The Years 2009-2011: A Once-in-a-Generation Opportunity
In 2009, 140 banks failed. Yet, the number of banks with nonperforming assets that exceed 5 percent of total assets has continued to climb and now exceeds 1,000. Even the banks that are not deemed to be in a “troubled” condition are suffering the effects of the economic conditions. With commercial real estate values expected to continue to deteriorate in most markets through 2010, the incentive for many financial institutions is to “hunker down” to get through to the other side when economic conditions are expected to improve.
This approach may very well be a tremendous mistake. Such institutions could miss out on a once-in-a-generation buying opportunity. Moreover, once conditions do improve, they might face a form of survivor’s hell.
As we saw in the last economic collapse coming out of the savings and loan crisis, those institutions that were aggressive buyers were better positioned to compete in the improved environment. Last time, some of the biggest banks in the country, as well as a host of regional competitors, gained tremendous market share at nominal cost, thereby increasing shareholder value and positioning themselves to expand further once circumstances warranted it.
Circumstances may not be different this time around. Financial institutions are buying failed banks, branches and other assets of stressed sellers and expanding organically. Moreover, it appears that customer loyalty may improve after this collapse, translating into higher net interest margins (“NIMs”). These buyers will be well positioned for the recovery. Thus, there is risk to standing on a pat hand. Accordingly, I have set forth below certain of the types of transactions that financial institutions now should be considering.
Trust-preferred Buybacks
We have assisted a number of our clients with repurchases of their trust-preferred securities (“TRUPS”). A TRUPS buyback can free an organization from its debt service obligation or reduce it — an important opportunity if we are entering an inflationary environment.
After 2001, TRUPS were mainly issued by community and regional banking organizations in pools. Pools were either managed or static. In a managed pool, the collateral manager has some discretion to replace the existing TRUPS issued by a bank holding company with another security or with cash. A TRUPS repurchase involving a managed pool is a negotiation with the collateral manager and the investors in those pools. Consequently, it is important to understand the role, responsibilities and potential conflicts of the collateral manager in the repurchase process and take steps through agreements to address such issues.
In contrast to a managed pool, in a static pool the assets in the pool were not intended to change. There is no collateral manager for such a pool. The trustee of the pool has no investment discretion.
In connection with a static pool, the objective of the issuer is to be able to communicate directly with the note holders (the investors in the pools). The trustee will seek to avoid disclosing the identity of the note holders. Accordingly, the issuer must push the trustee to facilitate the issuer’s tender to the note holders.
In fact, CIB Marine Bancshares, Inc., in Pewaukee, Wisconsin (“CIB Marine”), filed for bankruptcy under Chapter 11 in an effort to bring the note holders to the table in connection with a proposed swap of preferred stock for TRUPS. The preferred stock was convertible to common shares. The purpose of the offer was to make CIB Marine more attractive to buyers. Our experience is that such offers work best when there is a viable recapitalization plan already in place.
As can be imagined from the discussions set forth above, it is much easier to work through the process with a managed pool than with a static pool. The process can be considerably quicker with a managed pool. Nonetheless, we have had success with both types of pools. In fact, we believe that we are the only firm to have succeeded in three offers involving static pools.
A TRUPS buyback also requires approval by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). Accordingly, the offer must be well structured to convince the Federal Reserve that use of corporate resources to buy back the TRUPS is consistent with the Federal Reserve’s Source-of-Strength Policy Statement.
M&A
There were very few bank M&A transactions in 2009. The approximately $2 billion of aggregate deal size paled in comparison to prior years. I do not expect the environment to change much this coming year. Potential acquirers are deeply concerned regarding the asset quality of potential sellers. In light of the structure of FDIC deals, such transactions will significantly reduce the volume of M&A transactions that do not involve government assistance. Sheila Bair anticipates the volume of bank failures to start to come back down sometime in 2011. If she is correct, M&A activity without government assistance is likely to continue to be depressed until then.
I do expect an increase in merger-of-equals (“MOE”) transactions. The acquisition by $4.3 billion-asset Chemical Financial Corp., of Midland, Michigan (“Chemical”), of $840 million-asset O.A.K. Financial Corp., (the parent for Byron Bank) of Byron, Michigan (“O.A.K.”), epitomizes these types of transactions. In the merger transaction, shareholders of O.A.K. will receive common stock of Chemical equal to 1.08 times O.A.K.’s tangible book value. The transaction will increase Chemical’s presence in the Michigan oasis community of Grand Rapids, Michigan, from 14 to 31 locations. MOE transactions can provide significant benefits in the current market. Such transactions allow participants to grow without reducing capital levels. The combination provides an opportunity to enhance earnings from cost savings as well as a larger platform upon which to enhance the sophistication of customer services offered.
A MOE is a transaction between two or more somewhat similar-sized banks where the banks combine with each other, rather than one acquiring the other(s). These transactions were relatively common before bank pricing exploded. Now that we are in a period of reduced premiums from sales, MOEs may become a relatively attractive way to grow the platform and earnings by forming a strategic alliance between two or more community banks.
Some of the more common features of a MOE transaction are:
- somewhat similar asset size among the banking companies involved (but this need not be the case);
- neither bank initially dominates the combined senior management group;
- the form of consideration is primarily common stock;
- no “premium” price is paid (a MOE is less an acquisition/sale than a financial combination); and
- the negotiating atmosphere is usually friendly.
In such transactions, the nonfinancial (“social”) issues are extremely important. Accordingly, serious discussions/negotiations should be held, early on, to resolve the many social barriers to consummating a transaction of this sort. Compromises will absolutely be necessary because neither shareholder group will own 100 percent of the combined company, one shareholder group will likely become the “minority” shareholders, and decision making at the board and senior management levels will be shared. Many prospective MOE transactions are never consummated due to unresolvable social problems.
MOE transactions involve some important distinctions from typical mergers. First, each party will perform a “due diligence” investigation of its prospective merger partner.
Recognizing that two or more similar-sized banks are involved, the opportunity to recognize significant merger savings enhances the importance of developing a specific integration plan early on. Key people should have designated responsibilities and an appropriate time schedule should be set.
MOE transactions provide the following advantages. They
- conserve equity capital and enhance debt capacity;
- increase access to alternative forms of financing;
- increase the marketability/liquidity of shares by increasing the number of shareholders, and possibly enhancing the market price per share;
- improve senior management depth;
- limit earnings and equity per share dilution as compared to an acquisition at a competitive purchase price level (no “premium” price is paid by either party);
- achieve economics of scale/merger from savings usually available through reduction in duplicate operations/staffs, thereby materially enhancing combined shareholder value (without having to “sell out”);
- allow the diversification of trade area economic/customer base concentrations; and provide for a combination of the financial and market strengths of one merger partner with those of the other merger partner.
MOE transactions have the following disadvantages:
- They are a difficult form of transaction to close, typically due to problems in resolving the many social issues.
- The merger partners must be willing to dilute existing shareholder ownership percentages.
- The merger partners must be willing to share decision-making responsibility/authority at the senior management level and at the combined board of directors.
- Significant organizational, operational and producer integration of the merger partners, while very common in this type of transaction, is never easy. (People frequently do not embrace significant change willingly.)
- The corporate cultures of the merger partners may be substantially different, requiring a major effort to re-orient the combined company in a unified direction.
- A significant layoff of the combined company’s staff may be necessary in order to achieve the potential shareholder value enhancements available.
The ultimate financial success of a MOE transaction will be determined by how well the combined managements and boards from both merger partners work together to realize the financial benefits that are almost always present in a transaction of this type. The development and implementation of a sound operational integration plan is a must. However, if the important social issues are not agreed upon early, it is highly unlikely that a transaction will ultimately be consummated.
Subchapter S
A Subchapter S corporation that sells assets that have built-in gains must pay taxes on those assets if the built-in gain existed when the financial institution made its Subchapter S election. If, however, the financial institution has been an S corporation for at least 10 years, this built-in gains tax goes away.
For Subchapter S corporations, the elimination of the built-in gains tax provides a potential win-win for the buyer and the seller. In the event the parties elected for the transaction are to be taxed as a sale of assets (the stock is still being sold, but it is treated as an asset sale), then the buyer would be able to deduct any premium paid over the next 15 years. To the extent the premium is significant, then there is an opportunity for the buyer and seller to share in some proportion of the tax benefit.
For the remainder of 2009 and 2010, the time frame triggering a built-in gains tax has been reduced to seven years. Accordingly, any sale of S corporation assets that have been held more than seven years, including the sale of the entire company in an asset sale, will not trigger a built-in gains tax. Starting in 2011, the time frame for a built-in gains tax goes back up to 10 years.
Problem Bank Acquisitions
As discussed below, failed bank opportunities may not be available for many financial institutions because of their size. Moreover, the franchise value of a failed bank has generally been significantly eroded by the time the FDIC liquidates it. Even in the best circumstances, to acquire a failed bank requires winning an auction process. In addition, the FDIC retains the failed bank’s tax attributes. Accordingly, an acquisition of a bank that still is solvent may be preferable to taking the chances of winning the bidding for a franchise that has been decimated.
Unquestionably, there are significant challenges to such acquisitions. There is no substitute for due diligence. If the acquirer concludes that the target truly is solvent, structural tools can be put in place to assist in protecting the acquirer from the target’s asset issues identified during diligence. For instance, in Chemical’s acquisition of O.A.K. discussed above, the purchase price to O.A.K. would decline $1.50 for every $1.00 in loan losses O.A.K. suffers above $10 million.
The acquisition by Tower Bancorp, Inc. (Harrisburg, Pennsylvania) of First Chester County Corp. (also in PA) (“First Chester”) also includes deal protection that provides for the deal value to decline based on charge-offs.
First Chester, a $1.3 billion-asset bank, experienced significant credit quality deterioration in 2009. Specifically, nonperforming assets increased to 3.7 percent of total assets, or $35.5 million, at September 30, 2009. The additional 30- to 89-day past-due loans were approximately $10 million.
Under the terms of the transaction, if delinquencies are less than $55 million, the purchase price will not change. If, however, delinquencies exceed that level, First Chester shareholders would receive a reduced amount.
There are other tools that are available for cash deals as well as stock deals. For instance, a portion of the purchase price can be placed in escrow to protect the acquirer from asset losses. Similarly, a portion of the merger consideration can be paid in the form of a promissory note, which would be written down and could even disappear based upon asset performance.
Such transactions involve a fair degree of negotiation around management and liquidation of assets as well as the determination of when a loss has occurred. Nonetheless, such structures are able to provide significant insurance against further asset deterioration.
Failed Bank Purchases
The current economic cycle and the regulatory response to asset quality issues will result in a significant number of failures. My own expectation is that these financial institution failures are likely to be closer to a thousand than to five hundred. At year-end 2009, financial institutions with assets below a billion dollars and between one billion and ten billion were experiencing higher percentages of asset quality issues than their bigger bank brethren. At September 30, 2009, 489 financial institutions had Texas1 ratios of 80 percent or higher. By any measurement, the volume of financial information failures will be significant.
In such transactions, the FDIC offers loss sharing. The FDIC provides a “stated threshold” on every transaction. The bidders are provided with the specific amount of the stated threshold a week to 10 days before the bids are due. Up to the amount of the stated threshold, all losses, net of recoveries, and reimbursable expenses are shared 80 percent to the FDIC and 20 percent to the assuming bank. Beyond the stated threshold, the FDIC absorbs 95 percent of such losses and expenses.
Currently, it is typical that a winning bidder will bid a discount on the transaction, meaning that the FDIC would pay it for engaging in the transaction. The discount can be expected to cover anticipated loan losses among other costs to the assuming bank. In most transactions, the winning bidder has booked a one-time gain on a bargain sale, which is a taxable one-time profit from engaging in the transaction.
There are other statutory and contractual protections to winning bidders. For instance, the FDIC will provide indemnification in certain circumstances. In addition, winning bidders have the ability to reprice the deposits of the failed bank. The assuming bank also has the option to reject the contracts of the failed bank.
Currently, financial institutions that are CAMELS 1- and 2-rated are contacted for failing institutions in their general geographic area, but there are size limitations for prospective acquisitions. Financial institutions considering failed-bank acquisitions should develop prospective take-down/management and capital plans for failed-bank transactions. The board should update its strategic plan to identify the size and geographic scope of potential acquisitions and the desired markets. Management should obtain from their regulators preclearance to bid on institutions in those markets. In light of the short due diligence period and unique structure and terms of the failed-bank transaction and the purchase and assumption agreement, considerable preparation and even a dress rehearsal for a desired transaction is appropriate.
We have been involved in the first shelf charter for an investor group, the first shelf charter granted to an existing holding company and more than 5 percent of the failed-bank transactions since the beginning of 2009, including representation of the assuming bank in four acquisitions of failed banks with over a billion dollars in assets. In addition, we have been involved in capital raises timed to close immediately prior to a failed-bank transaction. Accordingly, we would be happy to provide assistance in answering questions for financial institutions considering the pros and cons of failed-bank acquisitions.
Branch Purchases
As discussed previously, a significant number of regional financial institutions are struggling. Many times, such institutions will be subject to formal administrative action requiring them to achieve certain minimum capital ratios on a short deadline or suffer regulatory sanction. For those institutions, a sale of assets can help meet required capital ratios by reducing the denominator, while increasing the numerator.
Specifically, although there have been a couple of branch sales with no premium, they have proven to be the exception. In most branch sales, the purchaser pays a premium that is typically expressed as a percentage of deposits for the assets and liabilities associated with one or more branches. Because the selling institution is often in a net loss carry-forward position, the full amount of the purchase price increases the seller’s shareholders’ equity.
Conversely, the effect of a branch sale is to shrink the seller’s assets. Oftentimes, the seller will sell the loans associated with those branches as well. It is increasingly common to see the seller grant the acquirer a “cherry pick” right with regard to the loans to be acquired. The effect of such a sale is to reduce both total and risk-based assets. Thus, the cumulative effect of an asset sale is to increase the selling financial institution’s capital ratios.
For the acquirer, such a transaction provides the opportunity to grow the platform by adding relatively low-risk assets. Such a branch purchase may be immediately accretive.
Conclusion
Financial institutions should consider how to position themselves to take advantage of the opportunities presented in the current economic environment. Those who do so will have a once-in-a-generation opportunity to expand their banking platform and enhance shareholder value. Such opportunities may be truly transformative and, thereby, position the financial institution for the next turn of the economic dial.
1 The Texas ratio is nonperforming assets divided by the sum of shareholders’ equity and the allowance for loan losses.
By: Peter G. Weinstock
