Posted March, 2012

Why Do Deals Fall Apart?

By The Capital Corporation, LLC

The difference in pricing or valuation expectations between buyers and sellers is one of the most significant issues in getting a transaction completed.  However, even if the initial valuation expectations are satisfactorily resolved, other issues often prevent a potential deal from closing.

We have helped buyers and sellers work through valuation expectation issues and move forward only to have a potential deal fall through during the due diligence process.  This letter outlines the significant “deal killers” we have seen recently.  Buyers and sellers should consider all aspects of a transaction, not just price, before spending time and money on a potential deal.


We could write pages on pricing and valuation in today’s market, but want to focus on the other issues that are significant in a transaction.  We will touch on valuation because it is still the primary hurdle in getting a deal to closing and we believe that there is quite a bit of incorrect information in the market.

Potential sellers remember the 2003-2007 time period when prices regularly exceeded two times (2X) book value.  However, potential buyers looking at pricing between the 2009-2011 time period would see the average pricing much closer to one times (1X) book value. 

Market pricing is simply an average of the transactions included in the pool of sales that the writer is using when reporting the average valuations.  Therefore, if the pool of transactions includes the sale of several problem institutions at below book and several clean organizations above book the average may be closer to book – even if none of the transactions were actually at book value.

During the 2003 – 2007 time period there were very few “problem” institutions.  Valuation differences occurred primarily based upon location, size and earnings.  Today, however, the condition of the bank is the primary factor in determining value and since transactions are occurring with banks near failure and with banks that have record earnings (and everywhere in between) it is very difficult to gauge the true market value of banks in general.

Additionally, because market prices are lower today many banks that don’t need to do a deal are sitting on the sideline while the banks that have capital or other issues are moving ahead with deals despite the market. With more problem banks in the pool of transactions than clean banks, the market pricing reports are skewed towards the lower valuations.

Buyers look at bank stock loans, TARP funds and Trust Preferred Securities as debt that must be addressed in a potential acquisition. This has become a bigger issue with deferrals of interest payments that are reducing holding company equity of the sellers.

Because of many banks’ condition the deals today often have unique features – escrows, loan buy backs, dividends of excess capital, earn-outs, employment and non-compete agreements, etc. These features are very difficult to report and often are overlooked in the reporting of market pricing.

Finally, banks are selling that have very little capital or capital ratios in the mid-teens, and everywhere in between. A buyer will typically pay a premium on 8% capital. This ratio may be adjusted, but is pretty standard.  The difference in capital also distorts the reported prices of transactions.

Historically, when dividend tax rates were substantially higher than capital gains tax rates, a buyer would pay dollar for dollar for excess capital.  Today, many buyers are requiring the seller to dividend the excess capital out at closing as part of the purchase price.  The dividend is often overlooked in the prices reported.  The transaction values reported on the last three deals that we closed were all incorrect – either high or low depending upon the transaction.


Unfortunately, resolving the valuation expectation gap issues will not always result in getting a transaction completed. Below is a list of the deal killers we have seen in the past couple of years that have prevented a transaction from closing.

These issues are not necessarily new, but previously they may have been less significant in the overall valuation or a buyer just incorporated them into the cost of a transaction. With values lower today, and buyers being more cautious, these issues can very easily break a deal.

1. Loan quality and loan file documentation issues.   Potential buyers must be able to review loan files and know where the target bank stands relative to the adequacy of the ALLL.  If you have missing documentation in the loan file a buyer will assume the worst and downgrade the credit.  Remember, they don’t have a history with the borrower and are relying solely on what is in the file during due diligence.


During the 2003 – 2007 time period loan risks were minimal.  The past four years have shown that material risks do exist in a loan portfolio and buyers will not assume unknown risks. Buyers typically expect a 1.5% reserve on the clean loan portfolio and fully funded specific reserves on all classified loans.  Because a buyer is normally assuming the risk of loss they almost always require a higher reserve than the regulators may have required in the last exam.


2. OREO / Other Assets valuation issues.  Real estate and other assets should be recently appraised and marked to market.  This is similar to loan file documentation above – if a buyer cannot ascertain the true value of foreclosed or repossessed property, it will assume the worst and reduce their offer.  Sometimes there is a significant difference between what a seller carries these assets on their books for and what it’s true value is.  Just because the regulators have not required additional charge-downs does not mean that a buyer will accept the current book value of the asset.


3. Vendor contract issues.  Sellers should investigate penalty clauses in contracts, especially data processing contracts, and understand the potential costs of termination penalties.  These can be significant – in one situation (where a transaction did not occur) the data processing termination penalty equaled over 10% of book value.  Today buyers will require a seller to pay this fee, or will incorporate the cost of the termination penalty into the price offered.


4. Litigation issues.  Sellers should attempt to settle all lawsuits where they are a defendant or with a counter claim before due diligence.  During the 2003 – 2007 time period lender liability claims were few and far between.  Today the threat of litigation is more common, and buyers will not assume the risk of defense and possible judgment.


5.  Future growth issues.   Buyers are normally looking for growth potential of assets, deposits and earnings; poor growth potential and/or a poor branch network can cause buyers to exit. 


Valuation is directly affected by the size and location of bank or branch. Buyers will consider the cost of shutting small or poorly performing branches as part of the transaction costs.   Additionally, we are seeing more cases where there are no buyers for certain banks or branches solely because of the size or location.  Buyers look at the viability of the market 5 and even 10 years post closing when determining whether they have an interest in a specific bank.


6. Overpriced deposit base issues.  Buyers look for a stable, core deposit base that does not include excess high priced, brokered, or internet deposits.  Public funds, if priced appropriately, are normally not an issue, but in many cases a buyer will value them differently than a retail deposit.


Buyers will reduce the valuation of a bank or branch if the deposit costs are high – basically reducing the value by the higher cost for the term of the deposits. If they anticipate a runoff of deposits that are repriced after closing, that will also impact the value.


Finally, buyers will look closely at FHLB advances – both the cost and the prepayment penalty. In today’s market where deposits are readily available at low costs, FHLB advances that carry a high cost and long term directly impact valuation.

7.  Employee contracts, BOLI issues and ESOPs.  Many buyers do not want to assume employee contracts and bank owned life insurance contracts, especially on employees that may not remain after the deal is closed. Additionally, most buyers will require a pension fund and ESOP, if applicable, to be fully funded at closing and start the termination process.  The cost and time to terminate these plans is often quite high and is typically absorbed by the seller.

 8.  Employee issues.  Buyers normally are not interested in an acquisition if management and/or all loan officers plan to exit following a transaction.  Too often a bank decides to sell when its management team is ready to retire.  Losing the employees that have customer relationships can significantly reduce the value of a bank, and in some cases eliminate buyers altogether.

Additionally, buyers do not want to face bad public relations by being the “bad guy” if they need to terminate excess employees.  Finding qualified employees is often difficult in many markets and with retirements most buyers will retain most or all employees in a transaction.

However, in many cases a seller may have too many employees for the size of operation and the buyer may need to look at additional personnel cuts.  Buyers will weigh the bad publicity and impact on employee morale in evaluating whether to move forward with a transaction.

There is no question that market prices for banks are substantially lower than they were five years ago.  However, reported market price statistics are not always a fair reflection of the market or a particular bank’s value.


Additionally, issues that previously either did not exist or were much less significant are very common today. It is these issues that buyers and sellers often overlook until they have spent a lot of time and money working on a transaction.  In many cases these items can be resolved or substantially mitigated before due diligence if proper planning is done.


We believe transactions that are good for both the buyer and the seller can get done if potential sellers address the above issues before due diligence begins.  If you are considering the purchase of a financial institution or the sale of a financial institution, we can help you through the process.