Here is some advice for my friends at large regional banks: with respect to tangible book value (TBV) dilution in acquisitions, heed the prescript (here slightly paraphrased) of Benjamin Jowett and never apologize, never explain.
If you are not familiar with the concept of TBV dilution and its earnback period in bank mergers and acquisitions, you will get no explanation here beyond the following:
First, focusing on TBV accretion or dilution in an acquisition is an extremely defensive way to look at and evaluate the merits of a bank acquisition. I don’t recall exactly when this fixation took hold, but it is properly viewed as a remnant of the financial crisis and its immediate aftermath when bank earnings were essentially non-existent and preservation of capital was paramount. To the extent that TBV dilution was ever a particularly useful metric, that time has passed—this is an expansionary, not defensive period for banks and bank acquisitions should primarily be judged on earnings accretion or dilution and strategic merit. Given the recent earnings performance and prospects for most banks, capital preservation and generation is not the issue—rather it is capital deployment or return.
Second, the desire to limit TBV dilution earnback periods to less than five years has been perhaps the single biggest impediment to bank M&A during the last five years. Put extremely simply, it is hard for a bank to buy another bank that has a larger price to tangible book multiple without incurring tangible book value dilution. One of my biggest gripes about this metric is that it makes it really hard for banks with lots of capital (usually raised for them to be able to buy other banks) to buy banks that are more leveraged. Since there is no normalizing capital levels in calculating TBV dilution, a buyer with lots of capital is more likely to have a lower price to TBV multiple (because the denominator is higher) than a target that is more highly leveraged (because the denominator is lower). This problem is particularly acute when the target is private, since private banks tend to be more highly leveraged than public banks (because, among other reasons, they do not have public stockholders who might be concerned about prospective capital raises).
Finally, not only is it a metric that, due to reliance on forecasts and a lack of a truly standard method of calculation, is easily manipulated, but it is also almost impossible to look back and determine whether the actual impact was close to what was predicted, particularly if the buyer has done any subsequent acquisitions.
So, to put my above advice to regional banks in more specific terms: stop including TBV dilution and earnback calculations in merger related investor presentations. Blunt advice, yes, but my reasons are as follows:
First, going off price to TBV multiples, most larger regional banks trade at a discount to the smaller banks they might want to acquire. This is almost inevitably going to lead to TBV dilution in excess of “accepted” levels. A perfect example of this can be seen in Fifth Third’s (NASDAQ:FITB) recently announced acquisition of MB Financial (NASDAQ:MBFI). I don’t really see this valuation gap closing any time soon, so this will continue to be an issue, even in transactions that are otherwise very attractive and well thought out. Put differently, I don’t think that there is going to be any getting around larger amounts of TBV dilution in these types of deals than investors and research analyst are used to seeing, so regional bank acquirers may be faced with three choices: (i) don’t do the deal, (ii) get beat up for “long” TBV dilution earnback periods or (iii) ignore the metric all together. For otherwise attractive deals, (iii) would seem to be the best alternative.
Second, and this will sound cynical, I think investors and research analysts generally only care about TBV dilution and earnback periods because they think they are supposed to. By including these metrics in investor presentations, banks are endorsing their importance and ratifying their utility, both of which I think are negligible at best. To the extent that investors really care, they can do the math themselves.
Finally, and a corollary to the point above, I think trying to explain why TBV dilution and earnback is not particularly relevant or that a particular transaction might compare favorably to other alternatives, such as buying back stock, with respect to TBV dilution, is, frankly, somewhat of a waste of time. Not only do such explanations inherently give credence to the notion that TBV dilution remains an important consideration, but an acquisitive bank’s time and energy would be better spent on demonstrating the attractiveness of a particular deal (earnings accretion, strategic value, etc.) than comparing that specific use of capital to hypothetical alternatives.
Rather than just wait for this fixation on TBV dilution to finally fade from view, banks who have negotiated, structured and priced acquisitions that are financially and strategically sound should simply choose to ignore this holdover from the immediate aftermath of the Financial Crisis.