While still making up a small proportion of overall deal activity (<10% of total deal volume in 2021), acquisitions of banks by both Credit Unions and FinTechs have been increasing in recent years.
The first credit union to acquire a bank occurred in 2011/12.
Since then, approximately ~55 whole bank transactions have been announced with the peaks occurring in 2019 (14 transactions) and 2021 (13 transactions announced).
The first announced FinTech acquisition of a bank was Green Dot’s purchase of a small bank back in 2010 for $15 million. There were also several online brokers that acquired banks from the late 90s to mid-2000s. In 2021, there was a marked increase with six announced transactions whereby FinTechs announced acquisitions of banks.
This emerging breed of bank acquirers (CUs and FinTechs) provides bank sellers with an additional pool of potential buyers to consider when evaluating strategic options and liquidity events.
Mercer Capital’s Jay D. Wilson and Honigman’s Michael M. Bell presented this session at the 2022 Acquire or Be Acquired Conference sponsored by Bank Director.
In each “Meet the Team” segment, we highlight a different professional on our Family Law team. The experience and expertise of our professionals allow us to bring a full suite of valuation and forensics services to our clients. We hope you enjoy getting to know us a bit better.
Christopher Mercer, FASA, CFA, ABAR is the Chairman of Mercer Capital. He has been working in the valuation industry for over forty years and founded Mercer Capital in 1982.
Chris Mercer: Writing and speaking has been an integral part of my personal strategy and Mercer Capital’s strategy towards growth and development. When I started Mercer Capital, I had enough exposure to successful people in a variety of fields to know that one of the ways I could differentiate myself was through writing and speaking. I enjoy the process of writing and have written consistently ever since my first article was published. Writing to me, outside of being something I enjoy, was essential to create the reputation of Mercer Capital. With the firm headquartered in Memphis, we were at a disadvantage from firms located in major markets. Mercer Capital needed to differentiate itself from these firms. All of the writing and speaking I did put me in front of a national audience beginning in the late 1980s and the early 1990s, which eventually gave Mercer Capital national exposure, and our firm has continued to grow from there.
Chris Mercer: When I got into the valuation profession, it was sort of like the Wild West. Valuators did not have a set of universal processes. When I performed my first valuation in early 1979, there were no books on business valuation. So, I went around and talked to everyone I could talk of and asked them what valuation looked like. Then, in 1981 Shannon Pratt’s first edition of Valuing a Business was published which was really the only reference book back then. I call those times the Wild West because people did not know what a marketability discount was or what a control premium was. Marketability discounts were guessed at by looking at restricted stock studies.
I tried to change that in 1997 when I wrote Quantifying Marketability Discounts and developed the Quantifying Marketability Discount Model (QMDM), and people have been having to deal with the reality of cash flow, risk, and growth since then. We at Mercer Capital have been attempting to bring an organized financial focus to the business of valuation since the late 1980s. I have seen this profession evolve in terms of information, size, and credentialing. My hope over the next five to ten years is for the profession to embrace an integrated theory. We cannot continue as a profession to do things in a non-uniform way. I think that is what will change over time, that we will become a more cohesive profession.
Chris Mercer: When I started Mercer Capital, I already knew that I liked business valuation. As for litigation, I only had one testimony experience prior to starting the firm. However, litigation was one of the main avenues to get into the valuation business. I began to testify in the local area divorce courts, as working in this market was a way for appraisers to gain experience. I also did a number of statutory fair value cases. Overall, litigation is challenging, mentally stimulating, and I find it satisfying to deal with some of the best and brightest in the country.
Chris Mercer: My advice to anyone who wants a career in valuation is to take charge of building your own reputation and then the reputation of your firm. You create a brand within the brand. We have created a structure at Mercer Capital that allows people to create their personal brand within the firm brand by focusing on industry specializations, as well as service line specialization. Some of those industry specializations are banking, insurance, asset management, oil & gas, auto dealers, and so many more.
It is also important to gain credentials and credibility. At Mercer Capital, we support the CFA designation. We currently have 19 CFAs. We are proud of that. In addition, we support the ASA designation from the American Society of Appraisers (14 ASA credential holders and one Fellow (FASA)) and the CPA, ABV, and CFF designations from the AICPA (nine ABV credential holders), in addition to others. Continuous learning is part of the Mercer Capital way of life.
Chris Mercer: Hands down, I am most proud of the fact that we sit here today as a firm with almost 50 employees, that we are employee-owned, and that we have a succession plan in place and working that assures the continuation of the firm for decades to come. We have created a firm that is providing great careers for a lot of people. I am pleased that the firm is here, and that we have created the opportunity for our employees to save, invest, and build their futures.
Much has transpired since Bank Watch’s last review of net interest margin (“NIM”) trends in May 2019. The emergence of COVID-19 in early 2020 resulted in economic shutdowns that led to emergency rate cuts from the Federal Reserve and unprecedented monetary and fiscal stimulus. While the economic recession that followed COVID-19 proved to be short-lived, low rates and excess liquidity lingering in the system have weighed on margins.
As 2022 gets underway, the industry is hopeful that rate increases and loan growth, stemming from the continued economic recovery, will deliver a boost to margins. This potential inflection point provides a good opportunity to review recent margin trends and examine how banks may be impacted by rising rates this year.
As shown in Figure 1, NIMs contracted sharply in 2020 and have remained depressed relative to long-term averages. With deposits accumulating on the balance sheet and a lack of attractive lending opportunities, many banks’ asset composition shifted in favor of short-term, lower-yielding assets. According to FDIC data, the loan to deposit ratio for community banks reached record lows in 2020 and 2021, reported at 73% as of the third quarter of 2021. This compares to an average 83% from 2012 to 2019.
Aside from the earning asset mix and deposit base, NIMs reflect a lending margin over a base rate determined based upon competition. The base rate has been severely depressed, and excess liquidity in the system has squashed any additional lending margin to be had.
NIMs for small community banks (assets $100 million to $1 billion) fell 39 basis points from the fourth quarter of 2019 to the second quarter of 2021, while banks with $1 billion to $10 billion in assets experienced margin compression of 36 basis points over the same period. We would note that margins have been somewhat distorted by PPP loans and the associated fee income.
The third quarter of 2021 showed some positive trends for NIMs, with both small and large community banks reporting modest expansion of 2 to 11 basis points. Margins could expand further in the fourth quarter if loan growth materializes and payoffs subside. Lower premium amortization expense should provide another tailwind for banks with MBS exposure as prepayments speeds decline.
Banks are optimistic for 2022 with the Fed winding down its asset purchases and potentially raising rates as early as March. The 30 day and 90 day forward curves for LIBOR imply the Fed will raise rates three to four times by the end of 2022. The 10-year Treasury yield spiked to start the year, settling at 1.78% as of January 25, up from 1.52% at year-end
The absolute level of rates is an important factor on the deposit side of the equation, specifically rates out to about 3 years. Higher rates increase the value of non-interest bearing and very low-cost deposits as they provide more lift to the NIM. Banks with a higher proportion of non-interest bearing deposits stand to benefit more from a rising rate
Deposits accumulated during the pandemic have proven to be stickier than many initially thought, and 2022 should provide a good test of that stickiness. As a percentage of total assets, deposits have increased each quarter since Q2-20 for both small and large community banks.
Some banks are concerned about the possibility of deposit run-off with rising rates, but the prospect of deposit run-off significant enough to hinder lending opportunities seems unlikely. Deposit rate adjustments by banks in periods of rising rates tend to lag Fed rate movements. There is reason to expect, given banks’ liquidity, that deposit rate adjustments will have a longer than normal lag in this rate cycle.
Banks that were hesitant to deploy excess cash at low yields should have some opportunities to invest at higher yields in the bond market this year. Anecdotally, some banks reporting Q4-21 earnings have mentioned shifting a greater proportion of funds to the securities portfolio. For example, Independent Bank Corp. (INDB) expanded its securities portfolio by $445 million in Q4-21 and plans to be “aggressive” with securities investments in 2022.
Rising rates notwithstanding, margins may still not return to historical levels due to excess liquidity. For one, loan growth may not be enough to absorb the sheer amount of cash that banks accumulated in 2020 and 2021. In addition, loan pricing reflects a base rate plus a lending margin, as mentioned previously. The base rate will come up, but the additional margin could remain challenged if would-be lenders remain flush with liquidity and the intensity of competition for loans does not wane.
These challenges will likely be a driver of M&A activity this year. Sellers face profitability challenges with continued margin pressure, the loss of PPP fees, and normalization of mortgage income. Buyers may find it more attractive to acquire targets with legacy loan books at better rates versus trying to grow loans organically in the current environment or investing in securities at low yields.
Bank stocks have outperformed since mid-September when investors concluded the Fed was likely to raise rates in 2022 rather than 2023. As of January 26, the KBW Nasdaq Bank Index is up 6.1% from September 15th compared to the S&P 500’s 2.9% decrease.
Analysts are anticipating margins to bottom out in the first quarter of 2022. Smaller rate increases may have a limited near-term impact on loan yields. For example, Bank OZK (OZK) announced in Q4-21 that 63% of its variable rate loans would still be subject to rate floors after a 50bps change in the base rate.
Margins are forecast to begin increasing in subsequent quarters and pick up steam in early 2023. However, margins will likely remain below pre-pandemic levels for the foreseeable future. The chart below shows historical and forecast margin performance for a group of public regional banks.
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Banks with assets between $5 billion and $10 billion traded at 12.6x projected 2022 earnings and 1.60x tangible book value as of January 26. Banks with assets from $1 billion to $5 billion traded at 11.1x projected 2022 earnings and 1.29x tangible book value. Valuations presumably capture the impact of three rate hikes in 2022. As noted earlier, this has been the case since September when investors shifted their expectations for Fed rate actions.
Ultimately, rate increases on the horizon and economic recovery should provide a tailwind to margin expansion in 2022. However, excess liquidity still presents a challenge, and uncertainty remains as to further impacts from COVID-19.
This is the third of the three-part series where we focus on key areas to assist family lawyers and divorcing parties. Part III concentrates on Schedule K-1 (Form 1065 or Form 11-20-S) and additional business-related schedules which can be useful in divorce proceedings. Part I discusses Form 1040 and can be found here, and Part II discusses Schedule A (Itemized Deductions) and can be found here.
Entities taxed as general partnerships, limited partnerships, limited liability partnerships, limited liability corporations, and S corporations prepare a Schedule K-1 (“K-1”) for each of its owners. The Schedule K-1 identifies the owners of the business and specifies the percentage of equity, profits, and losses that will be attributed to each for tax purposes, among other information. K-1s must be distributed to each owner and filed with the entity’s tax return. Owners then utilize the K-1 when preparing their personal tax returns to substantiate the profits and/or losses they are claiming.
Schedule K-1 provides information regarding the business, the individual partner (or member or shareholder), as well as the portion of taxable income or loss that is attributable to each owner. A business owner may not receive a salary and therefore, might not get a Form W-2 Wage and Tax Statement. Schedule K-1 provides the details on profit and loss allocated to the individual from the business. Sometimes other agreements are in place for bonus sharing, etc. and the K-1 reflects each business owner’s proportionate share of taxable income or loss.
The K-1 provides evidence of ownership in a business, details the percentage of ownership, and shows business gains and losses for the year allocated to the specific owner, among other information. The business ownership (whether 100% or an interest in the business) may be divisible within the marital estate. If multiple business interests exist, each entity would generate a separate K-1 per owner. The Schedule K-1 can also be used in conjunction with other documents for income determination purposes.
Part II of Schedule K-1, Information about the Partner –provides details on each individual partner such as the type of entity, partner’s share (beginning and ending) of profit, loss, capital and liabilities, and the beginning and ending capital account of the individual. Box G will indicate if the taxpayer is a general, limited, or other type of partner. Another item to pay close attention to is Box J which is the line that states: “Check if decrease is due to sale or exchange of partnership interest.” If checked, more information may need to be requested to understand the transaction, amended agreement, or other type of sale or exchange.
While the K-1 offers helpful information on business ownership percentages and annual profit or loss, additional documentation of the business entity should be requested when performing a business evaluation and/or in conjunction with other forensic services such as income determination.
Box L – titled Partner’s Capital Account Analysis presents the ending capital account for the individual partner by showing the following: the beginning capital account, plus capital contributed and current year net income (loss) for the year, less withdrawals and distributions, if any.
One should pay attention to the information presented on the Partner’s Capital Account Analysis because it may be a starting point for evidencing distributions (which may or may not be included in W-2 salary), and investments into a business such as a capital call.
Part III of Schedule K-1 – is Partner’s share of current year income, deductions, credits, and other income. A few of the individual boxes are explained below.
Box 1 – represents the taxpayer’s share of Ordinary Business Income, or Loss, from the corporation. The individual’s income amount is further categorized within Form 1040 depending on whether the income is deemed active or passive. Passive income includes money earned from interest, dividends, and rental property. Active income includes pass-through income or loss, wages and salaries (these may also be included on an individual W-2) or supplemental income. Refer to Schedule E – Supplemental Income and Loss for information on the income; specifically Line 28, which includes column (H) for passive income and column (K) for active or nonpassive income.
Box 12 – Section 179 Deduction – is an immediate expense deduction that business owners have the option to utilize for purchases of depreciable business equipment rather than capitalizing and depreciating the asset over a period of time (referred to as straight-line depreciation). This allows businesses to lower their current-year tax liability rather than capitalizing an asset and depreciating it over time in future tax years, i.e., the tax reduction is taken in full versus in smaller amounts over a period of time. The Section 179 deduction is offered as an incentive for small business owners to grow their business with the purchase of new equipment. To qualify, the property is limited to items such as cars, office equipment, business machinery, and computers; this property also must be used for business purposes more than 50% of the time to qualify. This deduction election will also be reported for the individual taxpayer on Form 4562 – Depreciation and Amortization.
Information on the K-1 can guide questions to ask and subsequent documents to request in order to understand and evaluate business interest(s).
Form 4562 – Depreciation and Amortization is used to claim deductions for the depreciation or amortization for tax purposes. Other uses include making an election under Section 179 to expense certain property, and to provide information on the business/investment use of automobiles and other assets. Individuals and businesses can claim deductions for tangible assets, such as a building, and intangible assets, such as a patent. Section 179 property does not include property held for investment, property used outside of the United States, or property used by a tax-exempt organization.
The Depreciation & Amortization Schedule can assist the divorce process by providing a listing of depreciable assets. While the form refers to all as “property,” the term stems from an accounting identification of “property, plant & equipment.” These types of assets typically qualify for depreciation, while intangible assets are typically those that qualify for amortization. Amortization is similar to the straight-line method of depreciation in that an annual deduction to taxable income may be allowed over a fixed time period. The taxpayer can amortize such items as costs of starting a business, goodwill, and certain other intangible assets. Part VI – Amortization is the last section of Form 4562, where the business amortization costs are described and listed to calculate amortization for the year for the individual taxpayer.
Depreciation and amortization can be found on both the balance sheet and the income statement. Annual and accumulated depreciation/amortization are contra-assets to the respective underlying asset on the balance sheet. On the income statement (also referred to as the profit and loss statement), depreciation and amortization are expense items.
One other focus area for divorcing parties is Part V – Listed Property – specifically, Section A – Depreciation and Other Information – Lines 26 and 27. These lines are used to determine depreciation for property used more or less than 50% in a qualified business use, respectively. Generally, a qualified business use is any use in trade or business; however, it does not include investment use, leasing to a 5% or less owner, or the use of property as a compensation for services performed. Column (C) – Business/investment use percentage is where this will be displayed.
Schedule L – Balance Sheet per Books, Schedule M-1 – Reconciliation of Net Income/(Loss), and Schedule M-2 – Analysis of Partner’s Capital Account are also worthy schedules to review in conjunction with individuals who own business(es) or interest(s) in business(es). These schedules within Form 1065 or Form 1120-S for S corporations present the financial statements of the business and the activity on a capital account. If business financial statements, such as an income statement and balance sheet, are obtained, these schedules can be used in conjunction with the review of the financial records. Schedule C Profit or Loss from Business can also be helpful if the business owner is a Sole Proprietor, as this schedule is specific to sole proprietorships. As the name implies, this Schedule C provides income, expenses, cost of goods sold, and other expenses during the respective tax year.
Schedule L provides the beginning and ending balances on the items on the balance sheet. Schedule M-1, as its name implies, provides the reconciliation of income or loss. The reconciliation occurs because some items are allowed, disallowed, or capped for tax purposes, which may be present on the income statement of the business – travel and entertainment and depreciation are two examples included within Schedule M-1. As we previously discussed, the business may take all of its depreciation in one year for tax purposes, while using straight-line depreciation in accordance with GAAP (generally accepted accounting principles). Depending on the current tax laws, a maximum dollar threshold may be allowed for expensing travel and entertainment for tax purposes, while the business may choose to expense more for internal financial purposes.
A review of Schedule M-1 can provide information about potential differences between profits or losses prepared for tax purposes versus internal financial reporting purposes.
Some small businesses may not maintain financial statements beyond the information presented in the tax return schedules; hence, it is important to understand which schedules and sections to review if your client owns an interest(s) in a business. However, for businesses that have financial statements, one should request multiple years of financial statements in addition to multiple years of tax returns and understand how to review the documents in conjunction with one another.
Reviewing the items listed in these schedules can provide useful information and lead to further document requests in order to review and evaluate business assets, business ownership(s), and active and passive income, among other information.
Understanding how to navigate key areas of Schedule K-1 and supporting schedules is often necessary in divorce proceedings. While we provided background on Form 4562, Schedule C, Schedule E, Schedule L, Schedule M-1, and Schedule M-2, there may be further supporting schedules with helpful information or indicators to request further information. Remember that each case presents different facts and circumstances, and tax returns may vary (specifically which schedules are included).
Information within the tax return and supporting schedules can provide support for marital assets and liabilities (specifically those associated with business ownership and/or other types of assets), sources of income, and potential further analyses. Reviewing multiple years of Schedule K-1s and accompanying supplemental schedules may provide helpful information on trends and/or changes and could indicate the need for potential forensic investigations.
While we do not provide tax advice, Mercer Capital is a national business valuation and financial advisory firm and we provide expertise in the areas of financial, valuation, and forensic services.
At this time last year, bank M&A could be described as “on the runway” as economic activity accelerated following the short, but deep recession in the spring. Next year, activity should gain altitude. Most community banks face intense earnings pressure as PPP fees end, operating expenses rise with inflation, and core NIMs remain under pressure unless the Fed can hike short-term policy rates more than a couple of times. Good credit quality is supportive of activity, too.
Should and will are two different verbs, however.
One wildcard that will impact activity and pricing is the public market multiples of would be acquirers. Consideration for all but the smallest sellers often includes the issuance of common shares by the buyer. When bank stocks trade at high multiples, sellers obtain “high” prices though less value than when public market multiples are low and sellers receive low(er) prices though more value.
If bank stock prices perform reasonably well in 2022, after a fabulous 2021 in which the NASDAQ Bank Index increased 40% through December 28, then activity probably will trend higher as more community banks look to sell. MOEs may be easier to negotiate, too. If bank stocks are weak for whatever reason, then activity probably will slow.
As of December 17, 2021, there have been 206 announced bank and thrift deals compared to 117 in 2020. During the halcyon pre-COVID years, about 270 transactions were announced each year during 2017-2019.
As a percent of charters, acquisition activity in 2021 accounted for about 4% of the number of banks and thrifts as of January 1. Since 1990, the range is about 2% to 4%, although during 2014 to 2019 the number of banks absorbed each year exceeded 4% and topped 5% in 2019. As of September 30, there were 4,914 bank and thrift charters compared to 9,904 as of year-end 2000 and about 18,000 charters in 1985 when a ruling from the U.S. Supreme Court paved the way for national consolidation.
Pricing—as measured by the average price/tangible book value (P/TBV) multiple—improved in 2021. As always, color is required to explain the price/earnings (P/E) multiple based upon reported earnings.
The national average P/TBV multiple increased to 155% from 135% in 2020, although deal activity was light in 2020. As shown in Figure 1, the average transaction multiple since the Great Financial Crisis (GFC) peaked in 2018 at 174% then declined to 158% in 2019 as the Fed was forced to cut short-term policy rates three times during 3Q19 in an acknowledgment that the December and probably September 2018 hikes were ill-advised.
Earnings—rather than tangible book value — drive pricing as do public market valuations of acquirers who issue shares as part of the seller consideration. Nonetheless, drawing conclusions based upon unadjusted reported earnings sometimes can be misleading.
As an example, the national median P/E for banks that agreed to be acquired in 2018 approximated 25x, in part, because many banks that are taxed as C corporations wrote down deferred tax assets at year-end 2017 following the enactment of corporate tax reform. Plus, forward earnings reflected a reduction in the maximum federal tax rate to 21% from 35%.
Also, the median P/E in 2021 fell to about 15x from 17x in 2019 and 2020 in part because the earnings of many sellers included substantial PPP-related income that will largely evaporate after this year.
Buyers focus on the pro forma earnings multiple with all expense savings in addition to EPS accretion and the amount of time it takes to recoup dilution to tangible BVPS. Our take is that most deals entail a P/E based upon pro forma earnings with fully phased-in expense saves of 7x to 10x unless there are unusual circumstances.
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Figure 2 compares the annual average P/TBV and P/E for banks that were acquired for $50 million to $250 million since 1997 with the SNL Small Cap Bank Index average daily multiple for each year. Among the takeaways are the following:
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Public market investors often focus on what can be referred to as icing vs the cake in the form of acquisition premiums relative to the pre-announcement prices. Investors tend to talk about acquisition premiums as an alpha generator, but long-term performance (or lack thereof) of the target is what drives shareholder returns. Sometimes the market is suprised by acquisitions with an outsized premium, but in recent years premiums often have been modest.
As shown in Figure 4, the average one-day premium for transactions announced in 2021 that exceeded $100 million in which the buyer and seller were publicly traded was about 9%, a level that was comparable to the prior few years excluding 2020. For buyers, the average day one reduction in price was less than 1%, though there are exceptions when investors question the pricing (actually, the exchange ratio). For instance, First Interstate (NASDAQ: FIBK) saw its shares drop 7.4% after it announced it would acquire Great Western for about $2 billion on September 16, 2021.
M&A entails a lot of moving parts of which “price” is only one. It is especially important for would be sellers to have a level-headed assessment of the investment attributes of the acquirer’s shares to the extent merger consideration will include the buyer’s common shares. Mercer Capital has roughly 40 years of experience in assessing mergers, the investment merits of the buyer’s shares, and the like. Please call if we can help your board in 2022 assess a potential strategic transaction.
Last month I had the honor of co-chairing the AICPA & CIMA Forensic and Valuation Services Conference in Las Vegas, Nevada. I have served on the Conference Planning Committee since 2018 and served as the Valuation Chair for the 2020 and 2021 Conferences.
Over 920 were in attendance – including speakers from the U.S., Canada, virtual attendees, in-person attendees, exhibitors and AICPA staff team members. It was wonderful to be back in-person this year, while joined by our virtual audience during all concurrent sessions!
The AICPA & CIMA Forensic and Valuation Services Conference is a premier annual conference which provides timely updates on industry trends, cutting-edge information on new technology, and networking opportunities. In general, this conference is geared towards forensic accounting professionals, business valuation services professionals, litigation services consultants and experts, emerging FVS professionals, CFOs, Controllers, and senior financial professionals.
Four Mercer Capital professionals, Chris Mercer, Travis Harms, David Harkins and myself were on the agenda, speaking at five sessions.
Click the links below for session descriptions and objectives:
To promote the conference and selected sessions, I was interviewed by the Journal of Accountancy about the session Lessons in Career and Business Development During Times of Disruption given by me and Hubert Klein, Partner at Eisner Advisory Group. Below are a few excerpts from the interview.
Interpersonal skills, flexibility, understanding of new technologies, and adaptability are more important than ever, according to Calhoun, and your development plan should incorporate the skills that will be necessary for thriving in continuous disruption.
“This is an opportunity for us as a profession to come together and exchange general best practices, think about what the next roadblocks will be, and how we can hopefully overcome those together,” Calhoun said.
Hubert and I had a great time putting this session together. It’s full of hard earned lessons that you might find of interest. The article does a great job of encapsulating the session.
In addition to the above sessions led by Mercer Capital professionals, the full agenda including speaker biographies can be found here. Below is a list of other sessions you might be interested in.
Sessions of Interest:
The AICPA Conference Committee is already hard at work debriefing and planning for next year. Our committee works diligently to identify in-demand and current topics followed by inviting national and international thought leaders to lead our sessions. If you are interested in attending or submitting a topic for consideration at next year’s event, email me.
Last month I also had the pleasure of attending the 2021 AAML Annual Meeting and AAML Foundation Luncheon in Chicago, IL. There was a mixture of continued education sessions, networking, sponsor and exhibitor events, committee meetings, dining and social events. This year’s annual meeting marked the Diamond Anniversary of the AAML. It was wonderful to see and meet so many individuals in person in Chicago and discuss various current and complex topics!
Highlighted sessions:
We look forward to attending 2022 AAML and AAML Foundation events!
In recent years, financial sponsors such as private equity, venture capital firms, investment companies, and family offices have taken a more prominent role in funding and growing firms in the insurance industry. From insurance brokerage/distribution to underwriting to InsurTech start-ups, there are many opportunities for investment in the insurance sector and transaction activity in the space has steadily been increasing.
Mercer Capital has worked with financial sponsors in the insurance industry for years and we understand both the dynamics of the industry as well as the accounting and valuation issues that are likely to be encountered.
To discuss any of these services in confidence, please contact a Mercer Capital professional today.
In October 2021, the American Transportation Research Institute released its 2021 survey of Critical Issues in the Trucking Industry. The ATRI survey was open from September 8, 2021 through October 15, 2021 and includes responses from over 2,500 stakeholders in the trucking industry in North America. Respondents include motor carrier personnel (52.4% of respondents), commercial drivers (24.1%), and other industry stakeholders (23.5%, including suppliers, trainers, and law enforcement).
Driver-related concerns – including driver shortages, driver retention, and driver compensation – continued to dominate the list of top concerns. The driver shortage claimed the top position for the fifth year in a row. The driver shortage is being exacerbated by increasing demand for freight services, COVID-related training, and licensing backlogs, and drivers exiting the industry due to COVID risks. Driver compensation has been a top-ten concern for three years running and is strongly linked to the driver shortage problem.
Lawsuit abuse reform took the fourth slot in the overall ranking. ATRI estimates that the average verdict size increased 967% between 2010 and 2018, due largely to nuclear verdicts that have skewed the dangers of litigation to trucking industry participants (see our previous analysis of nuclear verdicts originally published in the second quarter of 2020). Lawsuit abuse, insurance costs and availability are linked – the rising expenses of trucking industry litigation has caused some insurers to drastically raise premiums or to exit the trucking industry altogether.
It is interesting to see the differences in opinions held by drivers versus motor carrier stakeholders. As one might expect, the commercial drivers tend to focus on the day-to-day issues of trucking, including parking, fuel prices, and legal compliance. Motor carriers are more concerned about driver retention, litigation, insurance, and technician shortages, as shown in the table below.
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ATRI also provided a breakdown of the top three concerns of company drivers compared to owner-operators or independent contractors. While both groups included compensation and parking in their top three concerns, company drivers rated driver training standards as a critical issue, while owner-operators and contractors were more concerned with fuel prices.
With year-end approaching, we are starting our annual process of recapping 2021 and considering the outlook for 2022. In doing so, we turned our attention to the bank M&A data to see what trends were emerging. While the number of bank and thrift deals is on pace to roughly double from 2020 levels (117 deals in 2020 vs 199 deals through 11/22/21), the number of deals still remains well below pre-pandemic levels. Valuations at exit illustrate a similar trend with the median price/earnings nationally for announced deals at ~15.0x earnings and the average price/tangible multiple at ~1.54x for the YTD period through mid-November 2021. These valuation multiples implied by YTD 2021 deals are up relative to 2020, roughly in line with 2019 levels, but are still down relative to 2017 and 2018 levels.
A bank acquisition could present an opportunity for growth to acquirers that are facing a challenging rate and market environment. Some recent data confirmed this as almost half of survey respondents in Bank Director’s 2022 Bank M&A Survey say their institution is likely to purchase another bank by the end of 2022 — a significant increase compared to the previous year, and more in line with the pre-pandemic environment.
For those banks considering strategic options, like a sale, 2022 could also be a favorable year, should the improving trends experienced in 2021 continue. These trends include a continued increase in buyer’s interests in acquisitions, a continued expansion of the pool of buyers to include both traditional banks and non-traditional acquirers like credit unions and FinTechs, and the tax environment for sellers and their shareholders remaining favorable relative to historical levels.
Against this backdrop of the potential for an active bank M&A environment in 2022, we consider the top three factors that, in our view, should be considered by bank acquirers to help make a successful bank acquisition.
Developing a reasonable valuation for a bank target is essential in any economic environment, but particularly in the current environment. We have noted previously that value drivers remain in flux as investors and acquirers assess how strong loan demand and the rate environment will be. In addition to those factors, evaluating earnings, earning power, multiples, and other key value drivers remain important. Bank Director’s 2022 Bank M&A Survey also noted the importance of valuation in bank acquisitions as pricing expectations of potential targets were cited as the top barrier to making a bank acquisition (with 73% of respondents citing this as a barrier).
Determining an appropriate valuation for a bank requires assessing a variety of factors related to the bank (such as core earning power, growth/market potential, and risk factors). Then applying the appropriate valuation methodologies – such as a market approach that looks at comparably priced transactions and/or an income approach focused on future earnings potential and developed in a discounted cash flow or internal rate of return analysis. While deal values are often reported and compared based upon multiples of tangible book value, value to specific buyers is a function of projected cash flow estimates that they believe the bank target can produce in the future.
Price and valuation can also vary from buyer to buyer as specific buyers may have differing viewpoints on the future earnings and the strategic benefits that the seller may provide. For example, 2021 has seen an emerging trend of non-traditional acquirers such as credit unions and FinTech companies entering the mix. They often have different strategic considerations/viewpoints on a potential bank transaction.
As someone who grew up as an avid junior and college tennis player, I have always admired the top pros and found lessons from sports to apply in my personal and business life. With fifteen grand slam titles and fifteen years as the top doubles team globally, the Bryan brothers – Bob and Mike – are often held out as the most successful doubles teams of all time and offer some lessons that we can learn from, in my view. Their team featured a unique combination of a left-handed and right-handed player, which provided variety to challenge their opponents and expand their offensive playbook. It also had many similar intangibles, such as how they approached practicing and playing since they were twins and taught by their father (Wayne) from a young age.
Their success illustrates the importance of identifying both the key similarities and differences of a potential partnership to strengthen the chances for success once combined. Key questions to consider regarding strategic fit and identifying the right partner/opportunity for a bank acquisition include: Does the Target expand our geographic footprint into stronger or weaker markets? What types of customers will be acquired (retail/consumer, business, etc.) and at what cost (both initially and over time)? Is there a significant branch/market overlap that could lead to substantial cost savings? Is the seller’s business culture (particularly credit underwriting/client service approach) similar to ours? Will the acquisition diversify or enhance our loan/deposit mix? Will the acquisition provide scale to expand our business lines, balance sheet, and/or technology offerings? What potential cost savings and/or revenue enhancements does the potential acquisition provide?
A transaction that looks favorable in terms of valuation and strategic fit may flounder if other key deal metrics are weak. Traditional deal metrics to assess bank targets include capital/book value dilution and the earnback period, earnings accretion/dilution, and an internal rate of return (IRR) analysis.
Below we focus a bit more on some fundamental elements to consider when estimating the pro forma balance sheet impact and internal rate of return:
To consider the pro forma impact of the bank target on the acquirer’s balance sheet, it is important to develop reasonable and accurate fair value estimates as these estimates will impact the pro forma balance sheet at closing as well as future earnings and capital/net worth after closing. In the initial accounting for a bank acquisition, acquired assets and liabilities are marked to their fair values. The most significant marks are typically for the loan portfolio, followed by intangible assets for depositor customer relationship (core deposit). Below are some key factors for acquirers to consider for those fair value estimates:
Loan Valuation. The loan valuation process can be complex, with a variety of economic, company, or loan-specific factors impacting interest rate and credit loss assumptions. Our loan valuation process begins with due diligence discussions with the management team of the target to understand their underwriting strategy as well as specific areas of concern in the portfolio. We also typically factor in the acquirer’s loan review personnel to obtain their perspective. The actual valuation often relies upon a) monthly cash flow forecasts considering both the contractual loan terms, as well as the outlook for future interest rates; b) prepayment speeds; c) credit loss estimates based upon qualitative and quantitative assumptions; and d) appropriate discount rates. Problem credits above a certain threshold are typically evaluated on an individual basis.
Core Deposit Intangible Valuation. Core deposit intangible asset values are driven by market factors (interest rates) and bank-specific factors such as customer retention, deposit base characteristics, and a bank’s expense and fee structure.
The last deal metric that often gets a lot of focus from bank acquirers is the estimated internal rate of return (“IRR”) for the transaction. It is based upon the following key items: the price for the acquisition, the opportunity cost of the cash, and the forecast cash flows/valuation for the target, inclusive of any expense savings and growth/attrition over time in lines of business. This IRR estimate can then be compared to the acquirer’s historical and/or projected return on equity or net worth to assess whether the transaction offers the potential to enhance pro forma cash flow and provide a reasonable return to the acquirer.
Mercer Capital has significant experience providing valuation, due diligence, and advisory services to bank acquirers across each phase of a potential transaction. Our services for acquirers include providing initial valuation ranges for bank targets, performing due diligence on targets during the negotiation phase, providing fairness opinions and presentations related to the acquisition to the buyer’s management and/or board, and providing valuations for fair value estimates of loans and core deposit before or at closing.
We also provide valuation and advisory services to community banks considering strategic options and can assist with developing a process to maximize valuation upon exit. Feel free to reach out to us to discuss your community bank or credit union’s unique situation and strategic objectives in confidence.
By this Thanksgiving, Congress hopes to pass two of the largest bills in American history, the $1 trillion infrastructure bill (which was signed into law by President Biden on November 15th) along with a $1.75 trillion Build Back Better bill. While the infrastructure bill made it through Congress with minimal tax hikes, the passing of the larger reconciliation bill may still create sweeping changes to American tax policy, specific to high-net-worth individuals.
Over the past several months, numerous tax code changes have been proposed to fund the two bills, and concessions have whittled away some of the more drastic proposals that made headlines back in the Spring of 2021. In this article, we look to address what policies are still on the table, which are most likely to pass, and what the implications for their passing might be.
On March 31, 2021, the Biden administration proposed The American Jobs Plan which outlined $1.7 trillion in infrastructure investment targeting a number of projects such as public drinking water, renewed electric grid, high-speed broadband, housing, educational facilities, veteran hospitals, and job training programs among various other projects.
The Made in America Tax Plan was proposed simultaneously with the American Jobs Plan as a source of funding. The plan enumerated on several proposed increases to individual and corporate tax rates as well as various other reforms. Some of which have found their way into current legislative efforts.
On April 28, 2021, President Biden proposed an additional spending plan, The American Families Plan, targeting “social infrastructural” works such as universal pre-school, universal two-year community college and postsecondary education (since dropped), childcare, paid leave (also has been dropped), nutrition, unemployment insurance, as well as various tax cuts to low-income workers. The Plan also outlined extensive tax reform directly targeting high income earners: setting capital gains and dividend taxes equal to taxes on wages and increasing tax rates on the top tax bracket from 37% to 39.6%. The sticker price of the American Families Plan was set at $1.8 trillion, with $1 trillion in direct government investment and the remainder in tax breaks.
On May 28, 2021, the Biden Administration further elaborated on his economic agenda in the unveiling of the 2022 fiscal budget plan to Congress alongside the Treasury Department “Green Book.”
On August 10, 2021, the Senate approved the $1.2 trillion infrastructure bill with bi-partisan support after months of debate. The bill includes many of the hard infrastructure objectives outlined in Biden’s American Jobs Plan. On the same day, a 100-member Congressional Progressive Caucus declared that it would refuse to vote for the bill before the larger reconciliation bill was passed in the Senate, despite overwhelming popularity of the infrastructure bill in Congress and in polling. In prioritizing Biden’s “soft infrastructure proposals” as specified in the reconciliation bill, Progressives effectively tied the fate of both the infrastructure and reconciliation bill in ongoing negotiations.
On August 24, 2021, the House Democrats approved a $3.5 trillion budget resolution which set in motion the reconciliation process by which Democrats could potentially sign the budget into law, requiring only a majority approval while circumventing an inevitable filibuster from Republicans in the Senate. The same measures were taken by the Republican Party with the passing of the American Tax Cuts and Jobs Act in 2017. Support from all 50 Democratic Senators and all but a handful of House Democrats would be needed to pass the legislation as objections from Republicans are widely expected. The budget resolution has since been negotiated down to a $1.9 trillion dollar package.
On September 12, 2021, the House and Ways Committee released a revised draft of the tax changes proposed as part of the budget reconciliation bill. Specific tax increases largely targeted trusts and estates and carried significant implications for gift and estate tax planning.
On September 27, 2021, under pressure from both moderates and progressives, Speaker of the House, Nancy Pelosi originally scheduled the House vote for the infrastructure bill for September 27th. But without the passing of the budget resolution bill, and therefore the support of Progressives, Nancy Pelosi postponed the House vote to extend negotiations. In doing so, ongoing government funding was jeopardized without a fiscal 2022 budget and government debt neared the self-imposed debt ceiling.
On September 30, 2021, the last day of the federal calendar, Congress narrowly avoided a government shut down by passing a temporary package funding the government through December 3, 2021 while the House suspended the debt ceiling through December 2022. The increase in the debt ceiling is widely expected to be rejected by Senate Republicans.
On October 21, 2021, the New York Times reported, Arizona Senator Krysten Sinema, would refuse to vote to support any increases in corporate or individual tax rates. The opposition came as a surprise to many and left the Democratic party scrambling to secure funding for the Build Back Better Bill from other avenues.
On October 28, 2021, President Biden unveiled a $1.75 trillion framework for the Build Back Better social spending bill, a draft of the legislation quickly followed. The announcement was released moments before Mr. Biden departed for Rome followed by Glasgow for the 2021 United Nations Climate Change Conference.
On November 8, 2021, the $1 trillion infrastructure bill passed in the House with bipartisan support after months of debate among members of the Democratic party looking to pass the Build Back Better bill before sending the infrastructure bill to a vote.
On November 15, 2021, the $ 1 trillion infrastructure bill was signed into law by President Biden.
Biden’s historically ambitious proposals made earlier in the year have since been trimmed by months of negotiations with more conservative members of the Democratic party. Most notably Joe Manchin of West Virginia and Krysten Sinema of Arizona have criticized the size of the bill, the tax hikes required for funding the bill, and the speed and process by which the party hopes to pass such landmark legislation. In efforts to gain the support of these two senators, and thereby achieve the unanimous support needed for the reconciliation, Democratic leaders have floated numerous tax proposals in recent months to fund the bill.
While many of the tax change proposals outlined in the House and Ways Committee draft for the reconciliation bill were not included in the most recent framework published by the Biden Administration on October 29, 2021, many believe the policies outlined in mid-September may still be in play as negotiations continue amongst the conservative and progressive members of Congress. It is widely believed that the intent behind some of the initial funding proposals outlined by the Biden administration and later incorporated in the House and Ways Committee draft were beyond economics and were intended to combat “wealth inequality” and disparities in effective corporate tax rates.
As reported in an article from CNBC, none of the three major holdouts, Joe Manchin, Krysten Sinema, or Bernie Sanders, have committed to supporting the framework as it stands. As many of the initial social spending policies have been cut, including most recently the federal paid family and medical leave proposal, uncertainty remains surrounding the scope of the bill and the funding it will require.
Tax changes proposed in the House and Ways Committee draft were numerous, albeit less drastic than those considered earlier in the year. A comprehensive summary of the funding provisions can be found here. Key tax reforms specific to closely held businesses include the following:
Because of recent opposition from conservative members of Congress, many of the proposed tax reforms recommended in the House and Ways Committee draft back in September were not included in Biden’s Build Back Better framework issued October 28. Funding proposals for the Build Back Better bill issued in Biden’s most recent draft included the following:
The new surtax on multi-millionaires and billionaires is intended to replace numerous other proposals to tax high income individuals such as: a rate increase to the top tax bracket, taxing unrealized gains annually, a wealth tax, taxing unrealized capital gains at death, and ending the practice of stepped-up in basis. The surtax is set to add an additional 5% tax on income exceeding $10 million and an additional 3% tax on income exceeding $25 million. While perhaps not too different than levying additional income taxes, the surtax was agreed upon after Krysten Sinema refused to support increases to income tax rates on high earners.
While the most recent draft still targets high income individuals and corporations, most of the significant tax changes have been avoided for now. Avenues for gift and estate planning and taxes related to closely held businesses were largely spared in the recent proposal. For now, it appears that there will be no changes made to the step-up in basis, reduction in estate and gift taxes, the application of marketability and control discounts, income tax rates on the top tax bracket, capital gains tax rates, or changes in the qualified business income deductions.
Much like the Infrastructure bill, which gained bipartisan support via not drastically changing the tax code, the Build Back Better bill may make it to the final yard line without incorporating the vast majority of major tax changes proposed earlier in the year or during the negotiations in recent months. The outline and proposals set forth represent the closest framework for consensus among the Democratic party, and tax proposals put forth have been forged by nearly a year of debate among party members. However, in no way is the recent draft set forth by President Biden final.
Much uncertainty still remains regarding the draft’s support from the party’s more progressive and conservative members. If the recent months have taught us anything, with a bill this large, funding measures are liable to shift upon further negotiations. Regardless, many expect the bill to be put to a vote within weeks.
Mercer Capital will continue to monitor any changes to the tax code and report on how they may affect our clients. In the meantime, to discuss a valuation need in confidence, please don’t hesitate to contact us.
This is the second of the three-part series where we focus on the key areas of tax returns to assist family lawyers and divorcing parties. Part II concentrates on Schedule A (Form 1040) Itemized Deductions. Part I discussed Form 1040 and can be found here.
Schedule A (Form 1040) Itemized Deductions is an attachment to Form 1040 for taxpayers who choose to itemize their tax-deductible expenses rather than take the standard deduction.
Schedule A provides information regarding marital property – assets and debts – and may reveal information about the taxpayer’s lifestyle and financial position. Reviewing the detailed information can potentially lead to further investigation such as uncovering dissipation of assets, discovering hidden assets, or providing an overview of true historical spending.
Taxpayers have the option on Line 12 of Form 1040 to elect the standard deduction or the itemized deductions from Schedule A. At the time of publication of this article, the standard deduction ranges from $12,400-$24,800 depending on the selected filing status of the taxpayer(s). Both deductions reduce the amount of Taxable Income on Line 15 on Form 1040. If the taxpayer’s qualified itemized deductions are greater than their standard deduction, the taxpayer typically forgoes the standard deduction and files Schedule A with Form 1040. For divorce purposes, reviewing the taxpayer’s elections over a historical period may also provide further insight into the financial snapshot of the estate over time.
Lines 5b and 5c: State & Local Real Estate Taxes, State & Local Property Taxes – Entries on Lines 5b and/or 5c show taxes paid on property. Line 5b focuses on state and local taxes paid on real estate owned by the taxpayer(s) that were not used for business, while Line 5c concentrates on state and local personal property taxes paid on a yearly basis based on the value of the asset alone.
If these lines are filled, it should lead to further questioning about what these properties are and if they are marital property. The amount of tax paid could also give insight into the taxpayer’s assets. Greater state and local real estate taxes entered on Line 5b usually indicate more expensive real estate. Similarly, a larger entry in Line 5c representing taxes on personal property indicate high-priced assets, such as an expensive car.
Line 8: Home Mortgage Interest – A home mortgage represents any loan that is secured by the taxpayer’s main home or second home. A “home” can be a house, condominium, mobile home, boat, or similar property as long as it provides the basic living accommodations. The rules for deducting interest vary, depending on whether the loan proceeds are used for business, personal, or investment activities. The deduction for home mortgage interest depends on factors such as the date of the mortgage, the amount of the mortgage, and how the mortgage proceeds are used.
An entry in Lines 8a-e indicates the taxpayer(s) has a home mortgage loan and documentation of the loan should be requested. This line is an indication of property ownership, and therefore, a potential marital asset (or separate asset if that scenario is applicable). Form 1098, the Mortgage Interest Statement, will provide more detailed information.
Line 14: Gifts to Charity – A charitable contribution is a donation or gift made voluntarily to, or for the use of, a qualified organization without expecting to receive anything of equal value. Qualified organizations include but are not limited to nonprofit groups that are religious, charitable, or educational.
Sometimes we see charitable giving allocated as a line item in a divorcing individual’s future budget. While this may not necessarily be an expense necessary for traditional living expenses, if, historically, the parties donated significant monies, this can be captured on historical charitable donation deductions and ought to be evaluated on a case-by-case basis. As a tip, sometimes these gifts may be captured elsewhere than a personal tax return, such as a trust’s estate tax return.
Line 16: Other Itemized Deductions – Only certain expenses qualify to be deducted as other itemized deductions including gambling losses, casualty and theft losses, among others. If there is an entry in Line 16, more detailed information on these deductions may be necessary.
A common “other itemized deduction” is for gambling losses, which may lead to further questioning and could potentially be dissipation of marital assets. Another example is the federal estate tax on income in respect of a decedent. Income in respect of a decedent (IRD) is income that was owed to a decedent at the time he or she died. Examples of IRD include retirement plan assets, IRA distributions, unpaid interest, dividends, and salary, to name only a few.
Along with other estate assets, IRD is eventually distributed to the beneficiaries. While most assets of the estate are transferred free of income tax, IRD assets are generally taxed at the beneficiaries’ ordinary income tax rates. However, if a decedent’s estate has paid federal estate taxes on the IRD assets, the beneficiary may be eligible for an IRD tax deduction based on the amount of estate tax paid. This is an example of a potential separate asset, however, the IRD could also be a marital asset depending on the beneficiary designation and/or potential commingling of assets.
Items included within other itemized deductions should typically be reviewed and potentially further investigated as they may represent assets, liabilities, and/or sources of income, whether marital or separate.
Understanding how to navigate key areas of Schedule A (Form 1040) can be very helpful in divorce proceedings. Information within Schedule A can provide support for marital assets and liabilities, sources of income and potential further analyses. Reviewing multiple years of tax returns and accompanying supplemental schedules may provide helpful information on trends and/or changes and could indicate the need for potential forensic investigations.
Mercer Capital is a national business valuation and financial advisory firm. While we do not provide tax advice, we have expertise in the areas of financial, valuation, and forensic services.
Last July I gave a presentation to the third-year students attending the Consumer Bankers Association’s Executive Banking School. The presentation, which can be found here, touched on three big valuation themes for bank investors: estimate revisions, earning power and long-term growth.
Although Wall Street is overly focused on the quarterly earnings process, investors care because of what quarterly results imply about earnings (or cash flow) estimates for the next year and more generally about a company’s earning power. Earning beats that are based upon fundamentals of faster revenue growth and/or positive operating leverage usually will result in rising estimates and an increase in the share price. The opposite is true, too.
For U.S. banks that have largely finished reporting third quarter results, questions about all three—especially earning power—are in flux more than usual. Industry profitability has always been cyclical, but what is normal depends. Since the early 1980s, there have been fewer recessions that have resulted in long periods of low credit costs. Monetary policy has been radical since 2008. What’s normal was also distorted in 2020 and 2021 by PPP income that padded earnings but will evaporate in 2023.
Most banks beat consensus EPS estimates, largely due to negligible credit costs if not negative loan loss provisions as COVID-19 related reserve builds that occurred in 2020 proved to be too much; however, there was no new news with the earnings release as it relates to credit.
Investors concluded with the release of third and fourth quarter 2020 results that credit losses would not be outsized. Overlaid was confirmation from the corporate bond market as spreads on high yield bonds, CLOs and other structured products began to narrow in the second quarter of 2020 as banks were still building reserves.
As of October 28, 2020, the NASDAQ Bank Index has risen 78% over the past year and 39% year-to-date.
Much of that gain occurred during November (October 2020 was a strong month, too) through May as investors initially priced-in reserve releases to come; and then NIMs that might not fall as far as feared as the yield on the 10-year UST doubled to 1.75% by late March. Bank stocks underperformed the market during the summer as the 10-year UST yield fell. Since late September banks rallied again as investors began to price rate hikes by the Fed beginning in 2022 rather than 2023.
No one knows for sure; the future is always uncertain. For banks, two key variables have an outsized influence on earnings other than credit costs: loan demand and rates. In other industries the variables are called volume and price. If both rise, most banks will see a pronounced increase in earnings as revenues rise and presumably operating leverage improves. Street estimates for 2022 and 2023 will rise, and investors’ view of earning power will too.
We do not know what the future will be either. Loan demand and excess liquidity have been counter cyclical forces in the banking industry since banks came into being. The question is not if but how strong loan demand will be when the cycle turns. Interest rates used to be cyclical, too, until governments became so indebted that “normal” rates apparently cannot be tolerated.
Nonetheless, at Mercer Capital we have decades of experience of evaluating earnings, earning power, multiples and other value drivers. Please give us a call if we can assist your institution.
In each “Meet the Team” segment, we highlight a different professional on our Family Law team. The experience and expertise of our professionals allow us to bring a full suite of valuation and forensics services to our clients. We hope you enjoy getting to know us a bit better.
Karolina Calhoun: During my college experience at Rhodes College, I interned at Mercer Capital, Morgan Keegan (now known as Raymond James) in investment banking and then another internship in wealth management, and ALSAC/St. Jude Children’s Research Hospital. I also interned internationally with Ernst and Young (EY) in Warsaw, Poland, which is where I was born and have many family members that still live there.
After graduating from Rhodes College, I completed my Master of Accountancy and CPA accreditation. I started working for EY in their Audit and Assurances department. During my 3+ years at EY, I had the opportunity to work with Fortune 500 clients, as well as other sized companies in diverse industries such as chemical and agriculture, logistics, medical devices, healthcare, and wealth management and investment management. At the time that I came back to Mercer Capital, I was ready to take my public accounting knowledge and experience and pivot to finance-related client work.
Karolina Calhoun: The knowledge of accounting and financial reporting is important. It helps me quickly understand the financial statements of businesses, personal financial statements, and tax returns, among other financial documents. My auditing experience was investigative in a sense, so I have a good idea of what to look for and other red flags. Additionally, from a client perspective, individuals and attorneys tend to trust a CPA’s professional expertise in litigation cases, especially in specialized areas like valuation and forensics. My additional credentials, the ABV and CFF, further bolster the expertise I can offer clients.
Karolina Calhoun: I am so thankful for the national and global opportunities/positions I hold now with the American Institute of Certified Public Accountants (AICPA). I am serving as the Valuation Chair of the AICPA Forensic and Valuation Services (FVS) Conference and I also serve on the CFF Exam Task Force. My committee and task force positions have provided me the opportunities to be involved with thought leaders across the globe and assist our evolving profession. During my tenure so far, I have met and collaborated with many colleagues from all over the United States and beyond North America.
I became involved with the AICPA FVS Section at an early point in my career at Mercer Capital. I attended the NextGen training program, which is catered towards rising leaders in the FVS profession. After meeting and networking with AICPA staff and volunteers, I applied to be considered for future volunteer opportunities. I was so excited when I was invited to join the AICPA Forensics & Valuation Services Conference Planning Committee. Then, in 2019 I was asked to be the 2020 & 2021 Valuation Chair. In this position, I am integral in leading the Committee’s efforts in planning our annual conference, selecting topics, inviting speakers, and collaborating with the AICPA staff & speakers.
In my role on the CFF Exam Task Force, I am contributing to the efforts to pivot the CFF (Certified in Financial Forensics) accreditation towards a universal body of knowledge and examination process. Our committee evaluated the existing test bank of questions and rewrote and wrote new questions to comply with our global framework. As I mentioned earlier, I was born in Poland and interned abroad, so I love being a part of this global initiative as our profession continues to evolve.
Karolina Calhoun: During my tenure at Mercer Capital, as a CPA with an interest in finance, valuation, and forensic accounting, I have helped establish the Litigation Services Group at Mercer Capital. We have extended our services beyond valuation and financial consulting to also encompass forensic services. I think it is very valuable to be able to provide a full suite of services as oftentimes, valuation and forensic services are interconnected.
Take a divorce litigation for example. Historically, Mercer Capital would be called for the valuation of a business, and an external forensic accountant would provide the lifestyle analysis and other forensic needs. However, now Mercer Capital can assist with both the valuation and forensic scope of that divorce engagement. Extending beyond divorce litigation, our team provides valuation, forensic accounting, and financial consulting for a variety of engagements: business damages, lost profits, shareholder disputes, breach of contract, trademark infringement, and estate and tax planning, among others.
Karolina Calhoun: I enjoy the combination of accounting, economics, finance, and forensics. Litigation services is a field where we have to put all of these skills together and evaluate the facts and circumstances unique to the particular matter(s) at hand – no fact pattern is ever the same. Our Litigation Services Group at Mercer Capital is comprised of qualified professionals who have the necessary skills and experience in accounting, finance, and economics and in a wide variety of industries and types of matters.
Depository M&A activity in the U.S. has accelerated in 2021 from a very subdued pace in 2020 when uncertainty about the impact of COVID-19 and the policy responses to it weighed on bank stocks. At the time, investors were grappling with questions related to how high credit losses would be and how far would net interest margins decline. Since then, credit concerns have faded with only a nominal increase in losses for many banks. The margin outlook remains problematic because it appears unlikely the Fed will abandon its zero-interest rate policy (“ZIRP”) anytime soon.
As of September 23, 2021, 157 bank and thrift acquisitions have been announced, which equates to 3.0% of the number of charters as of January 1. Assuming bank stocks are steady or trend higher, we expect 200 to 225 acquisitions this year, equivalent to about 4% of the industry and in-line with 3% to 5% of the industry that is acquired in a typical year. During 2020, only 117 acquisitions representing 2.2% of the industry were announced, less than half of the 272 deals (5.0%) announced in pre-covid 2019.
To be clear, M&A activity follows the public market, as shown in Figure 1. When public market valuations improve, M&A activity and multiples have a propensity to increase as the valuation of the buyers’ shares trend higher. When bank stocks are depressed for whatever reason, acquisition activity usually falls, and multiples decline.
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The rebound in M&A activity this year did not occur in a vacuum. Year-to-date through September 23, 2021, the S&P Small Cap and Large Cap Bank Indices have risen 25% and 31% compared to 18% for the S&P 500. Over the past year, the bank indices are up 87% and 79% compared to 37% for the S&P 500.
Excluding small transactions, the issuance of common shares by bank acquirers usually is the dominant form of consideration sellers receive. While buyers have some flexibility regarding the number of shares issued and the mix of stock and cash, buyers are limited in the amount of dilution in tangible book value they are willing to accept and require visibility in EPS accretion over the next several years to recapture the dilution.
Because the number of shares will be relatively fixed, the value of a transaction and the multiples the seller hopes to realize is a function of the buyer’s valuation. High multiple stocks can be viewed as strong acquisition currencies for acquisitive companies because fewer shares are issued to achieve a targeted dollar value.
However, high multiple stocks may represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be obvious even when the buyer’s shares are actively traded.
Our experience is that some, if not most, members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved, there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to “value.”
A fairness opinion is more than a three or four page letter that opines as to the fairness from a financial point of a contemplated transaction; it should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated.
Key questions to ask about the buyer’s shares include the following:
Liquidity of the Shares – What is the capacity to sell the shares issued in the merger? SEC registration and NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently. OTC traded shares should be scrutinized, especially if the acquirer is not an SEC registrant. Generally, the higher the institutional ownership, the better the liquidity. Also, liquidity may improve with an acquisition if the number of shares outstanding and shareholders increase sufficiently.
Profitability and Revenue Trends – The analysis should consider the buyer’s historical growth and projected growth in revenues, pretax pre-provision operating income and net income as well as various profitability ratios before and after consideration of credit costs. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated. This is particularly important because many banks’ earnings in 2020 and 2021 have been supported by mortgage banking and PPP fees.
Pro Forma Impact – The analysis should consider the impact of a proposed transaction on the pro forma balance sheet, income statement and capital ratios in addition to dilution or accretion in earnings per share and tangible book value per share both from the seller’s and buyer’s perspective.
Tangible BVPS Earn-Back – As noted, the projected earn-back period in tangible book value per share is an important consideration for the buyer. In the aftermath of the GFC, an acceptable earn back period was on the order of three to five years; today, two to three years may be the required earn-back period absent other compelling factors. Earn-back periods that are viewed as too long by market participants is one reason buyers’ shares can be heavily sold when a deal is announced that otherwise may be compelling.
Dividends – In a yield starved world, dividend paying stocks have greater attraction than in past years. Sellers should not be overly swayed by the pick-up in dividends from swapping into the buyer’s shares; however, multiple studies have demonstrated that a sizable portion of an investor’s return comes from dividends over long periods of time. Sellers should examine the sustainability of current dividends and the prospect for increases (or decreases). Also, if the dividend yield is notably above the peer average, the seller should ask why? Is it payout related, or are the shares depressed?
Capital and the Parent Capital Stack – Sellers should have a full understanding of the buyer’s pro-forma regulatory capital ratios both at the bank-level and on a consolidated basis (for large bank holding companies). Separately, parent company capital stacks often are overlooked because of the emphasis placed on capital ratios and the combined bank-parent financial statements. Sellers should have a complete understanding of a parent company’s capital structure and the amount of bank earnings that must be paid to the parent company for debt service and shareholder dividends.
Loan Portfolio Concentrations – Sellers should understand concentrations in the buyer’s loan portfolio, outsized hold positions, and a review the source of historical and expected losses.
Ability to Raise Cash to Close – What is the source of funds for the buyer to fund the cash portion of consideration? If the buyer has to go to market to issue equity and/or debt, what is the contingency plan if unfavorable market conditions preclude floating an issue?
Consensus Analyst Estimates – If the buyer is publicly traded and has analyst coverage, consideration should be given to Street expectations vs. what the diligence process determines. If Street expectations are too high, then the shares may be vulnerable once investors reassess their earnings and growth expectations.
Valuation – Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles.
Share Performance – Sellers should understand the source of the buyer’s shares performance over several multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.
Strategic Position – Assuming an acquisition is material for the buyer, directors of the selling board should consider the strategic position of the buyer, asking such questions about the attractiveness of the pro forma company to other acquirers?
Contingent Liabilities – Contingent liabilities are a standard item on the due diligence punch list for a buyer. Sellers should evaluate contingent liabilities too.
The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. The professionals at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business. Give us a call to discuss your needs in confidence.
After spending years, if not decades, building your business through hard work, determination, and a little luck, what happens when you are ready to monetize your efforts by selling part or all of your business? Exiting the business you built from the ground up is often a bittersweet experience. Many business owners focus their efforts on growing their business and push planning for their eventual exit aside until it can’t be ignored any longer. However, long before your eventual exit, you should begin planning for the day you will leave the business you built.
We suggest you consider these three things.
Many business owners have difficulty taking an objective view of the value of their company. In many cases, it becomes a highly emotional issue, which is certainly understandable considering that many business owners have spent most of their adult lives operating and growing their companies. Nevertheless, the development of reasonable pricing expectations is a vital starting point on the road to a successful transaction.
The development of pricing expectations for an external sale should consider how a potential acquirer would analyze your company. In developing offers, potential acquirers can (and do) use various methods to develop a reasonable purchase price. An acquirer will utilize historical performance data, along with expectations for the future, to develop a level of cash flow or earnings that is considered sustainable going forward. In most cases, this analysis will focus on earnings before interest, taxes, depreciation and amortization (EBITDA) or some other pre-interest cash flow. A multiple is applied to this sustainable cash flow to provide an indication of value for the company. Multiples are developed based on an assessment of the underlying risk and growth factors of the subject company.
Valuations and financial analysis for transactions encompass a refined and scenario-specific framework. The valuation process should enhance a buyer’s understanding of the cash flows and corresponding returns that result from purchasing or investing in a firm. For sellers or prospective sellers, valuations and exit scenarios can be modeled to assist in the decision to sell now or later and to assess the adequacy of deal consideration. Setting expectations and/or defining deal limitations are critical to good transaction discipline.
When analyzing the net proceeds from a transaction, you must consider the potential tax implications. From simple concepts such as ordinary income vs. capital gains and asset sales vs. stock sales, to more nuanced concepts such as depreciation recapture and purchase price allocation, there are almost unlimited issues that can come up related to the taxation of transaction proceeds. The structure of your own corporate entity (C Corporation vs. tax-pass through entity) may have a material impact on the level of taxes owed from a potential transaction.
We recommend consulting with your outside accountant (or hiring a tax attorney) early in the process of investigating a transaction. Only a tax specialist can provide the detailed advice that is needed regarding the tax implications of different transaction structures. There could be strategies that can be implemented well in advance of a transaction to better position your business or business interest for an eventual transaction.
Strategy is often discussed as something belonging exclusively to buyers in a transaction. Not true.
Sellers need a strategy as well: what’s in it for you? Sellers often feel like all they are getting is an accelerated payout of what they would have earned anyway while giving up their ownership. In many cases, that’s exactly right! Your Company, and the cash flow that creates value, transfers from seller to buyer when the ink dries on the purchase agreement. Sellers give up something equally valuable in exchange for purchase consideration – that’s how it works.
As a consequence, sellers need a real reason – a non-financial strategic reason – to sell. Maybe you are selling because you want or need to retire. Maybe you are selling because you want to consolidate with a larger organization, or need to bring in a financial partner to diversify your own net worth and provide ownership transition to the next generation. Whatever the case, you need a real reason to sell other than trading future compensation for a check. The financial trade won’t be enough to sustain you through the twists and turns of a transaction.
The process of selling a business is typically one of the most important, and potentially complex, events in an individual’s life. Important decisions such as this are best made after a thorough consideration of the entire situation. Early planning can often be the difference between an efficient, controlled sales process and a rushed, chaotic process.
Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have assisted hundreds of companies with planning and executing potential transactions since Mercer Capital was founded in 1982. Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor, encouraging the right decision to be made by its clients.
Our dedicated and responsive team is available to advise you through a transaction process, from initial planning and investigation through eventual execution. To discuss your situation in confidence, give us a call.
When equity markets fell in early 2020 due to the onset of the COVID-19 global pandemic, many business owners and tax planners contemplated whether it was an opportune time to engage in significant ownership transfers. Although equity markets have recovered to all-time highs, a confluence of three factors may make 2021 an ideal time for estate planning transactions for owners of private companies:
Mercer Capital has been performing valuations for complicated tax engagements since its inception in 1982. For many high net worth individuals and family offices, complex ownership structures have evolved over time, typically involving multi-tiered entity organizations and businesses with complicated ownership structures and governance. In this article, we describe the processes that lead to credible and timely valuation reports. These processes contribute to smoother engagements and better outcomes for clients.
Defining the valuation project is an important step in every engagement process, but when multiple or tiered entities are involved, it becomes critical. It is insufficient to define a complicated engagement by referring only to the top tier entity in a multi-tiered organizational structure. The engagement scope should clearly identify all the direct and indirect ownership interests that will need to be valued. This allows the appraiser to plan the underlying due diligence and analytical framework to design the deliverable work product.
For example, will the appraiser need to perform a separate appraisal at each level of a tiered structure? Or, can certain entities or underlying assets be valued using a consolidated analytical framework? Planning well on the front end of an engagement leads to more straightforward analyses that are easier to defend.
During the initial discussion of the engagement, the appraiser will usually request certain descriptive and financial information (such as governing documents, recent audits, compilations, and/or tax returns) to determine the scope of analysis needed to render a credible appraisal for the master, top-tier entity and the underlying entities and assets.
Upon being retained, one of the first things an appraiser will do is to prepare a more comprehensive information request list designed to solicit all the documentation necessary to render a valuation opinion. Full and complete disclosure of all requested information, as well as other information believed pertinent to the appraisal, will aid the appraiser in preventing double-counting or otherwise missing assets all together.
Requested information for complex multi-tiered entity valuations typically falls into three
broad categories:
The ultimate efficiency of the project often hinges on timely receipt of all requested information. Disorganized information or data that requires a lot of handling or interpretation on the part of the appraiser adds to project cost, and more importantly, can make it harder to defend valuation conclusions that are later subject to scrutiny.
In short, providing high quality information in response to the appraiser’s request list promotes a more predicable outcome with the IRS and with other stakeholders.
Upon completing research, due diligence interviews with appropriate parties, and the valuation analysis, the appraiser should provide a draft appraisal report for review. The steps discussed thus far – careful planning and timely information collection – are not substitutes for careful review of the draft appraisal report. The complexity of many multi-tiered structures increases the need for relevant parties to review the draft appraisal for completeness and factual accuracy.
Engagements involving complicated entity and operational structures are not easily shoehorned into typical appraisal reporting formats and presentation. Unique entity and asset attributes may require complex valuation techniques and heighten the need for clear and concise reporting of appraisal results. Regardless of the
complexity of the underlying structure and valuation techniques, the appraisal report should still be easy to read and understand.
We recently wrote about the market approach, which is one of the three primary approaches utilized in business valuations. In this article, we’ll be presenting a broad overview of the income approach. The final approach, the asset-based approach, will discussed in a future article. While each approach should be considered, the approach(es) ultimately relied upon will depend on the unique facts and circumstances of each situation.
The income approach is a general way of determining the value of a business by converting anticipated economic benefits into a present single amount. Simply put, the value of a business is directly related to the present value of all future cash flows that the business is reasonably expected to produce. The income approach requires estimates of future cash flows and an appropriate rate at which to discount those future cash flows.
Methods under the income approach are varied but typically fall into one of two categories:
The question if often asked, which method should you use, or should you use multiple methods? Also, does one use single period methods, or multi-period method? It depends on the facts and circumstances, including but not limited to, whether the business is in a mature or growing business cycle, if budgets/projections are prepared in normal course of business, among other considerations. More importantly, the analyst must evaluate if trends analyzed from the business’ historical performance provide a reasonable indication of the future, and which methodology or methodologies best capture that future economic stream of benefits.
Before analyzing each method, it is important to start with normalizing adjustments, which serve as a foundation for both income approach methodologies. Normalizing adjustments adjust the income statement of a private company to show the financial results from normal operations of the business and reveal a “public equivalent” income stream. In creating a public equivalent for a private company, another name given to the marketable minority level of value is “as if freely traded,” which emphasizes that earnings are being normalized to where they would be as if the company were public, hence supporting the need to carefully consider and apply, when necessary, normalizing adjustments. There are two categories of adjustments.
Mercer Capital dives deep into this subject in this article, but here are some highlights. These adjustments eliminate one-time gains or losses, unusual items, non-recurring business elements, income/expenses of non-operating assets, and the like. Examples include, but are not limited to:
These adjustments relate to discretionary expenses paid to or on behalf of owners of private businesses. Examples include the normalization of owner/officer compensation to comparable market rates, as well as elimination of certain discretionary expenses, such as expenses for non-business purpose items (lavish automobiles, boats, planes, personal living expenses, etc.) that would not exist in a publicly traded company.
For more, refer to our article “Normalizing Adjustments to the Income Statements” and Chris Mercer’s blog.
Once the analyst determines adjusted earnings, we can move forward to capitalizing these economic benefits.
The simplest method used under the income approach is a single period capitalization model. Ultimately, this method is an algebraic simplification of its more detailed DCF counterpart. As opposed to a detailed projection of future cash flow, a base level of annual net cash flow and a sustainable growth rate are determined.
The value of any operating asset/investment is equal to the present value of its expected future economic benefit stream.
If the growth in cash flows is constant, this can be simplified:
Where
CF = Next year’s cash flow
g = perpetual growth rate
r = discount rate for projected cash flows
The denominator of the expression on the right (r – g) is referred to as the “capitalization rate,” and its reciprocal is the familiar “multiple” that is applicable to next year’s cash flow. The multiple (and thus the firm’s value) is negatively correlated to risk and positively correlated to expected growth. There are two primary methods for determining an appropriate capitalization rate—a public guideline company analysis or a “build-up” analysis (previous article by Mercer Capital where we discussed the discount rate in detail).
Businesses may be valued using the DCF method because this method allows for modeling of varying or near-term accelerated growth revenues, expenses, and other sources and uses of cash over a discrete projection period. Beyond the discrete projection period, it is assumed that the business will grow at a constant rate into perpetuity. As that point, the future beyond the projection period is capitalized as the terminal value and the method converges to the single period capitalization.
In circumstances where no changes in the business model or capital structure are expected, a single period capitalization method may be sufficient. Ultimately, the DCF’s output is only as good as its inputs, therefore, testing of assumptions and reasonableness is critical.
The discounted cash flow methodology requires assumptions, but the formula can be broken down to three basic elements:
Discrete cash flows are forecasted for as many periods as necessary until a stabilized earnings stream could be anticipated (commonly in the range of 3-10 years). Ideally, projections will be sourced from management, but if management projections are not available, a competent valuation professional may choose to develop a forecast based on historical performance, industry data, and discussions with management. It is important to test the reasonableness of the projections by comparing historical and projected performance as well as expectations based on the subject company’s history and the industry in which it operates.
A discount rate is used to convert future cash flows to present value as of the valuation date. Factors to consider include, but are not limited to business risk, supplier and/or customer concentrations, market and industry risk, size of the company, financial leverage, capital structure, among others. For a detailed look into discount rates, see a recent article published by Mercer Capital.
The terminal value captures the value of the company into perpetuity. It uses a terminal growth rate, the discount rate, and the final year cash flow to arrive at a value, which is discounted and added to the discrete cash flow projections.
The income approach can determine the value of an operating business using financial metrics, growth rate and discount rate unique to the subject company. However, each method within the income approach must be selected based on applicability and facts and circumstances unique to the matter at hand; thus, a competent valuation expert is needed to ensure that the methods are applied in a thoughtful and appropriate manner.
It may seem an odd time for some publicly traded companies to consider cash-out merger transactions because broad equity market indices are at or near record levels. Nonetheless, the changing market structure means some boards may want to consider it.
Among a small subset of public companies that may are those that are traded on OTC Markets Group’s Pink Open Market (“Pink”), the lowest of three tiers behind OTCQB Venture Market and OTCQX Best Market. Pink is the successor to the “pink sheets” which was published by a quotation firm that was purchased by investors who rechristened the firm OTC Markets Group.
Today, OTC Markets Group is an important operator in U.S. capital markets because it facilitates capital flows for 11,000 US and global securities that range from micro-cap and small-cap issuers across all major industries to ADRs of foreign large cap conglomerates. Many issuers are SEC registrants, too.
The issue that may cause some boards of companies traded on Pink to contemplate a cash-out merger or other transaction to reduce the number of shareholders is an amendment by the SEC to Rule 15c2-11, which governs the publication of OTC quotes and was last amended in 1991. Since then, markets and the public participation in markets have increased significantly as trading costs have declined and information has become more widely disseminated. The amendment applies only to Pink listed companies because those traded on OTCQB and OTCQX already meet the new requirements.
Because of a quirk in how the rule was written in conjunction with a “piggyback exception” for dealers, financial information for some Pink issuers is not publicly available. The amended rule, which goes into effect September 28, 2021, prohibits dealers from publishing quotes for companies that do not provide current information including balance sheets, income statements and retained earnings statements. OTC Markets Group requires companies to comply with the rule through posting information to the issuer’s publicly available landing page that it maintains.
While the disclosure requirement presumably is not burdensome, not all companies want to disclose such information, especially to competitors. Companies that choose not to comply with amended Rule 15c2-11 will no longer be eligible for quotation. Because shareholders of these companies historically have had the option to obtain liquidity, boards may want to evaluate an offer to repurchase shares or a cash-out merger transaction that reduces the number of shareholders.1
Also, some micro-cap and small-cap companies whether traded on an OTC market or a national exchange may not obtain as many advantages compared to a decade or so ago.
Given the rise of passive investing in which upwards of 50% of US equities are now held in a passively managed fund, companies that are not included in a major index such as the S&P 500, Russell 1000, NASDAQ or Russell 2000 are at a disadvantage given the amount of capital that now flows into passive funds. In some instances, it may make sense for these companies to go private, too.
Cash-out transactions can be particularly attractive for companies that have a high number of shareholders in which a small number of shareholders have substantial ownership. Cash-out merger transactions require significant planning with help from appropriate financial and legal advisors. The link here provides an overview of valuation and fairness issues to consider in going private and cash-out transactions for companies whether privately or publicly held.
Mercer Capital is a national valuation and financial advisory firm that works with companies, financial institutions, private equity and credit sponsors, high net worth individuals, benefit plan trustees, and government agencies to value illiquid securities and to provide financial advisory services related to M&A, divestitures, capital raises, buy-backs and other significant corporate transactions.
Going Private 2023 presentation by Mercer Capitals’, Jeff K. Davis, CFA, that provides an overview of issues surrounding a decision to take an SEC-registrant private.
In our last update regarding core deposit trends published in August 2020, we described a decreasing trend in core deposit intangible asset values in light of the pandemic. In response to the pandemic, the Fed cut rates to effectively zero, and the yield on the benchmark 10-year Treasury reached a record low. While many factors are pertinent to analyzing a deposit base, a significant driver of value is market interest rates. Although there has been some recovery in longer-term treasury rates since this time last year, shorter-term treasury rates (maturities of two years or less) have eased as investors concluded the Fed will not raise short-term policy rates in the near-term.
For the full year of 2020, bank M&A activity fell sharply to 111 announced transactions from approximately 250 to 300 transactions per year during 2014 to 2019. More deals have been announced in the first eight months of 2021 than were announced in all of 2020. As shown in Figure 2, on the next page, the majority of the 2021 announcements occurred in the second quarter.
With 63 announced deals, the second quarter of 2021 represented the highest level of quarterly deal announcements since the third quarter of 2019 (83 deals). For comparison, only nine whole-bank transactions were announced in the second quarter of 2020, representing the fewest deals announced during a quarter over the time period analyzed. At this time last year, there were several factors hindering deal activity. Unknowns surrounding credit quality and the severity of loan deferrals in the midst of the pandemic gave pause to many deal talks in progress prior to the pandemic. Constraints surrounding travel and due diligence also hampered activity.
Ultimately, credit losses were not as significant as were feared initially, and travel has begun to normalize in the wake of widespread vaccine distribution. As a result, there appears to be a degree of pent-up demand in the bank M&A market. Moreover, many of the factors driving acquisitions have intensified over the past year.
Revenue pressure is causing institutions to seek operational efficiencies via synergies, as loan growth (excluding PPP loans) has been exceptionally weak over the past year, deposit growth has been unprecedented, and interest rates remain near historic lows. Additionally, as more consumers adopted digital banking in a socially-distancing society, banks lacking capability in this arena saw a more acute need to seek partnerships with more technologically advanced institutions.
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Using data compiled by S&P Capital IQ Pro, we analyzed trends in core deposit intangible (CDI) assets recorded in whole bank acquisitions completed from 2000 through June 30, 2021. CDI values represent the value of the depository customer relationships obtained in a bank acquisition. CDI values are driven by many factors, including the “stickiness” of a customer base, the types of deposit accounts assumed, and the cost of the acquired deposit base compared to alternative sources of funding. For our analysis of industry trends in CDI values, we relied on S&P Capital IQ Pro’s definition of core deposits.1 In analyzing core deposit intangible assets for individual acquisitions, however, a more detailed analysis of the deposit base would consider the relative stability of various account types.
In general, CDI assets derive most of their value from lower-cost demand deposit accounts, while often significantly less (if not zero) value is ascribed to more rate-sensitive time deposits and public funds, or to non-retail funding sources such as listing service or brokered deposits which are excluded from core deposits when determining the value of a CDI.
Figure 3, below, summarizes the trend in CDI values since the start of the 2008 recession, compared with rates on 5-year FHLB advances. Over the post-recession period, CDI values have largely followed the general trend in interest rates—as alternative funding became more costly in 2017 and 2018, CDI values generally ticked up as well, relative to post-recession average levels.
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Throughout 2019, CDI values exhibited a declining trend in light of yield curve inversion and Fed cuts to the target federal funds rate during the back half of 2019. This trend accelerated in March 2020 when rates were effectively cut to zero. CDI values have shown some recovery in the past two quarters (average of 60 basis points for the first half of 2021 as compared to 50 basis points in the second half of 2020). Despite the recent uptick, CDI values remain below the post-recession average of 1.33% in the period presented in the chart and meaningfully lower than long-term historical levels which averaged closer to 2.5-3.0% in the early 2000s.
The average CDI value declined 11 basis points from June 2020 to June 2021, while the five year FHLB advance increased 25 basis points over the same period. Although the five year FHLB advance rate has increased year-over-year, rates on FHLB advances with terms of less than two years have declined an average of 11 basis points since this time last year.
Since the beginning of the pandemic, banks have been burdened with an excess of deposits. It was initially expected that the increase in deposits would be transient in nature as the economy re-opened, PPP funds were spent or invested, and consumer confidence improved. However, the glut of deposits has endured, and deposits at US commercial banks were at a record level of $17.3 trillion at the end of July despite earning historically low deposit rates. Weak loan demand has aggravated the issue for banks, and margin pressure remains a very real concern for financial institutions.
In past cycles, when interest rates declined, the change in the CDI/core deposit ratio was mostly caused by lower CDI values (the numerator in the ratio). In the pandemic, though, CDI values declined (due to lower rates) while core deposits increased (due to the governmental response to the pandemic among other factors). With market participants unwilling to pay a premium for potentially transient deposits, the CDI/core deposit ratio was squeezed by both lower CDI values (the numerator) and higher core deposits (the denominator). Time will tell how stable deposits will be after the deposit influx experienced in 2020 and the first half of 2021, which will affect CDI values going forward.
Core deposit intangible assets are related to, but not identical to, deposit premiums paid in acquisitions. While CDI assets are an intangible asset recorded in acquisitions to capture the value of the customer relationships the deposits represent, deposit premiums paid are a function of the purchase price of an acquisition. Deposit premiums in whole bank acquisitions are computed based on the excess of the purchase price over the target’s tangible book value, as a percentage of the core deposit base.
While deposit premiums often capture the value to the acquirer of assuming the established funding source of the core deposit base (that is, the value of the deposit franchise), the purchase price also reflects factors unrelated to the deposit base, such as the quality of the acquired loan portfolio, unique synergy opportunities anticipated by the acquirer, etc.
Additional factors may influence the purchase price to an extent that the calculated deposit premium doesn’t necessarily bear a strong relationship to the value of the core deposit base to the acquirer. This influence is often less relevant in branch transactions where the deposit base is the primary driver of the transaction and the relationship between the purchase price and the deposit base is more direct. Figure 4 presents deposit premiums paid in whole bank acquisitions as compared to premiums paid in branch transactions.
As shown in Figure 4, deposit premiums paid in whole bank acquisitions have shown more volatility than CDI values. Deposit premiums in the rangeof 6% to 10% remain well below the pre-Great Recession levels when premiums for whole bank acquisitions averaged closer to 20%.
Deposit premiums paid in branch transactions have generally been less volatile than tangible book value premiums paid in whole bank acquisitions. Branch transaction deposit premiums averaged in the 4.5% to 7.5% range during 2019 and 3.0% to 7.5% during 2020, up from the 2.0% to 4.0% range observed in the financial crisis. Only eight branch transactions were completed in the first half of 2021, but the range of their implied premiums is in line with 2019 and 2020 levels.
Some disconnect appears to exist between the prices paid in branch transactions and the CDI values recorded in bank M&A transactions. Beyond the relatively small sample size of branch transactions, one explanation might be the excess capital that continues to accumulate in the banking industry, resulting in strong bidding activity for the M&A opportunities that arise–even in situations where the potential buyers have ample deposits.
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 an accelerated amortization method was selected in approximately half of these transactions.
For more information about Mercer Capital’s core deposit valuation services, please contact one of our professionals.
In each “Meet the Team” segment, we highlight a different professional on our Family Law team. The experience and expertise of our professionals allow us to bring a full suite of valuation and forensics services to our clients. We hope you enjoy getting to know us a bit better.
Scott Womack: I started doing divorce work about 13 years ago. Personally, I have found this work to be very rewarding. Divorce clients are very appreciative and I feel like I am making a difference as their Trusted Advisor throughout the process, but especially in mediation or during the trial. Often the non-business or out-spouse is not directly involved in the couple’s business and doesn’t know the value of the business or understand the process of valuation. These clients look to us to educate them and guide them through the process. Business owners or the in-spouse also see us as a value-add to the process, as they may have not gone through the business valuation process during their ownership of their company.
Scott Womack: More often than not, I am involved in family law/divorce cases. The cases generally involve high wealth individuals and those that own businesses or business interests. In addition to the valuation and forensic work, I also participate in mediation to assist the client in an attempted settlement. If mediation is not successful, I generally submit a formal report to the Court and do testimony work at trial. Other litigation projects include breach of contract or shareholder disputes.
Scott Womack: A forensic credential allowed me to better analyze financial statements in divorce. Credentials help to frame your expertise and demonstrate your general ability to do your work. In a lot of divorce cases, especially if you are valuing a business, there can be forensic work. One example would be discretionary or personal expenses being paid through the business, which can have an impact on the value of the business as well as implications in the divorce such as possible dissipation or income available for support.
Scott Womack: Early in my career, the industry was comprised mostly of valuation generalists. In the early 2000s, financial statement reporting and valuations took on a whole new life of their own with purchase price allocations and stock based compensation. At this point, the valuation profession kind of exploded to become more specialized. We have people that now specialize in a specific service, be it divorce, financial statement reporting, or a particular industry. That is really what I have seen change. The movement from generalization to specialization. Especially for growth in your career, specialization is a great avenue for advancement by being able to be an expert in a field.
Scott Womack: I had a partner at my old firm who had several auto clients and I often got to work on those engagements. Some of these cases were related to divorce so I was able to see the litigation side as well. The Auto Dealership industry has some unique characteristics in its financial statements and operations. After being exposed to these differences I saw an opportunity to make an impact in this industry. I would be able to specialize in this area in order to provide the best valuation services possible.
Scott Womack: The financial statements are pretty unique in the Auto Dealership industry. Dealers have to submit monthly financials to manufacturers, and each manufacturer statement looks a little different, almost like trying to solve a puzzle. Due to the specialization and profit centers of the various departments, these statements have a lot of detail. They are very informative with not only the major categories like assets, liabilities, and revenues, but you can determine the size the service department or how many used vehicles they sold, what they’re selling them for, or how much inventory they have on the lot.
Not only do auto dealerships have to submit monthly statements, but some also report a thirteenth month statement. The thirteenth month takes the twelfth month with added year-end tax adjustments, normalization adjustments, etc. Furthermore, there is unique terminology in this industry. An example would be, “Blue-Sky”, which is the goodwill value of the dealership. It can encompass a number of factors and the Blue Sky value is often very meaningful to a dealer requesting a valuation.
There are also nuances in ownership and management that are important to know, as well as different valuation techniques and methodologies that are preferred. Someone specialized in this industry is better equipped to know what a client is looking for. I have found that my experience valuing auto dealerships has given me an advantage in knowing what to look for and what questions to ask.
Scott Womack: I have always enjoyed that the valuation and consulting business is project-based. On a project basis, you are able to work with different owners and different industries all across the board. One of my favorite parts of a project is conducting the management interviews and site visits. While the financial statements paint a picture and supply the quantitative results of operations, the management interviews provide much of the qualitative factors and allow you to gain an understanding of the company, the industry and the risk factors that they face. I enjoy meeting different business owners and learning about their successful companies and history.
In the previous article, we highlighted the various benefits of hiring a financial advisor when investigating the potential sale of a business.
In a transaction with an outside party, the buyer will almost always be far more experienced in “deal-making” relative to the seller, who often will be undertaking the process for the first (and likely only) time. With such an imbalance, it is important for sellers to level the playing field by securing competent legal, tax and financial expertise.
A qualified sell-side advisor will help ensure an efficient process while also pushing to optimize the terms and proceeds of the transaction for the sellers.
As with anything in this world, favorable transaction processes and outcomes require an investment. Fee structures for transaction advisory services can vary widely based on the type and/or size of the business, the specific transaction situation, and the varying roles and responsibilities of the advisor in the transaction process.
Even with this variance, most fee structures fall within a common general framework and include two primary components: 1) Project Fees and 2) Success Fees.
Project fees are paid to advisors throughout an engagement for the various activities performed on the project. Such activities include the initial valuation assessment, development of the Confidential Information Memorandum, development of the potential buyer list, and other activities. These fees generally include an upfront “retainer” fee paid at the beginning of the engagement.
Retainer fees serve to ensure that a seller is serious about considering the sale of their business. For lower middle market transactions, the upfront retainer fee is typically in the $10,000 to $20,000 range.
Often times, a fixed monthly project fee will be charged throughout the term of the engagement. These fees are meant to cover some, but not all, of an advisor’s costs associated with the project.
For lower middle market transactions, monthly fees are typically $5,000 to $10,000. In certain situations, the engagement will include hourly fees paid throughout the engagement for the hourly time billed by the advisor. Such hourly fees are billed in place of a fixed monthly project fee.
Hourly fees are typically appropriate when the project is more advisory-oriented versus being focused on turn-key transaction execution. Hourly fees serve to emphasize the objective needs of the client by counter-balancing the incentive for an advisor to “push a deal through” that may not be in the best long-term interests of the client.
An hourly fee structure typically front loads the fees paid throughout the transaction process and is paired with a reduced success fee structure at closing which brings total fees back in line with market norms.
Mercer Capital has had favorable outcomes with numerous clients when fee structures are well-tailored to the facts and circumstances of the seller and the seller’s options in the marketplace.
A success fee is paid to a transaction advisor upon the successful closing of a transaction. Typically, success fees are paid as part of the disbursement of funds on the day of closing. As with project fees, success fees can be structured in a number of different ways.
A simple approach is to apply a flat percentage to the aggregate purchase price to calculate the success fee. The use of a flat percentage fee seems to have increased in recent years, and makes a fair bit of sense as it allows the client to clearly understand what the fees will look like on the back-end of a transaction.
Traditionally, the most used success fee structure employs a waterfall of rates and deal valuation referred to as the Lehman Formula. This formula calculates the success fee based on declining fee percentages applied to set increments (“tranches”) of the total transaction purchase price.
For lower middle market transactions, the simplest Lehman approach is a 5-4-3-2-1 structure: 5% on the first million dollars, 4% on the next million, and so on down to 1% on any amount above $4 million. The Lehman Formula, which can be applied using different percentages and varying tranche amounts, pays lower percentages in fee as the purchase price gets higher. Smaller deals may include a modified rate structure (for example 6-5-4-3-2) or may alter the tranche increments from $1 million to $2 million.
The Lehman Formula, in its varying forms, has been utilized to calculate transaction advisory fees for decades. While the formula may add some unnecessary complexities to the calculation (versus say a flat percentage), it has proven over time to provide reasonable fee levels from the perspective of both sell-side advisors and their clients.
A success fee can also be structured on a tiered basis, with a higher percentage being paid on transaction consideration above a certain benchmark. If base-level pricing expectations on a transaction are $15 million, the success fee might be set at 2.5% of the consideration up to $15 million and 5% of the transaction consideration above this level. If the business were sold for $18 million, the fee would be 2.5% of $15 million plus 5% of $3 million. The blended fee in this case would total $525,000, a little under 3% of the total consideration.
Escalating success fees are often favored by clients because they provide an incentive for advisors to push for maximized deal pricing rather than settling for an easier deal at a lower price.
Transaction advisory fees, on a percentage basis, tend to be higher for smaller transactions and decline as the dollars of transaction consideration increases. Various surveys of transaction advisors are available online that suggest typical fee ranges.
Consensus figures from these sources are outlined below. Based on our experience, these “typical” ranges (or at least the upper end of each range) appear to be somewhat inflated relative to what most business owners should expect in an actual transaction advisory engagement.
At Mercer Capital, we tailor fees in every transaction engagement to fit both the transaction situation at hand and our client’s objectives and alternatives.
In situations where a client has an identified buyer, we understand that our role will likely be focused on valuation and negotiation. Many sellers are unaware that price is only one aspect of the deal, and terms are another. Altering the terms of a definitive agreement can move the needle by 5%-10% and can potentially accelerate end-game liquidity by 6 to 12 months.
Accordingly, we design each fee structure to recognize what we are bringing to the process, typically utilizing some combination of hourly billings and a tiered success fee structure on the portions of the deal where our services are making a difference in the total outcome.
If we are assisting a client through a full auction process, it may be appropriate to utilize a more traditional Lehman Formula or a flat percentage calculation. A primary focus of our initial conversations with a potential client is to understand the situation in detail so that we can develop a fee structure that ensures that the client receives a favorable return from their investment in our services.
Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982.
Mercer Capital leverages its historical valuation and investment banking experience to help clients navigate critical transactions, providing timely, accurate, and reliable results. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries.
Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor, encouraging the right decision to be made by its clients. We recommend to clients to accept the right deal or no deal at all.
Our dedicated and responsive team is available to manage your transaction process. To discuss your situation in confidence, give us a call.
In December 2020, the Securities and Exchange Commission (“SEC”) adopted a new rule 2a-5 to update the regulatory framework around valuations of investments held by a registered investment company or business development company (“fund”). Boards of directors of funds are obligated to determine fair value of investments without readily available market quotations in good faith under the Investment Company Act of 1940 (“Act”).
Rule 2a-5 specifies requirements to fulfill these obligations. Concurrently, the SEC also adopted rule 31a-4, which provides recordkeeping requirements related to fair value determinations. Rule 2a-5 was effective as of March 2021, and funds are required to be compliant upon the conclusion of an 18-month transition period following the effective date (voluntary early compliance allowed).
Prior to adopting rule 2a-5, the SEC last addressed valuation practices under the Act more than 50 years ago. Over the intervening period, the variety of securities and other instruments held by investment funds has proliferated. The volume and type of data used in valuations have also increased. Funds increasingly use third-party services to provide pricing information, especially for relatively illiquid or otherwise complex assets. In addition, accounting standards and regulatory requirements have advanced including developments related to ASC 820, Fair Value Measurement.
Against this backdrop, rule 2a-5 establishes a framework consisting of four primary functions required to determine fair value in good faith. A fund board may choose to determine fair value by executing the functions. Rule 2a-5 also allows a fund board to designate these functions to a “valuation designee.” The required functions are:
When fair value determinations are made by a valuation designee, which can be the fund adviser or an officer of an internally managed fund, the board is required to actively oversee the valuation designee’s work and compliance with the rule. In general, rule 2a-5 limits possible designees to entities that that have a fiduciary duty to the fund. While the adviser may have some conflicts, the fiduciary obligation to the fund would ensure that the valuation designee acts in the fund’s best interest and mitigates or discloses conflicts. The rule states that fund boards should approach oversight of the valuation designee’s work with a skeptical and objective view that considers valuation risks, the appropriateness of the valuation process, and the skill and resources devoted to the endeavor. In order to assist the fund board in its oversight function, a valuation designee is required to present both annual and quarterly written reports to the board.
Quarterly reports should include:
Annual reports should include:
In addition to periodic reporting to the fund board, the valuation designee is required to state the titles of the persons responsible for the valuation of portfolio investments. The valuation designee should also reasonably segregate fair value determinations from the portfolio management of the fund so that the portfolio manager does not determine or exert influence on the valuation of portfolio investments.
Rule 2a-5 updates decades-old valuation guidance from the SEC for investment funds. Fund boards have the primary responsibility to adhere to the valuation framework outlined in the rule. When a valuation designee performs these functions, active oversight is required of the board. The rule prescribes a framework that emphasizes understanding and managing risks around conflicts of interest and promotes a principles-based valuation regime that aligns with recent accounting and regulatory developments, notably ASC 820.
Originally published in the Portfolio Valuation: Private Equity and Credit, Third Quarter 2021.
COVID-19 has had a lasting impression on many industries throughout the world, but the U.S. trucking and transportation industry was among the first industries to feel the impact of the pandemic.
Lockdowns in China (initiated in December 2019) began affecting the U.S. trucking industry in very early 2020 as Chinese imports account for nearly 40% of all shipments entering the U.S. By the beginning of March, the U.S. had already begun to see massive declines in incoming freight with an escalation of shipping cancellations. The ports of Seattle and Long Beach experienced 50-60 container shipment cancellations reflecting declines of 9% relative to the prior year.
When discussing the decline of imports in the port of Seattle, Sheri Call of the Washington Trucking Association said, “That’s the kind of decline we’d normally see over the course of an entire year.” Disruption of international trade led to transportation companies reducing capacity as early as the beginning of March. Outbound rail and trucking shipments from LA dropped 25% and 20% respectively, in March 2020.
Due to social distancing requirements throughout the United States, many roadside eateries and rest areas were closed in the first several months of the pandemic, which reduced truck drivers’ access to food and other necessities for long days on the road. Trucking companies were forced to alter their transportation network, frequently carrying empty loads as a result of uneven and declining demand. According to Reuters, “trucks hauling food and consumer products north to the United State are returning empty to Mexico where mass job losses have hit demand, leaving cash-strapped truckers to log hundreds of costly, empty miles.” Empty loads increased nearly 40% worldwide in the immediate aftermath of the lockdown.
An indication of the health of U.S. trucking industry can be seen through the ratio of full north bound trips to full southbound trips at the Mexico-US border. The ratio is typically one full southbound trip to every three full northbound trips, but the ratio began to lean closer to a one to seven ratio during the pandemic with the remainder being empty or partially full. Additionally, new freight contracts have fallen 60% to 90% since the rise of COVID-19 in 2020.
Increased online shopping from consumers has led to a spike in demand for last-mile delivery services. Amazon reported $75.5 billion in 2020 first-quarter sales which was a 26% increase from the first quarter of 2019. Many last-mile delivery companies like FedEx and Amazon continued to hire workers with Amazon seeing an increase in company employment of nearly 175,000 workers from March to April of 2020. Last-mile delivery carriers also eliminated signature requirements so that they can now achieve a “contactless” delivery process.
The level of domestic industrial production is correlated to the demand for services within the transportation industry. The Industrial Production Index is an economic measure of all real output from manufacturing, mining, electric, and gas utilities.
Lockdowns that began in March of 2020, as a result of the pandemic, led to a sharp decline in the Industrial Production Index. The index began a rapid recovery during the summer months of 2020. At the end of the first quarter of 2020, the Industrial Production Index saw a quarter-over-quarter decrease of 16.7% while also being down 17.7% on a year-over-year basis. The index rebounded in the second quarter of 2020 with a quarter-over-quarter increase of 12.7%. The index continually increased over the last three quarters of 2020, but it had not reached pre-pandemic levels as of April 2021.
The outlook for the trucking industry at the beginning of 2020 was promising with economists predicting that freight rates would grow 2% over the course of the year. Strong economic growth in the first two months of 2020 was halted by the outbreak of the unforeseen pandemic. The impact was dramatic – though not entirely negative for all carriers. Carriers of essential goods like groceries, cleaning supplies, and medical supplies experienced skyrocketing demand for their services while industrial, manufacturing, and other non-essential carriers are still undergoing lasting effects from the pandemic.
One non-essential industry that experienced a downward turn at the onset of the pandemic was the vehicle shipping services industry. A strong economy with high disposable income and consumer confidence ramped up consumer spending for the American automobile industry in the periods leading up to the pandemic.
The industry’s growth prospects were halted during 2020 due to a high unemployment rate and a drop-off in disposable income. The success of the vehicle shipping services industry is closely intertwined with new car sales and consumer confidence. The graph below shows the relationship between revenue of the vehicle shipping services industry and new car sales and consumer confidence. Overall, decreased consumer confidence in 2020 led to many Americans electing to defer vehicle upgrades, which created a major economic downturn for the vehicle shipping services industry.
With many businesses closed, overall Cass Freight trucking shipments plummeted, seeing a decrease of 15.1% and 22.7% from April 2019 to April 2020. Truck tonnage also dropped 9.3% on a from March 2020 to April 2020 while declining 8.90% from April 2019 through April 2020.
The fall of the number of shipments along with overall truck tonnage caused transportation companies to lower contract and spot rates. Flatbed and reefer rates hit a five-year low in April of 2020, though they rapidly recovered and had surpassed pre-pandemic rates by the fourth quarter of 2020. Truck tonnage has not recovered at the same rate as spot and contract pricing and had not reached pre-pandemic levels by March 2021. These trends are reflected in the Cass Freight and Shipment Indices. While the Shipments index has increased relative to its April 2020 level and has surpassed pre-pandemic levels, the Expenditures index increased over 27% from March 2020 through April 2020.
Even though contract rates did not have as sharp of a decline in March of 2020 as spot rates, both experienced a drop-off at the onset of the pandemic. Spot rates dropped below numbers that had been seen in recent years. After the sharp decline of spot rates in March, rates for all categories began to steadily increase. Rates hit a seasonal decline at the end of December due to decreased consumer spending after the holiday season. Rates resumed their climb during the first months of 2021. Overall, the rising price of contract and spot rates spins a positive image for overall outlook of the trucking industry, while also encouraging new competition to enter the market.
At the beginning of 2020, there were strong predictions for revenue in both the long distance and local trucking industries. Once the COVID-19 pandemic hit, revenues for both parts of the trucking industry dropped along with future revenue predictions. After a few months of lockdowns, the trucking industry began a rapid rebound as a result of businesses reopening and increased online retail. Future revenue predictions from March and April of 2021 from both the long distance and local sectors exceed predictions made in October 2020.
Industrial production and consumer spending, spurred on by the substantial stimulus programs enacted by federal government, have recovered more rapidly than initially expected. This rapid recovery has seemingly reduced the expected long-term impacts of COVID-19 on the long-distance and local trucking industries.
The effects of rising trucking rates and revenues coupled with optimistic outlooks for both categories can be seen in the number of long-distance and local trucking establishments. Lured in by appealing spot and contract rates, March 2021 predictions for the number of establishments in the trucking industry look to be on the rise. Naturally, there was a drop-off in the number of establishments in 2020, but the industry seems to have recovered with numerous new entries into the market in 2021. The long-distance trucking industry is projected to have more than one hundred thousand more establishments than originally forecasted in January of 2020.
