M&A DILIGENCE CONSIDERATIONS: IS WHAT YOU SEE WHAT YOU GET

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1 M&A DILIGENCE CONSIDERATIONS: IS WHAT YOU SEE WHAT YOU GET David W. Giesen Managing Director

2 INTRODUCTION» Welcome Back.! Mergers and Acquisitions are back in vogue in Oregon and Washington after a couple of off years You re profitable You re growing so: You re attractive again!» But. Financial Dating and Marriage isn t what it used to be The accountants want more You need to know more You want the deal to be better! Page 2

3 WHAT S HAPPENING

4 MARKET TRENDS Oregon/Washington Banks Second Quarter ROAA Quartiles % Median Oregon/Washington Bank Loan Growth (Percent of Prior Year Loans) » Banks in these parts (Oregon and Washington) are performing better than in recent years Good loan growth Stronger ROAA Lower NPAs Negligible chargeoffs Page 4

5 MARKET TRENDS Median Oregon/Washington NPAs (Percent of Assets) Median Oregon/Washington Charge-Offs (Percent of Assets) Median Oregon/Washington ALLL (Percent of Assets) » Asset quality and financial condition Looking Good! Charge-offs are non-existent Strong loan reserves about 1.47% of average loans or about four years coverage based on recent trends (2011 to 2014) Page 5

6 MARKET TRENDS» Pricing ramped up averages up from 68% of tangible book to 157.2% in 2014» Impact of stronger balance sheets, better local and regional economies and better stock prices with stronger abilities to pay» P/E is between 20x and 25x trailing 12 month earnings» Key Considerations Cost take-out how much is reasonable? Announced take outs since 2012 are a median of 30% Revenue synergies also driving pricing the old can I lay my fee structure and services over their clients question How strong is the market? Oregon/Washington Average Price/Book Ratios Oregon/Washington Average Price/Earnings Multiples Page 6

7 MARKET TRENDS» Key Issue: Acquirer or Target?» Key issue: Can a bank grow to a size to cover the administrative costs associated with today s banking environment?» Some size based considerations Overall compound average asset growth in Pacific Northwest Banks has been 12.2% since 2004 But: Banks of less than $600 million in assets in 2014 have grown at CAGR of 7.2% Large banks have grown at a rate of 13.6% Smaller bank employees are comparatively less efficient, with one employee per $4.0 million in assets, versus $5.0 million for larger banks What additional compliance burdens will be placed on community banks?» Big issue: Can you work your market better than someone else can? 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 - Comparative Asset CAGR All OR/WA Banks Assets Per Employee 1-3 Quartile All OR/WA Banks 1-3 Quartile Page 7

8 MARKET TRENDS» Conclusion: Target or Acquirer:» Acquirer if: Your Bank has access to capital Your Bank s asset quality is good and any past problems are all cleaned up Your Bank s performance is strong Your Bank s Management and Board have a clear vision of where your bank is going and how you intend to get there You have strong growth and can only hope to get stronger with a deeper franchise» Target if Your Bank has an announced transaction Your Bank s ROAA shows no long-term trend toward 100 bps Your Bank s costs are comparatively high and shows no capability to be reduced Your Bank still has lingering asset quality problems Your Bank has a comparatively small legal lending limit and there s growth in your Bank s markets Your Bank s Board of Directors is tired and your Management has limited succession opportunities Comparative Operating Costs (as a percent of average assets) Quartile 1-3 Quartile 4 (Large) Page 8

9 LOAN TRENDS

10 MARKET TRENDS 0.00% -5.00% Navigant Clients Average Credit Discounts % -4.72% -3.11% -2.63% 2.00% 1.50% Navigant Clients Average Interest Rate Premiums/Discounts % % 1.00% % % % % YTD 0.50% 0.00% -0.50% -1.00% 0.15% -0.50% -0.66% -0.78% YTD» With improving credit, overall credit discounts are improving 2011 was a resolution year and we saw huge credit discounts Since then, credit discounts have fallen to 2.63% for a sample group of Navigant transactions in 2015 Interest rate adjustments have hovered between +1% and -1% since 2011 Page 10

11 MARKET TRENDS 18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% Navigant Clients Potentially Impaired Credit/Total Loans 5.66% 15.50% 10.79% 6.78% 2.30% YTD Median Credit Discounts as a Multiple of ALLL 6.06x 2.77x 2.49x 1.61x 1.54x YTD» PCI (ASC ) loans have decreased substantially among our clients So far this year, PCI loans have been 2.30% of total loans Means ASC follow-up will be relatively modest in the years ahead» Finally, credit discount multiples to Allowances for Loan Loss also are decreasing substantially Credit discounts are 1.54x ALLL this year and 1.61x ALLL last year Page 11

12 TODAY S CREDIT

13 TODAY S CREDIT» A dynamic credit assessment is essential to supporting acquisition credit discounts» Evaluations should consider three components in creating a discount: History, including not only what the target s NPAs and charge-offs are showing, but what does your bank s and market participant data show Experience, focusing on what your track record has been with types of credit Review, centering on what your bank will find in a credit review Has the condition of credits of the target changed? Acquisition Credit Triad History Review Experience Page 13

14 TODAY S CREDIT June 2001: SFAS 141 Promulgated Eliminates pooling of interests accounting Requires fair values on all assets and liabilities acquired December 2003: SOP 03-3 Creates new requirements for impaired assets September 2006: SFAS 157 Defines Fair Value December 2007: SFAS 141R Clarifies purchase accounting Prohibits carryover of ALLL April 2014: PCAOB publishes comment paper Identifies severe weakness in fair value reporting Seeking ways to improve review of audit work 2015 and Beyond: Possibility of significant changes in how credit discounts are reviewed : CECL Timeline of Significant Events Page 14

15 TODAY S CREDIT» Review: Review focus is on credit quality measurements: Debt coverage ratio Loan-to-value ratio Debt/Income ratio Comprehensive nature of the credit files» What is a Target s philosophy in lending? Coverage or Income lender? Collateral lender is the loan contingent on a liquidation of underlying collateral O/O or an investor property? Page 15

16 TODAY S CREDIT» Review (Continued): What does a target s past say about its future? Charged-off loans Make sure your diligence team reviews a good sampling of past problems Why did the loans go bad? Borrower cash flow/collateral problems, underwriting, administration, documentation Were there trends in the files and in the data that suggested problems were coming? How long was the lag between the end of the year and the receipt of borrower financials? How did loan officers/credit administrators maintain contact with the borrower? Few banks conduct loan autopsies during due diligence this is a concern we have in our valuation/diligence work Page 16

17 TODAY S CREDIT» Review (Continued): Their loan policy and your institution s loan policy Can you effectively bridge grades? Do this before actually reviewing loans.. Your 4 is the Target s? How consistent is the Target s grading? Page 17

18 TODAY S CREDIT» Experience: Has your bank experience with the same types of loans that are found in a Target s portfolio? Classic Example Hospitality loans Includes gas station convenience stores, restaurants and hotel/motels Were hit hard in the last recession Problems with cash flow and borrower guarantees One client: These are automatically 5 graded loans (on a 9 point scale) Internal problems with hospitality loans were so great that these loans were graded in a way that focused extra attention on them Key Issue: Does a 5 graded loan mean higher allowances? How would you justify this, given the underlying performance of the loans themselves? Page 18

19 TODAY S CREDIT» Experience: Does your experience translate well into the acquired loan portfolio Function of: Policy and administrative differences Exceptions when and where? Geography Portfolio Conditions How does their performance compare to your bank s? Is it translatable into an effective measure of loan discount for a Target? Page 19

20 TODAY S CREDIT» Experience: Does your experience translate well into the acquired loan portfolio Function of: Policy and administrative differences Exceptions when and where? Geography Portfolio Conditions How does their performance compare to your bank s? Is it translatable into an effective measure of loan discount for a Target? Page 20

21 BRIDGING DIFFERENCES

22 BRIDGING DIFFERENCES Acquired Loan Portfolio ASC ( FAS 91 ) PCI Discounts Based On: - Historical Charge-offs - Loss Factors - Loan Reviews/Analyses - Market Conditions - Appraisals - Disposal Costs - Transaction Expenses» Road Map Traditionally, FAS 91 (non-impaired) loans were evaluated based on grading, type and a buyer s FAS 5 factors Are you FAS 5 factors life of the loan loss estimates? Do they reflect the experience of the Target as well as the Acquirer? Do they reflect market participant measures for similar credit Page 22

23 BRIDGING DIFFERENCES» Validation Consider the target s loss estimates across periods Develop averages that show the annual performance of the portfolio over time Apply to the portfolio as a benchmark Net Chargeoffs by Year Before Acquisition Loan Category Average Construction and Development 2.20% 3.65% 3.00% -0.38% 2.12% One to Four Family Residential 1.20% 1.72% 0.76% 0.88% 1.14% HELOCs 0.23% 0.52% 1.01% 2.03% 0.95% Commercial Real Estate 0.22% 0.15% 0.13% -0.02% 0.12% Consumer Loans 1.25% 0.93% 1.01% 0.50% 0.92% C&I Loans 1.78% 0.29% 1.28% 0.28% 0.91% Net Charge-offs 0.94% 0.97% 0.73% 0.18% 0.71% Loan Category Balance (000s) Wtd Maturity (yrs) Charge-off Factor Credit Discount (000s) Disc/ Loans Construction and Development $ 10, % $ % One to Four Family Residential 53, % 3, % HELOCs 50, % % Commercial Real Estate 392, % 5, % Consumer Loans 94, % 1, % C&I Loans 139, % 3, % Total $ 740, $ 14, % Page 23

24 BRIDGING DIFFERENCES» Analysis Compare multiple results to determine market participant, your measures and other factors How do the results compare to each other? Market participant develop a group of guideline companies similar in nature to the seller s loan portfolio Guideline had 22 companies, pulled 5 to 15 years of data for evaluation Result in this case was $14.0 million of credit discount Type of Analysis Source Amount (000s) Target Allowances History $ 11,000 Target Four Year History 14,601 Target Ten Year History 15,000 Guideline Four Year History 13,200 Guideline 10 Year History 16,000 FAS 5 Test -- Buyer Experience 19,000 Portfolio Review Review 13,750 Average $ 14,650 Median 14,601 First Quartile 13,475 Third Quartile 15,500 Page 24

25 BRIDGING DIFFERENCES» Actual Situation Bank was consummating a transaction in which the target bank had net charge-offs in the first chart The buyer thought a credit discount of nearly 7% would be appropriate What has the bank done to document this? What s in the portfolio that the target s auditors and probably regulators missed? How would you sell your conclusions? Page 25

26 THANK YOU

27 FOR MORE INFORMATION: DAVID W. GIESEN MANAGING DIRECTOR NAVIGANT CONSULTING, INC. 30 SOUTH WACKER DRIVE SUITE 3100 CHICAGO IL (312)