This is the third article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read previous articles click here.
When given the choice between paying more or less for a good or service, it only makes sense that people prefer to pay less. Following this, a rational person would be expected to pay no more than the minimum available price for an item. Many modern business acquisitions appear to defy this logic – at least at first glance. According to Bloomberg, acquirers paid an average premium of 25.86% when making transactions in 2021. In other words, the average acquirer was willing to pay almost 26% above the intrinsic market value of a target business to successfully bid on an acquisition.
Theory holds that the value of any corporation, especially a controlling interest in such corporation, should have a value equal to the present value of the cash flows expected to benefit shareholders. This is called a financial control value and represents the intrinsic value of the company on a stand-alone basis. As evidenced by the premium data noted above, many acquirers buy businesses at a value higher than this intrinsic value, paying what is referred to as a strategic premium.
A strategic premium exists when a buyer expects that two plus two equals five, or possibly even some figure above five. In less abstract terms, acquirers pay a strategic premium when they expect that the combination of their business with another will generate more cash flow than both businesses on a standalone basis. A strategic premium reflects the portion of this added benefit that the buyer is willing pay to the seller to secure a deal.
To give an example, let’s say that Company A and Company B both generate $2 in EBITDA each year. Both companies may have an intrinsic stand-alone value of $12 (6x EBITDA). When Company A acquires B, they might pay 7.5x EBITDA ($15) because they expect that by combining into Company AB, the Company will generate a total of $5 of EBITDA per year (2+2=5) – providing for a combined intrinsic value of $30 (6x EBITDA). The difference between Company B’s stand-alone value of $12 and the $15 that Company A is willing to pay for it is $3, a 25% strategic premium. Company A spends $15 to increase their value from $12 to $30 – a deal that is accretive to shareholder value.
The framework we provided for the strategic premium begs a larger question: what justifies a strategic premium? Ultimately, there are several possible explanations. Acquirers pay a strategic premium when they expect to gain some sort of efficiency through a business combination. As outlined in our previous example, they expect that these efficiencies will generate more cash flows than both companies can produce on a standalone basis. There are many efficiencies that companies could expect from a transaction, but three are most common.
Cost savings are the most common justification for strategic premiums, often because they are comparatively easy to forecast.
Let’s go back to our two companies from earlier. Let’s say that Companies A and B both need to purchase the same raw material to create widgets. Once the companies combine, they still need the same amount of raw materials, but they will likely place a smaller number of larger orders. Since each order that comes in will now be larger, their suppliers may give them a bulk discount, which lowers the overall cost. By combining, Companies A and B are spending less money to bring in the same amount of revenue-generating raw materials, leading to larger amounts of profit and free cash flow.
Cost savings can come from supply costs, staff eliminations, or any number of other areas. These savings are usually both the most obvious and quickly achieved strategic enhancements following an acquisition.
Revenue enhancements are another common justification for strategic premiums but are harder to model.
There are many ways in which revenue enhancements can occur, but we focus on a simple example for the sake of this article. If Company A has a large distribution network, they can use that network to sell Company B’s products to a larger group of people than Company B had been able to previously. Bringing in this additional should increase profits and create more free cash flow.
Process improvements come about when the companies involved in a transaction absorb each other’s core competencies or assets. Mixing these competencies or assets can create revenue enhancements and/or operational efficiencies.
Continuing our examination of Companies A and B, Company A might pay a premium for Company B if they see that Company B has some sort of proprietary efficient process for creating widgets that Company A could learn and take advantage of. In today’s world, such considerations often focus on technology – be it software of some other form of technology. If the target company’s technology can be utilized by an acquirer to enhance the acquirer’s own cash flow, a strategic premium may be in the offing.
Now that we have reviewed the theory behind strategic premiums, we discuss how they can be advantageous or detrimental to acquirers.
Perhaps the most obvious benefit of paying a strategic premium is that it can prevent other firms from purchasing the acquiree first. Sellers in a transaction are incentivized to maximize price. By paying a higher premium, strategic acquirers can entice sellers away from financial buyers or other seemingly “less strategic” buyers. On the other hand, paying a strategic premium is a potential risk. A higher acquisition price increases the amount of cash flows necessary to recoup the acquirer’s investment. If the premium is too high, even an acquisition with compelling strategic benefits can become unprofitable.
Ultimately the reasonable price to pay for a target depends on the buyer. Different suitors will expect different efficiencies from the acquisition. To avoid paying too large of a premium, acquirers must have a realistic notion of what they can pay for a target before entering negotiations. Even then, buyers need to exercise discipline and know when to walk away from a bidding war that has gotten too heated.
Acquirers are most likely to be successful when they have an organized process for ensuring that the rationale behind the acquisition justifies the transaction price. Such a process usually includes the analysis (and scrutiny) of the specific enhancements anticipated from a transaction. Strategic enhancements often seem reasonable when considered generally but may fall apart (or at least shrink in magnitude) when under the light of detailed financial inspection. Premiums paid on the basis of only a general consideration of strategic enhancements could be doomed for failure. The success of such deals is often based more on luck than anything else.
To mitigate the risk of overpaying for an acquisition (and to reduce the impact of pure luck), we recommend a detailed financial inspection of both the target company and the potential strategic value of any transaction. As part of this analysis, it will likely benefit an acquirer to retain a transaction advisory team that possesses financial and valuation expertise.
Since Mercer Capital’s founding in 1982, we have worked with a broad range of public and private companies and financial institutions. As financial advisors, Mercer Capital looks to assess the strategic fit of every prospect through initial planning, rigorous industry and financial analysis, target or buyer screening, negotiations, and exhaustive due diligence so that our clients reach the right decision regardless of outcome. Our dedicated and responsive deal team stands ready to help your business manage the transaction process.
This is the fourth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.
When considering a buy-side transaction to expand, many middle market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well.
A merger is a combination of two companies on generally equal terms in which the transaction is structured as a share exchange although sometimes a modest amount of cash may be included, too. There are many questions that must be addressed. The key economic question involves the exchange ratio to establish the ownership percentages based upon the value of each company and the relative contribution of sales, EBITDA and other measures to the combined company.
Corporate governance and social issues are important factors to consider also. Because the “target” shareholders are not cashed out, a significant amount of time early in the process should be spent exploring the compatibility of directors, executive management and shareholders.
A basic premise from a shareholder perspective is that a merger will increase value through enhanced profitability, growth prospects and perhaps from the perspective of an acquirer of the combined company.
Stated differently, both shareholders should own shares in a company that will be more valuable than the interest in each independent company.
Assuming the parties are comfortable with governance and social issues, a merger can be an excellent means to grow the business when one of two conditions exist:
In the first situation, it may be that certain market, business or personal life cycle dynamics will keep one or both parties from wanting to sell the business. There is too much opportunity in the existing business to forego and owning a smaller percentage of a large pie is not an insurmountable hurdle. A merger gives both sets of ownership the value enhancements related to the expansion without forcing either group to exit their ownership position.
Mergers also have another very practical element. Cash is conserved because all or most of the consideration consists of shares issued by the surviving corporation to the shareholders of the company that will be merged into the surviving corporation. Some cash will be expended for professional fees, but the funds usually are nominal relative to the value of the combined companies. Importantly, existing excess liquidity and/or the borrowing capacity of the combined company can be used for expansion.
In a merger transaction, there is a two-sided valuation question. While in an acquisition, the buying party is typically bringing cash to the transaction (cash being easy to value), the merger parties are effectively both paying for the transaction with stock. The value of both companies must be set to determine the relative value percentages. If Company A (valued at $110 million) merges with Company B (valued at $90 million), the relative value percentages are 55%/45%. Following the merger, the former Company A shareholders should have 55% of the equity ownership in the merged entity, with the former Company B shareholders holding the remaining 45%.
In addition to considering the stand-alone valuation of each company, a contribution analysis should be constructed based upon sales, EBITDA, equity and other financial metrics. The valuations and contribution analysis then provides a range of exchange ratios (or ownership percentages) to conduct negotiations.
While the valuation and contribution math may be straightforward (or not at all), negotiating merger transactions can be complicated since one party is not paid to go away. Mercer Capital is often hired on a joint basis by entities seeking to negotiate a merger transaction.
While the final decision to go through with the merger remains with our clients in this situation, we serve as an independent advisor to both sides of the merger to establish the relative value parameters. An independent assessment of the relative values can help tremendously in building confidence with shareholders and boards that the terms of the merger are reasonable for both sides.
As with most deals, merger transactions usually include certain post-transaction “true-ups” to ensure that each entity delivers adequate levels of working capital (or other assets) at closing. A typical structure is for the parties to create escrow accounts funded with cash in amounts proportional to the post-merger ownership percentages. These escrow accounts serve as a mechanism to adjust for any shortfall at one entity.
If needed, a portion of the escrow cash is contributed into the merged entity, serving to make-up for any shortfall at closing. This keeps the ownership percentages at the agreed-upon relative value percentages. The excess cash left in the escrow accounts after these adjustments is distributed to the shareholders of the former (now merged) entities.
In our experience, shareholders and boards do not like the uncertainty of shifting ownership percentages – this escrow structure prevents the percentages from changing based on post-closing adjustments.
As with any acquisition, an organized post-transaction integration is critical to the success of a merger.
No matter how compelling the economics of a combination may be, the cultural fit of the two businesses will be a key element in determining the eventual success of the transaction. From the initial stages of the transaction, issues related to the cultural fit should be discussed and strategies should be implemented to increase the probability of a successful integration.
A basic question to be addressed early in the process is who will run the combined company. Public companies sometimes use co-CEOs, but not often for good reason. There should not be any question who is in charge, the responsibilities of subordinates, and the chain of command and accountability.
A comprehensive agreement on overall governance structures (including regional management, board construction, etc.) can provide some comfort for the side that might see themselves as being on the losing end of the potentially more political question of chief executive.
Shareholder control is another issue that has to be dealt with explicitly. If both entities consist of a large number of shareholders with no shareholder in direct control, the control issue is moot because there will be no controlling shareholder in the merged entity. Such prospective mergers are easier to negotiate because one shareholder (or voting block) does not have to give up control.
However, when one or both entities has a controlling shareholder (which could be represented by a single individual or a family block of stock), loss of control in a combined company may trump compelling economics. Both parties need to examine this issue closely and provide for conflict resolution mechanisms through the corporation’s by-laws and buy-sell agreements. Like marriages, getting out of a transaction is a lot harder and more expensive than entering into it.
We think mergers are a viable strategy to expand a business when the economics and social aspects are compelling for many small and middle market companies. Reasonable valuations and a detailed contribution analysis are the initial building blocks to quantify the economics. Mercer Capital is an active transaction advisor. While we most often are retained by one party, some of our most successful and rewarding projects have been those where we were jointly retained by both parties to advise on the transaction structure. If you are considering a merger (or in the middle of a current transaction), please call one of our Transaction Advisory Group professionals to assist.
Determining the value of financial assets in a divorce case can often be the most complicated aspect of the case.
The value of certain assets, such as a retirement account or a bank account, can be determined by a brokerage or bank statement/balance as close to the date of trial or settlement as possible.
An asset such as a closely held business may be the most valuable asset in the marital estate and can require a business appraiser to determine its fair market value since no market indication of value is generally available (unlike a publicly traded company).
The valuation date is also important. In addition to the value of the business or business interest (%) at the current date, other indications of value, such as the value at the date of marriage, may also be required. This varies depending on the facts and circumstances of ownership as well as state statutes.
Net asset division in divorce proceedings are further complicated because they are governed by laws that differ by state. The majority of states are referred to as Equitable Division (“ED”) states as opposed to Community Property states. In ED states, courts determine the equitable or fair distribution of the marital assets based on the characteristics of each case. Further, a majority of ED states are referred to as Dual Property ED states, meaning that assets are categorized as either marital or separate.
While definitions vary by state, some states define marital assets as those acquired or earned during the marriage. Those states then define separate assets as those consisting of property owned by a spouse prior to marriage or property received by gift or inheritance that has not been commingled or transmuted during the marriage. Generally, marital assets are subject to division in a divorce proceeding whereas separate assets, as the name implies, are held separately and not factored into the equitable division of marital assets.
Can a separate asset ever become a marital asset? Yes. In many states, the increase in value of a separate asset during the course of the marriage can potentially be considered a marital asset. Using the example of a closely held business, the increase in value, or appreciation, is often measured by the fair market value of that asset at the date of marriage and some other date as defined by the individual state law or statutes. Other measurement dates are the date of trial, date of separation, or date of filing, among others. In an article published in Family Lawyer magazine, we discussed the importance of the valuation date and its impact on the value of a closely held business.
Consider a simple example of a closely held business that one spouse owned at the time of marriage. Let’s assume that the fair market value of the business at the date of marriage is $1 million and the fair market value of the business at the date of trial is $10 million. The simple calculation of the appreciation, or increase in value, is $9 million. Is the entire difference of $9 million considered marital property in this example? The answer may be “it depends,” because it may not be that simple depending on the state or jurisdiction of the case.
In many states, the entire portion of appreciation is not treated as marital property, though, valuation experts must confirm state statute and precedent with the attorneys.
Many states make the distinction between “active” and “passive” appreciation. Active appreciation refers to the increase in value, due to the active, direct and indirect, efforts of one or both spouses. Passive appreciation refers to the increase in value, due to external factors such as market forces, or efforts of other individuals other than the spouses in the divorce.
Depending on the state, courts may then classify active appreciation as marital property, while passive appreciation generally remains separate property.
Active and passive appreciation can also be illustrated by looking at certain assets, such as retirement accounts or real estate. Assuming no contributions during the marriage, the growth in value of a retirement account as a result of the increase in the market values of the underlying investments since the date of marriage would be an example of passive appreciation. The rise in value of a piece of real estate or property due to general market conditions and absent any additional investment, improvement, or management of that real estate during the marriage would also constitute passive appreciation.
Appreciation in retirement accounts and real estate can be simply illustrated and defined through reasonable methodologies. Determining active and passive appreciation in the value of a closely held business can be much more complex. The assumptions used in the overall valuation of the business requires the business appraiser to use qualitative and quantitative analyses. Active appreciation can be supported through direct efforts of one or both spouses such as financial investment in the business, ownership and labor hours contributed to the business, management, marketing strategy, etc. Passive appreciation can consist of economic or market conditions and/or the efforts of non-divorcing individuals.
Market forces refer to the economic or market conditions that affect the price, demand, or value of an asset. Market forces happen naturally and are outside of the control or direct efforts of the owners of the company or spouses involved in a divorce. For a closely held business, market forces that can affect value include changes in interest rates, discount/capitalization rates, tax rates, pricing of products or billing rates, legislation that causes an increase in demand for a company’s products or services, etc. Value appreciation attributable to market forces would generally be classified as passive appreciation and as a result, would not be included in the marital estate in those states that recognize active/passive appreciation as marital/separate.
Consider a simple example of a company before and after the tax rate changes brought on by the 2017 Tax Cuts and Jobs Act (“TCJA”). Let’s assume the Company has $1 million in earnings, and the capitalization factor to determine value is 5x. Let’s also assume the tax rate changed from 35% to 21% after TCJA with no state income tax. In this example, all else being equal and not changed, the change in tax rate caused a 21.5% increase in value of the company.
Efforts from individuals other than the spouses could be another area where passive appreciation is present. Business appraisers can perform analyses of these third-party efforts through several techniques. When considering ownership, the following questions are addressed. What is the overall ownership of the company? Is the divorcing spouse the only owner or is he/she one of several owners? The presence of other owners could indicate efforts of other individuals. Management of the Company is also a consideration. Who are the key members of management and how are decisions made? Is the company controlled by a board of directors, and if so, how many individuals serve on the board? In terms of the the role of the spouse, appraisers can analyze these roles and the roles of other key individuals and determine what impact those duties have on the company’s strategy and performance overall. Finally, business appraisers can perform an analysis of the revenue contribution of each owner or key member of management to the overall revenue of the company. Does the company have multiple locations? If so, is the divorcing spouse active and participating at all locations?
Balance sheet factors can also impact the overall value of a company. The presence of excess cash or non-operating assets can add to the value determined under an income or capitalization method (used in the tax rate example above). The Company may have experienced an increase in these items from the date of marriage to the current date of measurement. From our experience, it is not uncommon to see companies in certain industries with more cash on the balance sheet in the last two years as a result of remaining funds obtained from PPP loans or elevated profits. Non-operating assets can consist of real estate not used in the core operations of the business or an investment account. We discussed both of these assets earlier and illustrated how their values can increase due to passive appreciation factors.
Consider a company with the following changes to its balance sheet: excess cash increased by $250,000 and non-operating assets increased by $500,000. In this example, the change in potential value to the company could be $750,000 and may be characterized as passive appreciation depending on the specific factors. While these are assets and liabilities of the business, they may be categorized as “non-core” assets that have different considerations for separate or marital appreciation from those of the core business operations.
Once the appraiser identifies and quantifies the areas of passive appreciation, the remaining appreciation, or increase in value, is concluded to be active appreciation. The conclusion of passive appreciation could be in dollars of value or percentage of overall value.
Let’s revisit our original example involving a company worth $1 million at date of marriage and $10 million at the date of trial. If the appraiser had determined passive appreciation to be $4 million, then the resulting active appreciation would be $5 million as seen below:
Determining the value and classification of financial assets can be challenging during a divorce proceeding. As we have discussed, the classification of an asset can also change from the date of marriage to the current date of measurement (trial, separation, filing, etc.) and depending on state statute and precedent. Many states make the distinction between active and passive appreciation, only considering the active appreciation to be a marital asset.
The value of a couple’s closely held business could be the most valuable asset in the marital estate. If the business was owned prior to marriage, the identification and quantification of any appreciation as active or passive could be critical to the overall marital value placed on that asset.
A detailed valuation analysis of the appreciation will be needed in addition to the valuation of the business at each measurement date. A qualified business appraiser can perform both tasks, including examining the specific factors that contribute to the overall value of the business. It’s important for the appraiser to understand the applicable state laws of the jurisdiction in question and to discuss those with the attorney.
Over the past year we have seen an uptick in transactions (and contemplated transactions) in which boards seek to reduce the number of shareholders via reverse stock splits and cash out mergers. The central question for a board aside from fairness and process is: what price?
While the terms “fair market value” and “fair value” appear to be similar, they are very different concepts. When seeking a business valuation, it is critical to ensure that the appraisal is performed according to the relevant and proper standards.
Fair market value (“FMV”) and fair value as defined in Accounting Standards Codification (“ASC”) 820 define value in the context of a market clearing price. Statutory fair value (“FV”) is defined in state statutes and is interpreted through precedents established in case law over the year, most notably in Delaware.
The accounting profession defines fair value in ASC 820 as:
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the
measurement date.
The accounting profession defines fair value from the seller’s perspective with the indicated value used for a variety of purposes including disclosure in financial statements for Level 1, 2, and 3 assets and liabilities.
In the business valuation community, FMV is the most widely recognized valuation standard. FMV is the primary standard used in valuations for estate tax, gifting, and tax compliance.
The IRS defines fair market value in Revenue Ruling 59-60 as:
The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.
What brings hypothetical, willing buyers and sellers to the intersection point of fair market value is their respective assessments and negotiations regarding the expected cash flows, risk, and growth associated with the subject interest. Depending on the corporate governance of the specific interest, fair market value also may incorporate discounts to reflect a business interest’s lack of control or lack of marketability. 1, 2
Statutory fair value is governed by state law and interpreted by state courts in which dissenting shareholders to certain corporate transactions (e.g., a merger approved by a shareholder vote) petition the court for the fair value of their shares.
Most state statutes provide appraisal rights that allow shareholders to obtain payment of the FV of their shares in the event of various corporate actions, including amendments to the articles of incorporation that reduce the number shares owned to a fraction of a share if the corporation has the right or obligation to repurchase the fractional share.
In 1950, the Delaware Supreme Court offered this interpretation of fair value:
“The basic concept of (fair) value under the appraisal statutes is that the (dissenting) stockholder is entitled to be paid for that which had been taken from him viz. his proportionate interest in a going concern. By value of the stockholder’s proportionate interest in the corporate enterprise is meant the true intrinsic value of his stock which has been taken by merger.”
In effect, the noncontrolling shareholder who is dissenting to a transaction is entitled to his or her pro rata share of value of the company as interpreted in most jurisdictions. As a result, the controlling shareholder cannot expropriate value from the minority shareholder who is being forced out. Therefore, some state statutes explicitly declare and most case law affirms the view that neither a discount for lack of control and/or an illiquidity discount should be considered in determining fair value. 3
While there is no official valuation hierarchy in the Delaware Court of Chancery, based upon a review of recent cases a few observations can be made:
The observations from Delaware case law about the meaning of statutory FV are reflected in some states’ business corporation act. For instance, FV according to the Guam Business Corporation Act §281301(d) shall be determined:
Shown below is a graphic detailing the different levels of value and how we at Mercer Capital think about them in relation to fair value and fair market value.
Controlling interest basis refers to the value of the enterprise as a whole and may be analyzed from two perspectives:
Marketable minority interest basis refers to the value of a minority interest, lacking control, but enjoying the benefit of liquidity as if it were freely tradable in an active market. The marketable minority level of value also is an enterprise level of value that may align with the financial control value.
Nonmarketable minority interest basis refers to the value of a minority interest, lacking both control and market liquidity. The standard of value for a nonmarketable minority interest valuation is usually fair market value and is seldom statutory fair value.
Mercer Capital has decades of experience working with boards of directors regarding statutory fair value in the context of transactions that create appraisal rights and dissenters’ rights. While we sometimes are called to assist in such matters once a transaction has occurred, it is better to address the issue of fair value (and fairness) beforehand. Please call if we can assist your institution.
1 Valuation of Noncontrolling Interests in Business Entities Electing to be Treated as S Corporations for Federal Tax Purposes, page 8, Accessed Online March 31, 2022 | https://www.irs.gov/pub/irs-utl/S%20Corporation%20Valuation%20Job%20Aid%20for%20IRS%20Valuation%20Professionals.pdf
2 Statutory Fair Value, Accessed Online March 25, 2022, https://mercercapital.com/content/uploads/MerceCapital-Statutory-Fair-Value.pdf.
3 Tri-Continental v. Battye, 74 A 2d 71, 72 (Delaware 1950)
The first quarter of 2022 marked the most volatile period since the first quarter of 2020. The quarter began with significant deterioration in the market’s outlook for growth stocks, particularly those lacking demonstrable earning power. Then, a geopolitical crisis, building for some time, intensified with the invasion of a European country, roiling markets ranging from commodities to equities. Last, the Federal Reserve announced, as expected, a 25 basis point change in its benchmark rate and telegraphed six more rate increases in 2022, taking the Federal Funds rate to nearly 2.00% by year-end 2022. In a speech on March 21, 2022, though, Chairman Powell suggested a greater likelihood that future Fed moves may occur in 50 basis point, rather than 25 basis point, increments to combat inflation, which mirrors the position taken by Governor Bullard in dissenting to the Fed’s 25 basis point rate change at the mid-March meeting.
The following tables summarize key metrics we track regarding equities, fixed income, and commodity markets leading up to the invasion of Ukraine on February 23, 2022 and thereafter.
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This is the second article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.
Business is good for many middle market operators and investment capital is generally plentiful. Are you an investor whose capital is industry agnostic, or does your capital need to be targeted at add-on investments that build on a pre existing business platform?
All business investors are “financial” investors – the real question is how “strategic” is their ability to leverage the assets of the target. Providing practical guidance on approaching a business target and conducting initial due diligence depends on the investor’s criterion, competencies, and execution bandwidth.
In this article we assume you have identified a target or group of targets and you are attempting to learn enough about the target to determine whether to proceed with developing a meaningful indication of interest. Of course, an active seller is likely prepared for the sale process and represented by an advisor who is postured to provide the financial and operating information necessary for investors to quickly determine the suitability of a deal (i.e., a pitchbook and defined protocols for communication and information access).
However, many desirable targets may not be seeking a sale because business conditions are favorable, and their businesses have been managed to provide options to the owners regarding continued independence and turn-key ownership and management succession. If the former, you, as a prospective buyer may have already pinged on the radar of the seller, and if the later, you have mined for target opportunities and are ready for the next step to accomplish an acquisition.
Our focus here is to summarize some practical considerations for approaching and vetting an identified target.
M&A is not easy. For every transaction that is announced a very long list of items for both the buyer and seller were satisfactorily addressed before two parties entered into a merger or purchase agreement. For the acquirers, first impressions matter a lot. There are no second chances to make a good first impression.
How a target is contacted can be pivotal to achieving receptivity and obtaining a critical mass of information. In cases where market familiarity or professional collegiality already exist, it can make sense for an investor’s senior leadership to make direct contact with the target’s senior management and/or owners.
In cases where the target is not familiar to the investor, then following a respectful and empathic set of protocols is key. Investors using professional advisors and/or who involve their senior decision makers are likely to be taken seriously by the target. Peer-to-peer contacts too far down the chain of command are more likely to be dismissed.
Owners and senior managers are keen to prevent the rumor mill from derailing business momentum and disturbing internal calm. A mindful and considerate process of first contact and initial discussions that is highly sensitive to the discrete nature of exploratory discussions will increase the probability that initial discussions and diligence can proceed to the next phase as a relationship based on trust develops.
In our experience, contacting a target through a financial advisor has an important signal function that the potential acquirer is serious and has initiated a process to prioritize and vet targets. Diligence procedures will be thorough and well organized; deal consideration and terms will be professionally scrutinized. Alternatively, some business owners and investors who initiate a process may be perceived as canvassing to see what sticks to the proverbial wall. This can inadvertently serve to inflate seller requirements and expectations assuming the initial inquiry is successful.
Once the initial contact is established, it is important to follow-up immediately with an actionable agenda. Actions and processes include:
Organization begets pace and that pace culminates in a go or no-go decision.
Procedurally, our buy-side clients typically request that we perform a valuation of the target using a variety of considerations including the standalone value of the target and potentially the value of the target inclusive of expected synergies and efficiencies.
A properly administered valuation process facilitates an understanding of the target’s business model, its tangible attributes, its intangible value, its operating capacity, its competitive and industry correlations, and many other considerations that investors use not only for the assessment of target feasibility but as an inward-looking exercise to assess the pre-existing business platform.
For first-time buy-side clients, our services may also include building leverageable templates and processes for future M&A projects. Additionally, our processes may also be critical to the buyer’s Board consents, the buyer’s financing arrangements, and other managerial and operating arrangements required to promote target integration.
Conducting target searches, establishing contact, and performing initial due diligence are critical aspects of successful buy-side outcomes. In general, there are as many (if not more) consequential considerations for buyers as there are for sellers.
Some buyers covet the conquest and go it alone without buy-side advisory representation. Conversely, even seasoned investors can benefit from third-party buy-side processes. Unseasoned acquirers may find their first forays into the M&A buy-side world untenable without proper guidance and bench strength.
As providers of litigation support services, we have seen deals that have gone terribly wrong as if predestined by inadequate buy-side investigation. As providers of valuation services, we have valued thousands of enterprises for compliance purposes and strategic needs. As transaction advisors, we have rendered fairness opinions, conducted buy- and sell-side engagements and advised buyers concerning a wide variety of deal structures and financings. If you plan to take a walk on the buy-side, let Mercer Capital’s 40 years of advisory excellence guide and inform you.
In previous posts, we wrote about the income and market approaches used in business valuations. This article presents a broad overview of the third approach, the asset approach. While each approach should be considered, the approach(es) ultimately relied upon will depend on the unique facts and circumstances of each situation.
The asset approach refers to methodologies used under the economic principle that the value of a business can be viewed as an assemblage of net assets. In practice, appraisers begin with the company’s balance sheet, which lists the assets, liabilities, and equity of the company. The values shown on a company’s balance sheet are the “book” values of the assets and liabilities, which are based on accounting standards. As such, these book values may or may not align with current market values. The appraiser will analyze each asset and liability and adjust values (as needed) to reflect market value. The market value of the company’s liabilities are then netted against the market value of the company’s assets to arrive at a Net Asset Value of the business.
The asset approach is appropriate for valuing real estate holding companies, investment holding companies, and capital-intensive operating companies. In the case of operating companies, the asset approach’s indicated value can be interpreted as the value of an assemblage of revenue-producing assets. However, sometimes the operating company is worth more than its assets, for a myriad of reasons. Understanding how well the balance sheet represents the business’s ability to generate earnings is a logical way to evaluate if the value per the asset approach is appropriate.
The asset approach is applied based on the identification and discrete appraisal of the company’s assets and liabilities. The assets, if necessary, are adjusted to reflect their market values. Generally, the identifiable assets fall into five categories:
Financial assets include cash and highly liquid investments like marketable securities, accounts receivable and prepaid expenses. This class of asset is typically the most straightforward to adjust, as the book values of cash and receivables usually require no adjustments to reflect market value.
In some cases, inventory can be marked up or down based on the economic reality underlying those inventory balances. If there is identified obsolete inventory, a downward adjustment might be necessary. If the company carries its inventory at historical cost and the value of that inventory has increased or decreased, an upward or downward adjustment might be necessary. An example of this could be a company that holds commodities as inventory.
Tangible real property includes furniture, fixtures, and equipment. The value of these assets may decrease over time through use or obsolescence. Accountants capture this effect by depreciating the book value of these assets over a period of time. If the assumptions used in the accounting depreciation of these assets are in line with the economic depreciation of these assets, the book value may be a reasonable indication of the assets’ market values. Otherwise, appraisals of the individual furniture, fixtures, and equipment may be necessary.
Sometimes, businesses may choose to take accelerated depreciation for tax benefits, while the financial statements may reflect either that same tax depreciation, or straight-line depreciation; it is important to be careful in understanding the historical depreciation methods within the financial documents.
The book value of real estate may reflect current market values of the underlying properties or may be dated and require a current appraisal. This can be attributed to appreciation or depreciation in value over time.
Intangible Assets
A company might have intangible assets on its balance sheet. Intangible assets are typically added to the balance sheet during the accounting process of an acquisition, and can be comprised of customer relationships, customer files, existing favorable contracts, existing workforce, tradenames, intellectual property, proprietary technology and general goodwill. In practice, Net Asset Value typically does not include value attributable to intangible assets because it is presented on a tangible, operating basis.
The asset approach is an intuitive approach to valuation, as it is based on the market value of a company’s equity, i.e. assets less liabilities. The asset approach can be a more insightful business valuation approach for entities which hold and manage assets, or perhaps entities which have high balances of machinery and equipment. A competent valuation expert is needed to thoroughly review a company’s balance sheet and assess the adjustments necessary to reflect market value of the underlying assets and liabilities, as well as determine if the approach best represents the value of the business at hand.
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Many observers predict that the market is ripe for an unprecedented period of M&A activity, as the aging of the current generation of senior leadership and ownership pushes many middle-market companies to seek an outright sale or some other form of liquidity. Obviously, not all companies are in this position. For those positioned for continued ownership, an acquisition strategy could be a key component of long-term growth. This article is the first in a series on buy-side considerations that we will share over the next few months. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. Our first topic starts at the beginning – identifying and assessing acquisition targets. |
With aggregate M&A activity setting records in 2021 and continuing a strong pace in 2022, many businesses are exhibiting a thirst for growth or conversely their shareholders are eyeing an exit at favorable valuations.
With labor tightness, supply chain disruptions for capital goods, and financing costs fluctuating in real time, buyers and sellers are increasingly strategic in their mindset. Inflation and interest rates represent potential headwinds, but pent-up demand and plentiful war chests are likely to fuel elevated M&A activity in the foreseeable future. More than a few baby boomers have held on to their business assets making ownership succession and liquidity significant concerns.
Additionally, many middle market business assets are churned by financial investors with defined holding periods. Large corporate players and private equity buy-out groups generally have their own corporate development teams. However, small and mid-market companies, occupied with day-to-day operations, often find themselves with limited bandwidth and a lack of financial advisory resource to identify, vet, and develop a well-crafted strategic M&A rationale and then execute it.
This article provides touch points and practicalities for identifying viable merger and acquisition targets and assessing strategic fit.
A rejuvenated appreciation for optimal capital structures and fine-tuned operations has largely debunked the oversimplified notion that bigger is always better. However, right-sizing is about achieving a proper, often larger scale at the proper time for a supportable price. A classic question in strategizing to achieve the right size is that of “buy” versus “build.”
Many acquisitions are as much about securing scarce or unavailable hard assets and labor resources as they are about expanding one’s market space.
Whether your investment mandate is to alleviate scarcities or to achieve vertical or horizontal diversification and expansion, tuning your investment criterion and financial tolerance to motivations and objectives is key.
These collective questions, among others, help address the who and the what of recognizing potential targets and assessing the pricing and structural feasibility of a business combination in whatever form that may take (outright purchase or merger in some form).
Given our experiences from years of advising clients, we have learned that the most obvious or simple solution is generally best. Many buyers already know the preferable target candidates but lack the ability to assess and the capacity to engage those targets. Additionally, many well-capitalized buyers lack the financial discipline to score, rank, and sequence their target opportunities with the expertise employed by large, active corporate developers and private equity investors.
Understanding the magnitude and timing of the returns resulting from your investment options is critical. Constructing financial models to study the options of now-versus-later and the interactive nature of deal pricing, terms, and financing is vital to the process. These technical and practical needs must be addressed competently to grant buyers the freedom of mind and energy to critically assess deal intangibles that often influence the overall decision to move forward with a target or not. Cultural fit, command and control for successful integration, brand and product synergies, and many other factors ultimately manifest in an investment’s total return on investment.
Scoring opportunities by way of traditional corporate finance disciplines using NPV and IRR modeling as well as using various frameworks such as SWOT Analysis or Porter’s Five Forces is highly recommended. However, blind ambition and soulless math may not result in the best choice of targets.
One common sense and often overlooked assessment is how a seller’s motivations may have a bearing on the risk assessment of the buyer. A seller today may be alerting today’s buyer about future realities the buyer may experience. In some cases, sellers are motivated by a deficit of ownership and management succession. In other cases, a seller’s motive may be the result of industry dynamics and disruption that may one day be the concern of today’s consolidators. Get informed, get objective and be rational when assessing a target. If you cannot do that with in-house resources, get help. If you have in-house resources, have your mandates reviewed and your target analysis checked by an experienced advisor with the right balance of valuation and transaction awareness.
We know that sellers often fear opening-up their financials and operations to certain logical strategic buyers. This may stem from generations of fierce competition or from a concern that not selling means the seller has revealed sensitive information that will compromise their competitive position or devalue the business in a future deal. Many sellers are extremely sensitive to retaining their staff and keeping faith with suppliers and customers. Buyers should understand that sellers require comfort and assurance regarding confidentiality.
Being proactive with non-disclosure agreements and even better using a third party such as Mercer Capital to establish contact may facilitate a process of mutual assessment that is initially a no-go for many tentative sellers. Buyers that demonstrate empathy for the seller’s position and who employ a well-conceived process to initiate exchange are more likely to gain access to essential information.
It is common for the seller’s initial market outreach to set the hurdle price for the winning buyer. That may occur as a result of the seller having reasonably skilled advisors who help establish deal expectations or through first-round indications of interest. As such, it should be no surprise for truly strategic buyers to be able to hurdle the offers of first round financial buyers or less optimal fringe buyers.
Buyers should also be aware that third party deals must win against the seller’s potential ability to execute a leveraged buy-out with family members or senior managers, which may facilitate favorable tax outcomes versus the asset-based structures in open-market M&A processes. Of course, strategic buyers should be equally aware that many private equity or family-office buyers may also be strategic in their motivations and pricing capabilities based on pre existing portfolio holdings.
Awareness of competing concerns for the target must be considered if you intend to win the deal. Buyers, with the help of skilled advisors, can actually help sellers address the balance of considerations that underpin a decision to sell. Having plans for human resource, communicating employee benefits and compensation structures, and laying the groundwork for a smooth integration process are part of walking the talk of a successful acquisition.
Whether your motivations are based on synergies, efficiencies, or simply on the inertial forces of consolidation that cycle through many industries, a well-organized and disciplined process is paramount to examining and approaching the market for hopeful growth opportunities.
Regardless of your past experiences and deal acumen, we recommend retaining a transaction advisory team familiar with your industry and possessing the valuation expertise to maximize transaction opportunities and communicate the merits your firm has to offer the target and all its stakeholders.
Since Mercer Capital’s founding in 1982, we have worked with a broad range of public and private companies and financial institutions. As financial advisors, Mercer Capital looks to assess the strategic fit of every prospect through initial planning, rigorous industry and financial analysis, target or buyer screening, negotiations, and exhaustive due diligence so that our clients reach the right decision regardless of outcome. Our dedicated and responsive deal team stands ready to help your business manage the transaction process.
After going virtual in 2021, the Omicron waved peaked just in time for the Acquire or Be Acquired (AOBA) conference to resume its normal physical presence in Phoenix, Arizona during late January. The virtual sessions in 2021 lacked their normal impact, given the inability, through face-to-face communications, to delve deeper into emerging strategies and industry trends with peers and subject matter experts. The most common sentiment expressed this year was simply the gratitude that we could gather once again, connecting with existing industry contacts and establishing new relationships.
AOBA’s emphasis has evolved. When we first attended the conference, the sessions emphasized acquisitions of failed banks to such a degree that presenters struggled to avoid overlapping content. Then, the conference shifted to emerging from the Great Financial Crisis and the transition to unassisted M&A transactions. We still remember the years that distressed debt buyers roamed the halls looking for unsuspecting bankers with loans to sell.
More recently, the traditional financial services industry structure—with separate, and somewhat inviolable, silos for banking, insurance, wealth management—has been fractured by new challengers from the FinTech sector. Armed with venture capital funding, a willingness to tolerate near-term losses, and a mindset not shackled by traditional operating strategies, the FinTech challengers have sought product lines prone to automation and homogeneity, like consumer checking accounts and small business lending. However, while seeking to disrupt the banking industry, FinTech companies also need the banking industry for compliance expertise, funding, access to payment rails, and the ability to conduct business across state lines.
AOBA 2022 sought to unify several discordant themes. The first theme is fracturing and convergence. While FinTech companies seek to challenge the traditional banking industry, they rely on the industry and, indeed, have entered into M&A transactions to acquire banks. The second theme is threat and opportunity. Banks face challenges from FinTech companies for certain customer segments, but FinTech products and partnerships offer access to new products, new markets, and more efficient operations. For fans of price/tangible book value multiples, though, AOBA 2022 still offered plenty of perspective on recent bank M&A trends. We’ll cover four themes from AOBA 2022.
FinTech’s presence continued to increase at AOBA, both in terms of conference sponsors and mentions throughout the conference. The most popular breakout session we attended was entitled “Crypto/Digital Assets – A Threat or Opportunity for Your Bank,” although it is difficult to ascertain whether the attendance reflects mere curiosity or a leading indicator that more banks will enter the Crypto space.
One common thread of FinTech-related presentations is that bankers should take a more expansive view of their competitors. Three FinTech-related companies would rank among the twenty largest U.S. banks, as measured by market capitalization, including Paypal Holdings (#4), Square (#9), and Chime (#12, based on the value implied by its last funding round). One speaker encouraged banks to adopt an “ecosystem” strategy instead of an “industry” strategy, noting that families often have 30 to 40 relationships with financial services providers, defined broadly.1 Thus, banks’ strategies should not be defined by traditional boundaries but rather embrace the entire financial “ecosystem” in which a range of competitors seek to displace banks from their traditional roles. In this view, banks compete for customers from the “inside out,” while FinTech companies challenge from the “outside in.”
It remains difficult to quantify the direct impact on community banks from the current crop of non-bank competitors. Nevertheless, banks’ strategic plans should evolve to reflect the growing population of well-financed non-traditional competitors, for which the pandemic has in some cases accelerated customer adoption.
The last FinTech theme related to “partnerships.” This term has evolved towards a somewhat expansive definition this millennium, with seemingly any relationship (even as a customer/vendor) deemed a “partnership.” Certainly, many banks are evaluating FinTech products, with an eye on both expanding revenues and increasing efficiencies. Others are becoming more intertwined with FinTech companies, either as investors or as the banking platform used by the FinTech company itself. There is some evidence that banks more closely allied with FinTech companies are being warmly received by the market, given their potential revenue upside.
When evaluating “partnerships,” we suggest deploying a risk/reward framework like banks use in evaluating other traditional banking products. The lower risk/lower reward end of the spectrum would entail limiting the “partnership” to a particular FinTech product or service, such as for opening consumer checking accounts or automating a lending process. The higher risk/higher reward part of spectrum would include equity investments or facilitating the FinTech’s business strategy using the bank’s balance sheet, compliance expertise, and access to payment rails. Like with any bank product, different banks will fall in different places along this spectrum, given their histories, management and board expertise, shareholder risk tolerance, regulatory relationships, and the like.
Mercer Capital provided its outlook for bank M&A in the December 2021 Bank Watch . Naturally, the investment bankers at AOBA are bullish on bank M&A in 2022. This optimism derives from several sources, including the pressure on revenue from a low interest rate environment and the technological investments needed to keep up with the Joneses.
Several headwinds to activity exist though:
Another trend to watch is M&A activity involving non-traditional buyers. Mercer Capital’s Jay Wilson presented a session on credit union acquisitions of banks, focusing on the perspective credit unions take when evaluating potential acquisition targets. In a reversal of roles, FinTech companies now have entered the scene as acquirers. In February 2022, SoFi completed its acquisition of Golden Pacific Bancorp, and several other precedent transactions exist.
The subordinated debt market has been quite active, with bank holding companies issuing debt typically with a ten-year term, a fixed rate for the first five years and a variable rate tied to SOFR for the second five years, and a call option in favor of the issuer after five years. Pricing tightened throughout 2021. Through early 2022, pricing of newly-issued subordinated debt has remained stable in the 3.50% range, despite rising Treasury rates. This implies that the spread between the fixed rate on the subordinated debt and five-year swap rates has tightened, falling to levels even below those observed in 2021.
Subordinated debt counts as Tier 2 capital at the bank holding company level but can be injected into the bank subsidiary as Tier 1 capital. If bankers expect rising loan volume as the economy continues to recover from the pandemic, then it may behoove institutions to issue subordinated debt now and lock in a low cost source of capital.
Some attendees expect greater regulatory enforcement and rule making activity in certain areas, with the most likely suspect being fair lending. However, leadership at some regulatory agencies remains in flux, such as at the OCC where President Biden’s nominee was withdrawn in the face of Senate opposition. This would not be a constraint, though, at the CFPB, which has a Senate confirmed director who appears ready to take a more active stance on fair lending matters. Interestingly, many larger banks have moved to limit overdraft and insufficient funds charges, even absent any actual (as opposed to hinted at) regulatory changes. Tightening practices around overdrafts appears to be another risk to community banks, which may lack the revenue diversification that permits larger banks to absorb a loss of consumer banking fee revenue.
We sense that AOBA is moving into a new era, as it did when the Great Financial Crisis passed. Attendees and sponsors are, to an ever greater extent, coming from outside the traditional banking industry. This mirrors the banking industry itself, with its widening set of non-traditional competitors targeting different customer niches. Future conferences will reveal the extent to which traditional and non-traditional competitors converge. Regardless of what happens with the intersection of banks and FinTech companies, we can only hope that we’ve attended our last virtual conference.
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.
Click here to expand the chart above
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.