Benefits of a Financial Expert in Family Law: Why & When to Hire

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:

• Determine financial documentation requests for subpoena
• Examine submitted financial documents
• Evaluate the accuracy of previously mentioned documents
• Assess whether further support is necessary
• Assemble relevant information
• Quantify the financial elements of a case
• Identify and classify marital and nonmarital assets and liabilities
• Assist with interrogatory drafting
• Support deposition questionnaire drafting
• Attend depositions for real-time financial support

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

The Important Role of Personal Financial Statements in Divorce

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 secondary information? One such piece of financial information that varies wildly in its interpretation and importance to the case is a personal financial statement.

What Is a Personal Financial Statement?

Depending on the jurisdiction, most family law attorneys are familiar with documents often referred to as Sworn Financial Affidavits, Asset/Liability Statements, Marital Balance Sheet or Divorce Financial Statements that are included with the filing of the divorce case.

A personal financial statement is a similar document that is typically 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 akin to a balance sheet. Therefore, the couple’s or individual’s net worth is the sum of all assets, less the market value of all liabilities. For most liquid assets, such as cash/bank accounts, and investment/retirement accounts, the values can easily be obtained from the most recent account statement. Market value estimates for other assets, such as residential and personal real estate, can be obtained from recent appraisals, recent purchases, property tax assessments, and/or realtor websites. If the individual or couple owns a business, there generally is an estimate of value assigned to that asset. Since a business represents a non-liquid asset, the source of that value estimate can vary widely.

Below, is a common example of a personal financial statement:

Generally, the following items are excluded from a personal financial statement:

Leased/Rented Items: These assets are excluded since they are not actually owned by the couple or individual. However, if the couple owns a piece of property that is rented to someone else, it would be included as an asset. Further, some personal financial statements include a summary of all forms of income and expenses, often expressed in the form of monthly or yearly amounts, if the personal financial statement is used to obtain credit or to show the couple’s or individual’s overall financial position in addition to their net worth.

Personal Property: Refers to items such as furniture and household goods. Generally, the value of these items is not readily known and they are generally not considered for credit as they are unable to easily be sold. If there is any personal property with significant value, such as jewelry, cars, antiques or collectibles, their value might be included with an appraisal as the source of value. Family law attorneys will note that values for personal property are also generally not listed on divorce filings. Opinions on value can widely vary and often the true value to an individual may be rooted more in sentimental reasons than actual value. Unfortunately, the allocation of value to these items or the selection as to who ends up with each item can be one of the last and most challenging aspects to settling a case.

Why Is a Personal Financial Statement Important?

Family law attorneys, financial experts and business appraisers should ask for personal financial statements as part of their discovery or information request process. If one exists, how important is this document and how much weight should be given to it? Here’s where there are different views of the same document.

One view of a personal financial statement is that no formal valuation process was used for business assets; so at best, it’s a thumb in the air, estimate of value of the business. Did the business owner complete the form without consulting any external data or did the business owner recently conduct a business valuation on the business or consult with a business appraiser? Chances are the spectrum of possibilities is generally closer to the former than the latter, but it might bear to ask questions regarding the circumstances of the personal financial statement.

Another view is that 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/her business, its future growth opportunities, competition, and the impact of economic and industry factors on the business.

With such considerations, 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. Personal financial statements can be helpful in some cases or they can lack third party independent analysis as to the value of the business assets in other cases.

Do You Like Surprises?

Attorneys and business appraisers do not want to be surprised by not knowing about information or documents that exist. Therefore, 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 or other market indications of value such as prior company transactions or contemplated sales/mergers, consideration should be given to the following factors: First, what is the timing of submission for the personal financial statement or data point to either the date of filing or date of trial. In other words, a recently submitted personal financial statement or data point is more relevant than one from five or ten years prior. Second, what was the context, relevance and motivation involved in the event? Why was the personal financial statement submitted or did the event represent an arm’s length transaction between two unrelated parties, as opposed to family members. Finally, do the values submitted in the personal financial statement or other data points caused by events represent elements of fair market value or do they reflect strategic value. A recent issue of Family Law Valuation and Forensic insights, covers the definitions of some of these standards of value in the overall context of understanding and defining the assignment.

If the value indicated for the business by the personal financial statement falls within a reasonable range of the estimates from the other methodologies, it could probably be given more weight. Be cautious if the value indicated for the business 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 or why conditions might have changed drastically from the submission to current day.

Conclusion

Bottom line, ask for personal financial statements, review 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.

Observations of New Tax Reform Law on Personal Goodwill in Family Law Cases

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?

Personal Goodwill Under Tennessee Law

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.”

Section 199A of the TCJA and Personal Goodwill

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:

1. Size of business and number of owners/practitioners
2. Presence/lack of covenants not to compete
3. Dependence on owner(s) for selling feature with Company’s products
4. Presence/lack of ancillary income

Conclusion

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

Management Succession in Family Businesses

Next Man (or Woman) Up?

Perhaps no group is as proficient at the art of clichéd answers as football coaches. When confronted with the season-ending injury of a star player, the coach will inevitably stare stoically into the camera and solemnly declare “Next man up.” Whether the coach truly believes that the replacement player will be adequate, the cliché is intended to convey the idea that the coach has created such a “culture of success” that the “Process” (two of the newer clichés) that the team’s performance will be unaffected.

From the perspective of family business, “Next Man or Woman Up” is one approach that the board of directors can take to management succession. Perhaps for some family businesses, management succession is as simple as pulling the next available candidate from the management depth chart. But we suspect that approach falls short for most family businesses. The combination of business growth, generational dynamics, and intra-family relationships that make family businesses unique precludes one-size-fits-all solutions to management succession. The primary questions associated with management succession are (1) Who will be the next leader of the business? and (2) How will the transition occur?

First Question: Who?

In our experience, many succession struggles are rooted in a failure to distinguish between being a good family member, a good employee, and a good business leader. The combination of native ability, education, character, social IQ, technical skills, and strategic savvy necessary to run a large business successfully is rare. The often-unspoken assumption that, since Dick has been a good son, or Jane a good daughter, that he or she is entitled to run the business when his or her turn comes up is unfair to the shareholders and employees of the business, not to mention Dick or Jane. While there are abundant examples of capable and energetic second, third or later generation family members that are great business leaders, it is a mistake to think that management of the business should simply be a matter of inheritance.

The second common myth is that since Bill and Suzie have demonstrated themselves to be great employees (in whatever functional area) that they will, therefore, be great leaders. Being good at one’s job does not guarantee success as the leader of a family business. Further, as companies grow, new challenges may require a different set of leadership skills than were required in the prior generation. The skills and personality traits that made Uncle Phil the ideal leader of the business twenty-five years ago may be different from what Cousin Carlton needs to possess for success in the same role today.

If the family has successfully distinguished family membership from family business management, it may be easier for the board to cast a wider net to find the best candidate to assume leadership of the business. Having an “outside” CEO does not mean the company has ceased to be a family business any more than hiring the first non-family employee on the shop floor did. Rather, it simply means that the directors have fulfilled their responsibilities to shareholders, employees and the community by seeking the right candidate for the job. Family members are by no means ruled out from consideration, but directors must acknowledge that the requisite skills may not reside in the family. And that’s okay. Having “professional” management may actually help family cohesion – and therefore business sustainability.

In many cases, the combination of outside perspective and family loyalty that make a successful leader can be found among the family’s in-laws. Such “married-ins” are often sufficiently removed from family dynamics that they can see business issues for what they are, uncolored by what may be decades’ worth of emotional baggage. At the same time, their membership in the family may give a head-start in aligning economic incentives. In other words, “married-ins” will likely have plenty of skin in the game.

Second Question: How?

In the long run, management succession is inevitable: the proportion of managers that are eventually replaced is 100%. In the short run, however, there are generally three circumstances giving rise to management succession.

1.     Planned Retirement: When the senior executive is approaching a natural retirement age, the directors should identify potential candidates to replace the retiring leader. With a multi-year planning horizon, the board can give due consideration to family candidates, develop mentoring opportunities for those candidates, and evaluate the performance of those candidates in areas of increasing responsibility. If it becomes apparent that no family candidates represent the right fit for the job, the board can extend the search to include existing non-family employees and non-employees.

The appropriate retirement age for family business executives is a vexing issue. There simply is no one-size-fits-all for when a successful family business leader should step away. In our practice, we have seen examples of departures that – in hindsight – were premature, because the designated replacement was not yet ready to assume leadership. Perhaps more commonly, we see examples of businesses that plateau and stagnate because an aging senior executive refuses to move out of the corner office.

2.     Performance-Driven Transition: We wrote in a previous post about the unique challenges associated with management accountability in family businesses. If the directors determine an existing senior executive is not generating acceptable results, it may be appropriate to seek a replacement. Family dynamics can make this an extremely difficult decision, and the prospect that such a decision may be in the best interest of the principal stakeholders (family shareholders, employees, local community, customers, suppliers, etc.) is one good reason to include qualified independent non-family members on the board. The independent directors can provide an objective assessment of managerial performance uncolored by internal family dynamics. If a performance-driven transition is necessary, the ultimate replacement should not be selected hastily; the long-run health of the business may be better served by a deliberate selection process, during which an experienced executive can manage the company on an interim basis.

3.     Unexpected Vacancy: Finally, management succession may be forced upon the company because of an untimely illness, death, or other unforeseen circumstances. No business is immune to such circumstances, which underscores the need for directors to proactively think about management succession, even when the current leader is successful and expected to have a lengthy remaining tenure. When tragedy strikes, selecting the next leader should still be considered a measure-twice, cut-once project, with the long-term health of the organization taking precedence over the short-term desire to fill the position.

As noted in the Harvard Business Review, recent research by Stephanie Querbach, Miriam Bird, and Nadine Kammerlander offers some interesting insights into best practices for management succession in family businesses. After studying over 500 management successions, they concluded the likelihood that successor-managers would be able to implement needed changes and improve the long-term sustainability of the family business was linked to three strategies: (1) limiting the power of the outgoing CEO subsequent to his or her retirement, (2) crafting a formal agreement regarding the how and when of power transfer, and (3) selecting a non-family successor. Of course, these observations reflect probabilities – they’re not absolute prescriptions for how every succession should occur. But they do provide a somewhat counter-intuitive perspective on the topic that family businesses would do well to consider.

In the end, every management succession plan will be as unique as the family business it is designed for. But one constant for all family businesses is that now is the time to begin thinking and planning. “Next Man Up” may work in football, but your family business deserves better than that.

Father Knows Best? Management Accountability in Family Businesses

One of the greatest sources of strife in family businesses is ill-defined roles.

• What does a good shareholder do?
• What is expected of a family business board member?
• How will the performance of management be evaluated?

Management accountability is hard for any company; effective management accountability within a complex web of family relationships can be an order of magnitude more difficult. Since some family members may fill multiple roles, clear and appropriate expectations paired with measurable outcomes are foundational to a management accountability structure that promotes business sustainability and family cohesion.

Who Sets Expectations?

Management accountability is an element of overall corporate governance. In family businesses, corporate governance and family governance can sometimes be hard to separate, but working to distinguish between the two pays dividends for both the business and the family.

The first step for many families in developing more formal governance is moving strategic business deliberations from the dining room to the board room. In the first generation, it is common for the board to consist only of mom and dad. As the business matures, the natural result of such arrangements is that the board meets continually, but never effectively. What works for the bootstrapping startup does not work for the established multi-generation family business. Formalizing the board governance process may be as simple as scheduling regular meetings, establishing appropriate sub-committees, and preparing real agendas which are distributed to members in advance of meetings. The addition of one or more independent directors may be appropriate for some companies. Independent directors with industry expertise and relevant experience can provide fresh perspective to deliberations and model how to provide frank feedback unencumbered by family baggage. The appointment of independent directors also signals that the board’s job is company oversight, not to serve as the final arbiter for non-business family disputes.

A second common step is to establish a family council. While all family councils are unique, the principal role of the family council is to provide a forum for group decision-making on non-business family matters. Many family councils also provide opportunities for education regarding the business and collect input from family members about business decisions including distribution policy, capital structure, and capital budgeting (i.e., reinvestment). This input is valuable to the board, but is not binding; the board has sole responsibility for business oversight.

A parallel governance structure like that illustrated above helps to clarify that management (whether comprising family members or non-family professionals) is accountable to the board of directors, who in turn owes a fiduciary duty to the shareholders. As a result, the board of directors has the authority and responsibility to establish expectations for management, assess performance, and determine whether remedial actions are appropriate. In other words, the CEO is accountable to the board of directors and not her obstreperous second cousin.

How Should Expectations Be Set?

One reason successful family businesses remain privately-held is that such businesses can more easily avoid the “short-termism” perceived to afflict public markets, where success or failure might judged by next quarter’s earnings release. Since family businesses are free from the constraints of the quarterly reporting treadmill, management expectations should reflect the long-term goals that will promote the sustainability of the business and the financial success of the family.

Developing a so-called “balanced scorecard” to evaluate management performance can help promote a long-term perspective that aligns management accountability with the overall health of the company. As developed by Professor Robert Kaplan of the Harvard Business School, a balanced scorecard can help to promote management accountability by focusing on four key elements of business success.

• Customer perspective: How do customers see the business?
• Internal business perspective: What must the business excel at?
• Innovation and learning perspective: Can the business continue to improve and create value?
• Financial perspective: How does the business look to shareholders?

Notice that the financial perspective is only one component of the balanced scorecard. To be sure, if management succeeds with regard to the other perspectives, financial success should follow. The idea is to take a broader view of corporate health, balancing traditional financial metrics with a few measurable operating metrics that will reveal whether the company is engaging in the activities that will promote the long-term sustainability (and financial performance) of the business.

The essence of a balanced scorecard – or any other management accountability tool – is pairing observable measures with business-specific goals under each perspective. Metrics that are not correlated to the company’s strategies won’t get traction, and goals that can’t be measured won’t be achieved. To be useful as a management accountability tool, the selected metrics should describe processes or outcomes over which management has at least some degree of control. For example, revenue per day of operation and number of rainout days are both measures that contribute to the financial success of a theme park, but only one is subject to management influence.

Making Accountability Work

Managing the family business is not a birthright, nor is it a responsibility that must be borne simply because of one’s birth. It is a job, and the associated compensation and financial incentives should reflect market conditions. The hardest part of a management accountability system is deciding what to do when clearly-communicated goals are not met. An ill-conceived accountability framework that does not have the support of all the major stakeholders can – in the end – create more problems than it solves.

Goals may fail to be met for multiple reasons:

•  The goal was unrealistic. In retrospect, it may be obvious that no management team could have delivered the specified results.
• Management performed unsatisfactorily. Given the available resources and prevailing market conditions, management simply failed to meet expectations.
• Market or other forces outside of management’s control negatively affected the business. Going back to our prior example, the theme park may have suffered through an abnormally rainy summer.
• The business strategy proved to be ineffective and needs to be revised. Management has executed the plan flawlessly, but the plan did not accurately reflect the customer, supplier, technological, or competitive forces shaping the industry.

The reasons for failure are not always easy to discern. If the goals were unrealistic, management accountability should look different than if management performed unsatisfactorily. If the business strategy proved to be ineffective, who was responsible for developing the strategy? If the board supported, or perhaps even mandated, the strategy, to what degree should management be accountable for its failure? Evaluating management performance requires both strong nerves and the ability be flexible when warranted. A seasoned, independent outside voice on the board can be especially valuable when poor performance needs to be evaluated.

Conclusion

Management accountability in family businesses is hard. Overlooking the failures of a favored relative and magnifying minor faults because of a strained family relationship are both ever-present temptations. In the end, management is accountable to the board of directors, not the family at large. Management performance should be evaluated relative to a set of clearly-defined and measurable objectives that further the long-term health and sustainability of the company. Evaluating management performance when goals are not met is difficult, but failing to evaluate performance (and thereby letting problems fester) is not a responsible course of action.

Fairness When the Price May Not Feel “Right”

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.

NewStar Example

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.

Acquisition Price

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.

Transaction Multiples

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.

Performance and Timing

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.

Other Support for the Transaction

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.

Financial Advisors

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.

The Lesson from the NewStar Example

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.

Conclusion

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.

2018 Trends to Watch in the Banking Industry: Acquire or Be Acquired Conference Recap

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.

Bank M&A and Scarcity

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.

Tax Reform and Valuation

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.

FinTech

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.

Diversification and the Family Business

The following is an installment in our series “What Keeps Family Business Owners Awake at Night”

Consider the following perspectives on diversification and risk:

“Diversification is an established tenet of conservative investment.” – Legendary value investor Benjamin Graham

“Diversification may preserve wealth, but concentration builds wealth.” – Legendary value investor Warren Buffett

The appropriate role of diversification in multi-generation family businesses is not always obvious. One of the most surprising attributes of many successful multi-generation family businesses is just how little the current business activities resemble those of 20, 30, or 40 years ago. In some cases, this is the product of natural evolution in the company’s target market or responses to changes in customer demand; in other cases, however, the changes represent deliberate attempts to diversify away from the legacy business.

What is Diversification?

Diversification is simply investing in multiple assets as a means of reducing risk. If one asset in the portfolio takes a big hit, it is likely that some other segment of the portfolio will perform well at the same time, thereby blunting the negative impact on the overall portfolio. The essence of diversification is (lack of) correlation, or co-movement in returns. Investing in multiple assets yields diversification benefits only if the assets behave differently. If the correlation between the assets is high, the diversification benefits will be negligible, while adding assets with low correlations results in a greater level of risk reduction.

To illustrate, consider a family business deciding which of the following three investments to make:

There is no unambiguously correct choice for which investment to make. While the capacity expansion project offers the highest expected return, the close correlation of the returns to the existing business indicates that the project will not reduce the risk – or variability of returns – of the company. At the other extreme, the warehouse acquisition has the lowest expected return, but because the returns on the warehouse are essentially uncorrelated to the existing business, the warehouse acquisition reduces the overall risk profile of the business. The correct choice, in this case, should be made with respect to the risk tolerances of the shareholders and how the investments fit the strategy of the business.

Diversification to Whom?

Business education is no less susceptible to the lure of fads and groupthink than any roving pack of middle schoolers. When I was being indoctrinated in the mid-90s, the catchphrase of the moment was “core competency.” If you stared at any organization long enough – or so the theory seemed to go – you were likely to find that it truly excelled at only a few things. Success was assured by focusing exclusively on these “core competencies” and outsourcing anything and everything else to someone who had a – you guessed it – “core competency” in those activities. Conglomerates were out and spin-offs were in. With every organization executing on only their core competencies, world peace and harmony would ensue. Or something like that.

I don’t know what the status of “core competency” is in business schools today, but it does raise an interesting question for family businesses: whose perspective is most important in thinking about diversification? If the relevant perspective is that of the family business itself, the investment and distribution decisions will be made with a view to managing the absolute risk of the family business. If instead the relevant perspective is that of the shareholders, investment and distribution decisions are properly made with a view to how the family business contributes to the risk of the shareholders’ total wealth (family business plus other assets).

Modern finance theory suggests that for public companies, the shareholder perspective should be what is relevant. Shareholders construct portfolios, and presumably the core competency of risk management resides with them. Corporate managers should therefore not attempt to diversify, because shareholders can do so more efficiently and inexpensively. In other words, corporate managers should stick to their core competencies and not worry about diversification.

That’s all well and good for public companies, but for family businesses, the most critical underlying assumptions – ready liquidity and absolute shareholder freedom in constructing one’s portfolio – simply does not hold. Family business shares are illiquid and often constitute a large proportion of the shareholders’ total wealth. Further, as families mature, shareholder perspectives will inevitably diverge.

For example, consider two cousins: Sam has devoted his career to managing a non-profit clinic for the underprivileged, and Dave has enjoyed an illustrious career with a white-shoe law firm. Both are 50 years old and both own 5% of the family business. Sam’s 5% ownership interest accounts for a significantly larger proportion of his total wealth than does Dave’s corresponding 5% ownership interest. As a result, they are likely to have very different perspectives on the role and value of diversification for the family business. Sam will be much more concerned with the absolute risk of the business, whereas Dave will be more interested in how the business contributes to the risk of his overall portfolio.

We wrote in a previous post about the four basic “meanings” that a family business can have. What the business “means” to the family has significant implications for not only distribution and reinvestment policy, but also the role of diversification in the business.

So how should family businesses think about diversification? When evaluating potential uses of capital, family business managers and directors should consider not just the expected return, but also the degree to which that return is correlated to the existing operations of the business. Depending on what the business “means” to the family, the potential for diversification benefits may take priority over absolute return. There are no right or wrong answers when it comes to risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know not just the “what” but also the “why” for significant investment decisions.

To Invest or Not to Invest, That is the Question

The following is an installment in our series “What Keeps Family Business Owners Awake at Night”.

Successful family businesses are built over time, and building well requires investment. Since a given dollar of cash flow generated by a business will either be returned to capital providers or reinvested in the business, a company’s reinvestment policy is essentially the inverse of its distribution policy: businesses that reinvest heavily will make modest distributions, while those that emphasize large distributions will have less available for reinvestment in the business.

Cash distributed leaves the business, providing current returns to investors, while reinvested funds remain in the business with the expectation that the retained capital will generate returns which contribute to capital appreciation. In other words, the tradeoff between current return and capital appreciation is rooted in the corresponding tradeoff between distribution and reinvestment.

For a family business, investment can take different forms.

• Capacity maintenance and modernization. Tangible assets wear out, and technological advances can render existing assets inefficient relative to available replacement assets. It may be possible to defer certain expenditures with few observable consequences in the short-term, but the bill always comes due eventually. While investments in capacity maintenance and modernization are not always the most exciting, successful family businesses recognize their priority for long-term sustainability.
• Capacity Expansion. In our experience, businesses are either growing or dying – holding steady is nearly impossible over the long-term. Investments in capacity expansion help keep family businesses on a growth footing. Depending on the company’s circumstances, growth investments may involve penetrating new geographic markets, introducing new product lines, or research to develop products for an unmet market need.
• Acquisitions. Rather than building incremental capacity, managers and directors of a family business may determine that it is more efficient to assimilate existing industry capacity through an acquisition. Acquisitions offer the opportunity to “hit the ground running” with a built-in customer base, workforce, tradename and other intangible assets that typically accrue slowly over time. On the other hand, acquisitions present integration and culture challenges (and the risk of overpayment) not relevant to other forms of investment. For perspective, during the most recent year, the companies in the S&P 600 small cap index spent $24.2 billion on acquisitions, compared to $28.7 billion on capital expenditures, with nearly 40% of the companies having completed at least one acquisition.
• Diversification. Acquisitions are often classified as either vertical (purchase of a supplier or customer) or horizontal (purchase of a competitor). Both types of acquisitions have some organic connection to the existing business. Sometimes, however, family businesses make investments that are unrelated to legacy operations. It is not uncommon for family businesses to make investments for the sake of diversification, particularly as the business matures and the number of shareholding generations increases.

One of my favorite Seinfeld moments (among many) is set at the car rental counter, where an exasperated Jerry explains to the uncomprehending agent the difference between taking a reservation and holding a reservation. Taking the reservation is easy, but holding the reservation is what really matters. In the same way, investing for growth is easy: there are plenty of equipment dealers eager to sell shiny new machines and investment bankers who can’t wait to describe an exciting acquisition target. But making good investments – those for which the tradeoff between current returns and capital appreciation worthwhile – is considerably harder. So, what are the marks of a good investment?

• Market opportunity. A good investment addresses an identifiable need in the market. Further, given the competitive environment in the relevant markets, the identified need can be met profitably. In other words, management should have a simple and straightforward answer to the threshold question: Why does this make sense?
• Strategic fit. Family business managers and directors should also have a concise and credible answer to the natural follow-up question: Why does this make for us? In other words, how does the proposed investment complement the company’s corporate strategy? If it extends or deviates from the current strategy, why is the strategy adjustment appropriate? As we described in the context of distribution policy, the business can have a variety of potential “meanings” to the family – does the proposed investment cohere with the “meaning” of the family business?
• Financially vetted. A thorough capital budgeting process will involve calculating relevant return measures (internal rate of return, net present value) to assess whether the investment opportunity is likely to increase or decrease the value of the company. Of course, figures lie and liars make spreadsheets. For a proposed investment that addresses a real market opportunity and is a strategic fit for the company, the financial vetting process should be geared to answering another vital question: What financial results are necessary for this investment to be good for us? Has management assembled a compelling case for the expected returns, or is the investment more of a “trust me” exercise?
• Plan for monitoring. The most often neglected component of the capital budgeting process is establishing a feedback mechanism for the investment. Too often, capital investments simply melt away into the general corporate asset pool, with no reliable means of evaluating whether the investment generated an appropriate return. In other words, how will we know if this investment was, in fact, good for us? The ability to evaluate past investments is critical to making better investments in the future.

All family businesses need to evaluate how they are investing for future growth. Managers and directors must navigate carefully between the risks of depressed future returns through over-investment (i.e. empire building) and losing existing competitive advantages through insufficient reinvestment. The long-term sustainability of the family business depends on it.

Dividend Policy and the Meaning of Life (Or, At Least, Your Business)

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.

• Meaning #1 – The family business is an economic growth engine for future generations. For some families, the business is perceived as a vehicle for increasing per capita family wealth over time. For these families, distributions are likely to take a backseat to reinvestment in the business needed to fuel the growth required to keep pace with the biological growth of the family.
• Meaning #2 – The family business is a store of value for the family. For other families, the business is perceived as a means of capital preservation. Amid the volatility of public equity markets, the family business serves as ballast for the family’s overall wealth. Distributions are generally modest for these families, with earnings retained, in part, to mitigate potential swings in value.
• Meaning #3 – The family business is a source of wealth accumulation. Alternatively, the business may be perceived as a mechanism for accumulating family wealth outside the business. In these cases, individual family members are expected to use distributions from the business to accumulate wealth through investments in marketable securities, real estate, or other operating businesses. Distributions are emphasized for these families, along with the (potentially unspoken) expectation that distributions will be used by the recipients to diversify away from, and limit dependence on, the family business.
• Meaning #4 – The family business is a source of lifestyle. Finally, the business may be perceived as maintaining the family’s lifestyle. Distributions are not expected to fund a life of idle leisure, but are relied upon by family shareholders to supplement income from careers and other sources for home and auto purchases, education expenses, weddings, travel, philanthropy, etc. These businesses typically have moderate reinvestment needs, and predictability of the dividend stream is often more important to shareholders than real (i.e., net of inflation) growth in the dividend. Continuation of the dividend is the primary measure the family uses to evaluate management’s performance.

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.

Making Shareholder Communication a Family Business Priority

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:

• Frequency. Public companies communicate results quarterly.  Depending on the nature of the business and the desires of the shareholder base, less frequent communication may be appropriate for a family business.  The frequency of communication should correspond to the natural intervals over which (1) genuinely “new” information about the company’s results, competitive environment, and strategy is available, and (2) shareholders perceive that the most recent communication has become “stale”.  As a result, there is no one-size-fits-all frequency; what is most important is the discipline of a schedule.
• Level of detail. Public company reports are quite detailed.  Family business leaders should assess what level of detail is appropriate for shareholder communications.  If the goal is to communicate, the appropriate level of detail should be defined with reference to that which is necessary to tell the company’s story.  The detail needs to be presented to shareholders with sufficient supporting context regarding the company’s historical performance and conditions in the relevant industries and economy.  A dashboard approach that focuses on key metrics, as illustrated below, can be an effective tool for focusing attention on the measures that matter.

• Format/Access. The advent of accessible webcast and data room technology makes it much easier for family businesses to distribute sensitive financial information securely.  Use of such platforms also provides valuable feedback regarding what is working and what is not (since use of the platform by shareholders can be monitored).  Some families may have existing newsletters that provide a natural and existing touchpoint for communicating financial results.
• Emphasis. The goal of shareholder communication should be to help promote positive shareholder engagement.  To that end, the emphasis of the communication should not be simply the bare reporting of historical results, but should emphasize what the results mean for the business in terms of strategy and outlook for the future.  It is probably not possible to re-tell the company’s story too many times.  Shareholders that are not actively involved in the business will be able to internalize the company’s strategy only after repeated exposure.  What may seem like the annoying repetitions of a broken record to management will for shareholders be the re-exposure necessary to “own” the company’s story.

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.

It’s Tax Time: Implications of Tax Reform for Banks

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

C Corporations & The Act

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.

Implications

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:

1. “Allocation” of Tax Savings
2. Lending
3. Miscellaneous

Implication #1: “Allocation” of Tax Savings

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.

Customers

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

Employees

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.

Shareholders

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.

Implication #2: Lending

The Act potentially affects loan volume with future possible effects on credit quality.

Volume

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.

Quality

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:

1. Net Operating Loss (“NOL”) Limitations. Tax policy existing prior to the Act allowed businesses to carry back net operating losses two years, which provided an element of countercyclicality in periods of economic stress. The Act eliminates the carryback provision. Further, businesses can apply only 80% of future NOLs to reduce future taxable earnings, down from 100% in 2017, thereby potentially pressuring a business’ cash flow as it recovers from losses. As a result, less cash flow may be available to service debt.
2. Interest Deductibility Limitations. The Act caps the interest a business may deduct to 30% of EBITDA (through 2021) and EBIT (thereafter) for entities with revenue exceeding $25 million.⁶ Assuming a 5% interest rate, a business’ debt must exceed 6x EBITDA before triggering this provision. Several issues arise from this new limitation. First, community banks may have clients that manage their expenses to achieve a specified tax result, which could face disallowed interest payments. Second, in a stressed economic scenario, cash flow may be diverted to cover taxes on nondeductible interest payments, rather than to service bank debt.
3. Real Estate Entities. The Act appears to provide relatively favorable treatment of real estate managers and investors. However, banks should be aware that the intersection of (a) the interest deductibility limitations and (b) the Act’s depreciation provisions may affect borrower cash flow. Entities engaged in a “real property trade or business” may opt out of the 30% interest deductibility limitation. However, such entities (a) must depreciate their assets over a longer period and (b) cannot claim 100% bonus depreciation for improvements to the interior of a commercial property.

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.

Implication #3: Miscellaneous Considerations

Additional considerations include:

Effect on Tangible Book Value

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.

Regulatory Capital⁷

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

Business Investments

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

Mergers & Acquisitions

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.

Permanence of Tax Reform

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?

S Corporations & The Act

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

Conclusion

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.

End Notes

1. Lest we be accused of imprecision, the Act’s formal name is “An act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018.”
2. Before proceeding, we include the de rigueur disclaimer for articles describing the Act that Mercer Capital does not provide tax advice and banks should consult with appropriate tax experts.
3. We recognize that some of the tax savings may be invested in capital expenditures or community relations, but these expenditures ultimately are intended to benefit one of the three stakeholder groups identified previously.
4. Transcript of J.P. Morgan Chase & Co.’s Fourth Quarter 2016 earnings call.
5. Transcript of Renasant Corporation’s Fourth Quarter 2017 earnings call.
6. Floor plan financing is exempt from this provision.
7. See also Federal Reserve, Supervisory & Regulatory Letter 18-2, January 18, 2018.
8. Generally, DTAs are includible in regulatory capital up to a fixed percentage of common equity Tier 1 capital.
9. In addition, §179 allows entities to expense the cost of certain assets.  The §179 limit increases from $500 thousand in 2017 to $1 million in 2018.  The Act also expands the definition of assets subject to §179 to include all leasehold improvements and certain building improvements.
10. We recognize that the risk of exploding heads is acute with reference to §199A.  Therefore, we avoided discussion of the limits on the 20% deduction relating to W-2 and other compensation, “qualified” property, and overall taxable income, as well as the various income thresholds that exist.  Suffice to say, §199A is considerably more complex than we have described.
11. It does not appear that banks are SSTBs (and, thus, banks are eligible for the 20% deduction), although the explanation is mind numbing.  An SSTB is defined in §199A by reference to §1202(e)(3)(A) but not §1202(e)(3)(B).  Existing §1202 provides an exclusion from gain on sale to holders of “qualified small business stock.”  However, §1202(e)(3)(A) and §1202(e)(3)(B) disqualify certain businesses from using the QSB stock exclusion.  Banks are specifically disqualified from the QSB stock sale exclusion under §1202(e)(3)(B).  Since §199A’s definition of an SSTB does not specifically cite the businesses listed in §1202(e)(3)(B), such as banks, §199A has been interpreted to provide that banks are not SSTBs.  Interested in more SSTB arcana?  Architects and engineers are excluded specifically from the list of businesses ineligible for the 20% deduction, apparently speaking to the lobbying prowess of their trade groups (or their ability to build tangible things).
12. We are not aware that the Act limits the increase in an S corporation shareholder’s tax basis arising from earnings not distributed to shareholders.  However, the tax basis advantage of S corporation status typically is secondary to the immediate effect of an S corporation election on a shareholder’s current tax liability.
13. To be fair, we should limit the “math exercise” comment to C corporations; the S corporation provisions in §199A undeniably are abstruse.

The Valuation Implications of the 2018 Tax Reform

Significant Corporate Changes

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.

Tax Rate
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

Foreign Income
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

Like-Kind Exchanges
Changes to availability

The Impact on Valuation

Enterprise Valuation

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.

Pass-Through Valuation

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.

Word to the Wise

These significant changes should be evaluated on a company-by-company basis to determine what effect, if any, the changes will have on expected cash flows. Appraisers with deep experience in the relevant industry are best positioned to evaluate the potential effects.

Download the full presentation here.

How to Promote Positive Shareholder Engagement

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.

Why is Shareholder Engagement Important for Family Businesses?

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.

What are the Marks of an Engaged Shareholder?

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.

• An appreciation of what the business means to the family. Engaged shareholders know the history of the family business in its broad outline. Few things promote a sense of community like a shared story. A successful family business provides a narrative legacy that few families possess. Engaged shareholders embrace, extend, and re-tell the story of the family business.
• A willingness to participate. Full-time employment is not the only avenue for participating in the family business. Engaged shareholders understand their responsibility to be active participants in the groups that are appropriate to their skills, life stage, and interests, which may include serving as a director, sitting on an owners’ council, or participating in a family council.
• A willingness to listen. Positively-engaged non-employee shareholders recognize that there are issues affecting the family business, the industry, and the company’s customers and suppliers of which they are unaware. As a result, they are willing to listen to management, regardless of whether management consists primarily of non-family professionals or their second cousins.
• A willingness to develop informed opinions. A willingness to listen does not mean passive acceptance of everything management is communicating. A competent and confident management team recognizes that non-employee shareholders have expertise, experiences, and insights that members of management lack. Engaged shareholders acknowledge their responsibility to develop and share informed opinions, not just gut reactions or prejudices.
• A willingness to consider perspectives of other shareholder groups. Engaged shareholders do not seek the benefit of their own branch of the family tree to the detriment of the others. Multi-generation family businesses inevitably have distinct shareholder “clienteles” with unique sets of risk tolerances and return preferences. Privileging the perspective of a single shareholder clientele is a sure way to promote discord.
• A commitment to deal fairly. Fairness needs to run in both directions: non-employee shareholders should not be penalized for not working in the business, and shareholders that do work in the business need to be fully and fairly compensated for their efforts. Fairness also extends to distribution and redemption policy, both of which can be used to this disadvantage of one group within the family. Engaged shareholders are committed to fair dealing in transactions with the business and within the family.

How to Develop an Engaged Shareholder Base?

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.

• Develop mechanisms for appropriate involvement. Not everyone can have a seat at the board, but family and owner’s councils can be great ways to broaden opportunities and prepare family members for greater involvement.
• Emphasize the privilege/responsibility of being a shareholder. This will look different for every family, but a visible commitment to charitable contributions and service opportunities can be a powerful signal to the family that being a shareholder involves a stewardship that transcends simply receiving dividends.
• Basic financial education. Family members will have many different talents, interests, and competencies. Offering rudimentary financial education (i.e., how to read a financial statement, and understanding how distribution policy influences reinvestment) can empower the healthcare professionals, educators, and engineers in the family to develop and communicate informed opinions on family business matters.
• Actively solicit shareholder feedback. While it is true that the squeaky wheel gets the grease, it is often the un-squeaky wheels that have the most valuable insight. Periodic shareholder surveys can be an effective tool for promoting positive shareholder engagement.
• Demonstrate a commitment to fair dealing. Shareholders who are also managers in the business need to be wary of the tendency to pursue empire-building activities at the expense of providing appropriate returns on the shares in the family business.

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.

What Keeps Family Business Owners Awake at Night?

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:

• Shareholder engagement: How many of your second cousins do you know? As families grow into the fourth and fifth generations, common ownership of a successful business can serve as the glue that holds the family together. However, as the proportion of non-employee family shareholders increases, maintaining productive shareholder engagement grows more challenging.
• Communication: Effective communication is a critical for any relationship. Multi-generation family businesses are complex relationship webs. Identifying best practices for communicating effectively with family shareholders was a common objective for conference attendees.
• Distribution policy: Hands down, the most frequent topic of conversation was establishing a distribution policy that balances the lifestyle needs and aspirations of family shareholders with the needs of the business.
• Investing for growth: The flip-side of distribution policy is how to invest for growth. Can the family business keep up with the biological growth of the family? Is that a desirable goal? Regardless of the selected goal, family business leaders are concerned about identifying and executing investments to support the growth of the family business.
• Diversification: A striking number of the family businesses represented at the conference had diversified rather far afield from the legacy business of the founding generation. What are the marks of effective diversification for a family business?
• Management accountability: Evaluating managerial performance is never easy; adding kinship ties to the mix only makes things dicier. The family business leaders we spoke with were eager to develop and implement effective management accountability structures.
• Management succession: Whether it comes simply through age or as a result of poor performance, management succession is somewhere on the horizon for every family business. By our unofficial count, most of the family businesses in attendance were still led by a family member (often enough by so-called “married-ins”). A meaningful minority, however, had professional (i.e., non-family) management teams.
• Next Gen development: Rising generations are naturally more diffuse than prior generations, with regard to geography, interests, skill sets, and desires. Family leaders were interested in identifying appropriate pathways for next generation leaders to engage, learn, and grow in their contribution to, and impact upon, the family business.
• Generational transfer/estate planning: Attendees were keenly interested in tax-efficient techniques for transferring ownership of the family business to succeeding generations. While certainly important, there may be unanticipated pitfalls if estate and other taxes are the only factors considered when transferring wealth.
• Evaluating acquisition offers: There’s a definite selection bias at a family business conference: attendees are necessarily shareholders of family businesses that have not been sold. Even if the family does not plan to sell, credible acquisition offers at what appear to be attractive financial terms need to be assessed. Family business representatives were interested in learning how best to evaluate and respond to such offers.
• Share redemption/liquidity programs: There are many reasons family members may want to sell shares: desire for diversification, major life changes (such as divorce), funding for estate tax payments, starting a new business, or funding other major expenditures. What is the best way to provide liquidity to family shareholders on fair terms without sparking a run on the bank?

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 Importance of Size, Profitability, and Asset Quality in Valuation

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.

Data Analysis & Quantitative Factors Affecting Your Bank’s Value

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

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.

Profitability

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.

Asset Quality

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.

Conclusion

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.

How to Value an Early-Stage FinTech Company Webinar Recording

Complete the form below to view the webinar.

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.

Calculating the WACC: Estimation and Evaluation

Travis W. Harms, CFA, CPA, ABV hosted the webinar, Calculating the WACC: Estimation and Evaluation, November 21st, 2017. The webinar was sponsored by the American Society of Appraisers (ASA).

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:

• Traditional techniques for measuring the WACC
• Challenges associated with measuring various components
• Ex post vs. ex ante perspective
• Review of market evidence regarding WACC
• Review of market evidence regarding the size effect

Valuing Investments in Start-Ups

Travis W. Harms, CFA, CPA/ABV, Senior Vice President, presented Valuing Investments in Start-Ups at the AICPA’s 2017 Forensic & Valuation Services Conference November 15, 2017, in Las Vegas, Nevada.

An explanation of Travis’ presentation, Valuing Investments in Start-Ups, is available below:

Confessions of a Reluctant Expert Witness

When Z. Christopher Mercer, FASA, CFA, ABAR began testifying as an expert witness in the early 1980s, he didn’t have a clue about what to do or how to do it. Since then, Mercer has testified scores of times and learned some important lessons the hard way. As he shares his experiences with you, gain insights on how to prepare for and conduct yourself in depositions. From acceptance to final billing, understand how to organize expert witness engagements. Plus, learn how to be an effective witness on the stand by providing impactful testimony.

What Every Estate Planner Should Know About Buy-Sell Agreements

Unless your client has had their buy-sell agreement reviewed from a valuation perspective, they don’t know what it says. This comes as a surprise to many – an often unpleasant surprise as too many find themselves caught up in unexpected and costly legal wrangles or personal turmoil.

Originally presented by Z. Christopher Mercer, FASA, CFA, ABAR at the 2017 Southern Federal Tax Institute, this session provides you with information from a valuation perspective that will help ensure that your clients’ buy-sell, shareholder, or joint venture agreement results in a reasonable resolution and is not a ticking time bomb set to explode upon a triggering event. In other words, you will leave this session understanding how your clients’ buy-sell agreement will work – before a trigger event occurs.

Evaluating Financial Projections as Part of the Diligence Process

Timothy R. Lee, ASA, Managing Director, moderated an educational session on the importance of due diligence regarding financial projections at the ESOP Association’s 2017 Las Vegas ESOP Conference & Trade Show.  Phillip Chou, managing director at AmbroseAdvisors, and Erin Hollis, ASA, CDBV, director of Dispute Resolution & Litigation Support at Marshall & Stevens, Inc., were co-presenters alongside Tim.

A description of the session is below:

Management’s financial projections are a key input into the analyses underlying ESOP fairness opinions and annual appraisal reports. Furthermore, the DOL Process Agreement highlighted the importance of thoroughly evaluating management’s financial projections. This session will review methods and procedures that fiduciaries and valuation professionals can use to evaluate the reasonableness of projections as part of the valuation process. Furthermore, the panel will address the importance of obtaining sufficient industry-related information and/or employing outside experts when dealing with industry-specific nuances. Finally, panel will address the feasibility of a quality of earning (Q of E) report, and what alternatives may be available in connection with the financial due diligence process.

Core Deposit Intangible Asset Values and Deposit Premiums Update

In 2016, Mercer Capital published an article on core deposit trends through November 1 just before the presidential election. At that time, core deposit intangible (CDI) values remained near historical lows. Following the financial crisis, CDI values decreased as deposits have less worth, so to speak, in a very low rate environment than in a “normal” environment as existed before the crisis.

Despite a rate increase by the FOMC in December 2015, the costs of alternative funds such as FHLB advances had not materially increased and were not expected to increase more than the gradual pace the Fed had targeted for short-term interest rates since late 2015. The persistent low rate environment limited both deposit premiums paid in acquisitions and CDI values booked.

A week later, the presidential election defied market expectations and drove bond yields higher almost immediately on expectations of stronger economic growth and rising inflation. Three more rate increases by the FOMC followed in December 2016, March 2017, and June 2017. Since the post-election run-up, the yield curve has flattened, but overall yields remain well above pre-election levels (Chart 1).

Using data compiled by S&P Global Market Intelligence, we analyzed trends in CDI assets recorded in whole bank acquisitions completed from 2008 through the third quarter of 2017, and we compared CDIs recorded as a percentage of core deposits acquired to 5-year FHLB rates over the same period. CDI values generally have followed interest rate trends. Prior to the start of the financial crisis, CDIs recorded in acquisitions averaged 1.5%–2.0%, but post-crisis CDIs stabilized at approximately 1.0%–1.25% in the 2014 to 2016 period. Since the November 2016 election, CDI values have risen through mid-2017 as yields rose, before declining in the third quarter as the yield curve flattened. CDIs represent the benefit of having a low-cost, stable funding source, and in times when alternative sources of funds have higher rates, core deposits have greater “worth” to an acquirer (see Chart 2).

Although CDI values have increased since the post-crisis lows, CDI values remain well below long-term historical average levels. CDI values have averaged approximately 1.5% in 2017, compared to averages in the 2.5%–3.0% range in the early 2000s. Even as CDI values remained largely stagnant through 2016, deposit premiums paid in whole bank acquisitions have shown more volatility, driven by improved deal values that have pushed deposit premiums up at a quicker pace from their 2009 lows, a trend that has continued through 2017.1 The flattening yield curve that pushed CDI values lower in the third quarter of 2017 did not have the same effect on deposit premiums, but for deals closed in the third quarter deposit premiums largely reflected transaction values determined earlier in the year when the yield curve was steeper, and this lagged effect could push deposit premiums back down in upcoming quarters. Regardless of the near-term outlook, current deposit premiums in the range of 10% remain well below pre-financial crisis levels when premiums for whole bank acquisitions averaged closer to 20%.

Deposit premiums paid in branch transactions, defined as the value paid in excess of deposits acquired, have generally been less volatile than tangible book value premiums paid in whole bank acquisitions. Branch transaction deposit premiums are up some from the lows observed in the financial crisis but have remained in the 4%–5% range for the last 12 months.

For our analysis of industry trends in CDI values, we defined core deposits as total deposits, less accounts with balances over $100,000. In analyzing core deposit intangible assets for individual acquisitions, however, a more detailed analysis of the deposit base would consider the relative stability of various account types. In general, CDs tend to be more rate sensitive and less stable. Even in cases where a CD base is considered a stable customer base, given their relatively higher cost compared to non-time deposits, CDs often do not contribute to the core deposit intangible asset recorded. Furthermore, account types such as brokered or Qwickrate accounts and certain public funds that may be subject to a competitive bidding process are generally excluded from core deposits when determining the value of a CDI.

Based on the data for acquisitions for which core deposit intangible detail was reported, a majority of banks selected a ten-year amortization term for the CDI values booked. Less than 10% of transactions for which data was available selected amortization terms longer than ten years. Amortization methods were somewhat more varied, but the accelerated amortization method was selected in approximately half of these transactions.

For more information about Mercer Capital’s core deposit services, please contact us.

Financial Institutions: Black Holes of Valuation

Originally presented at the ASA’s 2017 Advanced Business Valuation Conference.

In his session, Jeff reviewed the business model for banks and other financial institutions and how the model differs from that of non-financial institutions. He reviewed various valuation methodologies for financial institutions and what pitfalls valuation professionals may grapple with vis-a-vis non-financial institutions. Overlaid will be a perspective on factors that matter for stock selection and why these factors can differ somewhat from valuation factors. Further, Jeff reviewed issues related to valuing securities issued by financial institutions that are in the capital stack above common equity.