We’ve written several articles this year on the topic of M&A; more specifically, the generally poor reaction to announced deal activity in the market. Prior to the pick-up in M&A activity earlier this year, we cautioned that this might occur, for a variety of reasons. Most notably, we observed that the anticipated rapid recovery from the economic downturn and the bank sector’s emergence from the recession relatively unscathed would likely result in an M&A wave that was marked by higher-than-normal deal pricing than what is typically seen in the early stages of economic recovery.
…in stark contrast to the trends witnessed in prior M&A cycles.
Following every deep recession over the past two decades prior to the COVID-19 pandemic, the early stage of bank M&A merger waves tended to be very fruitful for the stocks of acquirers. Targets wounded by credit stumbles and capital shortfalls during the preceding downturn were priced accordingly, leading to very favorable “deal math” for stronger institutions that maintained their premium stock currency. But more importantly, the risk profile of these transactions was attractive due to low absolute pricing on TBV. Deal metrics tended to be based on the target’s depressed earnings capacity during the downturn, rather than the earnings stream it was likely to generate during the subsequent recovery.
The pandemic and the downturn that ensued was unique, altering the typical M&A playbook in the early stages of recovery that investors had successfully relied upon for several decades.
The COVID-induced recession was different, in the sense that banks were the beneficiary of regulatory forbearance, unprecedented monetary and fiscal stimulus in response to the crisis, and the fact that COVID-aside, there just weren’t any significant underlying problems in the economy. Moreover, higher reserve levels that proved detrimental to earnings last year were, for the most part, funded by PPP proceeds that have more than helped to fill the gap this year.
So, when M&A activity picked up earlier this year, deal pricing reflected the aforementioned positives and was much closer to mid-to-late cycle M&A pricing metrics (when stocks of active acquirers tend to underperform) than early-stage recovery pricing (when acquirers have historically strongly outperformed). Also contributing to the confused reaction early on amongst market observers (analysts, investors, bankers, etc.) is our belief that many are focused on metrics that don’t tend to be accurate predictors for post-deal announcement share price performance. For instance, the data is clear – going back over a decade – that the absolute price paid on TBV is the single best predictor of post-announcement performance, with favorable deal math for the acquirer as an important but distinctly secondary consideration. If you couple these considerations with the fact that the pick-up in M&A earlier this year occurred mostly after the YTD peak in long-term interest rates and the bank stock index, one can understand why the stocks of acquirers have noticeably underperformed the broader bank sector so far this year.
That being said, and while there are still likely to be some major exceptions, we’ve observed a not-so-subtle shift of late, suggesting that the tide may be turning.
Since late summer, stock prices of banks that have announced acquisitions have performed much better. We have a few thoughts as to why:
- First, pricing on an absolute basis has been more reasonable. Despite most recent acquirers sporting healthy premium currencies, deal pricing has been held in check. Indeed, we’ve yet to see a deal recently that exceeds 1.7x TBV, even in attractive markets such as Texas, where Home BancShares (HOMB) seemed to kick-off this most recent spate of industry M&A activity with its well-received acquisition of privately-owned Happy Bancshares, Inc. Looking back historically, the “breakpoint” for deal pricing above which the acquirers begin to materially underperform seems to be right around the 1.6x – 1.7x range on TBV, regardless of how well the deal pencils out on paper. Rob Fleetwood, Partner and Co-Chair of the Financial Institutions Group at law firm Barack Ferrazzano, noted, “Over the past six weeks, we have been a part of more preliminary deal discussions than in the past 18 months. It seems as if the pick-up in M&A is finally gaining some traction and boards are focusing on all factors that may impact the acquirer’s stock price following the announcement.”
- Second, the backdrop for bank stocks improved. As noted above, M&A activity picked up earlier this year just as bank stocks and longer-term interest rates were cresting (and then falling into the summer). In contrast, bank stocks now seem to have the wind at their back, amidst a steepening yield curve, and so a pick-up in merger activity now could be better received.
- Third, the acquirers are increasingly among the companies better positioned in many facets of the business, and as a result, it stands to reason that so long as deals are properly structured, these stocks should perform relatively well. For instance, a deal primarily reliant on expense synergies, without many other redeeming qualities, is likely to be met with more skepticism than one in which the acquirer can achieve the requisite cost savings, but also attain additional scale, added technological expertise (or the ability to layer its tech-forward advantages onto the target franchise), and/or perhaps a larger balance sheet to accommodate a growth niche. “We expect consolidation to accelerate during the coming years. Customer expectations regarding digital service offerings are accelerating, and many banks are struggling to make the investments necessary to stay relevant. As a result, many organizations will view partnering with a larger organization leading in the digital space as a quicker path to generating growth and delivering appropriate shareholder returns,” said Chuck Shaffer, CEO of Seacoast Banking Corporation of Florida (SBCF).
- Fourth, while it took a while for Wall Street expectations (analysts/investors/bankers) to adjust to the market reality earlier this year, eventually the herd moved rapidly in the other direction. Analysts noted in published reports the sluggishness of acquirers’ stock prices following deal announcements, while investors increasingly hooked on to a “short theme” that seemed to work well. In other words, Street sentiment shifted from head-scratching and confusion as to why the market’s reception to M&A was so poor, to an expectation that virtually any M&A deal wouldn’t be well-received. Indeed, shorting the acquirers (and potential acquirers), particularly those with outsized valuation premiums and limited organic growth potential or, even better, the undisciplined acquirers sporting weak stock currencies, seemed to be a “no-lose” proposition throughout the summer. Eventually, however, the “short the acquirers” trade got too crowded, which of course only provided fuel to the reversal of this trade. So, when well-structured, reasonably priced deals were announced and were initially well-received, there was a “rush to cover”. In some cases, this drove acquirers’ stock prices that were up in the range of 2% immediately post deal announcement to double or triple that level.
- Finally, whether by coincidence or not, most of the banks announcing deals of late are very well-respected, sport premium stock currencies (USB, HOMB, GABC, among others), and seemingly checked every box required for the Street to deem the deal a success. Now, to be very clear, our updated thesis isn’t meant to suggest that all announced deals will be favorably received. We’ve seen several deals where the prime motivation for the transaction seems to be job protection for senior execs of both companies, mostly larger MOE-type deals that don’t really seem to accomplish much aside from additional scale, with no real enhanced technological edge. We would expect the market to remain unforgiving in its assessment of these transactions. The bottom line is that as M&A activity likely heats up again into year-end, it begs the question of whether the sector at large has truly discovered the formula for successful M&A, or if we just had a spate of deal announcements from smart acquirers, only to see a quick return to the prior trend as the herd becomes more active. We hope it’s the former, but only time will tell.