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Community banks: Prepare for a mergers and acquisitions surge

June 11, 2013

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The confluence of several factors — including a struggling economy, intense competition and a challenging regulatory environment — is putting pressure on community banks to consider mergers and acquisitions (M&As) as a growth strategy. Each bank is different, so there’s no single right answer to the question of whether to buy, sell or remain independent. But one thing is certain: Many bank directors will be asking themselves this question in the coming months.

Expected consolidation in the sector doesn’t mean that community banks are on the verge of extinction. On the contrary, a recent FDIC study observed that “community banks continue to play a unique and important role in our economy.” But the study suggests that small community banks might consider mergers to remain viable. (See the “FDIC Community Banking Study” section below.)
If your bank is exploring M&A opportunities, you’ll need to consider a number of issues as you go through the merger or acquisition process.

Getting a valuation

It’s important to obtain an independent, professional valuation of your bank. If you’re selling, it helps ensure that you receive a fair price and protects the board against claims that it failed to act in the shareholders’ best interests.

If you’re buying, a valuation of the target helps ensure that you don’t overpay. It’s also important to conduct a valuation of your bank, particularly if all or part of the purchase price will be paid with the bank’s stock. Valuing your bank also helps you evaluate the transaction’s potential impact on its capital.

In certain situations it’s a good idea to obtain a fairness opinion — that is, a statement by a financial professional that a proposed transaction’s terms are fair to the bank’s shareholders from a financial perspective.

Structuring the transaction

Generally, community banks prefer mergers over asset or stock acquisitions, for two reasons. First, if properly structured, a merger can be tax-free to the seller’s shareholders. And second, a merger allows the buyer to acquire all of the seller’s stock upon approval by the seller’s shareholders (typically, by a two-thirds vote).

Asset purchases are relatively uncommon because they usually result in substantial tax liabilities for the seller. But in some cases, they’re desirable. For example, a buyer may be unwilling to assume certain seller liabilities. Unlike a merger, in which the buyer assumes all of the seller’s liabilities, an asset purchase gives the parties some flexibility when determining which liabilities the buyer will assume.

From the buyer’s perspective, there may be tax advantages to an asset purchase. For sales where a premium is paid, it gives the buyer a stepped-up basis in the assets, which will reduce the capital gains on assets that are later sold. In some cases, including certain sales of S corporation banks, a buyer may be willing to pay a higher purchase price in exchange for these advantages.

Performing due diligence

During the due diligence process the buyer should examine a variety of financial, operational and compliance items, with emphasis on the quality of the target’s loans and deposits, and the transaction’s impact on regulatory capital. For the seller, due diligence is usually less extensive, but still important, especially if the seller is receiving the buyer’s stock as payment.
You should execute confidentiality and nonsolicitation agreements to prevent the other party from disclosing or using sensitive information learned in the due diligence process or from raiding your employees in the event the deal falls through.

Dealing with uncertainty

One of the biggest challenges in negotiating an M&A transaction is reconciling the parties’ conflicting views on the target’s value. In many cases, for example, the seller has a more optimistic view about its projected earnings or the collectibility of loans. One potential solution used to reconcile differences of opinion on value is an “earnout” provision in the purchase agreement. An earnout makes a portion of the purchase price contingent on future events, such as achievement of a specified level of earnings, collection of certain loans or settling a litigation matter.

Handling with care

These are just a few of the many factors to consider when contemplating M&A opportunities. Other issues include negotiating the purchase agreement, obtaining regulatory approval, and dealing with employee compensation and benefits issues. Experienced financial and legal advisors can help you navigate this complex process.

FDIC Community Banking Study

In December, the FDIC published its Community Banking Study, a “data-driven effort to identify and explore issues and questions about community banks.” Among other things, the study examined industry consolidation from 1984 to 2011 to determine whether that consolidation was related to economies of scale, which placed smaller banks at a competitive disadvantage.

The study suggests that small community banks can reduce their costs and enhance their viability through growth. But the FDIC concluded that most of the benefit from economies of scale is realized once a bank reaches $100 million to $300 million in total assets, depending on its lending specialty. This conclusion is supported by data from the study period, during which the number of banks with assets of less than $25 million declined by 96%, while the number of banks in the $100 million to $10 billion range increased by 19%.

For more information contact Doug Michel at [email protected]

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.

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