After rebounding sharply in the second quarter, M&A deal volume suffered through the Summer doldrums during July and August with just 19 announcements for the two-month period. No doubt a victim of sovereign debt travails in Europe, debt limit “debates” in the United States, and crumbling economic fundamentals. The quarter’s final tally rebounded to a more normal level as monthly volume almost doubled in September to 16.
Looking at the broader picture presented in Exhibit 1, deal volume has been weaker in 2011. Announcements totaled 113 for the nine months ending September 30, 2011, down 9% from the 124 for the comparable 2010 period.
Over this same period, median deal pricing began a slow decline for four quarters before bottoming in the first quarter of 2011. Since then pricing has gradually improved. It should be noted that the overall median pricing tends to mask the two types of transactions occurring: healthy bank sales and distressed bank sales. ( See Exhibit 2).
The chart results, similar to past periods, show a near-equal number of healthy bank deals (<2% NPAs) at a median price/tangible book of 1.34x as distressed bank deals (>6% NPAs) at a median price/tangible book of 0.63x. Pricing for seller banks with NPAs/Total Assets between 2% and 4% is nearing the median pricing for healthy banks, indicating that more sellers and buyers are successfully negotiating the intricacies of asset quality and capital issues.
To better understand the causes behind weaker volume in 2011 versus 2010, we divided the buyers into two groups: investors and banks. An investor was defined as an entity with no current banking operations. An investor group making subsequent acquisitions was classified as a bank.
As Exhibit 3a shows, investors were prolific buyers during the first two quarters of 2010, accounting for 59% of total deal volume in those quarters. Investor participation has plummeted since that time to a low of 5 transactions in the third quarter of 2011 as targets that meet their profile prove elusive.
Factoring the investor group transactions out of the total reveals that transactions involving two banks has exhibited less volatility recently as shown in Exhibit 3b. In fact, merger transactions between banks totaled 91 for 2011 through September, up 44% from 63 for the comparable 2010 period. While total deal volume is down from 2010, banks, which are the universe of natural buyers, accounted for 81% of total deal volume so far in 2011 versus 51% in 2010. From this aspect, the M&A market today is a healthier, more viable market than that of 2010 which augurs well for the future.
A subset of this volume is made up of mergers of equals (MOEs), which have averaged about four each quarter for the last six quarters. (We defined MOEs for this analysis as transactions between (i) two banks one of which has no more than twice the assets as the other or both banks having $100 million or less in assets and (ii) the “seller” has NPAs/Total Assets less than 4%.) Three MOEs were announced in the month of September alone. Is this sudden surge in volume the result of Dodd-Frank going effective and fading economic prospects or just coincidence? Time will tell. But, we believe that an MOE represents an attractive means of gaining scale necessary to achieve sustainability while staying invested in the industry.
Exhibit 4 breaks down pricing data and buyer information by the three groups of buyers above (MOE, investor buyer, bank buyer). Pricing metrics for transactions in which investor groups are buyers are higher than metrics for the other two groups in both years. Investor groups typically pay a premium to entice sellers into a transaction due to a higher level of execution risk associated with non-bank buyers. They also are able to lay off much of the balance sheet risk onto the existing capital structure of the seller and have no legacy issues of their own. As expected, the book premium was lowest for MOEs; the 2011 median price/tangible book was 0.99x.
In the final analysis, as the moon’s gravity affects the tides, so investor groups have affected the M&A market over the last 18 months. As their interest has waned so have transaction volume and pricing.
But, as markets recover and the industry finds its footing, traditional bank mergers are replacing investor-led transactions. Questions still abound regarding the overall economic environment, the implementation of new legislation such as Dodd-Frank, and whether the industry’s performance can build upon its nascent signs of recovery. Local economies tend to dramatically affect bank performance and thus M&A pricing, but in many areas the stage is set for bank consolidation.
Such a consolidation involving healthy banks in stable regional economies will price out between 1.50x and 2.0x tangible book, or roughly 11x earnings – this appears to be the “new normal”. In the pockets of economic weakness that are inundated with poorly performing banks, deal prices will be at or near tangible book with many of the distressed assets carved out of the transaction. The government, through the FDIC resolution process, may lead the consolidation in some of these areas, but traditional unassisted transactions are set to increase as long as buyers maintain confidence in the overall economy and focus on leveraging their equity.
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