We’ve all been there. You’ve really got a busy day tomorrow, but your best bud is throwing a party and he says it’s going to be great. You figure you’ll swing by, check it out and follow the two drink rule—no problem. Only thing is, the party is great and one thing just leads to another. Next thing you know, it’s really late, the two drink rule was dismissed as more of a guideline and you already know that tomorrow is going to be a struggle. You’re also pretty sure that decision to go for tacos at two in the morning is something you are going to regret. Not a pretty picture.
Sometimes it feels like the right thing to do, but staying too late at the party almost never works out. Unfortunately, looking across the banking landscape, there are a number of banks that raised excess capital coming out of the financial crisis that have done just that and now have some tough decisions to make. In most cases, both the original plan that was pitched to investors and the intentions of the management team were sound. Taking advantage of the disruption caused by the financial crisis, the blueprint was pretty simple—find a small and/or troubled bank, over- or re-capitalize it, clean it up if necessary, try to make a few acquisitions, take advantage of some low hanging fruit in terms of deposit and loan generation and then sell for a nice multiple. In a number of cases, this plan was executed to perfection while, in other instances, the outcome was less than optimal. However, there are a number of examples out there of management teams that, despite solid to excellent execution of the first few steps of the plan, have failed to deliver on the most important step: the sale.
So what happened? It varies from case to case. In some instances, management teams may have been just cutting it a little too fine by holding off potential buyers until some perceived optimum level of profitability and/or scale was achieved. In other cases, unforeseen developments, such as regulatory, credit or other issues, pushed out the timing of a potential sale. Some were never able to deploy their excess capital, creating a drag on returns. Occasionally, management teams just start to get a little too comfortable with their jobs to make good on their understanding with their investors. Others are some combination of any or all of the above.
As anyone who has modeled these re- or over-capitalization type of investments can attest, the real returns are made on the exit and most investors are looking to exit in a sale. Sure, given the expansion in bank multiples and the general rotation into bank stocks since the Trump election, a lot of investors who backed these type of plays have the opportunity to sell into the open market at attractive valuations. However, given the choice between the two, most large investors would probably rather get their liquidity all at once at a premium to prevailing market prices (i.e., in a sale) rather than dribble shares out into the market or sell in a block trade or secondary offering at potentially a significant discount to the market price.
If you are wondering why these management teams can’t just rectify the situation now, I would offer a number of reasons. First, and perhaps more importantly, there might not be any buyers. As I noted in an earlier post, the pool of potential buyers is not as deep as one might expect. Based on reviewing the “background to the merger” section in a random sampling of merger proxies, it is clear that, even in broadly marketed auction proceedings, it is difficult to get more than one real bid. A corollary to the observation that the buyer pool for any given bank may be pretty shallow is that banks that might have been potential buyers may, once our subject bank starts seriously thinking about selling, no longer be interested. Again, this could be for a variety of reasons--regulatory issues, a move away from M&A as a core strategy or even because the potential buyer itself was bought.
Of course, the actions taken by our subject bank may also impact its ability to find a buyer (or a buyer willing to pay the price sought by our subject bank), though they would probably still be better off pursuing a sale, even if at a lower premium. Perhaps the subject bank has grown into that $10 billionish in assets range and become a “tweener”—a little too big for many of the serial acquirers out there to comfortably take on, but not big enough to move the needle for those large regional banks who may be returning to the M&A arena. Perhaps, more concerningly, our subject bank may have grown to that size with the assumption that a takeout was on the horizon—theoretically eliminating the need to make (as well as to take the hit to earnings from) necessary investments in infrastructure—and are now facing a meaningful expense ramp to catch up (particularly if they can’t find a suitable target in order to jump over the $10 billion in assets threshold). Or, in order to show rapid earnings growth, they may have relied upon earnings streams that are either unreliable (such as small acquisitions where current capital is traded for later earnings when purchased loans are aggressively marked down to generate higher yields in future periods) or would garner a lower multiple in a sum of the parts analysis (such as mortgage warehouse). Maybe, while the party was rocking, our subject bank failed to adequately develop a true core deposit franchise and now, in a rising rate environment, is potentially looking at higher than peer deposit betas.
So what are our subject bank’s options now? Obviously, they can remain independent and take their medicine, as applicable, in terms of higher expenses and/or earnings and funding challenges, but such a course of action would probably result in lower multiples and a bit of a slog for management, particularly as most of the anticipated industry wide catalysts for expected earnings growth (e.g., tax cuts and rising rates) have either happened and/or are pretty well baked into stock prices.. Alternatively, they could try to find a “merger of equals” partner and effectively sell for no premium. Or they could abandon any remaining pretense of coyness and market themselves widely in hopes that a bid representing some reasonable premium appears.
It’s never good to stay too late at the party.