Are You Ready to Acquire?

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1 promontory.com APRIL 30, 2013INFOCUS Are You Ready to Acquire? BY WILLIAM S. HARAF AND MICHAEL PHLEGER Consolidation has been the prevailing theme in U.S. banking for the past 25 years, but what it takes to be a disciplined acquirer is changing in the vigilant regulatory environment that developed in response to the global financial crisis. Bill Haraf is a managing director at Promontory and advises financial institutions on corporate governance and organizational design, compliance, anti-money-laundering programs, management reviews, and strategic planning. The economic case is as compelling as ever. Community banks in particular face daunting revenue challenges, including sluggish loan demand, thin lending margins, and competitive pressure from large banks with cheaper funding sources. Conditions on the expense side of the equation are hardly much better, as higher regulatory expectations and technology investment imperatives have made it difficult for companies to cut their way to prosperity. Under these circumstances, a growth model fed by well-planned purchases may be more profitable, and provide a better chance at survival, than one based on organic growth. Unforgiving conditions for mediocre and underperforming banks have created opportunities for healthy, well-managed institutions that are ready to make acquisitions. But the core competencies of acquisition have subtly shifted in recent years. Savvy pricing and quick integration are as important as ever, but banking companies are discovering the increasing importance of a strong risk and control infrastructure to their M&A strategy. Regulatory approvals and a successful integration of a target company hinge on careful planning. Anticipating how an acquisition will influence risk management, internal controls, and compliance requirements can position banks for growth, and eliminate regulatory obstacles that may hold back less prepared competitors. Consolidation is Coming Mike Phleger is a director at Promontory and advises clients on enterprise risk management, compliance, governance, and corporate strategy. The Federal Deposit Insurance Corporation reported that banks 2012 profits were the highest they ve been since , but the industry s largest banks account for a substantial portion of the gains and a significant number of banks are struggling. The accompanying tables illustrate bank performance on some standard industry metrics, and within each size category compares the top and bottom 20% performers with the peer averages. Community banks 2 have always struggled to match large banks in generating noninterest income, but what stands out in these metrics is the performance gap between the best and worst community For the purposes of this article, defined as those with less than $10 billion of assets. WASHINGTON, D.C. ATLANTA BRUSSELS DENVER DUBAI HONG KONG LONDON MILAN NEW YORK PARIS SAN FRANCISCO SINGAPORE SYDNEY TOKYO TORONTO

2 SMALL BANKS LAG IN FINANCIAL AND MARKET PERFORMANCE 70% 60% 50% 40% 30% 20% 10% 0% NII/Operating Income 120% 110% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Efficiency Ratio <$1B $1-$10B $10-$50B $50B-$500B <$1B $1-$10B $10-$50B $50B-$500B 3.5% ROAA 200% Market/Book 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% 180% 160% 140% 120% 100% 80% 60% 40% 20% -1.0% 0% <$1B $1-$10B $10-$50B $50B-$500B <$1B $1-$10B $10-$50B $50B-$500B Top 20% Bottom 20% Average banks on efficiency ratios and return on average assets. Of course, a bank s single-year performance may be the result of unusual circumstances, but there are over 1,200 community banks in the bottom 20% performing well below industry norms, not all due to special factors. For publicly traded banks, the underperformance of the bottom 20% of community banks, as measured by the ratio of market value to equity, is particularly stark. Trading at a substantial discount to book value is likely to leave shareholders dissatisfied. These banks face pressure to either raise their returns or seek a partner who is more efficient or better at generating revenue. Underperforming banks also need to be realistic about the financial consideration they can expect to receive as a seller in this environment. Although healthy, well-managed sellers operating in attractive markets have received premiums to book value in recent transactions, underperformers will typically sell at a discount. PROMONTORY Sightlines InFocus APRIL 30,

3 Healthy community banks have much to gain from acquisitions more so than large banks that cannot meaningfully increase scale through community-bank deals. However, a bank pursuing an acquisition must be prepared to extend the range and scope of its internal controls and risk management to cover a larger and potentially more complex organization to protect shareholder value, reputation, and regulatory relations. The Importance of Risk Management STRONG IS THE NEW SATISFACTORY Leaders of regulatory agencies are sensitive to the difficult conditions that community banks face, but examiners in the field have raised expectations for banks of all sizes. Management processes that may have satisfied regulators in the past may not in the future. The Office of the Comptroller of the Currency has taken the lead in articulating the view that satisfactory risk management is no longer good enough. Though that emphasis has been particularly directed at large banks, this tone seems certain to migrate towards smaller banks especially fast-growing, acquisitive banks and to other regulators. Moreover, the specific risk-management requirements that kick in at the $10 billion threshold (the board risk committee, stress tests, direct supervision by the Consumer Financial Protection Bureau) do not constitute a safe harbor for those beneath it. Risk culture is an increasingly important determination in measuring the effectiveness of riskmanagement programs. Beyond strong processes and procedures, regulators will assess the extent to which the board and management have instilled a culture that is consistent with stated riskmanagement objectives. It is a crucial consideration in acquisitions, because the risk management of the surviving entity will be heavily influenced by the risk culture that survives with it. The bottom line is that acquirers should be prepared for the spotlight and potentially a lengthier approval process when submitting a merger application. WHAT DO REGULATORS WANT TO SEE? Many of the things that regulators want in an acquiring bank are obvious: abundant capital, strong integration skills, profitability, stable funding, and a healthy portfolio. Less obvious, but increasingly important, is a comprehensive approach to risk management that would be considered strong even for the larger, post-acquisition company. This includes: A sound business plan with prudent growth projections based on realistic drivers Internal controls that are well-established and scalable A strong management team An involved board with well-qualified directors capable of posing a credible challenge to management A sound business plan should look at projections and performance drivers over at least the next three years, and include a realistic assessment of what the bank can deliver consistent with its risk appetite in the current market. The plan should carefully explain, support, and analyze expected PROMONTORY Sightlines InFocus APRIL 30,

4 INTERNAL CONTROL TOPICS Accounting systems Bank Secrecy Act/antimoney-laundering Capital plan Compliance Consumer complaints Enterprise risk management External audit Internal audit Inter-company transactions Liquidity-management plan New business and activity controls Vendor management growth, assumptions about new business, and any changes in risk appetite. The plan should present a conservative likely, not best-case view of an acquisition s impact on capital, revenues, expenses, asset/liability composition, and downside risks. When internal controls are well-established, the institution is in a stronger position to enhance those controls to address the risks of a larger and potentially more complex company. The accompanying graphic lists internal-control topics that a bank might typically cover in its business plan. The corporate-governance framework that supports the various control programs is just as crucial as the controls themselves. Checks, balances, and recordkeeping for business activity maintained through people, policies, and organizational and committee structures are essential to making internal controls effective. The all-too-typical diagnosis of a failed initiative or strategy is that the bank possessed good intentions and expertise in abundance, but lacked the governance processes to bring them to bear. Regulators have little patience with managerial disregard for paperwork and committees. A strong management team will convince regulators that it is prepared for the next level of scale and complexity. Tenure at respected organizations within the industry is just as important, if not more so, than tenure at a specific bank contemplating growth. Internal seasoning is valuable, but a growing bank needs to bring in proven performers who have experience at the bank s aspirational size. Many skills learned at large banks cannot necessarily be learned at smaller banks, including: Project-management and integration skills to execute repeated acquisitions without significant snags Information-technology management skills to scale up or integrate one or more small-bank platforms simultaneously The quantitative and governance skills necessary to instill and routinize risk-management processes If critical functions are outsourced because the bank currently lacks the scale to support them, it is important to decide at what scale the function needs to come in-house. Some community banks are just beginning to develop dedicated risk-management and internal-audit teams. These are luxuries at the small end of the asset-size scale, but necessities at any bank growing through repeated acquisitions. The definition of a strong board changes as banks grow. A board of outstanding community leaders is rarely, if ever, the board that can oversee a regional bank. Between the $1 billion and $10 billion mark, regulators expect to see board members with significant industry background who have the capability to challenge management on the nuts and bolts of banking and risk management. PROMONTORY Sightlines InFocus APRIL 30,

5 Community banks that intend to become acquirers should add directors with banking and riskmanagement experience to their boards. The board should demonstrate a record of independence in action, particularly through its compensation and audit committees, as well as the risk-management committee if it has one. The board should consult regularly with key independent managers (for example, the independent auditor and the chief risk officer), as well as outside experts of its choosing. The board should demonstrate sound governance processes by requiring high-quality reporting from management, as well as thorough, written proposals delivered for advance review. Board records should clearly indicate what the board knew and what the board did to execute its duty to oversee the bank. Get an Early Start on New Controls INTEGRATING AN ACQUIRED BANK STRAINS CONTROLS Integrating the portfolio and operations of an acquired bank can be a tricky business. The heart of the exercise may seem as simple as porting the data of an acquired bank into strong host-bank systems, but customers don t always behave according to plan, internal conflicts can emerge, and employees who have institutional knowledge of undocumented processes can leave unexpectedly. Portfolio or other data definitions may not align precisely, even when the two banks share common systems and platforms. Analytical models that were valid for the separate pieces may not behave as expected for the aggregated portfolio. The day-to-day workload of line and support managers will inevitably be heavier. Post-acquisition is not the time to launch new governance processes, implement new policies, roll out new control programs, deploy new risk organizations, or rebuild audit functions these should be done prior to acquisition. These are expensive up-front investments, but waiting until the deal closes always presents a risk of unintended consequences that inevitably compounds the normal disruption of integration. It s far better to have seasoned risk and audit teams on the job with the organization already comfortable with their roles, and processes that are embedded and well-understood by the each business line before facing the stress of combining two banks. BUILD THE LEVEES BEFORE THE FLOOD A bank s strategic business plan is a basic and critically important internal control. The board should fully understand and support the plan. Not only should it detail the bank s expected growth and the risks that the bank is willing to accept, but also the steps the bank will take to build its infrastructure and manage its business and associated risks at it scales up. In the planning process, bank management should compare the bank s present control structure against its future scale, and schedule deployment of risk personnel and resources, policies, and governance practices to anticipate the requirements of the best-case growth scenario. When will the bank need a dedicated chief risk officer? When will it need to upgrade auditing or bring more of internal audit in-house? When will it need to enhance its portfolio-risk metrics and analyses? When will it need the augmented board membership and committee structure to oversee a greater PROMONTORY Sightlines InFocus APRIL 30,

6 and more sophisticated volume of risk information? Developments like these can take time to plan, to gather the people, and to embed in the operating culture of the organization. It s important to build a track record, because demonstrated internal controls may to some extent inoculate a bank against regulatory suspicion of a management breakdown if there are any signs of trouble. Banks with significant growth aspirations should get their operations into shape as soon as possible, especially if the necessary enhancements require thoughtful planning. These steps include: Establishing a strong board and board record of oversight Evaluating managers and upgrading to the standards of a larger institution Investing in accounting, risk management, and operational systems, including scalable technology platforms Considering whether the scale and sophistication of the bank s external auditors are appropriate for its anticipated growth and complexity Strengthening project- and change-management capabilities Evaluating and strengthening the bank s risk culture HOLDING COMPANIES SHOULD PAY PARTICULAR ATTENTION TO INTERCOMPANY GOVERNANCE A new holding company, one acquiring another bank, or one planning to maintain separate operating bank or nonbank subsidiaries should anticipate the Federal Reserve s heightened scrutiny of intercompany governance, not just intercompany transactions. The Federal Reserve is interested in firm-wide risk management and wants a clear roadmap for how the separate companies will make decisions, especially those that may affect affiliates. In all holding companies, management and the boards should focus on detailing and documenting the governance and management of the holding company and subsidiary banks. How will the company protect the bank charter while also managing the strategy of the company as a whole? If the company will make a nonbank acquisition, how will it organize itself to meet its obligations as a financial holding company and, crucially, what will it do to maintain and demonstrate a safe and sound commercial banking culture in the chartered subsidiary? Regulatory Readiness: the Payoff Community banks looking to increase shareholder value may determine that an acquisition strategy is a lower-risk path than an organic growth strategy. However, a sound acquisition strategy includes advance preparation for managing and controlling the company-to-be. Though deals often simmer in the background for a long time, they generally surface suddenly, with an unforgiving timeline for conclusion, and sometimes a fair amount of disruption in the completion. PROMONTORY Sightlines InFocus APRIL 30,

7 Demonstrating the requisite risk-management capabilities and infrastructure or a well-conceived plan to get there improves the chances of securing regulatory approval of an acquisition and of integrating the purchase without disruption. Even if the acquisitions happen more slowly than anticipated or, in a turnabout, the acquirer becomes the acquired, risk-management infrastructure and governance with strength to spare will contribute to the stability of the bottom line and to the inherent value of any bank. Calvin Liu contributed to this article. Contact Promontory For more information, please call or your usual Promontory contact, or: William Haraf Managing Director, San Francisco wharaf@promontory.com Mike Phleger Director, San Francisco mphleger@promontory.com BJ Sanford Managing Director, Washington, D.C. bsanford@promontory.com Mark Schmidt Managing Director, Atlanta mschmidt@promontory.com To subscribe to Promontory s publications, please visit promontory.com/subscribe.aspx Follow Promontory on PROMONTORY Sightlines InFocus APRIL 30,

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