Counter-Trend M&A Can Often Prove The Wisest Course In The Long Run

M&A waves typically reflect a “follow-the-herd” mentality.  More often than not, periods of heightened bank sector M&A activity seem to be driven by a few common themes in each cycle.  But no matter the reason for the pick-up in M&A for a particular period, it usually tends to play out the same way.  Early movers are rewarded for their foresight in capitalizing on what eventually becomes the “trend du jour” for that cycle, leading others to attempt to emulate their actions, but with very mixed results as the cycle matures.  Competition for deals intensifies, prices rise, and bank stock valuations reach parity over the course of the cycle, leaving very little room for error in the integration phase and thereafter as acquirers look to realize the promised financial and strategic benefits of the merger. 
While there are several illustrative examples we could point to over the past few decades, one that stands out is the period after The Great Recession. Banks such as Home BancShares (HOMB) and Bank OZK (OZK), among a few others, weathered the crisis period relatively better than peers, quickly recognized the value inherent in distressed bank acquisitions, and embarked on an acquisition spree that resulted in premium stock valuations for these acquisitive banks.  Some copycats of this strategy were still successful later in the cycle, but the benefits seemed to lessen with each successive transaction. This inflected around the midpoint of the decade, with active acquirers as a group underperforming the bank index for several years thereafter, particularly after M&A pricing crested in mid-2018.
As this latest bank sector M&A wave gathers steam, the “herd mentality” is taking shape.  M&A activity has picked up notably over the last few months, and we suspect it will continue for the foreseeable future.  While it is far too early to ascertain the implications for the acquirers, there are certainly a few themes that have the potential to attract the “herd”, and questions in the meantime as we wait and see how it is all likely to shake out. 
Will merger-of-equals (MOE’s) transactions fulfill the promise of the attractive valuation math or will social issues torpedo deals that “on paper” appear to be “value-creating”?  With transaction multiples in traditional deals quickly approaching pricing that we usually see later in the M&A cycle (click here for our commentary on this topic last week), will all but the savviest acquirers underperform for the duration of this cycle? Perhaps bank stock multiples will trend much higher from current levels, making transactions completed at today’s prices seem attractive in retrospect?  Will the early proponents of fintech garner the lion’s share of the benefits, or is there value still to be realized for the later entrants in the coming years?  Will purchases of national asset generators prove problematic from a credit perspective in the long-run, as acquirers look to absorb excess liquidity and protect margins?  These are but a few of the themes likely to attract the “herd” through this M&A cycle, and it will be interesting to see how it all plays out.
As in past cycles, counter-trend M&A may remain under the radar but could prove very beneficial in the long run.  Setting aside for a moment the cycle-specific themes and associated questions noted above, there is another aspect of the typical M&A cycle that we think bears watching and will likely be applicable to this period of heightened deal activity as well. From virtually every bank we speak with, we sense angst and hand-wringing on the topic of excess liquidity and questions abound: 

  • How long will it be with us?
  • How can margin compression be contained in the interim?
  • What if net loan growth doesn’t materialize?
  • What if we get even more stimulus?
  • Given the uncertain outlook for interest rates, should excess liquidity be deployed into the investment portfolio or should “dry powder” be maintained

Legitimate questions for sure, but there is another side to the argument, in our view – one that augurs for a different approach and that will perhaps yield significant longer-term opportunity. 

Bank sector observers will likely recall the years following The Great Recession when balance sheet liquidity was plentiful amidst a very lackluster economic recovery.  We covered a bank in Upstate New York called Community Bank System (CBU), a company we’ve admired for quite a long time – we clearly aren’t alone in that regard, as CBU shares are consistently among the highest valued amongst all publicly traded banks.  In 2012 and 2013, CBU went the other way, bucking the trend at the time, and completing two significant branch transactions.  The company purchased 19 branches from First Niagara Financial Group in September 2012, including $218 mil. in loans and $955 mil. in deposits, at a deposit premium of 3.2%; later, in December 2013, the company purchased 8 branches from Bank of America, including $369 mil. in deposits, at a premium of 2.4%.

Some, at the time, considered these transactions to be head-scratchers.  Why target low-cost deposits even at low single digit deposit premiums at a time when most banks were looking to divest of excess liquidity?  However, we would argue that while there was undoubtedly some short-term pain associated with the trade, given the macro backdrop at the time, in the long run, these transactions proved extremely beneficial, and quite savvy in retrospect.  And that’s because over the course of the cycle, in our view, companies create more value from the right side of the balance sheet then the left side. Low-cost core deposits provide funding stability, are fee generators, and tend to have much longer longevity than loans, which in a best-case scenario are simply repaid as agreed.  Indeed, this view would seem to be validated by the higher market valuations (and M&A takeout premiums) through the cycle accorded to those banks that are considered to have the most valuable deposit franchises.

We note other potential benefits as well:

  • First, in a deposit-heavy branch transaction, the acquiring bank can typically cherry-pick the assets that are brought over, which minimizes the credit risk in the transaction. 
  • Second, there are considerably less social issues with which to contend.  Employees brought over in a branch deal can be made to feel as though they were specifically chosen by the acquirer, which promotes better “buy-in” from the employee base, and likely an easier cultural transition and assimilation.  This benefit that accrues to the acquirer likely extends to the customer base, as we are firm believers in the notion that happy employees make for better-serviced customers that are more likely to be retained through deal integration and beyond. 
  • Third, the premiums paid are generally tax-deductible, and in the grand scheme of things, are largely immaterial.

Short-term pain could translate to long-term gain!  Again, as it relates to this M&A cycle, we are not discounting the near-term dilemma posed by this form of counter-trend M&A.  The excess liquidity conundrum dwarfs that experienced in the years following the last crisis. Though in fairness, the economic recovery is also projected to be much stronger, which should lessen the risk of stagnation and the likelihood that excess liquidity will be with us for years to come.  Still, the risk isn’t insignificant, and the near-term challenge is very real.  But we are also confident in predicting that at some point, the cycle will inevitably turn, the value of low-cost funding will be higher than it appears to be today, and savvy acquirers will be rewarded. 
Some already seem to be on that path, though the transactions have been less heralded.  Recently, we noted the announcement by Horizon Bank that it planned to purchase 14 branches from TCF Financial ($278 mil. in loans; $976 mil. in deposits) at a deposit premium of 1.8%.  That’s not to say that these deals today (or the companies that pursue them) will ultimately prove successful, but it should give all of us something to think about as this M&A wave further heats up in the months ahead.

Joe Fenech is the Managing Principal of SMBT Consulting, LLC, which provides consulting services to banks. The article represents the views and beliefs of Mr. Fenech and does not purport to be complete. The information in this article is provided to you as of the dates indicated and the data and facts presented herein may change. You should not rely on this article as the basis upon which to make an investment decision; this article is not intended to provide, and should not be relied upon for, tax, legal, accounting or investment advice. Mr. Fenech is also the Chief Investment Officer and Managing Member of GenOpp Capital Management LLC, an investment adviser that maintains exempt reporting status in the State of Indiana. Affiliates of SMBT Consulting, LLC may recommend to such affiliates’ clients the purchase or sale of securities of companies discussed in articles published by SMBT Consulting, LLC.

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