Bottling the Magic of Small Bank Success

January 16th, 2017

community-banks-1-16-17.pngIn 1871, the Great Chicago Fire destroyed much of the city, including the Merchants Savings Loan and Trust Company building, but not before its president and two clerks rescued $4 million—roughly $75 million today—from the vault. In the aftermath of the fire, the bank reopened for business without any of its records. However, the bank took the word of its customers on the balance of their accounts and paid out all accounts in full. Other banks affected by the Great Chicago Fire offered to only pay 25 cents on the dollar for unverified accounts.

Like Merchants Savings Loan and Trust Company, smaller community banks have been at the heart of America’s growth and prosperity for hundreds of years and are integral to their communities. Their lending and banking services enable small business growth through trust, creativity, flexibility and appropriate risk-taking. These small banks often lend to borrowers based on firsthand insight into the loan quality and an understanding of the people behind the venture.

Although these institutions play a critical role in today’s economy, sometimes they’re in a position where finding a larger partner is warranted. At the end of September 2016, there were 100 transactions involving target banks with less than $150 million in assets. These banks sold at an average of 19.21 times earnings and 1.16 times tangible book value. There are currently more than 2,000 banks in the U.S. with less than $150 million in assets.

Each of these banks presents a unique set of opportunities and challenges to a prospective buyer. Often, small bank transactions involve close-knit ownership, competitive concerns, high-level community and institutional pride, long-standing traditions, noneconomic considerations and size-appropriate record keeping and compliance challenges. Navigating these issues can be difficult. Staying disciplined and focused on the underlying, future-earnings capacity drivers of the target bank can help buyers traverse some small bank acquisition challenges.

Historical measures and balance sheet assessments are foundational to the value discussion and can often help predict the risks and growth likely associated with future earnings, but the assessment shouldn’t stop there. Beyond the foundational work on the balance sheet and income statement of smaller banks, we see two key drivers of current performance that buyers need to deeply understand to fully assess the future earnings opportunity presented by a smaller bank—customer relationships and institutional flexibility.

Large, successful banks often have well defined competitive advantages, high-performance cultures, cutting-edge technology, a deep menu of financial products and services and other easily identified performance drivers. They’re like battleships with significant momentum and are likely well positioned to weather institutional and environmental changes. However, a small bank’s performance drivers may be harder to identify and quantify—the magic may be more difficult to bottle.

It’s one thing to see quality loans on the balance sheet and a healthy net interest margin on the income statement; it’s another to understand what’s driving such success. Some small banks have been able to maintain solid net interest margins because of customer relationships that reflect deep, long-standing connections between the bank and important customers. Maintaining and enhancing these are likely key to future earnings opportunities for a new buyer. Alternatively, some small banks have carved out profitable niches through institutional flexibility: being ultra-responsive to customer needs, lending to small businesses or those in difficult situations, providing flexible rates and terms or making quick decisions with small groups of key decision makers.

Likely, the success story of a small bank involves some measure of both customer relationships and institutional flexibility. However, it’s imperative that the buyer understands the exact performance driver mix—the magic—that the small bank has developed.

This understanding will likely have a direct impact on valuation as the buyer adjusts its inputs for asset growth rates, cost synergies, profitability, deposit runoff and capital structure in the acquisition model. While pursuing a small bank acquisition can present challenges, there are also significant opportunities for those who understand how to measure and bottle the magic of small bank performance.

This article is for general information purposes only and is not to be considered as legal advice. This information was written by qualified, experienced BKD professionals, but applying this information to your particular situation requires careful consideration of your specific facts and circumstances. Consult your financial advisor or legal counsel before acting on any matter covered in this update.

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Wyatt Jenkins is a vice president with BKD Corporate Finance LLP.