Banking on Consolidation (Part 1)
An investor's guide to merger & acquisition activity in community banks
Reading Time: ~ 8 minutes.
This article is part 1 in a series on community banks. In part 2 (to be published next Thursday, March 10), we will identify and analyze specific takeover targets within the community banking sector.
“There’s more bank consolidation that will occur, not necessarily of significant sizes. You’ll see more smaller banks getting together because there is scale to this business.”
“At the smaller end, I think you’ll see an enormous amount of M&A” in 2022
A special situation investor constantly searches for clues of an upcoming catalyst that will force the market to realize a company’s intrinsic value.
Receiving a takeover bid is one such catalyst, often creating a quick and substantial rise in stock price that is largely unrelated to the undulations of the broader market. To the untrained eye, it may appear that takeover bids occur at random. But to the trained special situation investor, clues and interrelated developments act as signposts and point to takeover activity.
The first and most important clue is the overall incidence of takeover activity in a particular sector or industry. Often, one transaction begets more transactions:
“The M&A domino effect occurs in industry after industry. It has played out over the past decade in pharmaceuticals, automotive manufacturing, and financial services. When a major rival executes a headline-making merger, companies often feel under attack. These events can be so emotionally charged that it’s hard not to get drawn into a competitive acquisitions game.”
Beyond management hubris and the emotional need to “keep up,” other structural reasons cause merger dominoes to fall one after another. For example:
In sectors facing limited opportunities for organic growth, companies will turn to acquisitions to enter new markets or expand share in existing markets.
In sectors with high fixed infrastructure costs, cutting duplicative spending and achieving economies of scale can boost shareholder returns.
Domestic community banks neatly fit the bill of a sector prime for a high rate of takeover activity. Community banks are defined as having less than $10bn in assets (regional banks have $10-$100bn in assets). The sector is characterized by a commoditized product offering and limited organic growth opportunities. The last year of consolidation in regional banks has put additional pressure on those further down the food chain to compete. And the benefits of scale are widely recognized – one industry expert suggests that up to 30% of bank costs are duplicative and can be cut in a merger.
Some other benefits of the community bank sector:
It’s too boring to be mainstream news.
Too small for significant institutional coverage.
And therefore, a less likely target for antitrust regulators.
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The historical reasoning for this fragmentation was described in a 2004 speech by former Fed Governor Mark Olson:
…forces favoring decentralization, led by Thomas Jefferson, fought the proponents of a more centralized government, led by Alexander Hamilton. The Jeffersonian forces largely prevailed. As a result, the United States lacked a strong central bank presence but had no authority even to grant national charters to commercial banks until the Abraham Lincoln Administration. All bank charters were originally granted by the states and, as a consequence, the United States at one time had more than 25,000 bank charters. Today, we have about 8,000 separate bank charters. By contrast, most other developed nations have fewer than 100 separately chartered banks.
And this fragmentation endures today despite a wave of consolidation in the industry that has persisted since the early 1990s:
Recently, consolidation has only accelerated. According to S&P Global, “U.S. banks struck 208 deals with an aggregate deal value of $77.58 billion in 2021, the highest level since 2006.” Larger, transformational transactions by regional and super-regional banks characterized merger activity, with 13 deals of values greater than $1bn announced (the most since 1998).
Given the industry dynamics outlined below, large-cap bank M&A will likely continue (for example, see the $13bn First Horizon / TD Bank deal announced on February 28). But there are a couple of headwinds. One is simply a lack of potential partners – as several large banks have already made significant acquisitions, they will likely wait on the sidelines and gestate their deals before pursuing additional transactions:
“It’s kind of like musical chairs and when the music stops there are only a few chairs left. A number of institutions have made their choices, and once they have picked their acquirer or merger partner, they are essentially off the board for a few years.”
Another is the current regulatory environment. President Biden’s administration has called for increased scrutiny of M&A, particularly for deals in specific sectors (defense, healthcare) and sizes. Maxine Waters, chair of the House Financial Services Committee, has vociferously derided large-cap bank M&A, calling for a cessation of deals that resulted in a bank having over $100bn in assets. And in December, FDIC Chairman Jelena McWilliams submitted her resignation after partisan disputes over bank merger process reviews.
I expect to see more regulatory scrutiny around larger deals by regional banks, like the proposed First Horizon / TD Bank combination that would have over $600 billion in assets. Indeed, aware of likely regulatory scrutiny, the merger agreement states that TD Bank would pay an extra 65 cents per share if the acquisition is not completed by November 27. Given the highly regulated nature of bank holding companies, regulatory hurdles for community banks also exist but should be less of a near-term deterrent. Some industry experts suggest that community banks are feeling an urgency to get deals done now before more regulatory pressure emerges.
“The bigger banks are already seeing more scrutiny; we know that. The trickle-down concern is always a concern, but I just think there are so many discussions going on and so many banks determined to do deals that the smaller acquisitions, at least, are going to pile up again this year.”
To date, community banks have been a small part of the consolidation wave in the banking sector. Often there has been a lack of a catalyst to sell – the community bank industry is replete with public company “orphans,” led by entrenched management teams and Directors who are happy to exist in the shadows and enjoy the benefits of being public company directors. Small banks have also escaped the merger wave partly because they are too small for regional banks to consider acquiring.
But this is changing:
Current Industry Pressures
“The demands of this business now are real and especially challenging for the smallest banks. This is true as it relates to technology and the economies of scale needed to invest in digital platforms and services that people increasingly need and expect.”
Interest spread income (difference between rates charged on loans and paid on deposits) has been an unreliable mechanism for growth due to persistently low interest rates and a relatively flat yield curve.
Fixed infrastructure costs are high and rising, anchored by extensive brick & mortar branch networks and increasing due to necessary investments in technology and increased regulatory oversight.
Foot traffic into physical bank branches is in structural decline. Although the need for brick & mortar bank branches remains, there is a greater desire than ever for digital banking.
Fintech and non-bank lenders are taking share. Less-regulated entrants like PayPal and Square facilitate the transfer of money (and, in Square’s case, increasingly operate as a bank). At the same time, non-bank lenders like Rocket Mortgage can compete nationally without a substantial physical presence.
In what has been a challenging earnings environment, larger peers have turned to acquisitions and mergers to drive profitability improvements, putting further pressure on smaller banks.
“I believe the low valuations of small banks will lead to more mergers and acquisitions…I also think the M&A environment for banks is strong due to the increased regulatory and technology costs of running a bank. Increased scale through M&A can mitigate these increased costs.”
Community banks operate within a fragmented industry – there are several hundred publicly traded community banks with less than $10bn in total assets – and offer a generally commoditized product. Here is why you will see more of those businesses merging:
With limited organic growth opportunities, M&A is one of the only ways to deliver growth to investors – either through entering new markets or increasing share in existing markets.
Significant identifiable cost savings can mitigate the impact of high infrastructure costs and enable community banks the scale and resources to invest in technology and compete with larger competitors.
Small-cap banks continue to trade at a discount to their larger competitors, perhaps reflecting the investors’ strategic concerns in sub-scale operators but certainly making them more attractive takeover targets.
Activists are beginning to speak up to prod public “orphans.”
Limitations to M&A
Bank holding companies, including their subsidiaries and entities controlling bank holding companies, are subject to strict regulation and oversight from the Federal Reserve under the Bank Holding Act. Accordingly, there are several federal restrictions on bank equity shareholders that are unique to the industry:
Ownership limits – investors cannot obtain greater than a 9.9% share in voting common stock without approval under the Change in Bank Control Act.
Board of Directors restrictions – limitations on the number of directors an investor can place on the board (not to mention, community banks often feature classified Boards anyway).
Importantly for activist investors and investors seeking takeover targets, in 2020, the Federal Reserve loosened several ownership restrictions. However, regulatory hurdles remain an obstacle to be aware of when considering bank stocks.
“The amount of people who want to meet is through the roof. If I went to every event at this conference, I’d get bombarded. If I tell an investment banker I’m open to one meeting, he’ll schedule 10. That’s how active it is right now.”
In part 2 (to be published next Thursday), we will analyze specific takeover targets within the community banking sector.
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