M&A DILIGENCE CONSIDERATIONS: IS WHAT YOU SEE WHAT … diligence.pdf · › Since then, credit...

©2015 Navigant Consulting, Inc. All rights reserved.

David W. Giesen

Managing Director

M&A DILIGENCE CONSIDERATIONS:

IS WHAT YOU SEE WHAT YOU GET

©2014 Navigant Consulting, Inc. All rights reserved.©2015 Navigant Consulting, Inc. All rights reserved.

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!


WHAT’S HAPPENING


MARKET TRENDS

» Banks in “these parts” (Oregon and Washington) are performing better

than in recent years

› Good loan growth

› Stronger ROAA

› Lower NPAs

› Negligible chargeoffs

0.55

0.85

1.06

- 0.50 1.00 1.50 2.00

Oregon/Washington BanksSecond Quarter ROAA Quartiles

4.50%

17.4616.56

15.35

10.21 8.91

-1.61 -4.35 -2.891.89

3.42

7.57

-5.00

0.00

5.00

10.00

15.00

20.00

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Median Oregon/Washington Bank Loan Growth(Percent of Prior Year Loans)


MARKET TRENDS

» 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)

0.24

0.13

0.09

0.22

1.52

3.28

3.91 4.02

3.66

2.16

1.36

-

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Median Oregon/Washington NPAs(Percent of Assets)

0.10 0.04 0.01 0.02

0.27

1.14

1.01

0.88

0.44

0.14

0.08

-

0.20

0.40

0.60

0.80

1.00

1.20

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Median Oregon/Washington Charge-Offs(Percent of Assets)

1.24 1.21 1.21 1.15

1.41

1.82 1.92 1.95 1.85

1.63

1.47

-

0.50

1.00

1.50

2.00

2.50

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Median Oregon/Washington ALLL(Percent of Assets)


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?

-

50.00

100.00

150.00

200.00

250.00

300.00

2000 2002 2004 2006 2008 2010 2012 2014

Oregon/Washington Average Price/Book Ratios

-

5.00

10.00

15.00

20.00

25.00

30.00

35.00

2000 2002 2004 2006 2008 2010 2012 2014

Oregon/Washington Average Price/Earnings Multiples


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?

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

All OR/WA Banks 1-3 Quartile

Comparative Asset CAGR2004-2014

-

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

2004 2014

Assets Per Employee

All OR/WA Banks 1-3 Quartile


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

2.90

3.00

3.10

3.20

3.30

3.40

3.50

3.60

3.70

3.80

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Comparative Operating Costs(as a percent of average assets)

Quartile 1-3

Quartile 4(Large)


LOAN TRENDS


MARKET TRENDS

» 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

-21.95%

-4.86% -4.72%

-3.11% -2.63%

-25.00%

-20.00%

-15.00%

-10.00%

-5.00%

0.00%

2011 2012 2013 2014 2015 YTD

Navigant ClientsAverage Credit Discounts 2011-2015

-0.50%

1.62%

0.15%

-0.78%-0.66%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

2011 2012 2013 2014 2015 YTD

Navigant ClientsAverage Interest Rate Premiums/Discounts

2011-2015


MARKET TRENDS

» PCI (ASC 310-30) loans have decreased substantially among our clients

› So far this year, PCI loans have been 2.30% of total loans

› Means ASC 310-30 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

5.66%

15.50%

10.79%

6.78%

2.30%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

2011 2012 2013 2014 2015 YTD

Navigant ClientsPotentially Impaired Credit/Total Loans

6.06x

2.77x2.49x

1.61x 1.54x

-

1.00

2.00

3.00

4.00

5.00

6.00

7.00

2011 2012 2013 2014 2015 YTD

Median Credit Discounts as a Multiple of ALLL


TODAY’S CREDIT


TODAY’S CREDIT

History

ExperienceReview

» 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


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

2017-2019: CECL

Timeline of Significant Events


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?


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


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?


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?


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?


BRIDGING DIFFERENCES



Acquired Loan Portfolio

ASC 310-20 (“FAS 91”)

- Historical Charge-offs- Loss Factors- Loan Reviews/Analyses- Market Conditions

PCI- Appraisals- Disposal Costs- Transaction Expenses

Discounts Based On:

» 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



» 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

Loan Category 4 3 2 1 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 10,016$ 0.63 2.12% 134$ 1.33%

One to Four Family Residential 53,415 6.22 1.14% 3,788 7.09%

HELOCs 50,867 1.70 0.95% 819 1.61%

Commercial Real Estate 392,243 11.11 0.12% 5,229 1.33%

Consumer Loans 94,555 1.76 0.92% 1,535 1.62%

C&I Loans 139,819 2.44 0.91% 3,096 2.21%

Total 740,915$ 2.79 14,601$ 1.97%

Net Chargeoffs by Year Before Acquisition



» 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



» 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?


THANK YOU


FOR MORE INFORMATION:DAVID W. GIESEN

MANAGING DIRECTOR

NAVIGANT CONSULTING, INC.30 SOUTH WACKER DRIVE

SUITE 3100

CHICAGO IL 60606

(312) 583-2602

[email protected]

M&A DILIGENCE CONSIDERATIONS: IS WHAT YOU SEE WHAT … diligence.pdf · › Since then, credit...

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