Movement To Increase In Bank M&A

The recent "Deal Driver" report from mergers and acquisitions intelligence firm Mergermarket outlines exactly what is going in the small, regional and community banks.

So far this year, there have been 135 bank mergers, compared to 115 deals last year. Deal volumes are the highest since 1998, which is about when the M&A wave resulting from the savings and loan crisis was peaking. This time, the merger wave is just getting started and is probably in the second inning of a long game. The pace of M&A is also picking up. It will accelerate as the social and economic forces driving consolidation continue to develop.

Small Bank Action

All the action is in the small banks. Ninety percent of all deals this year have involved banks with less than $1 billion in assets, and a whopping 70 percent involve the very small banks with less than $400 million in assets. The report cites Thomas Hayes, a director at DA Davidson & Co., about the perfect storm developing in the banking sector.

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Hayes points out that "regulatory costs are also putting pressure on smaller banks to look for partners. Loan growth is still slow, leading many banks to prefer to grow through M&A.” The little banks need to sell, and the regionals need to grow to keep their shareholder happy.

Adjusting Expectations

The wave is just building, and there is still resistance from smaller banks who just do not wish to sell or boards who want a much higher multiple of book value. As the reality of a still slow economy with little wage growth and a much softer than hoped housing market set in, many of these banks will begin to relialize that they are not going to fetch anything close to the 2.75 times book value that they could have had in 2007 and adjust their expectations.

Those who desire to remain independent will eventually see that the rising cost of regulatory compliance is going to make that pretty much impossible. They need to either engage in a merger of equals or sell out to a larger institution. The ironic part of this is that much of the time, a merger of equals between two small banks merely creates a much more attractive target for the growth-starved regional banks.

Investor Demand

The banks that might try to tough it until the world changes are finding there is another obstacle: Becuase the bottom line remains flat to down because of low interest margins, in addition to soft loan demand and rising regulatory costs, their stock prices have suffered. A small but growing cohort of activist investors is entering the small bank stock sector and accumulating large stakes in banks trading at a discount for their book value. These activists are demanding that banks improve condition or sell the bank to unlock shareholder value. They have the buying power to enforce their will, and they will push the merger wave along at great profit to shareholders who ride their coattails.

Improving conditions in the sector should also add some fuel to the merger movement. There is serious pent-up demand for deals, as most banks have traded at very low multiples of assets and earnings and could not use their stock as currency. As conditions have improved, and most of the credit problems have moved into the rear view mirror, many banks can now offer their targets a more acceptable currency in the form of stock trading at more reasonable valuations. Acquirers can now also be more comfortable about the quality of the loan portfolio and balance sheet they will be buying. The pace of community bank M&A should begin to pick up in the second half of 2014 and continue to do so for several years, at least.

Super-Strong, Little Banks

In addition to the M&A wave as a source of profits, there will be some banks that will just dominate their local market and earn returns on equity that drive the price higher for years to come. These institutions are usually found in smaller towns, and the board is made up of leading local business people. These banks will successfully take share from the bigger banks and generate profits high enough to cover the increased regulatory costs.

Theses super-strong, little banks rarely have loan problems, as they know every player and every project in town. They can also cherry pick the best loans and avoid those that carry elevated risk. Historically, they have provided not only exceptional price appreciation most of them are heavily owned by insiders who pay themselves though consistent dividend increases. These dominate community banks are hard to find, but owning one or two of them can build wealth over time at an astounding rate.

The opportunity in community banks is real, and it is going to be incredibly profitable for those who get involved in the early innings of the game.