why the pervasive rules of thumb suggest that many private companies were worth 4.0x to 6.0x EBITDA, plus or minus, have had such stickiness. He will then address the likely impact of the Tax Cut and Jobs Act on private company enterprise value multiples. This session suggests a methodology based on the Adjusted Capital Asset Pricing Model, whereby business appraisers can independently develop EBITDA enterprise value multiples under the Income Approach and includes private and public company market evidence
With the Fed positioned to hike the Fed Funds and IOER rates several more times following the September meeting, it is a good time to look at the recent trend in core deposit values. Mercer Capital previously published articles on core deposit trends in 2016 just before the November election, and again in October 2017.
Coming out of the recession, the prolonged low interest rate environment held values of core deposit intangible assets acquired in bank transactions at historical lows. Deposit premiums paid in transactions likewise remained below pre-recession levels. Following the 2016 election, amid expectations of stronger economic growth and rising rates, core deposit values and deposit premiums both saw some modest increases by the fourth quarter of 2017. Three rate hikes by the Fed in 2018 have driven rates sufficiently high that banks are now beginning to price deposits more competitively as liquidity tightens.
Using data compiled by S&P Global Market Intelligence, we analyzed trends in core deposit intangible (CDI) assets recorded in whole bank acquisitions completed from 2000 through August 2018. CDI values represent the value of the depository customer relationships obtained in a bank acquisition. CDI values are driven by many factors, including the “stickiness” of a customer base, the types of deposit accounts assumed, and the cost of the acquired deposit base compared to alternative sources of funding. For our analysis of industry trends in CDI values, we relied on S&P Global Market Intelligence’s definition of core deposits.1 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, CDI assets derive most of their value from lower-cost demand deposit accounts, while often significantly less (if not zero) value is ascribed to more rate-sensitive time deposits and public funds, or to non-retail funding sources such as listing service or brokered deposits which are excluded from core deposits when determining the value of a CDI.
Current CDI values reported in acquisitions remain well below long-term historical average levels, averaging approximately 1.5% in the 2017-2018 timeframe compared to averages in the 2.5%-3.0% range in the early 2000s. Chart 2 summarizes the trend in CDI values since the start of the 2008 recession, compared with rates on 5-year FHLB advances. Over the post-recession period, CDI values have largely followed the general trend in interest rates—as alternative funding has become more costly in recent years, CDI values have generally ticked up as well. However, despite remaining above post-recession average levels, CDI values in the second and third quarters of 2018 (through August) have lagged the broader trend in interest rates with some decline in CDI values observed in these quarters. In addition to a flattening yield curve, some of the easing in CDI values in recent months may result from increasing deposit costs which reduces the value of deposits relative to other funding sources. Despite Fed increases in interest rates since late 2015, deposit costs have lagged the broader trend of rising interest rates (Chart 3).
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 (Chart 4). Less than 10% of transactions for which data was available selected amortization terms longer than ten years. Amortization methods were somewhat more varied, but an accelerated amortization method was selected in approximately half of these transactions (Chart 5).
Core deposit intangible assets are related to, but not identical to, deposit premiums paid in acquisitions. While CDI assets are an intangible asset recorded in acquisitions to capture the value of the customer relationships the deposits represent, deposit premiums paid are a function of the purchase price of an acquisition. Deposit premiums in whole bank acquisitions are computed based on the excess of the purchase price over the target’s tangible book value, as a percentage of the core deposit base. While deposit premiums often capture the value to the acquirer of assuming the established funding source of the core deposit base (that is, the value of the deposit franchise), the purchase price also reflects factors unrelated to the deposit base, such as asset quality in the acquired loan base, unique synergy opportunities anticipated by the acquirer, etc. Additional factors may influence the purchase price to an extent that the calculated deposit premium doesn’t necessarily bear a strong relationship to the value of the core deposit base to the acquirer. This influence is often less relevant in branch transactions where the deposit base is the primary driver of the transaction and the relationship between the purchase price and the deposit base is more direct.
Deposit premiums paid in whole bank acquisitions have shown more volatility than CDI values, rising more substantially in the post-recessionary period and continuing to improve through the year-to-date 2018 period as a result of improvement in deal values. Despite improved deal values, current deposit premiums in the range of 12% remain well below the pre-financial crisis levels when premiums for whole bank acquisitions averaged closer to 20% (Chart 6).
Deposit premiums paid in branch transactions have generally been less volatile than tangible book value premiums paid in whole bank acquisitions. Branch transaction deposit premiums are up from the 2.0-4.0% range observed in the financial crisis, but have remained in the 4.0-5.5% range since 2017, as shown in Chart 7.
For more information about Mercer Capital’s core deposit valuation services, please contact us.
Originally published in Bank Watch, September 2018.
1 S&P Global Market Intelligence defines core deposits as, “Deposits, less time deposit accounts with balances over $100,000 and foreign deposits if available or deposits, less all deposit accounts with balances over $100,000 and foreign deposits.”
Struggling to find a page-turning read for that late summer beach escape? May we recommend the 184 pages of blissful decadence that comprise the Internal Revenue Service’s August 2018 Notice of Proposed Rulemaking (NPR) regarding the Qualified Business Income (QBI) deduction under the Tax Cuts & Jobs Act (TCJA). Like a tightly wound murder mystery, the regulations weave a complex web. Tax code sections take the place of characters, the regulation’s intricacies unspooling as the narrative continues, relationships between Tax Code sections becoming (somewhat) clearer as the story (i.e., the regulation) progresses. As the NPR continues its inexorable march, certain storylines (i.e., planning opportunities) are forestalled, yet the NPR creates a glimmer of other opportunities.1
Bank shareholders are eligible for the 20% Qualified Business Income deduction.2 Intrigued? If so, the story continues.
Before examining the NPR, several tax-related trends are evident in 2018 regulatory filings.
Despite the attention it receives, tax reform is not solely responsible for improving bank profitability in 2018. Table 1 illustrates that pre-tax return on tangible common equity (ROATCE) has expanded in 2018, consistent with widening net interest margins for many banks and constrained credit costs. Effective tax rates declined from approximately 30% in the first half of 2017 to 21% in the comparable 2018 period, allowing banks to leverage the 50 to 100 basis point pre-tax ROATCE expansion into 150 to 200 basis points of after-tax ROATCE expansion.
Table 2 indicates conversion activity from C corporation to S corporation status. Following tax reform, conversions increased significantly, as 53 banks changed their tax status in the first six months of 2018 versus nine in the prior year period. Nevertheless, this represents only a sliver of the approximately 2,000 banks taxed as S corporations. Several large S corporation banks elected to be taxed as C corporations in 2018; as a result, banks collectively holding $44 billion of assets converted in 2018, relative to only $5 billion in the prior year period.
After passage of tax reform, some observers speculated that more conversion activity from S corporation to C corporation status would occur in states with relatively high personal tax rates, due to the $10 thousand limitation on the deductibility of state and local taxes. However, this trend is not yet apparent in conversion activity, as the states experiencing the most conversion activity include jurisdictions with both higher and lower personal tax rates.
While more banks converted from S corporations to C corporations in 2018, relatively few did the reverse. As indicated in Table 3, nine banks converted from a C corporation to an S corporation in the first half of 2018, relative to 14 such conversions in the first half of 2017.
Third, tax reform may influence banks’ investment portfolio positioning. While portfolio allocations reflect many factors, Chart 1 suggests that tax reform has affected investment strategies. Municipal securities remained relatively stable throughout 2017 at 28% of total securities; however, the proportion of municipal securities dropped to 26.9% at March 31, 2018 and 26.5% at June 30, 2018. This trend is consistent with our experience, where banks are not liquidating municipal securities due to tax reform but, at the margin, may prefer taxable alternatives for new purchases.
Internal Revenue Code Section 199A provides a 20% deduction against the income reported by owners of sole proprietorships, partnerships, and S corporations. If only tax code provisions could be described in one sentence, though. The deduction may be taken against income generated by a Qualified Trade or Business (QTB). A QTB, in turn, is any business, other than a Specified Service Trade or Business (SSTB).
In addition, certain W-2 income and asset limitations exist that may limit the 20% deduction. Lastly, individuals with income below certain levels may escape the SSTB and W-2 income/asset limitations; therefore, these owners would receive the 20% deduction whereas owners with higher incomes would not. The NPR provides guidance regarding, among other items, the definitions of QTBs and SSTBs.
While banks definitely are eligible for the 20% Qualified Business Income deduction, several other items covered by the NPR may be of interest to bankers.
An entity must be a Qualified Trade or Business to receive the 20% QBI deduction. From the TCJA, however, it was unclear if a QTB must be a “Section 162 trade or business.” While the Internal Revenue Code and regulations contain various definitions of a “business,” Section 162 contains a relatively restrictive definition. Unfortunately for taxpayers, the NPR adopts the Section 162 definition.
While Section 162 has existed for many years, the regulations and case law interpreting the provision remain somewhat vague. One significant concern is that certain real estate entities will not be deemed Section 162 trades or businesses, therefore becoming ineligible for the 20% QBI deduction. For example, entities holding properties subject to triple net leases may face difficulties meeting the Section 162 requirements. From a credit standpoint, banks should be aware that tax savings expected by owners of certain real estate entities may not materialize.
Entities providing professional services generally are deemed SSTBs. The business reality, though, is that some companies provide both a tangible product (like a widget) and services that would meet the definition of an SSTB (such as educational services regarding widgets). Will a company offering some consulting services, no matter how small a share of revenues, be deemed an SSTB? Under the TCJA, it was unclear. The NPR creates a de minimis exception for companies with small amounts of service revenues, although the thresholds appear relatively low to us.
The TCJA also includes a “catch-all” provision deeming as SSTBs any businesses for which the reputation or skill of its owners or employees is a principal asset. This broad provision potentially captures a large swath of small businesses; for example, the reputation of a restaurant’s chef may result in the restaurant being deemed an SSTB. This result appears inconsistent with the TCJA’s statutory intent, and the NPR significantly limits the scope of the catch-all provision.
Commentators noted that the TCJA created a tax planning opportunity for businesses deemed SSTBs. For example, consider a law firm that owns a building in which it operates. The law firm is an SSTB and its partners ineligible for the 20% deduction. The partners could transfer the building to a new real estate holding company, which is not deemed an SSTB. Therefore, the law firm partners have shifted income – via rent payments from the law firm to the real estate holding entity – from the SSTB (the law firm) to an entity qualifying for the QBI deduction (the real estate entity).
Alas, the IRS cracked down on the “crack and pack” strategy. The NPR provides that income from a commonly-controlled entity that provides services to an SSTB is ineligible for the 20% deduction. However, the NPR may not entirely foreclose on all planning strategies. While the NPR limits the QBI deduction for commonly-controlled entities, commonality is deemed to exist if the businesses share 50% or more ownership. Therefore, the law firm may transfer its building to an entity owned equally by the law firm partners, an accounting firm’s partners, and a physician group. Since common control does not exist (i.e., neither the attorneys nor the accountants nor the physicians control more than 50% of the real estate firm’s ownership), the owners of the various services firms would be eligible for the 20% deduction on the real estate entity’s earnings. To bankers, business reorganizations triggered by the deduction limitations applicable to SSTBs may trigger lending requirements.
Like a good novel, the NPR’s “plot” is not fully resolved – some questions remain unanswered and multiple interpretations of other provisions are possible. Perhaps a sequel to the NPR is in order.
Originally published in Bank Watch, August 2018.
1As for literary criticism, Mercer Capital does not render tax or legal advice, and readers should consult with appropriate professionals regarding the application of Section 199A to any specific circumstances.
2 To expound upon our arbitrary one sentence limitation, it was relatively clear in the Tax Cuts & Jobs Act that bank shareholders are eligible for the 20% Qualified Business Income deduction, but the August 2018
NPR confirms this eligibility.
This presentation will review the factors that impact bank valuations in the private, public and M&A markets and look at how the pricing cycle has evolved the past 25 years and ask the question: how is it different this time?
Jeff K. Davis, CFA, Managing Director of Mercer Capital’s Financial Institutions Group, delivered this presentation at the 2018 Bluegrass Community Bankers Association Convention on August 27, 2018.
eSports is a rapidly expanding industry that has drawn viewers and investments alike. The introduction of streaming platforms as well as the improvement in mobile technology has allowed the industry to grow from its arcade hall beginnings in the 1970s to competitors streaming games to millions of viewers globally. In addition to being highly visible (192 million frequent viewers in 2017), the eSports industry is also lucrative ($906 million projected industry revenue in 2018).
Sprouting from humble beginnings, researchers trace the roots of the eSports industry to informal competitions held at video game arcades in the 1970s. One of the first breakthroughs came in 1980 when Atari’s National Space Invaders Championship drew 10,000 participants across the U.S. As a spectator sport, eSports first took off in South Korea, when cable networks broadcast StarCraft tournaments in the early 2000s. By 2004, StarCraft stadium events in South Korea drew 100,000 fans. In the U.S., the coming of age moment arrived in 2013 when 13,000 people flooded the Staples Center to watch the world championship final of League of Legends.
The eSports industry has experienced rapid growth in recent years. According to data from Newzoo, an eSports researcher, the global eSports audience totaled 204 million in 2014. Approximately 56% (114 million) were considered frequent viewers/enthusiasts while the remaining 44% (90 million) were categorized as occasional viewers. By 2017, the global audience grew to 335 million, a compound annual growth rate of approximately 36% and the viewership ratio was approximately the same (57% categorized as frequent viewers/enthusiasts and 43% as occasional viewers).
The number of frequent viewers grew at a compound annual growth rate (CAGR) of 36% from 2014 to 2017 and is projected to grow at a CAGR of 12.5% to 2021.
By comparison, occasional viewers grew at a CAGR of 35% from 2014 to 2017 and are projected to grow at a CAGR of 15% to 2021.
The primary delivery method for eSports is Twitch, a livestreaming video platform owned by Twitch Interactive, a subsidiary of Amazon. Twitch was introduced in 2011 and, as of February 2018, the platform has 2 million monthly broadcasters and 15 million daily active users. Twitch operates like traditional television in that the broadcasters can be “channels” that are not necessarily broadcasting 24/7, differentiating it from on-demand platforms like YouTube and Netflix.
Twitch is unique in its ad revenue model, which supports the livestreaming aspect of the platform. The top 17,000 streamers, which include professional eSports players, participate in an ad-revenue-sharing program, where the players, not Twitch, decide in real time when the ads run during their streaming sessions. For example, a top eSports player might practice on Twitch and draw thousands of viewers then when the player takes a quick break, he asks viewers to watch an ad. Despite encroaching competition from YouTube, Twitch out-streams other platforms and, given its momentum, it continues attracting sponsors to reach the growing audience.
Like traditional sports, eSports have occasional tournaments that draw big audiences. In 2017, the Intel Extreme Masters (IEM) in Katowice, Poland drew 46 million unique viewers. IEM featured three games with a total prize pool of $688,750. This viewership figure was exceeded only by the Super Bowl, which drew 111.3 million U.S. viewers in 2017.
By comparison, the 2017 baseball World Series had average viewership of 18.7 million U.S. viewers over seven games. Therefore, the average viewership of the 2017 World Series would rank 14th on a list of worldwide eSports tournaments ranked by viewership from 2012 to 2017. The 2017 NBA Finals, which featured the Golden State Warriors against the Cleveland Cavaliers for the 3rd year in a row, averaged 20.4 million U.S. viewers over a five game series. The 2017 Stanley Cup Final trailed the other three major sports with average viewership of 4.6 million in the U.S. over six games.
To underscore the growing popularity of eSports, the combined average viewership of the championship series for three of the major sports in the United States was less than the viewership for one eSports tournament (IEM) in 2017.
The large tournament viewership has attracted the attention and dollars of global brands. Coca-Cola sponsors the League of Legends World Championship, one of the largest global eSports competitions. Since 2006, Intel has sponsored Intel Extreme Masters alongside the Electronic Sports League (ESL), the longest running eSports tournament in the world. To support the growing demand, investments in eSports sponsorships will continue to rise.
Since its introduction on July 25, 2017, Fortnite has become a global phenomenon. As of June 3, 2018, Fortnite ranked as the top game watched on Twitch with 4.43 million hours watched. Counter-Strike: Global Offensive ranked second with 2.7 million hours watched (approximately 40% less hours watched than Fortnite). Other games ranking in the top 10 include: League of Legends, Dota 2, IRL, PlayerUn- known’s Battlegrounds, Overwatch, Hearthstone, Path of Exile, and FIFA 18. Releases of new games can attract viewers to those games. A challenge for Twitch broadcasters is to be up-to-date on new games so that viewers don’t get bored with older games.
Newzoo defines industry revenue as the amount generated through the sale of sponsorships, media rights, advertising, publisher fees, tickets, and merchandising. Global eSports revenues are projected to reach $906 million in 2018. North America is projected to account for approximately 38% ($345 million) of global eSports revenue in 2018. Global revenue for eSports is projected to reach $1.65 billion in 2021.
Despite the tremendous growth, eSports fan spending is lower than traditional sports. According to Newzoo, eSports enthusiasts spent an average of $3.64 per person compared to basketball fans who spent an average of $15 per person. The primary factor for this gap is that eSports content is largely available for free and spending on merchandise remains relatively small.
Originally named BlueStar Sports, Stack Sports began in April 2016 with the goal of transforming youth sports. With this goal in mind, Stack has acquired 20 companies as of July 2018 in order to provide a variety of services. Services provided by Stack Sports include league and competition management, athlete and team solutions, event solutions, brand advertiser solutions, and payment solutions. The company’s various tools include building team websites, online registration for leagues and tournaments, and software that analyzes game day video.
The accompanying chart was compiled using data from Crunchbase and shows Blue Star/ Stack acquisitions from May 2016 to February 2018.
Uinkrn is a Seattle based eSports betting startup. Founded in 2014 as a platform for eSports betting, Unikrn has since added hosting physical tournaments to its services. Mark Cuban, owner of the Dallas Mavericks is among the investors in the company.
ChallengeMe.gg is an eSports matchmaking service headquartered in Berlin, Germany. While an exact dollar amount was not disclosed, Unikrn CEO Rahul Sood said it was “a multi-million dollar acquisition.”
Headquartered in Mumbai, Nazara aims to create a full eSports system including competitive online and offline play, localized leagues, and global events. Nodwin Gaming was started in 2014 and has exclusive rights for ESL (Esports League) in India, the Intel Extreme Masters qualifiers for India, and the Electronic Sports World Cup India Qualifiers. In acquiring a majority stake in Nodwin, Nazara hopes to leverage Nodwin’s relationships to create an Indian eSports ecosystem. India’s eSports audience is still developing with only 2 million enthusiasts and an additional 2 million occasional viewers according to market researchers Frost & Sullivan and Newzoo.
Multiplay is a division of UK-based Game Digital. Multiplay provides server hosting for games such as Titanfall 2, Day Z, Rocket League, and Rust. The terms of the deal provide that Unity pay $22.7 million at the time of acquisition (November 2017) and $2.5 million in July 2019. The Multiplay division includes a digital business and an eSports and events business.
The growth of eSports has attracted the attention from high profile investors. For example, in November 2017 Jerry Jones along with John Goff acquired the eSports team Complexity. Complexity was founded in 2003 by Jason Lake and currently competes in six games: CS GO, DOTA 2, Call of Duty, Rocket League, HearthStone, and Gwent. Complexity will move facilities to The Star, which also houses the Dallas Cowboys World Headquarters in Frisco, Texas.
Magic Johnson and motivational speaker Tony Robbins partnered acquire ownership interest in Team Liquid, an eSports team based in Santa Monica, California. Another former Laker, Shaquille O’Neal is a co-owner of NRG eSports. The teams mentioned above compete with other eSports teams from around the world in various tournaments held throughout the year.
Esports is a relatively new industry with potential. Advances in streaming and mobile technology have allowed the industry to expand in recent years. Newzoo projects the global eSports audience will be approximately 557 million in 2021, a compound annual growth rate of 14.4% from 2016. In addition to a growing global audience, Newzoo projects global revenue for the eSports industry to reach $1.65 billion by 2021, a CAGR of 27.4% from 2016.
The potential growth has drawn interest from a wide range of investors as approximately 84% of 2021 global revenue is projected to be from brand investments such as media rights, advertising, and sponsorship.
Mercer Capital will continue to follow the industry and discuss the valuation issues facing the industry in future articles.
Originally published in Mercer Capital’s eSports: An Emerging Industry whitepaper.
After a slow start, M&A activity among U.S. commercial banks and thrifts picked up to the point where 2018 should look like recent years. Historically, approximately 2% to 4% of the industry is absorbed each year via M&A. Since 2014, the pace has been at or slightly above 4% as a well performing economy, readily available financing, rising stock prices for bank acquirers, and strong asset quality and earnings of would be sellers have supported activity.
There were 140 announced transactions according to S&P Global Market Intelligence through early July, which equates to 2.4% of 5,913 FDIC-insured institutions that existed as of year-end 2017. The average assets per transaction based upon YTD activity was $656 million, which is below the 28 year average of $1.1 billion.
Pricing has trended higher as measured by the average price/tangible book value (P/TBV) multiple, which increased to 172% in 2018 from 164% in 2017 and about 140% in 2014-2016 before the sector was revalued after the national election on November 8, 2016.
The median P/E based upon trailing 12 month earnings increased to 26x in 2018 from 23x in 2017 and 21x in 2016; however, the 2018 P/E based upon trailing 12 month earnings does not reflect a full year impact of the reduction in the top marginal federal tax rate to 21% from 35% that occurred on January 1. The adjusted P/E assuming the lower tax rate was in effect for 2017, too, is around 20-22x.
Lower tax rates notwithstanding, it appears that buyers are still paying roughly 9-13x pro forma earnings assuming all expense savings are fully realized, a level of pricing that we believe has existed for many years excluding periods when industry fundamentals are stressed. For example, Fifth Third Bancorp (FITB) estimates the $4.6 billion consideration to be paid to MB Financial (MBFI) shareholders equates to 16.4x consensus 2019 earnings and 9.6x assuming all expense savings realized in 2019 (which will not be the case due to the phase-in lag).
Dig deeper and, of course, there is more to the pricing story. The reduction in tax rates has had a material impact on profitability. Depending upon the index bank stocks rose 25-30% in the three months after the national election on November 8, 2016, on the expectation of what has mostly played out: a reduction in corporate tax rates, less regulation, higher short rates and faster economic growth.
The improvement in public market multiples has supported expansion of M&A multiples when the majority of the consideration consists of the buyer’s common shares. As shown in Table 1, the median P/TBV and P/E ratios for transactions announced in the 20 months since the election were 173% and 23.0x compared to 147% and 20.3x for the 20 months ended November 8, 2016. Multiple expansion is even more pronounced when only 2018 deals are considered because the YTD median P/TBV and P/E multiples are 193% and 25.4x.
Not surprisingly (to us), the median multiples for cash deals did not rise as much, increasing to 141% after the election compared to the 20 month pre-election median of 123%. Cash did not inflate in value over this period like public market bank stock valuations; hence, the only meaningful factor that drove the limited improvement in cash acquisition multiples was the increase in ROE.
In addition, cash activity slowed post-election because buyers and sellers waited to see if would be sellers’ earning power would increase from a reduction in corporate tax rates, which was not confirmed until late 2017. Transactions in which the primary form of consideration consisted of the buyer’s common shares did not have to wait for the tax issue to be resolved because buyer and seller both faced the issue.
M&A is largely a story of the consolidation of the small banks by large community and small regional banks. Two decades ago the theme was the same, but overlaid was the formation of the nationwide and multi-region franchises through mega-mergers such as NCNB/Bank of America and Wells Fargo/Norwest.
Since the financial crisis, activity has mostly been confined to small deals with deal values a fraction of the pre-crisis and especially pre-2000 amounts. Annualized year-to-date deal value is $33 billion, which compares to approximately $26 billion annually during 2015-2017. By comparison, the value of announced transactions in 1997 and 1998 were many multiples greater at $97 billion and $289 billion, respectively.
During the past five years, there only have been 10 deals that exceeded $2 billion of consideration and 22 deals in which the consideration exceeded $1 billion. As shown in Table 2, the two largest transactions involved Canadian banks, while three involved the large Ohio-based banks.
Change may be afoot, however. Fifth Third’s $4.6 billion pending acquisition of MB Financial is its first bank acquisition since 2008, and it was announced a couple of days before President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act. Among other things, the financial deregulation law moved the SIFI asset threshold from $50 billion to $100 billion and provided significant relief for institutions such as Fifth Third that fall within the $100 billion to $250 billion asset bucket.
Notably, during the past five years only CIT Group crossed the prior $50 billion SIFI threshold via acquisition, and apparently did so at the urging of regulators who wanted CIT to shore up its deposit funding.
We look for more activity among mid-sized regional banks that are near or over $50 billion of assets; however, deal activity among the very largest banks is off the table given the $250 billion asset threshold for the global SIFI designation and the 10% nationwide deposit market share cap if pierced via acquisition.
The potential fly in the ointment to the robust bank M&A environment is the flattening yield curve and the attendant underperformance of bank stocks this year. If bank stocks lag and valuations compress further, then it may be difficult for buyers to meet inflated seller expectations that rarely take into account downward moves in buyers’ share prices.
The adage banks are sold rather than bought is largely true, meaning most banks transact when the sellers are ready to do so. Sometimes that occurs after years of planning; sometimes it occurs unexpectedly when another institution makes a casual inquiry.
Mercer Capital has over three decades of experience as a financial advisor helping institutions navigate the process as buyer and seller. Even if your board has no interest in selling (or buying) we would be happy to present an overview to your board about the lay of the land as it relates to the public market, M&A market and what actions your board might consider to enhance value. Please call if we can be of assistance.
Originally published in Bank Watch, July 2018.
For years, cases such as Bertuca1 and Barnes2 governed the landscape on the issue of marketability in the valuation of marital assets in Tennessee family law cases. Specifically, Bertuca involved a company called Capital Foods which held several McDonald’s franchise locations. In the decision, Bertuca did not allow for a discount to be taken for the lack of marketability for a nonpublicly traded company and offered the following reasoning:
“…no indication…has any intention to sell…thus, the value of the business is not affected by the lack of marketability and discounting the value for nonmarketability in such a situation would be improper.”
While Barnes involved a dental practice, the Court offered a similar explanation for excluding a discount for lack of marketability:
“…inappropriate because no sale was ordered and there [was] no indication in the record that the Husband ha[d] any intention of selling his minority stock.”
Both cases focused on the lack of an actual/imminent sale rather than the lack of marketability of these two underlying companies when compared to a publicly traded equivalent. The cases also left business valuation appraisers in a quandary, since this treatment of the lack of marketability didn’t seem to match the fair market value standard. The fair market value standard, discussed in Revenue Ruling 59-60, discusses the relevance of a willing buyer and a willing seller and also allows for potential discounts for lack of control and lack of marketability, where applicable.
So what has changed now? In April 2017, House Bill 348 was passed by the Tennessee legislature. This Bill amends the Tennessee Code Annotated Title 36, Chapter 4 (TCA 36-4-121), relating to the equitable division of marital property. Specifically, this Bill allows for “considerations for a lack of marketability discount, a lack of control discount, and a control premium if any should be relevant and supported by the evidence for such assets” “without regard to whether the sale of the asset is reasonably foreseeable.”
Effective July 2017, discounts for lack of marketability can now be considered in the valuation of assets in family law disputes. As with the valuation itself, it’s important to hire an accredited/credentialed business valuation appraiser to assist in the determination, documentation and support of any discounts for lack of control and marketability, along with any applicable premiums.
1 Bertuca v. Bertuca, No. M2006-00852-COA-R3-CV, 2007 WL 3379668 (Tenn Ct. App. Nov. 14, 2007).
2 Barnes v. Barnes, No. M2012-02085-COA-R3-CV (Direct Appeal from the Chancery Court for Bedford County No. 27833, April 10, 2014).
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Second Quarter 2018
Valuation of a business can be a complex process requiring certified business valuation and forensic accounting professionals. Valuations of a closely held business in the context of a divorce are typically multifaceted and may require forensic investigative scrutiny for irregularities in the financials that may insinuate dissipation of business/marital property. Business valuations are a vital element of the marital dissolution process as the value of a business, or interests in a business, impact the marital balance sheet and the subsequent allocation/distribution of marital assets.
To begin, the financial expert will request certain information and interview management of the Company. Information requested typically includes:
The financial expert must assess the reliability of the documentation and decide if the documents appear thorough and accurate to ultimately rely on them for his/her analysis. The three approaches to value a business are the Asset-Based Approach, the Income Approach, and the Market Approach.
The asset-based approach is a general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on the value of the assets net of liabilities. Asset-based valuation methods include those methods that seek to write up (or down) or otherwise adjust the various tangible and intangible assets of an enterprise.
The income approach is a general way of determining a value indication of a business, business ownership interest, security or intangible asset using one or more methods that convert anticipated economic benefits into a present single amount.
The income approach can be applied in several different ways. Valuation methods under the income approach include those methods that provide for the direct capitalization of earnings estimates, as well as valuation methods calling for the forecasting of future benefits (earnings or cash flows) and then discounting those benefits to the present at an appropriate discount rate. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market.
The market approach is a general way of determining a value indication of a business, business ownership interest, security or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities or intangible assets that have been sold.
Market methods include a variety of methods that compare the subject with transactions involving similar investments, including publicly traded guideline companies and sales involving controlling interests in public or private guideline companies. Consideration of prior transactions in interests of a valuation subject is also a method under the market approach.
A proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations.
Does it make a difference in value per share if you own 10% or 75% of a business? You bet it does. A 10% interest is a minority interest and does not enjoy the prerogatives of control. How does this affect value per share? The minority owners bear witness to a process over which they may have no control or discretion. In effect, they often play the role of silent partners; therefore, the fair market value per share of a minority owner is likely worth less per share than the shares of a 75% owner.
Likewise, a minority owner of a private business likely does not have a ready market in which to sell their interest. Minority ownership in a publicly traded company enjoys near instantaneous liquidity such as trading stock on organized and regulated exchanges. The unique uncertainties related to the timing and favorability of converting a private, minority ownership interest to cash gives rise to a valuation discount (lack of marketability discount) which further distances the minority owner’s per share value from that of a controlling owner’s value per share.
The following chart provides perspective of the various levels of value. In most cases a valuation is developed at one level of value and then a discount or premium is applied to convert to another level. These discounts are known as discounts for lack of control and lack of marketability. Knowing when to apply such adjustments and quantifying the size of these adjustments is no simple matter, requiring the need for a credentialed business valuation professional.
Normalizing adjustments adjust the income statement of a private company to show the financial results from normal operations of the business and reveal a “public equivalent” income stream. Keep in mind the levels of value in business valuation, discussed above. In creating a public equivalent for a private company, another name given to the marketable minority level of value is “as if freely traded,” which emphasizes that earnings are being normalized to where they would be as if the company were public, hence supporting the need to carefully consider and apply, when necessary, normalizing adjustments. There are two categories of adjustments.
These adjustments eliminate one-time gains or losses, unusual items, non-recurring business elements, expenses of non-operating assets, and the like. Examples include, but are not limited to:
These adjustments relate to discretionary expenses paid to or on behalf of owners of private businesses. Examples include the normalization of owner/officer compensation to comparable market rates, as well as elimination of certain discretionary expenses, such as expenses for non-business purpose items (lavish automobiles, boats, planes, etc.) that would not exist in a publicly traded company.
For more, refer to our article “Normalizing Adjustments to the Income Statements” and Chris Mercer’s blog.
The process of valuing a business is complicated and the financial expert, during the course of his/her analysis, must consider various levels of value, normalization adjustments, as well as methods of valuation to most appropriately conclude on the business.
Valuations of a closely held business in the context of a contentious divorce can be especially multifaceted and may require additional forensic investigative scrutiny for any irregularities in the financials that may insinuate dissipation of business/marital property in anticipation of the divorce and valuation. Examples may include, but are not limited to:
It is important to consider these types of situations if only one spouse is involved with the operations and management of the company, otherwise referred to as the “in-spouse.” That spouse may, or may not, have been altering the financial position of the business in anticipation of divorce and a potential independent business valuation. The services of a financial expert can be vital to you and your client in such matters, as the accuracy of the valuation may impact the equitable distribution of the marital assets.
If suspicions do not necessitate forensic services, perhaps only a business valuation scope is necessary. Furthermore, if the business or an interest was recently bought or sold, if it was recently appraised, or if its value is in a financial statement or a loan application, that information may go a long way in establishing the value of the business (if both parties feel that this value is a fair representation). However, since a business valuation report and expert witness are admissible in court as evidence and since the value of a business or interest impacts the marital balance sheet and the subsequent asset distribution, it may be exceedingly beneficial to hire a professional for evidentiary support.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Second Quarter 2018
On May 15, the AICPA’s Financial Reporting Executive Committee released a working draft of the AICPA Accounting and Valuation Guide Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies. The document provides guidance and illustrations for preparers of financial statements, independent auditors, and valuation specialists regarding the accounting for and valuation of portfolio company investments of venture capital and private equity funds and other investment companies. The comment period ends August 15, 2018.
Weighing in at nearly 650 pages, the guide defies quick summary. As noted in the preliminary “Guide to the Guide” section, different chapters in the working draft are likely to be of greater interest to some groups of intended users than others. In this introduction to the Guide, we provide a brief overview of the chapters and appendices with which PE and VC managers should develop familiarity.
The Guide distinguishes between the economic and non-economic rights typical of senior classes of preferred stock. Analysts generally value the economic rights attached to different share classes using one of four methods: scenario-based methods, the option pricing method, the current value method, or the hybrid method. The Guide provides a comprehensive overview of the relative strengths and weaknesses of these methods and describes which circumstances are most conducive to the use of each.
Chapter 10 of the Guide discusses the calibration framework and provides examples of how initial valuation assumptions used in valuing a debt or equity investment in a business can be calibrated with the original transaction price and subsequently adjusted to take into account changes in the subject investment and market conditions at the measurement date. When subsequent funding rounds take place, calibrating to the most recent transaction is typically most relevant, and the Guide outlines six different types of transactions and the process of potentially inferring value from these types of transactions.
The primary purpose of backtesting is to assess and improve the valuation process going forward. The Guide provides an overview of the backtesting process and advice on how to identify and evaluate factors that can contribute to a difference in value for a particular investment between the measurement date and event date. The final section of Chapter 11 provides nine examples illustrating the backtesting process across different types of investments and under various scenarios.
In short, the new Guide is a welcome addition to the resources available for fund managers in developing reliable fair value measurements for portfolio investments. We expect that having a common set of acknowledged best practices will promote efficiency in the preparation and auditing of fair value measurements. We will provide more detailed comments on specific elements of the draft Guide in the coming weeks. In the meantime, please do not hesitate to call us to discuss how any element of the new Guide may affect your portfolio valuation process.
This article originally appeared in Mercer Capital’s Portfolio Valuation Newsletter, Second Quarter 2018.
I recently attended FinXTech, an industry event where the hosts at Bank Director bring together FinTech founders and bank directors and executives for productive conversations about the road ahead as partners (and competitors).
Those discussions occurred against a backdrop in which FinTech, as a concept to enhance the customer experience and to drive operating efficiencies, is widely accepted by bank management, shareholders, and regulators. How “FinTech” is implemented varies depending upon resources. As shown in the Table 1, there has been no surge of M&A in which banks buy FinTech companies. Only nine of 276 transactions announced since year-end 2016 entailed a bank or bank holding company acquirer. KeyCorp, which has been one of the nine active FinTech acquirers, announced in June 2018 that it would acquire digital lending technology for small businesses built by Chicago based FinTech company Bolstr. At best, activity can be described as episodic as it relates to bank acquisitions, which appears to be designed to supplement internal development.
The very largest banks such as JPMorgan Chase & Co. are spending billions of dollars annually to upgrade technology—a level of spending that even super regional banks cannot match. In contrast, community and regional banks have been left scratching their heads about how to address FinTech-related issues when money is a constraining factor.
During the FinXTech 2018, the focus shifted from the potential disruption of a bank’s franchise by FinTech to the potential to partner with FinTech companies, which stood out to me as a marked change from prior years.
Both banks and FinTech companies realize that they need each other to some degree. For banks, FinTech offers the potential to leverage innovation and new technologies to meet customer expectations, enhance efficiency, and compete more effectively against the biggest banks. For FinTech companies, the benefits from bank partnerships can include the potential to leverage the bank’s customer relationships to scale more quickly, access to funding, and regulatory/compliance expertise. Several examples of successful partnerships between banks and FinTech companies were highlighted at the FinXTech event. (You can read more about some of them here.)
The FinTech/Bank partnership theme also was evident in GreenSky’s recent IPO, a FinTech company based in Atlanta. GreenSky arranges loans primarily for home improvement projects. Bank partners pay GreenSky to generate and service the loans while the bank funds and holds the loans on their balance sheet. As more partnerships emerge, it will be interesting to see if FinTech impacts the valuation of banks that effectively leverage technology to achieve strategic objectives such as growing low-cost core deposits, opening new lending venues, and improving efficiency. One would think the answer will be “yes” if the impact can be measured and is meaningful.
Another trend to look for will be whether smaller banks become more active as investors in FinTech companies. For the most part, investments by community and regional banks in FinTech companies remains sporadic at best even though FinTech companies raised nearly $16 billion of equity capital between year-end 2016 and June 2018 in both private and public offerings. An interesting transaction we observed was a $16 million Series A financing by Greenlight Financial Technology, Inc., a creator of smart debit cards, in which the investors included SunTrust Bank, Amazon Alexa Fund, and $619 million asset NBKC Bank, among others.
FinXTech 2018 included several sessions related to due diligence for FinTech partnerships; however, with limited M&A and investing activity by banks there was little discussion about valuation issues, which can be challenging for FinTech companies and differs markedly from methods employed to value a bank.
Not surprisingly, we have lots of thoughts on the subject.
With the emerging partnership theme from FinXTech 2018 in mind, view our complimentary webinar “How to Value an Early-Stage FinTech Company.” Additionally, if you have questions, reach out to one of our professionals to discuss your needs in confidence.
Originally published in Bank Watch, June 2018.
Most family law attorneys do not have a background in finance or accounting, yet are often confronted with complex financial issues in divorce matters. The services of an experienced financial expert can be vital to you and your client in such matters.
In vetting financial experts, look for those who specialize in business valuation and forensic accounting. However, don’t pigeon-hole your expert. If your matter doesn’t require a business valuation or the tracing of dissipated assets, a financial expert can still be of great help to you in each phase of the process: discovery, deposition, and trial.
Beyond valuation, tracing, and testifying, below is a list of services a skilled financial expert provides to help you uncover and understand financial issues:
In financial situations that may be scrutinized by regulators, courts, tax collectors, and a myriad of other lurking adversaries, the financial, economic, and accounting experience and skills of a financial expert are invaluable.
To receive the highest benefit of financial expert services, hire the financial expert with ample time to assist with the various stages of the case and provide the expert access to pertinent documentation and information.
A competent financial expert will be able to define and quantify the financial aspects of a case and effectively communicate the conclusion.
For more information or to discuss your matter with us, please don’t hesitate to contact us.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, First Quarter 2018
High dollar, contested divorce litigation engagements often involve complex financial issues. In turn, those financial issues usually include business valuations and voluminous amounts of documents and financial information. How does an attorney or business appraiser determine what is crucial to the case and what is trivial or secondary information? One such piece of financial information that varies wildly in its interpretation and importance to the case is a personal financial statement.
A personal financial statement is a document submitted to a bank or lending institution for the purpose of securing financing by representing an individual or couple’s financial position or net worth. In other words, it’s an asset and liability statement with estimates of value for each item. If the individual or couple owns a business, there generally is an estimate of value assigned to that asset.
Family law attorneys and business appraisers should always ask for personal financial statements as part of their discovery or information request for the business valuation. If one exists, how important is this document and how much weight should be given to it? Here’s where there are wildly different views of the same document.
One view of a personal financial statement is that no formal valuation process was used; so at best, it’s a thumb in the air, blind estimate of value of the business.
The opposing view would say the individual or couple submitting the personal financial statement is attesting to the accuracy and reliability of the financial figures contained in that document under penalty of perjury. Further, some would say the business owner is the most informed person regarding his business, its future growth opportunities, competition, and the impact of economic and industry factors on the business.
With such polar views, how do family law attorneys and business appraisers use personal financial statements? Dismiss them and throw them out? Use them as a gold standard and forego a formal business valuation? As usual, the two adages “it depends” and the “truth lies somewhere in the middle” are both probably accurate in this situation.
Attorneys and business appraisers never want to be surprised by not knowing about information or documents that exist. Therefore, you should always ask for personal financial statements. They should then be used as another data point along with the other indications of value that a business appraiser is considering, such as an asset value, income value, market value, recent transactions within the Company’s stock, etc. As with recent transactions within the Company’s stock, consideration should be given to the timing of submission for the personal financial statement and the relevance and motivation involved in the event.
If the value indicated by the personal financial statement falls within a reasonable range of the estimates from the other methodologies, it should probably be given more weight. Be cautious if the value indicated by the personal financial statement is materially higher or lower than a reasonable range indicated by the other methodologies. In which case, it may require the business appraiser to ask more questions regarding the thought process behind the estimate in the personal financial statement.
Bottom line, ask for personal financial statements, analyze them, but consider them along with other factors and methodologies before concluding on a value for the business. These documents can be helpful in the divorce process, but don’t let them become the smoking gun by not asking for them or by not being aware that they exist.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, First Quarter 2018
Most professionals have seen countless reports of the 2017 Tax Cuts & Jobs Act (TCJA) on national news and been bombarded with requests to discuss the impact and various changes in the new law. For the family law community, obvious takeaways are the change in the deductibility, or lack thereof, in alimony payments after 2018, elimination of personal exemptions, and expanded use of 529 plans to include secondary and lower-level education expenses. Can a provision in the TCJA actually provide some insight into the presence of personal goodwill?
Under Tennessee case law, personal goodwill is not a divisible marital asset. As discussed in the seminal case Koch, the Court reiterates the findings and definition of personal goodwill provided by the Wisconsin Court of Appeals in Holbrook. Holbrook describes personal goodwill as follows:
“The concept of professional goodwill evanesces when one attempts to distinguish it from future earning capacity. Although a professional business’s good reputation, which is essentially what its goodwill consists of, is certainly a thing of value, we do not believe that it bestows on those who have an ownership interest in the business, an actual, separate property interest. The reputation of a law firm or some other professional business is valuable to its individual owners to the extent that it assures continued substantial earnings in the future. It cannot be separately sold or pledged by the individual owners. The goodwill or reputation of such a business accrues to the benefit of the owners only through increased salary.”
So, what does personal goodwill have to do with the TCJA? Upon closer examination of the provision for a Section 199A deduction, some individual’s trusts and estates could be eligible for a 20% deduction on certain pass-through income. However, there are special limitations that apply to “specified service businesses.” According to the TCJA, “specified service businesses” are defined as follows:
A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities.
Sound familiar? Both the Holbrook and “Specified Service Businesses” definitions have some common elements including reputation and skill of the employee. Under the TCJA, can tax returns now be used to assist attorneys and business appraisers to determine if the presence of personal goodwill exists? In other words, if an individual fails to qualify for a Section 199A deduction because of the “specified service businesses” limitation, does that illustrate that personal goodwill is present?
We think the Section 199A provision and a person’s deductibility or exclusion of this deduction can provide another data point for attorneys and appraisers in determining whether personal goodwill is present. As with any thorough analysis of personal vs. enterprise goodwill, other important factors to consider are:
The 2017 Tax Cuts & Jobs Act may assist attorneys and appraisers in determining if personal goodwill is present via the Section 199A deduction.
As we’ve pointed out, this deduction/exclusion is just one of several data points that should be considered. It should also be noted, that determining whether personal goodwill is present or not is only the first step to an analysis. If personal goodwill is present, the second step is to determine or assign value to the personal goodwill. In other words, a company’s value could be comprised of both enterprise and personal goodwill. A qualified business appraiser is necessary to make this determination and to provide an allocation of the goodwill.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, First Quarter 2018
Viewed from the prism of “fairness” in which a transaction is judged to be fair to shareholders from a financial point of view, many transactions are reasonable; some are very fair; and some are marginally fair. Transactions that are so lopsided in favor of one party should not occur absent a breach of corporate duties by directors (i.e., loyalty, care and good faith), bad advice, or other extenuating circumstances. Obtaining competent financial advice is one way a board exercises its duty of care in order to make an informed decision about a significant corporate transaction.
The primary arbiter of fairness is the value of the consideration to be received or paid relative to indications of value derived from various valuation methodologies. However, the process followed by the board leading up to the transaction and other considerations, such as potential conflicts, are also important in the context of “entire” fairness.
A tough fairness call can occur when a transaction price appears to be low relative to expectations based upon precedent transactions, recent trading history, management prognostications about a bright future, and/or when the value of the consideration to be received is subject to debate. The pending acquisition of commercial finance lender NewStar Financial, Inc. (“NewStar”; Nasdaq-NEWS) is an example where the acquisition price outwardly seems to be low, at least until other factors are considered.
On October 16, 2017, NewStar entered into a merger agreement with First Eagle Holdings, Inc. (“First Eagle”) and an asset purchase agreement with GSO Diamond Portfolio Holdco LLC (“GSO”). Under the merger agreement, NewStar will be acquired by First Eagle for (a) $11.44 per share cash; and (b) non-transferable contingent value rights (“CVR”) that are estimated to be worth about $1.00 per share if the transaction closes before year-end and $0.84 per share if the transaction closes in 2018. The CVR reflects the tax benefit associated with the sale of certain loans and investments at a discount to GSO for $2.37 billion.
Also of note, the investment management affiliate of First Eagle is majority owned by an entity that is, in turn, partially owned by Corsair Capital LLC, which is the largest shareholder in NewStar with a 10.3% interest.
As shown in Figure 1, the acquisition price including all of the CVR equates to 83% of tangible book value (“TBV”), while the market premium is nominal. Although not relevant to the adequacy of the proposed pricing, NewStar went public in late 2006 at $17.00 per share then traded to around $20 per share in early 2007 before sliding to just about $1.00 per share in March 2009.
“Feel” is a very subjective term; nonetheless the P/TBV multiple that is well below 100%, when combined with the nominal market premium, feels light. NewStar is not a troubled lender. Non-performing assets the past few years have been in the vicinity of 3% of loans, while net charge-offs have approximated 1% other than 2015 when losses were negligible. Further, the implied haircut applied to the loans and investments that will be acquired by GSO is modest.
While the P/TBV multiple for the transaction is modest, the P/E multiple is not at 26.5x (the latest twelve month (“LTM”) earnings) and 18.4x (the consensus 2018 estimate). The P/E could be described as full if NewStar were an average performing commercial bank and very full if it was a typical commercial finance company in which low teen P/Es are not unreasonable.
What the P/TBV multiple versus the P/E multiple indirectly states is that NewStar has a low ROE, which has been less than 5% in recent years. The culprit is a highly competitive market for leveraged loans, a high cost of funds absent cheap bank deposit funding and perhaps excess capital. Nonetheless, management’s projections incorporated into the recently filed proxy statement project net income and ROE will double from $20 million/3% in the LTM period ended September 30 to $41 million/6% in 2020.
In spite of a doubling of projected net income, the present value (assuming NewStar is worth 18.4x earnings in 2020 discounted to September 30 at a discount rate of 13%) is about $507 million, or about the same as the current transaction value to shareholders. Earnings forecasts are inherently uncertain, but one takeaway is that the P/TBV multiple does not appear so light in the context of the earnings forecast.
Additional perspective on the transaction multiples is provided in Figure 2 in which NewStar’s P/TBV multiple based upon its public market price consistently has been below 100% the last several years while the P/E has been around 20x or higher due to weak earnings.
As for the lack of premium there outwardly did not appear to be wide-spread expectation that a transaction was imminent (as was thought possible in 2013 when Bloomberg reported the company was shopping itself). There were no recent media reports; however, the shares fell by 17% between May 2–May 19 following a weak first quarter earnings report. The shares subsequently rebounded 19% between June 6–June 14. Both the down and then up moves were not accompanied by heavy volume. Trading during most of this time frame fell below the approximate 100 thousand daily average shares.
Measured from June 14–October 17, the day after the announcement, NewStar’s shares rose about 10% compared to 8% for the SNL Specialty Finance Index. Measured from May 19, when the shares bottomed following the weak first quarter results the shares rose 34% compared to 12% for the index through October 17. The market premium relative to recent trading was negligible, but it is conceivable some premium was built into the shares for the possibility of a transaction given the sharp rebound during mid-June when negotiations were occurring.
Further support for the transaction can be found in the exhaustive process that led to the agreements as presented in the proxy statement. The proxy confirmed the Bloomberg story that the board moved to market the company in 2013. Although its investment bankers contacted 60 potential buyers, only two preliminary indications of value were received, in part because U.S. banking regulators tightened guidelines in 2013 related to leverage lending by commercial banks. The two indications were later withdrawn.
During 2016 discussions were held with GSO regarding a going-private transaction, in addition to meetings with over 20 other parties to solicit their interest in a transaction. By the spring of 2017, consideration of a going-private transaction was terminated. Discussions then developed with First Eagle/GSO, Party A and Party B that eventually led to the announced transaction. Given the experience of trying to sell NewStar in 2013 and go private in 2016, the board elected not to broaden the marketing, calculating the most likely bidders would be alternative asset managers (vs. banks with a low cost of funding).
Fairness considerations about the process were further strengthened through a “go-shop” provision in the merger agreement that provided for a 30-day “go-shop” period in which alternative offers could be solicited. If a superior offer emerged and the agreements with First Eagle and GSO were terminated a modest termination fee of $10 million (~2.5%) would be owed. Conversely, if NewStar terminates because GSO cannot close, then a $25 million termination fee will be owed to NewStar.
The go-shop provision was activated, but to no avail. More than 50 parties were contacted and seven other unsolicited inquiries were received. NewStar entered into confidentiality agreements with 22 of the parties, but no acquisition proposals were received.
Other elements of the agreements that are notable for a fairness opinion include the use of two financial advisors, financing, and director Thornburgh, who was recused from the deliberations given his association with 10% shareholder Corsair, which holds, with Blackstone, a majority interest in First Eagle. Financing was not a condition to close on the part of the buyers because GSO secured $2.7 billion of debt and equity capital to finance the asset purchase. First Eagle will use excess funds from the asset purchase and existing available cash to fund the cash consideration to be paid at closing to NewStar shareholders. While two financial advisors cannot make an unfair deal fair, the use of two here perhaps gave the board additional insight that was needed given the four-year effort to sell, take the company private, or affect some other corporate action to increase value.
While the transaction price for NewStar seems low, there are other factors at play that bear consideration. When reviewing a transaction to determine if it is fair from a financial viewpoint, a financial advisor has to look at the entire transaction in context. Some shareholders will, of course, focus on one or two metrics to support a view that is counter to the board’s decision.
Every transaction has its own nuances and raison d’etre whether the price “feels right” or not. Mercer Capital has significant experience helping boards sort through valuation, process and other issues to determine what is fair (or not) to shareholders from a financial point of view. Please call if we can help your board make an informed decision.
Originally published in Bank Watch, December 2017.
For those readers unable to escape the cold to attend Bank Director’s Acquire or Be Acquired (AOBA) conference in Scottsdale, AZ, we reflect on the major themes: bank M&A and scarcity, tax reform and valuation, and FinTech. For those unfamiliar with the three-day event, over 1,000 bankers, directors, and advisors gather to discuss pertinent industry issues.
There are fewer than 5,500 banks today, which is roughly half from only 10 years ago when we first attended AOBA. This scarcity was top-of-mind for several panelists who noted variations on the same theme: Scarcity matters to both buyers and sellers as the number of banks dwindles at a rate of 3-4% per annum.
Unlike the 1990s and even the pre-crisis years when a seller could expect multiple offers, banks that sell today often have just one or two legitimate suitors. In our view, this means that sellers need to think more strategically about their valuation today and prospectively if their most logical suitor(s) is acquired. Even if the logical acquirer is unlikely to be acquired, board planning for some institutions should consider the potential to strike a (cash) deal with a credit union. For buyers, scarcity may translate into less desirable banks in targeted markets. If so, scarcity may mean greater emphasis on expansion through lift-outs from other banks, or even a push into non-traditional bank acquisitions/investments such as wealth management that could serve as a nucleus around which traditional banking services are bolted. One key question to watch: Will scarcity impact the pace of consolidation and the valuation of transactions? The short answer is seemingly “yes,” but rising acquisition valuations over the past couple of years correspond to the rising value of acquirers’ publicly traded shares.
The banking sector was revalued higher in the public markets following the November 2016 elections, reflecting four attributes that would favor banks: regulatory reform, tax reform, faster GDP growth, and therefore, higher interest rates. While the impact (thus far) of regulatory reform and higher interest rates is limited, passage of the Tax Cuts and Jobs Act of 2017 is a highly tangible benefit for banks and customers. With the stroke of a pen, ROE for many banks will rise to or above the institution’s cost of capital, returning to pre-financial crisis levels. However, tax reform is not a cure for strategic issues such as whether FinTech may radically disrupt the “core” in the deposit relationship between customers and their banks.
One panelist summed up the debate by noting that management teams who achieve a 10-15% increase in earnings and ROE in 2018 from tax reform are not geniuses; rather, they are around to cash the check. The real winners, as it relates to tax reform, will be banks that leverage the enhanced cash flows to make optimal capital budgeting and strategic decisions. Bankers will have to allocate the additional earnings before some of it is competed away among investments in staff, technology and/or higher dividends, share repurchases and acquisitions. Perhaps in the ideal world, the incremental capital to be created would be used to support faster loan growth, but few at the conference indicated their institution had seen an increase in loan growth as a result of tax reform.
A related theme that emerged in several sessions was the dichotomy in valuations between the “haves” and “have-nots” along key metrics such as size, profitability, core deposits, location, management team, and operating strategy/niche. This divergence could widen further following tax reform as the “haves” effectively take their higher cash flows and reinvest/deploy them more profitably than the “have-nots.” Ultimately, these strategic decisions and the trajectory of the bank’s performance will drive whether tax reform leads to sustainably higher bank valuations, likely varying case-by-case. For those interested, we discuss implications of tax reform for banks in greater detail here.
While FinTech wasn’t even on the agenda when we first made the trip to Scottsdale for AOBA in the mid-2000s, it was all over this year’s schedule. One panelist humorously compared bankers’ reactions to FinTech with the “Seven Stages of Grief” noting that bankers seemed to have finally progressed beyond the early-stages of anger and denial toward the latter-stage of acceptance. Bankers are considering practical solutions to incorporate FinTech into their strategic plans. Sessions included panel discussions on the nuts and bolts of structuring FinTech partnerships and creating value through leveraging FinTech to enhance profitability. (For those interested in FinTech, learn more about our book on the topic.) Niches of FinTech that garnered particular attention included digital lending, payments (both consumer and business), blockchain, and artificial intelligence. AI in particular was top-of-mind, and one panel noted it as an area of FinTech offering strong potential for banks in the next few years.
We look forward to discussing these three themes with clients in 2018 and monitoring how they evolve within the banking industry over the next few years. As always, Mercer Capital is available to discuss these trends as they relate to your bank – feel free to call or email.
Originally published in Bank Watch, February 2018.
The following is an 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 an 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.
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The following is an installment in our series “What Keeps Family Business Owners Awake at Night”
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.
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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: