FOCUSREPORT/Mergers: What’s Next?
Penning a column on the current state of credit union acquisi- tions of banks on thecusp of an election, during a pandemic, with three days to go before the end of the third quarter, inone of the most extraordinary ofyears is one of the more challenging tasks I’ve taken on recently.
On the mergers side, activityremains muted. But that doesn’tmean there aren’t buyers out therelooking for opportunities and sellers actively looking for buyers.The key is being able to recognizewhat potential transactions aretruly opportunities and whicharen’t. That’s where the right advisor can be of tremendous service.Certainly, one thing contributingto the opportunity potential is thefact that bank valuations todayhave declined from where theywere pre-pandemic. Let’s walk inthe buyer’s shoes for a moment.
Buyers have to be more cautious right now because of theimportance of assessing the creditrisk of a seller’s loan portfolio inthe pandemic scenario. Goodloan due diligence is important inany acquisition, but in today’s environment it’s crucial – especiallyif the seller is an active lender onretail, hospitality, multifamily andnon-owner occupied commercialproperties. Proper loan due diligence will quantify the portfoliorisk posed by the seller.
Third-quarter Call Reports arejust now coming out, but I expect that they will not reflect anysignificant changes in past dueloan levels or net charge-offs forthe quarter. More telling will befourth-quarter 2020 and first-quarter 2021 numbers. By then weshould know much more aboutthe quality of the sellers’ creditpolicies and loan underwriting.
And then there’s the recov-
ery. What type of recovery will
we experience? V, U, W or K? If
it’s a V, asset quality should stay
pretty strong. But if it is a U, W or
a K – well, those are much more
complicated scenarios. Let me
• V: A high percentage of in-
dustries and businesses have
reached bottom and are on the
way back up.
• U: A high percentage of industries and businesses havereached bottom but linger forsome time before going backup.
• W: A high percentage of industries and businesses havehit bottom and are on the wayback up but another downturnoccurs before the real recoverybegins.
• K: In this nightmare scenario,industries and businesses aresplit into two categories. Insteadof everybody experiencing thesame economic activity, somebusinesses will be the top arm ofthe K where activity is accelerating – and other businesses willbe the bottom leg, where economic conditions continue todeteriorate. And we don’t knowwho, what, when or where.
Elephant in the Room
What type of recovery are we going to experience? It really isn’tclear quite yet. Positive COVID- 19test results have more recentlystarted going back up, in somecases to record levels, and themarkets are on watch. If this current spike leads to a second shutdown or even a hybrid shutdown,the economy will slow down – impacting employment, businessconditions and, potentially, assetquality.
A lot of buyers are concerned,not only about a seller’s assetquality, but introspectively, abouttheir own portfolio dynamics.However, credit unions have always had a good understanding oftheir members and, therefore, thequality of their loan portfolios.
We Don’t Have a CrystalBall, but …
It takes a great deal of time to put
an acquisition transaction togeth-
er. For the contrarian thinker, this
is an excellent time to pursue a po-
tential transaction because seller
valuations have come down. For
those institutions, current valu-
ations will encourage making an
acquisition investment because
pricing is at a level low enough
to offset potential credit issues
one might acquire and still allows
them to meet ROI targets.
This year there have been new,unplanned costs for institutionsto deal with as a result of the pandemic and its shutdowns. As anexample, sanitation and additional safety protocols have increased organizations’ non-in-terest expense and are negativelyimpacting returns on assets. Thequestion is, how much longer willthese elevated expense levels impact operating performance?
In addition to higher non-inter-est expense, net margins have alsobeen under pressure as the yieldcurve is negatively impacting loanrates, on both new and existingloans, more quickly than depositrates are declining.
The scale provided by an acquisition, and the financial benefitsobtained therefrom, can certainlycontribute to the restoration ofan institution’s ROAA to pre-pandemic levels and help meet desired performance targets.
Another Arrow in the Quiver
Since we can’t yet define that all-
important letter for our economic
recovery, or predict the duration
of the economic cycle
we are experiencing,
is taking on a new
level of importance
for the credit union
industry. One of the
tools available to
many credit unions
for managing capi-
tal is the issuance of
subordinated debt to
support both organic
growth as well as the
increased size result-
ing from the acquisi-
tion of a bank.
There’s never been a betterenvironment for issuing subordinated debt. The yield curveis at a point where debt pricinghas never been better. (That’snot to say it may not go lower.)Certainly at some point interestrates will rise. Potential investorsin credit union debt are liquid,and they are looking for investment options. For many, creditunion debt is something that fitswithin their investment policies.
Regulatory attitudes supporting
the use of sub-debt to manage
capital have never been more
positive. Even if an institution
may not need the capital today,
the issuance of sub-debt is still
something to consid-
er because of current
pricing and investor
Start to finish, it’seasily a six- to nine-month time horizonto go through preparations, regulatoryapplication and review, and the placement of debt with investors. The long leadtime suggests developing an action planto take advantage ofthe current favorable issuanceenvironment.
History in the Making
Credit unions began with a simpleidea – that people could achieve abetter standard of living for themselves and others by pooling theirsavings and making loans to themselves and their coworkers. Creditunions have provided financial services to their members in the United States since the 1930s, and haveadapted and thrived during myriadeconomic downturns and recoveries. Our industry will get throughthis, and will continue to providequality products and services thathelp members achieve their financial goals and aspirations. n
Remembering Your ABCs