Last year’s election results—with promises of higher interest rates, reduced regulatory burden and a lower corporate tax rate—set bank stocks on fire and fueled a resurgence in bank M&A activity. Not surprisingly, bank stock performance and deal activity have always been highly correlated. When the markets are up, buyers take advantage of their stronger currencies to pursue sellers looking to lock in a premium valuation.
Since the election, 31 deals, each over $100 million in value, have been announced, the most prolific period for deals of that size since 2007. Pricing has been meaningfully higher than in previous years, with a number of sellers valued at more than 2 times tangible book value (TBV) and mid- to high-20s earnings multiples. Despite higher pricing, these deals were initially well received by investors. On average, buyers in the first 10 deals saw their stocks outperform the KBW Regional Bank Index by about 2.5 percent in the week following the announcement and by about 5 percent to date. Since then, however, outperformance has been more the exception than the rule.
Without question, macro factors are at least partially responsible for the shift in sentiment. After a run-up in the bank index of nearly 30 percent that ended in late winter, the index has since given back about one-quarter of those gains. Concerns about President Trump’s ability to advance legislative reforms and a flattening yield curve—to name two factors—have dampened the initial hysteria. In terms of M&A, investors would rather their banks sell than buy at what they see as inflated valuation levels.
But macro factors alone don’t tell the entire story. The primary distinguishing factor between well received and poorly received deals has been, almost exclusively, deal pricing. On average, post-election buyers who paid less than the median price/earnings (P/E) multiple of 24 times outperformed those who paid more by approximately 3 percent in the week following announcement. Even more significantly, banks that paid less than 20 times earnings outperformed banks that paid more than 25 times earnings by approximately 6 percent one week following announcement. The best performing deal—Veritex Holding’s acquisition of Sovereign Bancshares (up approximately 22 percent as of mid-June)—priced at under 20 times earnings.
What’s more surprising is that—notwithstanding the emphasis placed on earnings per share (EPS) accretion, TBV dilution and TBV earnback by the banking community—the market’s reaction to a deal does not appear to hinge on those metrics. To be sure, the best performing deals included significant EPS accretion and reasonable TBV earnback periods. But those appear to have only been necessary, not sufficient, criteria for a well received deal. For example, Simmons First National Corp.’s acquisition of Southwest Bancorp in December 2016 boasted of a 2.5 year TBV earnback period yet underperformed the bank index by 6 percent the day following announcement. Investors were focused more on pricing (approximately 30 times earnings) than the pro forma financial impact.
So why does pricing trump pro forma financial impact when it comes to market reaction? The transaction P/E multiple tells investors what the buyer paid for the target before the benefit of any post-merger adjustments. When the transaction P/E multiple is high relative to the acquirer’s P/E multiple, investors can infer that any EPS accretion—assuming a stock deal—is coming from post-merger initiatives such as cost savings, balance sheet restructurings or liquidity redeployment. Whether or not there’s risk to achieving these initiatives, the acquirer’s investors would prefer not to pay the target’s investors for benefits that the target failed to achieve on its own. In other words, investors want their banks to pay for the target’s stand-alone contribution, not for what they can do with the target after it has been integrated.
With some exceptions, the investment community’s singular focus on transaction pricing feels overly punitive. In the long run, value depends on the spread between a bank’s return on equity and its cost of equity. Putting leverage aside, this means that valuations ultimately depend on return on assets (ROA) and growth, regardless of the source. An M&A transaction that increases ROA and growth by more than the acquirer can achieve on a stand-alone basis is a good use of capital that should create value in the long run. Of course, the acquirer should aim to pay as little as it can to realize those benefits. But a high transaction P/E multiple should not be an impediment to an otherwise attractive deal.