Economic Jitters Threaten Recent Momentum in Bank M&A

Investment banker Donald Musso was feeling optimistic about bank mergers in May — his firm ended the month by handling one of the largest deals announced this year.

But Wall Street's bad reaction to that deal, coupled with the plunge in stocks last week, has him fretting about a repeat of August, when the steepest market sell-off since the crisis snuffed out momentum in bank M&A.

"The uncertainty is just going to squash deals," says Musso, the chief executive of FinPro, a Liberty, N.J., financial services consultancy that handles community bank mergers. "It seems like every time we get a little bit of momentum in the M&A game the wind just gets taken right out of the sails."

Other M&A experts share his concern following the most robust month for sizable bank mergers in well over a year. There were six whole-bank deals worth at least $50 million in May, the most in a single month since four such deals occurred in October 2010, according to Keefe, Bruyette & Woods.

But renewed economic volatility threatens to make the deal bounce in May short-lived, market watchers say.

The Dow Jones average fell 2.7% last week on bad news about U.S. jobs and Europe's economy, erasing its gains for the year. It dropped slightly on Monday before rallying the next two days. The Dow surged nearly 287 points on Wednesday.

The KBW Bank Index has fallen 2.7% in June after dipping as low as 7% earlier in the week. The index has risen 8.8% since Jan. 1 but fallen 9.2% in the last month.

Banks prefer to pay with deals in stock, which makes volatility a deal-killer. Bumpy markets also exacerbate the sell-offs that acquirers experience immediately after they announce a deal. Those can spook other banks weighing whether to do a deal, experts say.

"You are looking at the way the market has reacted to some of these transactions where there is large book value dilution up front," says Timur Braziler, an analyst with KBW. "That can certainly throw a monkey wrench in the system."

Musso's firm is advising New England Bancshares (NEBS) of Enfield, Conn., in its $91 million sale to United Financial Bancorp (UBNK) of West Springfield, Mass.

United Financial's shares as of Wednesday were down 6.5% since announcing the deal on May 31. Part of the problem is that investors are ignoring the long-term strategic benefits of the deal, Musso says. They are fixated on the steep dilution to tangible book that United Financial is to incur in the all-stock deal because its shares trade at a lower premium to its equity than it is paying for the target, he says.

Shares of Berkshire Hills Bancorp of Pittsfield, Mass., have fallen more than 3% since announcing its agreement to buy Beacon Federal Bancorp in Syracuse, N.Y., on May 31. The $132 million deal would be dilutive.

It will take both banks more than four years to earn back the capital that is to be exhausted in those transactions. The market is essentially telling other acquirers that they will be punished for such dilution, Musso says. The broader volatility may have amplified that message.

"If we're saying the only strategic combination that makes sense are those that are earnings accretive immediately day one and have a total earn-back period of three years, we're not going to see a lot of deals," Musso says.

Deals can still be done when the markets are volatile, and there is an argument that broad financial stress puts more pressure on banks to sell by squeezing profits.

But that increased pressure is offset by the complications of doing a deal in a rocky market. Should the volatility continue, look for fewer deals overall, mostly among small, private or thinly traded banks.

So-called caps and collars are likely to tighten in deals in which stock changes hands. A collar is a decline in the share price of a buyer relative to an index that would result in a deal's being terminated or renegotiated without penalty.

A typical collar is around 15%. In a volatile market it can narrow to below 10%.

Sellers tend to do more due diligence on the performance of buyers' stock in a bumpy market. Volatility also compels more cash-based deals. The problem with cash, of course, is that paying with cash leads to dilution in the book value of the buyer. The upside is it is a fairly stable currency.

"A lot of people in this low inflation environment are just looking for cash," says William W. Bouton 3rd, a partner with the law firm Hinckley, Allen & Snyder in Hartford, Conn. "You certainly know what it is worth in dollar terms — it is like comfort food. Everyone is looking for some comfort."