Executive Summary: Acquisition activity will increase dramatically over the next 18 months. However, buyers need to enhance their approach to risk management and in many cases supplement and strengthen their risk management capabilities.

 

 

FIC’s work with clients and our related analysis points to a significant pick-up in M&A activity.

 

Increasing Acquisition Opportunities
We expect deal flow to increase, whether resulting from open bank transactions or FDIC-sponsored deals.

 

Open bank transactions will increase for multiple reasons:

 

• The new financial regulations will serve as the “last straw” for some overburdened community banks; given increased reporting and capital requirements, many will decide that selling is a better alternative to being forced to increase non-revenue generating expenses.

 

• Community and regional banks operating with marginal capital and/or earnings potential will choose sale over dilution.

 

• Some banks that started up in the past ten years have owners who are actively looking to cash out.

 

• Many community and regional banks will actively sell “non-core” businesses or branches as a result of strategic reviews.

 

• The BP oil spill is harming businesses and consumers across the Gulf. For many this disaster will be another last straw, impacting them and their ability pay back loans. Some banks will suffer and raise their white flags as a result of this domino effect.

In addition, FDIC closed bank or assisted transactions will also continue. Most of the elements listed above impact bank closings as well as open bank deals. As of today, 96 banks have failed so far this year. These deals will continue through 2011 and probably beyond. A commentator writing in Monday’s The Street.com summarized the opportunity: “Despite numerous reports that the agency [FDIC] is getting tightfisted and that attractive deals for failed banks are on the wane, six 80/20 loss-sharing deals in one night show that lucrative opportunities remain for stronger banks and private equity investors.”

 

Preparing for M&A
Conversations with both open bank and FDIC-supported acquirers have revealed that many really did not know what they had bought until after the deal closed. In those cases, due diligence was either rushed or rudimentary. The fact is that it takes significant time to “peel back the onion” of a loan portfolio, particularly if a major component is commercial real estate and C&I lending.

 

As acquisitions occur, so too will the need increase for the acquirer to initiate a “SWAT team” focus on the risks embedded in the acquired portfolio both as part of the upfront due diligence process and beyond. FIC plays that role for acquirers whose own staff, understandably, is stretched, oftentimes due to working overtime on their current portfolios. Activities need to include a review of credit processes and portfolio performance and an assessment of as many individual loans as possible.

 

As critical, the acquirer needs to develop a perspective on the risk management team of the acquired bank. The rigor and consistency with which they managed the portfolio being acquired serves as a clear indicator of that portfolio’s likely quality. (Obviously the answer is clearer in a failed bank deal.) Ideally, this assessment will include direct meetings with the risk team and/or evaluating their reputation with other industry sources. The land mines are greater in an open bank deal that lacks the benefit of some percentage of loss absorption by the FDIC.

 

Managing Shared-Loss Risk
While acquirers derive clear benefits from the loss-share arrangement, the 125+ buyers of FDIC shared-loss banks so far also need to dive deeply into the risk profile of purchased portfolios:

 

• Buyers need to evaluate the portfolio quickly in order to prioritize immediate payment submissions to the FDIC under the “guaranty” agreement. Not doing so slows down cash flow and the return to investors from the transaction.

 

• Acquirers need to develop a game plan for those loans that are not immediate candidates for FDIC submission. Some loans may be performing today, but a review may indicate that they could move to non-performers over the next few quarters and, thereby, be submitted for payment.

 

• Among all the dross purchased in these transactions some good credits exist that can become part of the bank’s core portfolio and candidates for “organic” growth.

 

• Consistency in risk analysis is critical for the analytic process and the support material prepared as part of FDIC payment submission. As banks buy a second or third target, the issue of consistency increases in importance. The documentation within a single failed bank is often inconsistent and inadequate; of course, these inconsistencies are even greater from one acquired bank to another. While inconsistency is also an issue with open bank deals, the need to prepare for extensive FDIC audits of shared-loss transactions intensifies the importance of this area.

 

Pre-deal, due diligence is limited with a shared-loss transaction. Buyers may have only a few days to evaluate files and usually have limited or no access to bank personnel. This underscores the need for a strong post-purchase portfolio review process. Post-deal, the FDIC is intensifying its audit of the portfolios it sells, elements of which involve reviewing the quality of submissions for shared-loss payment as well as the quality of the underlying loan files.

 

Our experience in this area suggests that the future will involve increased examination by the FDIC of its shared-loss “partner’s” activities. Making sure you self-audit and improve your processes before you are audited by the FDIC or its representatives is a wise move.

 

Final Comment
The pace of industry consolidation will increase. Risk management practices, already important, will become even more critical. From our perspective in many cases this area is failing to receive the senior bank management and investor focus it requires.