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Look closely at the structure of the First PacTrust deal for Beach Business Bank to see how deal negotiators are hedging against stock volatility. Expect to see more creative pacts like this one.
August 31 -
With wild swings in the stock market, negotiations over protections form big changes in the stock values of buyers and sellers are bogging down an already slow deals market.
August 19
Pay for performance is a popular concept in executive compensation. Bankers have begun applying a version of it to unthaw the M&A market.
Two community bank takeovers this summer would pay shareholders of the selling bank more money if its loans do well over several years.
So-called contingent payments are common in other industries in the form of post-purchase awards when the selling company hits certain profit or revenue targets. They have been rare in banking given the simple nature of the industry and its heavy regulatory oversight. That reality tended to make for vanilla mergers: Bank A gave some cash for all of the stock of Bank B, and everyone was happy, assuming regulators had no problem with the partnership.
Bank deals have been evolving as volatile markets and high unemployment upend valuations. Wannabe buyers have become increasingly creative in protecting themselves, from using warrants as currency to carving out only a franchise's best loans and deposits.
Whether contingent payouts catch on in banking is an open question. The industry — like the economy — suffers a frustratingly murky outlook. If determining the value of a loan today is tough, guessing how much it may be worth years from now is even trickier.
They are "hard to negotiate" but are "doable," said Joseph Gulash, principal of investment banking with D.A. Davidson & Co. in Los Angeles, where he advises on mergers involving West Coast community banks, including one of the recent deals involving contingent payments. "It all comes down to the buyer's view of the seller's loan portfolio."
There are incentives for both parties. The payments can be an enticement to sellers worried about unloading assets at a discount that may be worth more when the economy rebounds. Buyers, in turn, want to avoid overpaying for an asset that could depreciate in value.
There is no hard formula for structuring them, Gulash said. But the basic idea is to take a single loan or a batch of loans and determine their current and future values. The payout may be based on the difference between those assumptions.
To use a single-loan example: Say a manufacturer has taken out from the selling bank a $1 million mortgage on an equipment plant. There may be doubts about whether it will be able to repay that entire loan with interest, so the loan is marked to $700,000. If the seller can make a case that in three years the borrower may be strong enough to repay the entire debt within three years, the buyer may agree to set $300,000 aside. The seller gets that money if the borrower makes good.
If that sounds simple in theory, in practice it is not. Three or more parties may be involved in evaluating an asset: the seller, the buyer and their regulators. That is a situation ripe for dispute.
There can be other complications. If the parties are publicly traded, the buyer may be wary of adding to its disclosure headaches. Analysts and investors may have a right to regular updates on how a batch of loans are performing if a sizable payout is on the table.
That is why the structure may work best when one or both parties are small, private institutions.
The two mergers that involved contingent payouts fit that description.
D.A. Davidson advised Chula Vista, Calif.-based First PacTrust Bancorp Inc. in its agreement in June to pay up to $17 million for Gateway Bancorp, a two-branch operation with $187 billion of assets in Cerritos, Calif. Gateway is primarily a business lender with a side business in originating and syndicating home loans in California, Arizona and Oregon. Though Gateway stopped extending credit to subprime borrowers in 2007, First PacTrust was concerned about the risk of having to repurchase questionable loans from investors or the federal housing agencies.
To address that, the parties agreed to set aside $2.5 million of the purchase price in escrow for 36 months to cover any repurchase costs. At the end of that time, Gateway's shareholders will receive that money minus any buyback-related reductions.
The other transaction involved California banks, too. First Foundation Inc., of Irvine, agreed in June to pay $16 million up front for Desert Commercial Bank, with shareholders of the Palm Desert bank potentially due another $4.05 million in cash and stock in two years, based on how well certain loans perform.
