Home Banking Competing Pressures: The 2021 M&A Outlook | ABA Banking Journal

Competing Pressures: The 2021 M&A Outlook | ABA Banking Journal

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By Robert Klingler

I absolutely expected a downturn in bank merger and acquisition activity during 2020, due in part to uncertainty related to the election. I got the magnitude, timing and primary cause completely wrong, and I certainly didn’t think that the greatest period of election uncertainty would be the period following Nov. 3 as the results were slowly counted, certified and contested. But the turning of the calendar presents a new opportunity to predict the future.

Many uncertainties remain for 2021, not the least of which is the efficacy of the various vaccines and their ability to restore a sense of normalcy in social and commercial activity throughout the country (and the world). Even for banks that aren’t thinking of M&A in 2021, anticipating asset quality metrics and growth opportunities (much less the general budget) is often directly or indirectly tied to the timing for people, and thus the economy, to return to normal activities. Most clients see a relatively flat first quarter, but our clients then project a variety of estimates for a strengthening economy in the second or third quarter of 2021.

While the actual timing of the COVID-19 recovery is likely to have a significant effect on year-end results, the perception of the timing (and variations on those perceptions) are likely to have a significant effect on the appetite of prospective buyers and sellers to engage in conversations about potential transactions. Finding a mutually agreeable valuation can be much easier when a buyer thinks the recovery is coming in March but the seller fears it won’t arrive until September.

Lies, damned lies, and statistics

As popularized by Mark Twain, numbers, particularly statistics, have significant persuasive power to bolster weak arguments. I have little doubt that that the bank M&A industrial complex will (of which I’m certainly a part), will tout the extreme percentage growth in bank M&A activity in 2021 over 2020.

By almost any measure, and certainly percentage-wise, 2021 M&A activity is likely to look off the charts relative to 2020. Of course, with M&A activity in 2020 down approximately 50 percent from the number of deals completed in recent years, merely returning to 2014 through 2019 levels would represent a 100 percent increase in the number of deals year-over-year. We could have a “record year” with deals up 50 percent in 2021 and still have materially fewer deals than were completed in 2019.

As the industry continues to consolidate, and de novo activity replaces only a small fraction of the banks sold in any year (even in a down year for acquisitions like 2020), we are likely to see fewer transactions over time. But management teams, boards of directors and shareholder bases continue to age, and M&A remains a very attractive exit and liquidity strategy for each constituency. Accordingly, a return to a range of 200 to 250 deals in 2021 should reasonably be expected, but it should not be a sign of a new stampede of consolidation or taken as a sign that the M&A opportunity will be lost if not pursued immediately.

Merger pressures continue

Banks are sold, not bought, and the many reasons a bank might sell all appear to still be present in 2021. As noted above, the age and experience of the bank’s management team, board of directors and shareholder base all frequently contribute to the pressure (from inside and outside) to maximize economic returns and sell the institution. While aging certainly has its negatives, I think we can all agree that it’s preferable to the alternative and—notwithstanding the pandemic—will continue.

Similarly, regulatory pressures continue to build and justify larger asset bases to bear the costs of compliance. While it will likely take time for implementation and for the full effects to be felt by community banks, I expect that the incoming administration is unlikely to take significant steps deemed favorable by bankers on issues of either bank regulation or taxation. Both factors are likely to suppress industry profitability and may thus decrease the attractiveness of the strategic choice to stay independent. But while the Biden administration may take a skeptical view of mergers among the largest banks, almost all bank M&A activity will remain at asset sizes unlikely to draw antitrust concerns.

Low interest rates and tight margins should also contribute to continued M&A activity. These factors strain the profitability of all banks, but with size comes greater ability to diversify and minimize overhead. Even with the potential for renewed economic growth associated with the COVID vaccines’ deployment, the Federal Reserve’s expressed desire to keep interest rates low for an extended period of time foretells a long recovery for banks. (The lack of inflationary pressures associated with the outstanding unemployment rates before the pandemic, the potential addition of monetary policy “doves” to the Federal Reserve Board and the appointment of Janet Yellen at Treasury each support a continued focus on lowering unemployment rather than raising rates to fight potential inflation.)

While many would argue that banks collectively had too many branches even prior to the pandemic, the pandemic has advanced everyone’s awareness of remote transaction capability. As the digitally driven case for reducing branch counts becomes stronger, many community bank managers may prefer to let an acquirer make the decision to close branches (and maximize cost savings) then to incur these tough decisions themselves. This may not be rational from a purely economic perspective, but I think we can all understand the human issues involved. In addition to the psychological costs, the reduction in branches relies upon the provision of sufficient technology to ease the transition for customers to digital banking platforms. While some community banks are able to use their size and nimbleness to achieve technological advantages, many community banks are likely to continue to reach the decision that selling to a larger bank is the most efficient way to achieve the technological solutions that are necessary to compete, particularly in a post-pandemic world.

But roadblocks remain

The first roadblock to additional M&A activity is both crystal clear and completely opaque: asset quality. Almost every banker believes that the pandemic will have a significant negative effect on certain asset portfolios. Dining out and travel simply can’t fall as far and as fast as they have during the pandemic without it having an impact on the viability of lots of businesses, and that necessarily means banks will be harmed as commercial real estate and business loans sour. Over the long run, a bank simply cannot outperform the community that the bank serves. But we also hear throughout our client base that the underlying numbers do not (yet) indicate a material decline in asset quality or justify larger provisions.

When bankers can’t trust their own asset quality metrics, it is virtually impossible for them to accept the accuracy of the asset quality metrics of a potential M&A target. This uncertainty directly contributed to the collapse of deal activity at the outset of the pandemic, and while some deals re-emerged in the fall, I expect this uncertainty will continue to significantly damper M&A activity, particularly in the first quarter. While additional due diligence can address some of this risk (and should be expected), it can’t resolve the underlying uncertainties alone. Only when the vaccine results ultimately allow a clear picture of the underlying economy will banks begin to get a clear picture of their customers’ long-term business prospects. Buyers that think they can achieve this clarity sooner rather than later will be in the best position to strike deals earlier in the year, but false overconfidence could also lead to some bad deals in hindsight.

The pandemic, and the effects of the government’s response to the pandemic, have also clouded the picture of the core business of most banks. Balance sheets are inflated, mortgage revenues are off the charts, and the recognition of Paycheck Protection Program fees contributes significantly to many income statements. The ability of potential acquirers to strip away these factors and identify the core attributes being acquired will be critical to successful M&A activity in 2021. For sellers, understanding the core and non-core elements of the bank’s performance will not only to help set expectations, but can also focus management and the board on the long-term aspects of the bank’s performance that drive real shareholder value.

As during and after the Great Recession, we are once again seeing a significant disparity in the perceived value of institutions looking to sell, particularly those without a public stock price. While the market hammered all publicly traded bank stocks in 2020 (presumably due in no small part to the same asset quality concerns discussed above), many privately held (or quasi-publicly held with limited trading markets) smaller banks saw continued earnings and built reserves without, at least initially, deterioration in asset quality. Accordingly, many of these smaller banks’ management teams and boards of directors believe their banks should continue to command the same multiples as seen before the pandemic.

Conclusion

Due to the small number of M&A transactions in 2020, be ready for headlines extolling the return of the M&A market in 2021. But these statistics, even if framed to support whatever investment thesis is being sold at the moment, won’t belie the continued pressures for consolidation among community banks. Getting hold of asset quality, the core business of the target and a mutually agreeable valuation will be key.

But history also tells us that some of the best deals for shareholders in the long run come in connections with transactions at the bottom of the market. Such transactions allow shareholders to surf the waves of the market to greater returns on the strength of larger, more profitable institutions—and with the possibility of a double-dip transaction down the road.

Robert Klingler is a partner with the law firm of Bryan Cave Leighton Paisner LLP in Atlanta.