Behind the Bank M&A Drought

Financial journalists sometimes refer to M&A bankers as "rainmakers." Do they make it rain, or do they just take credit when it starts raining?

There's no question investment bankers who structure bank mergers would very much like to make it rain. The drought has been long and painful. Since 1991, there have been more than 5,700 bank and thrift mergers comprising over $1.2 trillion in aggregate value. The best year was 1998, with over 400 deals comprising $289 billion in aggregate value. There have been nine $50 billion-plus years. Not one in a while, though. In 2008, aggregate deal value totaled only $32 billion, with $21 billion of distressed sales. We haven't had a year with more than $17 billion of deals since. And despite investment bankers' relentless optimism, 2013 is on track to be worse than 2012.

In fairness, the aggregate value stats are skewed by a very small number of giant deals. Of the 5,700 deals to date, the 24 with announced value above $10 billion account for 48% of aggregate transaction value. The smallest 5,400 deals account for only 14%. Very few megadeals are on the horizon; there simply aren't enough big targets left. And that implies that $50 billion of activity in a year is probably a thing of the past.

But smaller deal activity has slowed too. Why? Three reasons, in my opinion. First and most importantly, the economic recovery remains fragile, and astute acquirers are averse to buying another bank's problems when they may not fully comprehend their own. Second, some sellers still have unrealistic price expectations. Third, buyers have discovered that the hard part comes after the deal announcement, not before it. Several have failed to deliver on their deal promises, and this may have humbled them into abstaining from future deals. Or so their shareholders may hope.

Not all investment banks have suffered equally during this slowdown. Since the beginning of 2008, there have been 61 deals with announced value over $100 million. Who are the most prolific advisers? Sandler O'Neill tops the list, with 27 advisery assignments, followed closely by Keefe, Bruyette & Woods, with 25 (including 3 done by Stifel Financial). JP Morgan is a distant third, with 13 deals, although it ranks first by aggregate deal value. Advisers' deal counts fall off meaningfully from there. Many firms haven't done any deals.

So if you equate a firm's number of deals with expertise, choosing an adviser is easy. But should you equate the two? That's a complex question. A sell-side adviser's job is to drive the price higher. Overpaying is the acquirer's problem. And smart acquirers worry about it.  Even a properly-priced deal provides only modest benefits to the acquirer, but an overpriced one destroys value. Prudent buy-side advisers worry about this too, and they "lose" deals because of it.

If you define "overpaying" as paying a high price/tangible book value multiple given a target's ROE and capital levels, there is scant evidence that more experienced buy-side advisers avoid overpaying. Multiples are all over the map, and while they've fallen since the financial crisis began, so have targets' ROEs. What's interesting is that acquirers who use cash consideration tend to pay richer multiples.

To be able to materially overpay, an acquirer needs excess capital. An acquirer with a 10 P/E can pay up to $10 in stock for every $1 of pro forma target earnings. If it pays more, it incurs dilution. But another acquirer with a 15 P/E can pay up to $15. The higher P/E, the higher the acquirer's "tolerable" acquisition price. But using cash is even better. If that 10 P/E bank liquidates securities yielding 5% before taxes to fund an acquisition, it can pay up to $33.33 of cash for every $1 of target earnings. Although dilutive to tangible capital ratios and tangible book value per share, using cash boosts EPS accretion.

Only a few banking institutions, generally demutualized thrifts, have lots of excess capital. Whether confusing "high EPS accretion" with "good deal" is a buyer's fault or his adviser's is a question worth asking. But it seems clear that smart sell-side advisers know where to go for a full price.

Who knows, 2013 bank M&A volume may turn out to beat 2012's volume by a healthy margin. At some point, activity has to pick up. That's not an insightful prediction; mean reversion guarantees it. Many bank M&A advisers have been trying to make it rain for years, and most have little to show for it. And buy-side advisers that have made it rain often end up with disappointed clients.

It's enough to make you wonder who's really hoping for rain, besides the rainmakers themselves.

Harvard Winters, a former investment banker, writes research on banks.