After a sharp decline in bank M&A deals in 2022, this year could prove different, at least for smaller banks.
That's according to Piper Sandler's co-heads of financial services investment banking, Bill Burgess and David Sandler, who connected with American Banker for an interview this month.
Increased scrutiny from regulators, higher interest rates and economic uncertainty weighed on deal activity last year. Just over 160 banks merged in 2022, down from more than 200 in 2021, according to S&P Global Market Intelligence.
Many of the factors that held down M&A last year are still at play. But banks, especially smaller ones, still need to become more efficient — an imperative that could spur more deals, the bankers said.
Burgess and Sandler also spoke about other factors driving today's deals, how much pushback banks are getting from regulators and the one issue that could prevent an M&A uptick among banks of any size.
What do you think the M&A landscape will look like this year versus last year?
BILL BURGESS: The first thing I'd say is that all of this has one large caveat, which is if we see a rapid [decline] in credit in the bank space, then M&A stops. If you look at the number of transactions over $500 million in size over the last few decades … In 2009, there were zero, and there's a reason for that. So, if we continue on that trajectory right now where we're just kind of running sideways and credit is fine, then I think you're going to see a lot of what we had in 2022 again in 2023, which is a dearth of large transactions due to regulatory concerns and more of the same in terms of smaller transactions, particularly for acquirers looking for more funding. Deposits are more valuable to [acquirers] than they were a year ago, significantly so. You're gonna see smaller transactions that can get through the regulatory approval process to allow institutions that are looking to grow their asset base and retain deposits or add to liquidity.
DAVID SANDLER: The reasons that banks have been consolidating at a rate of 4% of the charters in the U.S. per year as far back as we look in the rearview mirror haven't changed. The need to drive efficiency, whether you're a $1 billion-asset bank or a $50 billion-asset bank, operating two institutions or several on the same expense base is a much better value proposition.
That, combined with the efforts of the [Federal Reserve] to drive alternative investments. In other words, deposits aren't going to sit in banks earning 0% when their alternative investment is a Treasury security at north of 4%. That actually threatens to reduce the asset base and investment base of these banks and further compels them to the efficiencies of consolidation. The underlying drivers have not changed, nor will they. As Bill says, the litmus test is whether the industry will face capital issues, and if they do, it may be less M&A and more capital raising.
What do you think are the characteristics of a bank that is likely to do a deal as an acquirer?
BURGESS: Having credibility with counterparties and regulators today is more important than it was a few years ago. Very few institutions can have two applications in with the Fed for M&A, so the opportunity cost becomes pretty important. If you're in good regulatory standing and have experience on the M&A side and credibility with the buyer universe, that matters greatly. Valuation always matters. Pricing for bank deals doesn't really change that much; it's basically 90% of the acquirers' multiple tends to be what they will pay for targets. That pricing is down today because all bank valuations are down. But if you have the ability to, with a stronger share price, pay it in a stock deal, your shares, that advantages you versus other competing acquirers and could rule the day for targets that are looking for liquidity or are just concerned about the economic outlook.
SANDLER: Next is capital. At this point, most deals, as a result of purchase accounting, end up reducing combined capital ratios. To the extent that's the case, a successful acquirer probably is an acquirer that is sitting on enough capital to be convincing that they can handle the integration.
Is there any kind of change you've noticed when it comes to banks' pre-deal interactions with regulators lately?
BURGESS: Regulators are like spouses; they don't like surprises. If you want to maintain a long-term relationship, you're best previewing things of consequence before you make a decision. It's the same with agencies or any other institution that is outside the organization that has an impact on the organization.
I do think banks today are having the conversations with regulators before they have a target in their sights or are close to signing, just to get a feel for how it will be received. It's best to know if you've got a hunting license before you go out into the woods. Institutions that are prolific with M&A are telling us that they have gotten some pushback in the last year or two in terms of the number of applications or the complexity of the business they pursue. Institutions that might try to do two or three deals a year are trying to do one or two.
SANDLER: On the regulatory front, successful and certainly serial acquirers since before the Great Recession were more communicative with their regulators. As a result, it felt like that dialogue was more two-way and reciprocated. Over the past two or three years, there's been less clarity in those pre-announcement conversations about what might get approved and over what period of time. That's in part because the oligopoly of counterparties are getting more involved. You're seeing more involvement from the [Consumer Financial Protection Bureau], more involvement from the Justice Department, more involvement when companies are jointly regulated by both the Fed and the [Office of the Comptroller of the Currency] or the Fed and the [Federal Deposit Insurance Corp.] and the state.
Regulators are very much focused on what these companies look like dynamically going into 2023. In other words, if you look at 2022 results on paper, rising rates have been great for margins, great for returns, great for return on equity. So far, we're not seeing any credit blips, but I don't think you can find a regulator or a banker for that matter that isn't concerned about the potential impact of all those things on 2023, both from a credit quality standpoint, but also ultimately from an earnings and capital standpoint.
How are most deals coming about these days? Do the deals start when you make a pitch to a bank or when a CEO you've worked with before expresses interest in buying another institution?
BURGESS: One of the tenets of banking that I heard around 1999 when I started is that bank deals are driven by either fear or greed. Over the past few decades, that's remained pretty accurate. Right now, the trend is more on the fear side. That's not surprising considering that the multiples and the valuations are lower on the successful deals.
The most successful transactions we have on the sell side are where we don't talk about selling the company. If we have the right relationship with a bank that's considering relinquishing control, we'll be talking to them about buying a smaller piece of a larger company.
If you do a stock-for-stock exchange, instead of having 100% of Bank X, now you've got 15% of Bank Y. Are you better off owning 15% of that company with its diversified geography, products and scale, etc., than you are by yourself? Particularly with the prospects for a recession in 2023, a number of banks said 'You know, I can swap into that stock tax-free, I get a higher dividend, and I've got some liquidity if I want to sell the stock that I received.' It just feels more comfortable to be part of a larger organization. I do worry about where we're going to be in the coming quarters economically, and I don't profess to have any clarity on where we're going to go. But the notion that you can get a tax-free swap, get a premium, get dividends, get liquidity in the smaller part of a larger organization is real solace for some sellers. That's been one of the key attributes of the deals we saw in Q4.
SANDLER: I'll add an adage that I heard back in 1991: Banks are sold not bought. The vast majority of the conversations that we have in the boardroom that Bill's describing are what drive the process. The seller, the target, makes a board-level decision to pursue the efficiencies Bill just described.
If you read the proxy statements of the public deals that have been announced over the last four years, you'll find that a lot of these banks went out and had a number of conversations and ultimately ended up with one counterparty at the altar.
To get a little bit more into the math that Bill's talking about, when you're sitting in a room with a board – and by the way, we are great advocates for independence and community and regional banking. The argument that we'll make in a boardroom is never, 'You can sell at a premium so you should sell now' because that's been true for the better part of my career.
When we sit down and have those conversations, remember you're in a room with a board of directors and a management team trying to drive earnings growth in a difficult environment with headwinds. So when you're sitting around and talking about an industry that grows earnings maybe in the mid single digits over time, and a merger transaction can bring their shareholders 10% or 15% or 20% more earnings per share, and the only risk is executing on the cost savings and integration, that may be less risk than introducing new products or services or hiring people or making additional loans or taking interest rate risk. These are the compelling reasons that they consider stock mergers and they consider coming to the altar in the first place.
