A few weeks ago, a writer for a banking magazine asked my top five challenges to a successful bank merger. That is a loaded question! The challenges to complete a merger agreement, the challenges to close the merger, and the challenges to make the merger a long-term success are all different. What stands in the way of successfully completing the merger? Here are my top five.
 
1. Due diligence, due diligence, due diligence.
Like the old adage about the three most important considerations in real estate (location, location, location), thorough due diligence is the most important factor in successfully completing a merger and avoiding unhappy post-merger surprises. And, it happens both ways.
 
Usually, the buyer finds something about the seller it did not expect and does not like. Sometimes this just affects the price, but when the seller brags to its shareholders about the price, it is difficult for management to accept less. The buyer may find that lending standards are looser than it believed. It may find that something in the accounting practices are inconsistent with how the buyer does business. This is particularly common when the seller is an SEC-reporting company and the buyer is not. The buyer may find that the seller is concentrated on a local industry that is waning.
 
Similarly, the seller may find that the financial basis for the buyer (and therefore, the stock price) is questionable. It may talk to a previous seller and learn that the buyer is misrepresenting itself. The seller or buyer may find the cultures are not compatible.
 
I’ll address many of these below. A bank that prepares its financials conservatively, discloses good and bad developments as soon as it is sure of them, runs its lending practices with discipline, and rewards management fairly (but not lavishly), should do fine. If the bank intends to put itself up for sale, it should prepare a digital due diligence folder and consult an attorney about its duties before seeking the best long-term deal.
 
2. Lending practices.
All banks are highly regulated, but some community banks still find ways to cover loans to weak borrowers. Most of the really bad loans from pre-2008 worked through the system during the Great Recession and the resulting Non-Recovery. A few have not. In addition, although bad loans may have been resolved (written off or down), many banks have not taken the hard steps of fortifying their lending practices and staff. Because new good loans are still few, banks acting too aggressively restock more bad loans. The buyer sometimes finds that, although the balance sheet is relatively clean now, the lending practices predict hidden or future problems. (See number 1 above for the importance of thorough due diligence.) That process should include a detailed review of lending practices.
 
3. Price.
This worm has turned very rapidly. Two years ago, any bank with a history of lending problems could not find a buyer, unless a regulatory agency brokered the deal. This included most community banks, since all banks were damaged by the Great Recession. Sometime during the past year that seemed to shift very rapidly. Now, some community banks with prior histories of bad loans, and even public regulatory problems, are receiving premium offers! What happened?
 
I think two things happened. First, larger, healthy regional and community banks have been sitting on capital. Enough good loans have not been available in which to invest that capital. Those banks have been afraid to unleash it on acquisitions, in part because the regulatory deal quagmire was quite deep. Deals (not brokered by a federal bank regulator) could take nine to 12 months or more, because of the levels of approval required for any deal. That regulatory delay seems to be resolved. Now it is common to complete a bank merger in six months. That shortens the lead time and makes a deal more predictable for the buyer; not as much time for something to go wrong.
 
Second, community banks have had enough time to clean up bad loans, correct procedures, pay off TARP, etc. Buyers now feel more comfortable that they are not buying a problem. Buyers are paying good premiums for what they perceive as good banks.
 
However, this raises expectations with sellers and their shareholders. Every bank is not worth 1.5 – 2.0 X Book (or more!). Some, due to location, lending practices, low (or high!) capital, unfavorable management compensation or competition, are worth less. Some public deals have been announced close to 2 X Book. That may make it difficult for a bank president to justify a lower premium to her board. Some deals that should get done don’t, precisely because expectations are too high. This truth also applies when the buyer finds something negative in due diligence and asks for a price adjustment. Management worries that the adjustment will send a message that management screwed up something, when really the price was too high all along. So many factors affect pricing a bank merger. This makes it difficult to compare two deals.
 
4. Management.
Management, particularly senior officers, sometimes worry about themselves. This is understandable. But, there often is not a place for the entire team in the new bank. The buyer doesn’t need two CEOs, CFOs, COOs, etc. This can create friction. How much is the selling CEO motivated to make the sale (and the later integration) successful if her job will disappear? Many buyers offer contracts to selling CEOs and sometimes CLOs, but most of the management team is not needed after the merger. This may apply to other employees, as well, since branches may be cut, departments eliminated, levels of management eliminated, etc. Also, until the buyer gets to know management better and learns the skills of the employees, it cannot be confident in the value of the bank. An uncooperative management team or employment base can scuttle the deal.
 
5. Management Compensation and Change of Control Agreements.
The management compensation agreements and change of control agreements usually are well-described in the bank’s regulatory filings, but not always. If the bank is not an SEC-reporting entity, the actual management agreements may not be available. Sometimes, these agreements provide unwelcome surprises. It is difficult for all community banks to hire and retain top-notch management, but this is particularly true for banks far away from metropolitan areas. Some of these more suburban or rural bank boards have to look for additional ways to attract and retain management.
 
Supplemental retirement plans, stock options, and change of control agreements, all of which often provide liberal vesting privileges upon sale of the bank, protect senior officers and benefit them if the bank sells. Unfortunately, if these compensation and change of control agreements were not drafted carefully, they can violate Section 280G or 409A of the Internal Revenue Code. These sections carry extreme penalties for non-compliance. Many banks run afoul of these sections, creating potentially large penalties when benefits vest early in a merger. When the buyer uncovers this in due diligence, the buyer faces the prospect of either adjusting the price, negotiating with management to amend or terminate the compensation arrangement, or terminating the deal. That places the selling bank officer’s interests at odds with the bank’s shareholders. This often is worked out between the buyer and the affected officers, but it is never a simple negotiation.
 
These are my top five challenges to completing a merger successfully. What are yours?
 
If you have questions about mergers, or face any community banking issue, please contact our Community Banking Practice Group.