Posted September 2012

Merger of  Equals- The Good, the Bad and the Ugly

By The Capital Corporation

As you are aware, The Capital Corporation works with a large number of banks in the Midwest on mergers, acquisitions, divestitures and other consulting projects.  Lately, a lot of the discussions we have had involve a conversation about mergers of equals.  Since this topic seems to be discussed more often now than in the past we decided to outline and share some of that information.

WHAT IS A MERGER OF EQUALS?

A true merger of equals involves two organizations that are very similar coming together to form a combined organization.  Typically this means that it is not clear who is buying whom, neither side receives a premium and management and boards are equally split.

In reality, there are no two organizations that are truly equal.  Likely one of the parties has more assets, capital, or earnings.  One party could have more capital and the other party could have higher earnings which could equalize the parties. Also, one entity may be owned by one stockholder or family, while the other may be widely held, so even if the banks are equally valued, the control may still not be equal.  Nevertheless, transactions can be structured as a merger despite the parties not being equal in every way. 

Since a true Merger of Equals is unlikely, we will refer to this type of transaction simply as a merger which has most of the same benefits and risks.

WHY CONSIDER A MERGER?

A merger can result in economies of scale, combined capital to allow for higher loan limits, the addition of new locations, products and services, deeper management support and succession, etc.

Much has been written about the difficulty that small banks are facing in today’s regulatory and economic environment.  We won’t address that here, but it is clear that many community banks are seeking growth opportunities. 

Banks have cut costs considerably in this downturn.  There are limited expense savings (and there will likely be increased costs with regulations) so banks must grow to retain or regain earnings.  There are two clear ways to grow a community bank – one is organically; the other by acquisition of a bank or branch.

Organic Growth - While a community bank may have the capital to grow, a 5 to 10 percent annual growth rate will not provide the size community banks likely need.  Many community banks cannot obtain significant organic growth without moving outside of their current market. 

If a community bank is not in a market that is growing, it is very difficult to obtain growth organically.  It is a zero sum game – to grow you must take it away from another bank.  This typically is done by pricing which hurts earnings.

A bank can find new growth by establishing a branch in a new market.  This, however, has substantial start up costs and risks. Additionally, most markets (maybe all markets) are overbanked.  Adding another bank location to the market just makes it harder for everyone to make money unless you branch to a market that has true growth. Therefore, if you want to grow, and organic growth is not a viable option, the only other option is acquisition. 

Acquisition Growth - Access to capital is probably the most significant issue a community bank has in acquiring by acquisition.  Bank stock loans can fund some of the necessary capital for an acquisition, but are limited in the amount you can borrow.  Simply put if you don’t have excess capital or access to capital from outside of your organization, you are limited in your ability to make an acquisition.

A merger, however, normally does not require new capital.  Assuming both parties are well capitalized prior to the transaction, the combined organization will remain well capitalized after the transaction.  This allows a bank without access to new capital, and which does not want to sell, to participate as part of a larger organization.

Therefore, if you need to grow your asset base, but cannot get the organic growth you need and you don’t have access to capital for an acquisition, a merger is an option worth considering.

Discussion Points in a Merger  While the following list does not include all of the items that need to be resolved in a merger, it does address some of the most common.

1.     Valuation

a.     How are the two institutions/holding companies to be valued?

b.    Primary value factors:

                                          i.    Capital

                                         ii.    Earnings

                                        iii.    Debt, including trust preferred securities

                                        iv.    Locations

                                         v.    Problem assets

 

2.     Personnel

a.     Board seats – how many total, how many from each?

b.    Chairman

c.     President

d.    CEO

e.     Senior Lender

f.     CFO

g.    Operations personnel

 

3.     Other

a.     Liquidity and Exit Strategy

b.    Name

c.     Business plan

d.    Compensation differences between banks

e.     Operating systems

f.     Staff personnel

g.    Type of charter (state or national)

 

Final thoughts  The biggest roadblock to a merger of equals that we have encountered is that the parties are never truly equal.  The concept that the two parties will be worth more together sounds great until you start looking at the transaction at closing. One party will be in control and it starts to feel like a sale of the non-control party without its shareholders getting cash at closing. 

The non-control party loses sight of the fact that although their piece of the pie is smaller, because the pie is much bigger the value of the smaller piece is still larger.  Often, the non-control party decides that if they are giving up control they should be paid a “control premium” that they could get in the market if they were to sell for cash, or at least remain independent so they have that option in the future.

There is no doubt that a merger looks good on paper – more assets, more capital, more efficiency, new markets, added expertise and significant cost savings.  And, if done between the right parties with a full understanding of how everything will work post-closing, a merger can improve both of the parties’ long-term value, income and potentially dividends.  However, navigating the process to reach the right result is very important.

The parties should really focus on where their investment will be in 3, 5 or 10 years down the road if they don’t do a transaction versus where it will be if they do a transaction.  At the end of the day shareholder value is what should drive a transaction.