Riding the Rollercoaster

When the stock market took a nosedive in July, the torrid pace of bank mergers skidded along with equity prices. With the bulk of the acquisitions structured as stock swaps, sudden declines of 25% or more in share price took the wind out of buyers’ sails and sapped sellers’ enthusiasm.

The proposed purchase of Peninsula Bank of San Diego by Western Bancorp, a Los Angeles holding company, was one casualty of the turmoil that engulfed the market last summer. On July 24, Western announced that the board of $450 million-asset Peninsula had agreed to Western’s offer to exchange its stock, then at $45.75, for each Peninsula share. The price was rich even by California’s top-of-the-line standards for bank salesu00e2u20ac”about 4.3 times Peninsula’s book value. But then the bottom dropped, and Peninsula’s directors watched in dismay as Western’s shares slid from $43.125 at the time the deal was announced to a low of $25.50 on Oct. 8. Although Western’s shares had rebounded by the end of the month to $31.50, Peninsula called off the deal on Oct. 30.

“It came down to three issues,” John G. Rebelo, Jr., Peninsula’s chairman and chief executive, says of Western’s unsolicited offer. “Price, price, and price. Our bank was not for sale, but they came at us and put a price on the table that we felt we had to look at for the benefit of shareholders, so we did.”

The terms of the transaction allowed Peninsula to reconsider the deal if the companies’ stocks rose or fell by 10% and gave Peninsula the option of walking away if Western’s stock fell to 85% of the offer price or of the Keefe, Bruyette & Woods bank index. It did, and they did, Rebelo says, though not without giving it a lot of thought.

“Our board made two very tough decisions,” he said in an interview shortly after the decision was made. “One was going into the deal to begin with, and the other was coming out of it. But I think we made the right decision both times.”

Even though Western’s stock had recovered from its lows, the market’s ongoing volatility made the smaller bank’s directors uncomfortable with any forecast of where things might stand two months down the line. “We were concerned about where the stock might have been in December, when we took it to our shareholders,” Rebelo says. “It just didn’t meet up with what we thought the shareholders would be kind to. And, of course, many of our biggest shareholders were in the room when the decision was made.”

Turmoil in the financial markets makes for a poor environment for bank mergers, and Peninsula’s directors were not alone in backing away from a deal that, two or three months earlier, had looked like a strong proposition. Investment bankers around the country say that

the number of deals, both announced and under negotiation, dropped sharply in the third quarter and the first part of the fourth quarter. Only in early November, as the stock market appeared to be stabilizing after months of stomach-churning gyrations, did the merger and acquisitions slowdown show signs of abating.

“We see lots of M&A activity among banks in good markets, of course, and we see a lot in bad markets,” says Michael Mayes, managing director and head of Advest’s financial institutions mergers and acquisitions group. “It’s unsettled markets that slow things down.”

From a director’s perspective, market volatility brings to light a whole new bundle of mergers and acquisitions issues. Among these are the structure of a deal, the evaluation of subtle aspects of the potential acquirer’s management strategy and business prospects, and forecasts of broad market trends going forward, based on underlying macroeconomic conditions.

Beyond the fundamental question in any saleu00e2u20ac”whether to pull the trigger at a given point in time or wait in the hope of getting a higher priceu00e2u20ac”volatility complicates such basic issues such as whether a stock swap or a straight cash purchase makes more sense; the appropriate valuationu00e2u20ac”as Peninsula’s directors discoveredu00e2u20ac”of both buyer and seller. Furthermore, there is a need to ensure that a seller is adequately protected against sharp changes in the buyer’s stock price between signing and completing a deal. More than simply putting a monetary value on the accounting benefits yielded to the acquirer in a stock-based pooling of assets, directors must determine whether such a deal will be acceptable to shareholders who will take away a new securityu00e2u20ac”the acquirer’s equityu00e2u20ac”rather than cash, if a deal is completed.

Practical considerations, particularly for a bank considering a buyout proposal, include putting in place mechanisms like pricing collars and performance standards and making sure directors have a firm grasp of the circumstances under which the protections are triggered. Beyond that, directors must evaluate the future prospects of a prospective partner.

“In today’s environment, directors need to ask questions that will give them a really good understanding of how the buying institution and its management intend to manage the stock price of the combined institution,” advises Rick Childs, senior corporate finance manager at Crowe Chizek & Co. in Indianapolis. He says the seller must determine whether the buyer’s management is taking steps to keep its stock price up in a volatile environment. “Are they doing splits to keep the stock at an attractive price?” he asks. “Are they putting stock dividends in place to facilitate buyback programs? Are there dividend reinvestment programs?”

A seller might even ask whether the buyer is actively managing its relationship with the investment banking communityu00e2u20ac”in particular, how effectively it presents its case to Wall Street analysts.

“You need to have the traditional understanding of the core issues,” Childs says. “But in a volatile market, you need to look at how they’re doing in other areas so that you’ll be comfortable even if the market goes bad. The question is, are these guys good enough that I’m going to be glad to have their stock, even if the market goes bad?”

Volatility in the stock market ratchets up the most fundamental difficulties in planning and pricing acquisitions, according to Gregory Benning, managing director in the financial institutions group at Tucker Anthony in Boston. When the stock market hit the skids in late July, Benning says, Tucker Anthony had several clients in negotiations “that were at the point that the principles had agreed that it would make sense to try to put two institutions together, but with all the volatility, it became very difficult to determine what the right price would be.”

As a result of those difficulties, not only did the absolute prices of deals come down, but multiples measuring various relative price comparisons fell, too.

Nationally, Benning found that announced bank and thrift deals since the stock market dropped were at markedly lower prices in terms of premiums paid. Of the small number of transactions done in the fourth quarter prior to Nov. 3, according to Benning, the average ratio of price/book fell to 242.3% from 267.8% in the third quarter; the median P/E ratio of the banks being acquired dropped to 16.2 from 22.1; and the median premium paid by buyers over the seller’s core deposits slipped to 19.33 from 21.28.

Identifying a similar trend, Charles Miller, managing director of Alex Sheshunoff Investment Banking in Austin, Texas says that after peaking at 24 earlier this year, the P/E multiples of bank acquisitions tracked by Sheshunoff has plunged to around 16 now.

“That has put off a number of banks that were in the early stages of a deal,” Miller says. “It’s kind of like the guy who almost had it in his hand, but then it slipped away.”

The sour taste left by the sharp decline in multiples being offered from prior to the market’s sell-off pushed many bankers who had been considering deals out of the market. These bankers have largely stayed away, even as the financial markets have begun to stabilize, Miller says. By contrast, he adds, as the pace of merger and acquisition activity has begun to pick up again, it is the bankers who had not previously expressed an interest in selling who are now testing the waters.

“The ones that went to the sidelines are still there,” Miller says. “What we’re seeing now are new ones coming out of the woodwork. These were people who were not chasing the bubble, and now they’re saying that it might not be so bad to take a stock that’s trading at 15 times earnings, even after the adjustment. In fact, these sellers are saying they are more comfortable taking a stock that’s trading at that multiple than they did considering one earlier in the summer that was trading at 22 times earnings, or even higher.”

While the pace of merger and acquisition activity midway through the fourth quarter remained far behind levels earlier in the year, investment bankers cited several factors that could quickly lead to a resumption.

“From a bottoms-up basis, I see a lot of value in community banks’ shares and in some of the regional banks that were taken down with the general market’s selloff,” said James Miller, managing director of Brookstreet Securities in Irvine, California. “A lot of that was because of problems at money-center banks that had nothing to do with them. And that was absolutely silly.”

Eric Hovde, president of Hovde Financial, describes a possible response on the part of potential sellers whose share prices may have stabilized at lower levels following the market turmoil of the previous quarter: They may view it as an opportunity. “They may now recognize that although the pricing values that the market has had through 1997 and 1998 were at all-time highs, things can change quickly. This has been a shock to a number of boards of directors, who have suddenly found that they can’t get too comfortable. They may decide that now is the time to take their chips off the table.”

Adds Sheshunoff’s Miller: “There are a couple of questions other than the relative price. If the alternative is to wait for another cycle, then when will that cycle come? And will there be buyers? If you’re thinking about deferring a deal, you have to consider that these are still good prices in comparison to decades of deals.”

Financial advisers, accountants, and lawyers active in the mergers and acquisitions area all report an increase in expressions of interest on the part of buying and selling banks in cash deals after the market dropped. Some predict that more deals would be done for cash instead of stock in the coming months.

For buyers, lower stock prices magnify the dilution issue inherent in stock swaps, while sellers may be reluctant, given an unsettled market, to accept a heavy investment in the acquirer’s shares.

“I think we’ll see a clear uptick in the number of cash deals in the next six months versus what they’ve been in the last six months,” Hovde said. “Sellers are going to say that they don’t want to take the market risk and that they don’t want to be heavily invested in an acquirer’s stock. Second, in cases where the acquirer’s stock is still off sharply from last spring, they may look at a transaction differently, because it may be more dilutive on an earnings basis.”

The question of whether a seller should take stock or cash, adds Frank Conner III, a partner in the Washington, D.C. law firm of Alston & Bird, remains at the heart of any decision to sell, regardless of market conditions, insofar as it reflects on the most basic of issues: control. “That really is the first issue,” he says. “One, should I be ceding control of my business; two, what is the value of the security I am getting; and, three, how can I be sure I will get that value on the day of closing?”

For directors, who must be concerned about liability issues in considering acquisition propositions, volatile markets magnify the importance of receiving sound outside advice, says Mark Barnes, a partner with Leagre Chandler & Millard, a law firm in Indianapolis.

“The key point is not to go it alone, particularly in a community bank setting,” Barnes says. “We have seen lots of boards of directors that think they can go ahead and negotiate deals themselves, and that really can be very risky to their pocketbooks.

“It’s not a question of whether they can negotiate a good deal, but more a question of prudence,” he continues. “The law requires that a board be able to show that it had a good defense for the decisions it made.”

Most professionals expect the slowdown in merger activity to abate quickly enough that it will be little more than a memory by early 1999. And that, they say, is as it should be in an industry still in the midst of top-to-bottom consolidation.

“We’re in one of those waves we’ve seen several times over the last 10 years,” says Scott Anderson, managing director and head of the financial institutions group at Wheat First Union. “Market volatility leads to less deal activity, and as that volatility abates, deal activity picks up. The basic underlying principals of bank mergers and acquisitions have not changed.”

Peninsula’s Rebelo notes that his bank has received expressions of interest from potential buyers several times over the years and says he would not be surprised to get more, though continued independence certainly remains an option. Every case is unique. “Directors have an obligation that, if somebody comes along who really does feel you would fit well with them, and puts an offer on the table, to take a close look at it,” he says.

At Western Bancorp’s headquarters in Los Angeles, meanwhile, the president and chief executive, Matthew P. Wagner, says his institution’s strategy of growing by buying smaller banks remains in place, even after the failure of its bid for Peninsula.

“We’ll make acquisitions as long as they can be positive for shareholders and accretive to earnings,” Wagner says, adding that he sees plenty of potential merger partners even in an unsettled market. Earlier in October, for example,Western agreed to buy Pacific National Bank, a $275 million institution in Newport Beach, California, for $74.2 million in stock. That deal, he says, is based on a fixed exchange rate of one share for one share and is on track to close in early 1999.

“The main reason to put banks together is that the whole is greater than the sum of its parts,” Wagner says. “The difficulty in a turbulent market is that multiples may change, and something that made sense at four times book 120 days ago, may not make sense, even at three times book, today.”