California Bank Consolidation Powers Through Harsh Drought

California's drought hasn't put a damper on bank M&A in the state.

Most of California has been suffering from a severe drought for the last four years, forcing banks to re-examine their risk management practices and be watchful of borrowers in water-intensive industries, like agriculture.

Still, these conditions have yet to act as a drag on bank M&A. Eight banks have agreed to sell themselves this year, through the end of May, at an average 154.5% premium to tangible book value, based on data from Keefe, Bruyette & Woods. That compares to 14 deals and an average 130% premium last year.

While California's water issues have yet to cause major headaches for lenders, the drought is forcing aspiring buyers to more thoroughly vet the markets and loan concentrations of potential targets. And more banks could consider consolidation — as buyers or sellers — if the drought continues for several more years.

A sustained drought could "create the need for diversification geographically for some banks," said Jeffrey Rulis, an analyst at D.A. Davidson. "It could lead to more M&A activity for those pushed to challenging situations."

The drought is "going to change the due diligence process and make it more intensive," said Chris Chouinard, portfolio manager at 1C Investment Co. "Diligence will take longer in the state with anyone, and that's probably a good thing."

Heartland Financial in Dubuque, Iowa, was meticulous as it vetted its recent agreement to buy Premier Valley Bank in Fresno, Calif.

Heartland had been looking to a buy a bank in California for more than a decade because of the state's "great growth dynamics," Lynn Fuller, the $6.6 billion-asset company's chairman and chief executive, said. Heartland had struggled to find a target that fit its requirements for size, profitability and culture.

The $648 million-asset Premier Valley was attractive to Heartland because of strong lending into the medical industry, complemented by a nice Small Business Administration loan book. Despite the seller's diverse loan portfolio, Heartland conducted extensive research on the drought that included reaching out to experts at the University of California, Davis, and poring through a report on the state's water conditions.

Heartland's management had questions on "everything, including California and the drought," said J. Mike McGowan, Premier Valley's president and chief executive. "We have been through an exhaustive due diligence. They aren't taking any undue risks."

Heartland was interested in the Central Valley, rather than urban centers such as San Francisco or Los Angeles, because of the region's similarities to its more traditional Midwestern markets, Fuller said. Heartland has been an active consolidator in several states with large agricultural sectors, including Illinois, Wisconsin and Kansas.

Taking on some agricultural exposure "is something we might consider given the fact that we have a good track record in ag lending," Fuller said, even though the ag industry in the Midwest differs vastly from that of middle of California. "We want to make sure we understand what is happening with the drought conditions and how they handle that long term."

Midwest farmers focus on a few commodities, such as corn and soybeans, and little irrigation is needed, said Curt Covington, senior vice president of agricultural finance at the Federal Agricultural Mortgage Corp., also known as Farmer Mac. A conservative estimate has more than 200 crops being grown in California, many of which rely on irrigation, he said.

"California is a unique model and requires a greater amount of specialization from the bank that provides the credit," Covington said. "The breadth and depth of what happens is much greater than what you see in the Midwest. Just because a bank can finance a Midwest corn grower doesn't mean it can finance an almond tree farmer in California."

Industry experts likened the drought to the current pullback in oil in Texas and other energy dependent markets. Though short-term problems exist on such markets, these are likely to be offset by longer-term benefits.

California banks, by and large, have strong credit quality and the state's farmers are still faring well, despite a strain on water resources, Covington said.

A lingering drought could shake up bank consolidation, forcing more institutions with underlying issues to sell, industry observers said. Over time, that could lead to "opportunistic pricing" for interested acquirers, Rulis said.

"When you think about the region, long term it's a place that's really attractive," Chouinard said. "This is potentially a time for long-term players to see who is available and maybe some folks that are on the bubble that are overly concentrated and need to sell. But no one is to that point yet."

Heartland is interested in pursuing more deals in the Central Valley over the next 24 months, Fuller said. The company is keen to reach $1 billion of assets in each of its markets, so the Premier Valley deal leaves Heartland short of that goal.

Fuller, meanwhile, said he is "aware of other banks through friends that would look favorably at joining our group," though there has been "no direct communication."

Heartland's mortgage unit has offices in California, so the Premier Valley acquisition and potential for future deals make sense with the company's overall strategy, said Dan Cardenas, an analyst at Raymond James.

"The drought could be a little bit of a worry, but Pacific Valley is a nice complement to their current operations," Cardenas said.