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Let’s make a bank deal!

6 metrics to make sure it’s a good one

Sold! You just bought yourself a bank. Should you celebrate? Jeff Gerrish discusses what makes for a good deal. Sold! You just bought yourself a bank. Should you celebrate? Jeff Gerrish discusses what makes for a good deal.

What makes for a good merger deal today?

Our consulting and law firms are fortunate to be able to serve as financial advisors and legal counsel on many community bank acquisition transactions, both on the buy side and the sell side. Many banks float around for sale these days that our buy-side clients look at.

Some will review a transaction and indicate that it is not a “good deal” at virtually any price, and some of them will price the deal to make sure it is a good one (for them). The question for the board of directors on both sides of a merger—and the issue I am going to address in this blog—is what constitutes a “good deal.”

Remember board’s “Job 1”

The fundamental underpinning of making a decision about what constitutes a “good deal” has to involve the board’s obligation to enhance the value for its existing shareholders.

Any transaction that the bank engages in, whether it is an acquisition transaction or some other transaction, that does not improve the “lot” of the existing shareholders of the holding company is not a transaction for which the bank should be strategically allocating capital.

Of course, “improvement” and “value” are often subjective.

So the board needs to consider what is important to its shareholders. Generally speaking, a transaction is deemed to be beneficial to the shareholders if it enhances shareholder value.

There are six baseline metrics to consider in this regard:

• Earnings per share growth.

• Return on equity improvement.

• Creating share liquidity.

• Increasing the dividend to the shareholders or distributions in a Subchapter S.

• A manageable book value dilution and recovery.

• Safety and soundness and execution risk.

Let’s look at each of these briefly.

1. Earnings per share growth

If a transaction priced appropriately is not accretive to earnings per share for the buyer’s shareholders, then it is probably not a good deal.

Earnings per share accretion has always been pretty much the bellwether for determining whether a transaction is viable and appropriately priced. This is simply due to the fact that earnings drive value to the marketplace or to any subsequent acquirer.

If earnings per share calculated post-transaction after considering cost savings (usually personnel cuts) and revenue enhancements (i.e., can we push more of our products through the selling bank’s distribution network) is not increased then the purchasing shareholders have not really benefited.

2. Return on equity improvement

The general test here is whether the return to the buyer exceeds some reasonable level, which really depends on the buyer’s current return on equity.

A number of community bank clients require a return on equity in the 10% to 12% range. If they are going to buy another bank they certainly do not want to buy one that will result in a 5% or 4% return.

Frankly, at that level of return they could buy some type of corporate instrument or treasury—with a whole lot less risk.

Return on equity is a similar analysis. If we can leverage our equity capital better at the buyer by making this transaction and improve return on equity from, say, 11% or 12% to 12% or 13%, then that is a positive indicator of a good transaction.

3. Creating share liquidity

For most community bank transactions, liquidity will not be impacted by an acquisition transaction. (Liquidity defined as the ability of a shareholder to sell a share of stock at a fair price at the time they want.)

Nonetheless, if the purchasing bank holding company has historically served as the source of share liquidity for its shareholders, it should think twice before it uses up all of its “powder” (i.e., ability to purchase shares or otherwise).

If the holding company leverages up so high and uses all of its cash and available excess capital out of the bank to do an acquisition transaction, then that transaction may by default take the holding company out of the market for purchasing its own shares, which may reduce shareholder value.

If a transaction is a stock-for-stock transaction, then the liquidity may be improved, because the holding company will have more shareholders in the market or may be listed on an exchange and have more float in its stock.

4. Cash flow

The cash dividend also needs to be considered post-transaction.

Consider this: The holding company is paying a healthy cash dividend before the transaction and uses up all of its resources to get the deal done such that it can no longer pay a dividend or not as strong a dividend.

In that case, the company needs to consider whether that wrinkle has a positive impact on the remaining shareholders.

For example, if the holding company is paying a $1 per share dividend now but post-transaction will only be able to pay $0.25 per share dividend on the same number of shares outstanding, then the existing shareholders may not be enthused about that type of transaction and its cut to their after-tax cash flow—even if it improves on some other metric.

5. Book value dilution

In an acquisition transaction, book value dilution appears to be the “darling” of the day’s consideration.

Book value dilution can be calculated a couple of different ways. The end result, however, is that book value should be recovered in a short period of years for most acquisition transactions to be considered to be a “good deal.”

6. Safety and soundness/execution risk

The transaction has to positively impact the safety and soundness of the organization.

Bank acquisition transactions have inherent risks—no transaction will be without risk. Transaction price must take that risk into account.

That is why the return should be 10%, not 2%.

Still, the risk must be manageable, and the execution must be solid. This includes making sure to obtain the identified cost savings and projected revenue enhancements.

A good deal

If the board goes through that type of analysis, then it will look at a transaction and determine whether it is a good deal or bad deal for the shareholders of the purchasing company.

I have seen a lot of bad deals. I have seen some potential transactions that our clients have been unwilling to bid on simply because they cannot get the benefit they would hope to have gotten out of the transaction.

Take the emotion out, look at the financials, and make a decision whether it is appropriate to enhance the value for the purchaser’s shareholders.

Jeff Gerrish

Jeff Gerrish is chairman of the board of Gerrish Smith Tuck Consultants, LLC, and a member of the Memphis-based law firm of Gerrish Smith Tuck, PC, Attorneys. He frequently contributes to Banking Exchange and frequently speaks at industry events.

In mid-2016 Gerrish's blog received a national bronze excellence award from the American Society of Business Publication Editors. This followed his receipt of the regional silver excellence award for the Northeastern Region from the same group.

Gerrish formerly served as regional counsel for the FDIC’s Memphis regional office and with the FDIC in Washington, D.C., where he had nationwide responsibility for litigation against directors of failed banks. Since the firm’s formation in 1988, Gerrish Smith Tuck has assisted over 2,000 community banks in all 50 states across the nation with matters such as strategic planning, mergers and acquisitions, common stock private placements, holding company formation and reorganization, and a wide variety of regulatory matters. Jeff Gerrish can be contacted at [email protected].

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