Underneath the Complex Deal for RBC Is Simple Uncertainty

There are two big unknowns in PNC Financial Services Group Inc.'s deal for RBC Bank: the final price, and how PNC will pay for it.

Uncertainties over capital and credit are two reasons few big bank mergers are getting done at the moment, experts said. RBC Bank's parent, Royal Bank of Canada, and PNC are addressing those issues by waiting to settle the two key terms when the deal closes. The target date is March 2012.

"Ideally when you're doing a deal you'd like to know how you're paying for it ahead of time," said Brian Foran, an analyst with Nomura Securities LLC. "They don't know what the minimal capital ratios are yet. This slightly complicated structure PNC created is evidence of that."

The final price depends on the size of RBC Bank's loan losses over the next three quarters: the higher they are, the less PNC will pay. PNC's final form of payment — a combination of cash and securities — hinges on capital buffers for globally risky banks that are still to be determined. PNC has an option to issue up to $1 billion of common stock to RBC to finance the transaction.

James Rohr, PNC's chairman and chief executive, said tentativeness about regulatory standards is restricting banks' strategic options.

"Uncertainty is never a friend of the market," he said in an interview Monday with American Banker. "To the extent that you can have things be more certain — clearly that would be better for the marketplace."

PNC's strategy for dealing with the unknown in this deal comes down comes down to flexibility and thrift, he said. The initially agreed-upon transaction value of $3.45 billion is a bargain-basement price, as far as bank mergers go. It could go lower, and the less PNC pays, the lighter the capital burden of the deal.

PNC has agreed to pay a negative deposit premium and less than book value for RBC Bank, two rarities in bank mergers. The deposit premium is negative 0.6%; the purchase price values RBC Bank at 97% of, or $112 million less than, its tangible book — or assets excluding intangibles.

PNC is getting a better deal than a handful of other comparable bank sales or mergers involving distressed takeover targets. That includes the sale of ING Group NV's U.S. online bank to Capital One Financial Corp. announced last week, as well Bank of Montreal's deal for Marshall & Ilsley Corp. of Milwaukee in December and M&T Bank Corp.'s acquisition of Wilmington Trust Corp. of Delaware in May.

Thought the final deal price could conceivably increase, it is not likely: PNC expects to charge off 12.5%, or $2.2 billion, of RBC Bank's loans. Why is RBC fetching less a premium than those other companies, which went for about one times book value?

"This is a company that hasn't made money in several years. The seller is somewhat motivated to exit," said Marty Mosby, analyst with Guggenheim Securities LLC. "There is a lot of work to be done." RBC Bank has no income stream to speak of, he said. PNC is essentially buying a blank slate: Its returns depend on using RBC Bank's 424-branch network in six Southeast states from North Carolina to Florida as a platform for offering loan syndication, capital markets, treasury and other services in which RBC was weak.

"We can take a franchise that has wonderful distribution in a high-growth market and plug in our products," Rohr said. "It's plug and play."

Rohr said the low price also reflects the stress low interest rates are putting on depository values. "The deposit business today is not a great business, because at these [low] interest rates you can't reinvest the deposits at a higher rate," he said.

That makes it an ideal time to buy banking assets like RBC in high-growth markets, he said, because banks will get more expensive as interest rates rise.

PNC officials did not say how much the deal value could change.

Richard Johnson, PNC's chief financial officer, said in a conference call with analysts Monday that PNC expects the purchase price to decline, if it moves at all. "RBC will continue to take provisioning against the book," he said. "To the extent that happens, they'll be reducing the tangible book on delivery at the end of the trade; we'll be reducing our marks as well." He added: "We'll pay less of a price for the acquisition. … The only thing that could go against us is if they make more money."

Rohr said PNC is confident it will be able to meet any pending capital rules because its capital levels are already high and because of the flexibility worked into the transaction. PNC will issue up to $1 billion of common stock, or no more than 3% of outstanding shares, to RBC Bank under a worst-case scenario, he said. Otherwise it will fund the purchase with cash, a debt issuance and issuance of preferred shares. Issuing preferred shares enables it to diversify its capital structure, he said. Should it have to issue common shares, doing so directly to RBC Bank means it will avoid the underwriting fees and uncertainty of an equity markets issuance.

"The real question for us is we can finance it a number of different ways," Rohr said.

"There are a lot of different capital requirements that are being bandied about. Whether we have to issue any common or not has yet to be determined."