Community bank M&A coming back

When $1.9 billion-assets Independent Bank Group announced its proposed acquisition of $122.9 million-assets Live Oak Financial Corp. on Aug. 22, the deal marked more than a large community bank’s combination with an in-market competitor. It represented a fruit harvested at just the right time.

The investor group behind Live Oak, established in 2001, had been attempting to cash out in 2008, before the clouds of the financial crisis broke, according to Curtis Carpenter, managing director, Sheshunoff  & Co. Investment Banking.

“They’d been ready then,” recalls Carpenter, whose company handled the deal for Live Oak. Based on what was going on, and concerns about obtaining a decent price, the advisory firm recommended holding off. “By waiting,” says Carpenter, “they were able to get 20 times earnings and 1.6% of book, and they were pleased.”

“It felt somewhat like old times,” says Carpenter.

Live Oak enjoyed the position of being a good fit for several potential acquirers, and many community banks won’t have the same number of potential bidders, according to Carpenter. However, while Live Oak is a bit of an exception, it is also an indicator of livelier times to come on the M&A front. “We will certainly see more of it,” says Carpenter.”

“All  year long, there’s been kind of a buzz going on,” says Jeff Gerrish, community bank attorney, consultant, and bankingexchange.com blogger.  His own operation has half a dozen deals in play, something that hasn’t been seen for some time.

“It’s no tsunami, but more a bubbling up under the surface,” says Gerrish of the trend he sees developing.

Community bank investor and consultant Joshua Siegel of StoneCastle Partners LLC agrees. Continuing the ocean metaphor, he describes the current M&A trend as more of a “swell” than a “surfable wave.” He sees increases in private deals (as opposed to FDIC-assisted deals) growing steadily over the next 18 to 36 months. Over that period, several thousand community banks will be merged away, he predicts.

“We need to get larger”

Experts interviewed indicate that the way things will play out, banks over $10 billion won’t be part of the picture. The days of them looking for community banks for in-filling territory have gone. There is even some doubt that many banks nearing the $10 billion line will be doing much buying of community banks. The predicted pattern has two parts: purchases by community banks of approximately $1-$7 billion in assets, and purchases by community banks of around $300-$500 million of smaller banks.

The mindset of community banking leaders is interesting. Sheshunoff recently conducted a small survey of client banks and found that 72% of the sample believe there is a minimum asset size that community banks must reach in order to survive. Nearly the same percentage reported that their board had discussed buying another bank in the last 12 months—yet only 13% had discussed the possibility of selling their own bank over the same period. Carpenter says it’s notable that respondents couldn’t come up with a target size—they only knew that it was “north of where they were. Everyone seems to want to buy, merge, and be larger.”

Carpenter says boards and managements are talking about selling or buying, and Siegel says this is something that they’ll find essential to settle soon: “Which are they, buyers or sellers?” And things won’t end there. Indications we’ll explore shortly are that serial mergers are anticipated—the fish that swallows the smaller fish in turn will be swallowed by a somewhat larger fish.

One point of general agreement is that the so-called “merger of equals” won’t be a template among upcoming deals. “For the most part, somebody has to be in charge,” says Jeff Gerrish, adding that “even the accounting profession now says that somebody must be classified as the acquirer.” Mergers of equals may look good on paper, but they are difficult to accomplish, says Richard Maroney, managing director and principal, Austin Associates, LLC.

What’s been going on

Figures from SNL Financial LLC, presented in the table above, track acquisitions of banks up to $3 billion in assets by buyers of up to $3 billion in assets. The 2013 figures are as of Aug. 22. While the total number of deals and overall assets involved lag 2012 levels thus far, there’s still more than a quarter to go.

A key driver will be the search for competitive mass. Siegel says many community bankers recognize that at their present size, they can’t strive against larger players long term. “We are seeing banks looking for capital now to take out their stalled competitors,” he says. In the recent past, the quest for capital concerned funds to fix up the bank itself, but now the intent is to be the “dining” fish, feeding on competitors to build market share or expand into nearby markets.

Many of the deals that SNL’s numbers track fit this category. Take Seattle’s $2.7 billion-assets HomeStreet Bank. In late July, HomeStreet announced two acquisitions on the same day: $141 million-assets Fortune Bank, also of Seattle, and, further away, $125 million-assets Yakima National Bank. Fortune’s offices will be transitioned into HomeStreet’s existing branches, while Yakima’s will remain, but be rebranded. The deal will raise HomeStreet’s deposit market share in Washington by a couple of clicks, nearing the top ten.

Looking at all deals announced in 2013, including some not reflected in the table because of institution size, the heaviest number of buyers has been seen in Texas, at 17. This is followed by California (9); Illinois (8); New Jersey (6); and a tie among Missouri, Pennsylvania, and Washington (5). Looked at by the target’s state, Texas (15 sellers) also leads; followed by Illinois (9); California (8); a tie between Florida, New Jersey, and Ohio (6); and a tie between Oklahoma and Washington (5).

While most deals have been intra-state, 35 sellers have sold to out-of-state buyers. (A handful of deals reported involve acquisitions by investor or management groups.)

Earmarks of the current trend

Sheshunoff’s Carpenter says a sign that the M&A market is changing has been a return of the classic friendly overtures that used to characterize many community bankers’ deals among themselves. “It’s relationship driven in the beginning,” he explains. Even if the lunch or dinner conversation where it begins doesn’t immediately work out, “a seed has been planted that may germinate down the road.”

But a seed needs good soil and favorable conditions to grow.

What is different that leads experienced observers to think that more M&A is coming? Five reasons are explored, below.

1. The distress sales are nearly over. When FDIC was closing banks by the handful every Friday, and offering mix and match troubled bank deals and loss-sharing, and when other banks not under FDIC control also had troubled portfolios, the government was the dealer of choice. As conditions improved, savvy buyers investigated banks with blemishes.

For the most part, the failed bank deals are done and new buyers have been exploring somewhat better deals, according to Richard Maroney.  With only 18 bank failures in 2013 thus far, says Jim McAlpin, partner at Bryan Cave LLP, the supply of such deals has pretty much dried up.

This is not to say that every bank is out of the woods and can look to a future of independence. A related factor is that as the failure rate tapered off, potential buyers began to look at banks with issues. But one might say that anyone still looking at those institutions is like someone who arrives at a tag sale at 4 p.m.

“The banks that are scratched and dented are well picked over now,” says Chris Nichols, chief strategy officer at CenterState Bank, Fla. CenterState is looking for more acquisitions in Florida, but hasn’t been looking for damaged goods. He says the company is looking for good assets, new opportunity, and talent. The bank announced a deal for $572 million-assets Gulfstream Bancshares, Inc., in July, in a deal that will result in a $2.9 billion bank.

2. Investor groups want to cash in. Experts says that the case of Live Oak’s owners looking for a good buyout is typical. Groups that started the crop of de novos a while back, when they could be easily opened, want to cash in their chips and pricing has returned to more-appealing levels.

Similarly, private equity investors who provided capital injections to some banks during the crisis never intended to be long-term players. Rick Maroney says these investors are looking for their exit strategy now, and will be pressuring boards and management to consider acquisition offers that will give them a decent gain on their capital. Maroney also expects to see little new private equity money coming in. Those investors will be looking at new opportunities in other areas.

3. Pricing is improving, as is position. As the industry’s health improves, sellers have been negotiating from stronger positions than they had been. A couple of years ago, experts said the days of price-to-book multiples were a memory—they were doing deals at discounts to book. Now, scanning SNL’s list of 2013 deals, while some discount deals are still being done, many are being done at book plus something, and a handful negotiated at multiples that are strong for the times.

Several experts interviewed point to the mid-August announcement that Texas’ $22.5 billion-assets Cullen/Frost Bankers, Inc., struck for $1.4 billion-assets WNB Bancshares, Inc., also of Texas. The deal is proposed for 2.84 times tangible book. WNB offered advantages Frost was willing to pay for. Among these were a new presence in Midland and Odessa, in the booming Permian Basin energy economy—and the acquirer’s investor presentation indicates that the target bank had lower chargeoffs through the downturn than Cullen/Frost—itself a notably conservative shop.

All generalizations are subject to exceptions, but there is a perception that sellers are increasingly working from a stronger position. Florida was among the states that took a beating during the downturn, but already, CenterState’s Nichols says that pricing in the region is picking up and that much of the talk in the state is between Florida would-be buyers and Florida potential sellers.

“It’s still early days,” says Nichols, but in the last six months he believes that Florida has shifted from being a buyer’s market to being a seller’s market. And Jim McAlpin, who is based in Atlanta and has many Georgia clients, says that “we have not seen a tidal wave, but we are seeing a trend towards transactions in the Southeast again.”

McAlpin tempers expectations with a dose of reality. “I still do have clients waiting for three times book,” he says. “They may be waiting for a while.”

4. Buyer currency is revaluing. Bank equity pricing is up by about 30% in 2013, according to Austin Associate’s Rick Maroney, and having shares worth that much more has given potential buyers more to work with—the shares they can offer are more attractive.

This applies especially to banks that truly have an active market in their shares, points out StoneCastle’s Joshua Siegel. Many community banks have taken advantage of the JOBS Act provisions that enabled them to go private, but Siegel points out that often small banks that were publicly traded didn’t have that much genuine liquidity anyway. These banks haven’t lost much by going private. “If you had an ‘Ebay’ for bank shares, then you’d have a market,” says Siegel, who has been looking at something along those lines.

The improvement in buyers’ stock value has driven the mix of currency used to do deals. Right now Austin Associates’ Maroney says deals are averaging out to 60% stock, 40% cash. A buyer that is very strong can offer a higher portion of the price in stock, he points out.

An interesting twist in some recent deals: Giving targets’ shareholders a choice of currency—all stock, all cash, or a mix.

For some sellers’ shareholders, the potential for a bonus for taking stock has allure. “There’s a renewed expectation of double-dipping on the part of some sellers,” says Maroney. They hope their acquirer will in turn be acquired. “I think that’s very realistic,” he says.

5. Acquirers want skilled people. In the past, it hasn’t been unusual for a target’s staff to get their resume up to date—and with good reason. But indications are that that’s changing.

More deals seem to be hinged on keeping talented staffers, says McAlpin—in fact, he’s heard of signing bonuses being offered to key players who will stay on.

Experts say there is more recognition that it’s a bank’s people who make the target’s revenue stream flow. Some deal announcements specifically mention key players at targets and what they’ll be doing after the buy. At HomeStreet, for example, the CEO of one acquisition will become EVP for commercial banking, and the CEO of the other will take on another, new key role in further expanding the bank’s footprint.

Fatigue versus future

For some time now more M&A was expected because regulatory fatigue and the impact from Dodd-Frank was making a future in banking look unappealing. That, and lack of management succession plans in some banks, was expected to lead to more sales. Experts acknowledge this as a factor, but no longer dwell on it.

But the regulatory impact on M&A among community banks remains very real, for other reasons.

One is the appeal a buyer or seller will see in their potential partner.

“In days gone by, people asked if you had the cash to do the deal,” McAlpin explains. Now, a prime question is how the other party, especially the buyer, stands with its regulators. Deals are perishable, and “there is fear of regulatory gridlock,” says McAlpin. And no one wants to inherit a major compliance issue—at either buyer or seller.

“If your bank is in the penalty box,” says Maroney, “your bank won’t do any deals until you get out.”

Jeff Gerrish says safety and soundness considerations also play a big part. “When you are proposing putting two banks together,” he warns, “they had better look like at least a CAMELS 2-rated bank when you are done.” Otherwise, regulators may not  give the deal a green light.

While these considerations darken the skies over community banks, StoneCastle’s Josh Siegel is optimistic.

First, he says, Americans overall have started to resist big brands. “There is a whole ‘local’ thing going on,” he says, whether it be the pie at the town diner versus McDonald’s mass-produced desserts or community bank service versus a mega bank’s branch. This gives the smaller banks a shot at grabbing share from larger competitors, even if the overall is a zero-sum game.

Second, he says, if the Obama Administration’s plan to revamp the mortgage markets flies, then there may be many more loans out there for community bank portfolios—making the future more than a zero sum game.

“There are a lot of things that play to community banks,” says Siegel, “just over the horizon.