By Jonathan Hightower and Robert KlinglerAt the beginning of each year, the banking industry awaits the next series of twists and turns in the bank merger and acquisition market. Recent years have seen the industry emerge from distressed deals into an era of consolidation focused on the pursuit of growth amid tepid loan demand. Now, the industry is thriving as regulatory relief and a surging economy put wind in the sails of banks across the nation.
At the end of 2018, M&A is being driven by true optimism about the future prospects of the industry along with a search for stable deposit funding to pair with improving loan demand. Below, we present our three top drivers of mergers and acquisitions for the banking industry in the year ahead.
Metro markets will see more large deals
As acquirers pursued targets in markets that offered expanded growth potential over the last several years, deals in metropolitan markets dominated the landscape of bank M&A. Many of the most prolific acquirers were publicly-traded bank holding companies with less than $10 billion in assets looking to continue to fuel their growth by creating or deepening their presences in fast-growing markets by acquiring a well-performing community bank located in that market. The U.S. banking landscape, with numerous banks holding under $1 billion in assets, offered plentiful opportunities to combine with a smaller bank—one that was itself looking to access the performance and stock liquidity offered by a larger, publicly traded partner.
In 2018, this tried and true formula ran into a problem, particularly in markets that were traditionally home to large numbers of small banks: there was simply too little product available for purchase. It wasn’t just increased optimism about the operating environment that was making banks less willing to sell (although that was undoubtedly a factor). Instead, the run of merger activity combined with a slow return to interest in the creation of de novo banks meant there were fewer and fewer small banks to acquire in interesting markets. Plus, many serial acquirers have now reached a size themselves that makes buying banks below a certain asset size inefficient for them.
This trend, along with the willingness of longstanding acquirers to look toward selling as they sense the economic cycle turning in the foreseeable future, means that metropolitan markets are bound to see an increasing share of larger deals. On the buyer side of the equation, there is reason to believe that larger banks will enter the fray to combine with those now-willing sellers. As a result of S. 2155, larger banks will no longer feel the pressure of the arbitrary barrier of reaching $50 billion in assets, thereby creating more interest in growth through M&A at the larger end of the scale.
New contenders will be on the rise
As larger banks focus their efforts on metropolitan and suburban markets, an opportunity has arisen for well-performing smaller banks. Many of these banks are situated in exurban and rural markets and are armed with a wealth of well-priced and stable deposits. With this solid funding base, these banks will look to move into suburban markets through acquisitions of banks that are either too small to attract attention from more established acquirers or that prefer the opportunity of combining with a smaller, community-oriented institution.
This new generation of acquirers, perhaps previously overlooked because of the markets in which they operate, have all the elements to launch successful M&A campaigns. Many of them have dynamic management teams, strong capital, favorable regulatory standing and a culture that allows a partner’s management team to contribute meaningfully to the success of the organization.
From a financial standpoint, the attractive funding base and relatively low loan-to-deposit ratios of many of these banks give them tremendous upside when combining with a bank offering significant prospects for loan growth in a suburban market. Moreover, applying the Federal Reserve’s Small Bank Holding Company Policy Statement to companies with assets of up to $3 billion, as S. 2155 did, gives these BHCs the financial flexibility to use more debt in acquisitions, providing the potential for enhanced returns to equity holders. Finally, the equity markets have opened for these smaller institutions, allowing for a realistic strategic plan involving an initial public offering and a true public currency.
Many have observed that banks with the best deposit funding bases will be the most attractive targets in M&A transactions. We look for many dynamic rural banks with outstanding deposit bases to instead become more aggressive acquirers in 2019.
Small rural banks will be transformed
Many of us have observed with considerable trepidation the plight of small, rural banks situated in markets with declining populations and deteriorating economic outlooks. These banks are now surviving on the margins, focusing on efficiency to enhance operating results. While such tactics can result in acceptable earnings and risk profiles, opportunities for a liquidity event through a sale transaction appear bleak for many of these banks.
While turning the tide on the economic prosperity of many rural markets is a challenge too large for individual banks to address, there is renewed hope for finding a strategic opportunity for a sale or other transformational transaction. This opportunity will come in the form of successful bank management teams who have sold their banks, left the acquiring institution, and are now looking to reenter the industry. As much as many industry participants—regulators included—want to see the trend of increasing de novo charter applications continue, the acquisition of small, rural banks provides a tremendous alternative to interested groups.
By acquiring or partnering with such a bank, a management team can capitalize on the existing earnings stream of the small bank as it gathers the resources it needs to execute on its business plan. This mode of operation contrasts starkly with the de novo process, in which expenses pile up with no revenue offset while regulatory applications are pending. In addition, these banks are typically situated in markets that are not covered by an executive’s non-compete restrictions, allowing management teams to “stay in the game” of banking while their non-competes run. When these deals can be found, they offer tremendous mutual benefits and an excellent alternative for each party.
Overall, we believe that 2019 will be filled with a wide variety of interesting transactions. Buoyed by a robust economy and supportive regulatory environment, we look forward to seeing the creative transactions that industry leaders strike.
Jonathan Hightower and Robert Klingler are partners in the financial services practice of Bryan Cave Leighton Paisner in Atlanta.