The Outlook for Bank M&A in 2011

Edward Herlihy is a partner and co-chairman of the Executive Committee at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum.

As we move into 2011, interesting shifts are taking place that could make the year a significant one for consolidation in the U.S. financial sector. The end of 2010 witnessed a flurry of concentrated activity, including repayments of TARP by several large institutions and significant announced acquisitions (such as Wilmington Trust by M&T, Marshall & Ilsley by Bank of Montreal, and Whitney Holdings by Hancock Holdings). All of this points to an active M&A landscape in 2011.

The Storm Clouds Are Lifting. The past two years have been marked by extremely difficult conditions for financial institutions. Bank balance sheets were battered by falling home prices, elevated loan defaults, volatile asset valuations and a generally depressed earnings outlook. High unemployment and excess industrial capacity made the new business climate sluggish. Political populism, increased regulatory scrutiny, concerns about a double-dip recession and European sovereign risk jitters undoubtedly made bankers more risk-averse and uncertain of the next shoe to drop.

Although the economy remains challenged, some conditions are moderating. Housing and unemployment show signs of stabilizing and a sense of cautious optimism is beginning to seep into the market. Additionally, banks have been hard at work addressing embedded loan losses. Many sizable institutions have made significant progress. As a result, bankers are feeling better about taking measured risks, and are rightly concerned that competitors might seize opportunities if they do not.

Dramatically increased capital, common equity in particular, has contributed to an increasing sense of confidence. Some institutions are generating further capital through rebounding earnings, particularly with current historically low dividend rates. These institutions are gradually turning their attention to the best way to deploy their excess capital and optimize return on equity. Alternatives include growing lending businesses sensibly where demand exists, selectively considering acquisition opportunities and, in some cases, considering returning capital to shareholders through dividends or stock repurchases. All options are considered in the context of the sobering events of the recent past and the desire for many firms to maintain a capital buffer beyond current or anticipated regulatory requirements. With the economy still not at full speed, near-term prospects of organic loan growth appear generally modest and regulators are likely to move cautiously on relaxing dividend and share buyback policy— each of which can render acquisitions comparatively attractive. At this stage potential deals will tend to be scrutinized with extra care as some firms sense the need to carefully ration excess capital among various opportunities.

Regulators Are Out of Triage Mode and Into Long-Term Clean Up. The chaotic conditions of late 2008 and 2009 have given way to a less urgent, although still challenged, environment. This has given industry players, including regulators, a chance to catch their breath and to take a longer-term, broader view of the industry, rather than constrained to being reactive and going from one crisis to the next. Some of the political winds also appear to be settling. While many key regulations remain to be written, banks can increasingly delineate the fundamental contours of the new regulatory regime wrought by Dodd-Frank and Basel III, facilitating their strategic planning.

As problems and crises have shaken out, regulators have taken a more proactive approach to dealing with the institutions deemed most likely to cause potential issues if left unaddressed. Selective industry consolidation has been, and likely will continue to be, favored by regulators and market participants as a way of pairing strategically attractive but challenged institutions with stronger firms in an effort to strengthen the industry. Indeed, regulators have grown more assertive over the past year in urging distressed banks to take prompt action to resolve lingering capital and other regulatory issues, often by conducting a large capital raise or pursuing a sale of the company to an appropriately strong buyer. An uptick in action by the FDIC in pursuing directors and officers of failed banks can be expected to provide additional impetus for distressed banks to thoroughly pursue all available avenues to avoid a slide into receivership, including selling the company.

Sellers Increasingly See M&A as an Attractive Option. Not so long ago, raising equity capital was the only viable option for some institutions to avoid failure— if indeed that option was available. During 2010, buyers cautiously returned. Now the M&A option is a distinct possibility for many institutions that otherwise would need to consider a capital infusion made particularly dilutive (if not impossible) by a low stock price. Compounding the issue is the fact that many institutions most in need of capital are the same banks that face a long and uncertain road to restoring the healthy earnings necessary to generate it organically. Institutions have also had time to acclimate to the new economic and regulatory environment and to do fresh thinking about the market value of their institutions and the reset of trading multiples in the banking industry. There has also been a considerable changing of the guard in the executive suite since the economic crisis began. In many cases there is new leadership that may be more open to possibilities that may have been culturally difficult to consider before. And as most of the larger institutions have exited TARP, a process that accelerated as 2010 drew to a close, many (but by no means all) of those remaining in the program may feel more inclined to address the issue sooner rather than later. The TARP rules have been wisely set up so as to generally not penalize potential buyers for acquiring TARP banks, undoubtedly a factor in facilitating several recently announced acquisitions.

Buyers Have Emerged. There can, of course, be no M&A recovery without a healthy supply of buyers. As the smoke has started to clear from the recent crises, a cadre of healthier institutions, both within and without the U.S., has emerged that appears well-positioned to pick and choose from among the available opportunities. Many of these institutions have repaid TARP or otherwise have comparatively strong and clean balance sheets — and demonstrated better earnings performance throughout the crisis period. Regulatory permission to increase dividends — which is widely expected this year— will serve to further differentiate these institutions.

Balancing the concerns about systemic risk posed by large financial institutions in the post-Dodd-Frank world is a realization by bank supervisors that substantial, healthy financial institutions can be highly useful to regulators tasked with mopping up after the financial crisis. Also, the early-mover private equity and blind pool players, many with initial transactions under their belts, have momentum. They are likely to be significant players in this next round of consolidation. As the evolution of FDIC auctions during 2010 has tightened projected returns on receivership deals, these acquirors are adjusting their initial strategies rapidly by shifting their sights beyond failed banks to open bank recapitalizations and other innovative transactions.

Potential acquirers — while still needing to do very thorough due diligence —are feeling more confident that they can size and price the risks of an acquisition and that there may now be opportunities to significantly strengthen their franchises at historically attractive prices. Numerous buyer deal teams have by this point been through multiple rounds of fire drills reviewing distressed balance sheets, giving them an important familiarity with the general landscape and honing their ability to come to grips rapidly with a new target’s assets. In a few early-mover cases, as described in our memorandum of November 9, 2010, buyers have been able to demand increased protection in the deal documents, such as walk-away options and price adjustments, to mitigate the risk of further deterioration of the target’s assets or business. But the traditional “material adverse effect” contract remains alive and well, and as the pace of nonassisted M&A accelerates, the scarcity value of attractive franchises will likely argue for the straightforward, MAE-conditioned acquisition agreement as the approach of choice.

The Wave of Assisted Deals Has Crested. There are continued bank failures, but the availability of substantial and attractive franchises through the FDIC process is not quite what it was. Indeed, there were more bank failures in 2010 than in 2009 (157 versus 140). But the average asset size of failed institutions declined markedly in 2010, a trend even more clearly pronounced if one excludes the coordinated resolutions of a few large institutions in Puerto Rico and the Chicago area in April 2010.

At the same time, competition for the more substantial franchises that do end up in the FDIC process has increased. The loss-sharing and other terms of FDIC-assisted deals are generally not as buyer-friendly as they were earlier in the cycle. And with the panic phase of the financial crisis abated, it appears that regulators may be willing to let distressed banks stay open longer before resorting to receivership— meaning that the wait “under the hoop” may be longer and less certain. The FDIC’s auction process also makes it challenging for a particular bidder to count on success.

The combination of these circumstances encourages buyers to be more proactive and to seek ways to strike deals for attractive targets without waiting for them to be closed. Numerous once-troubled institutions found willing partners or acquirers outside of receivership in 2010, including TD Bank’s acquisition of South Financial, Ford Financial’s investment in Pacific Capital and the private equity investment, including Warburg Pincus and Thomas H. Lee Partners, in Sterling Financial.

During 2010, the existence of significant senior claims, such as TARP and trust preferred securities at the holding company level and subordinated debt at the bank level, posed challenges to acquiring very distressed banks outside receivership. Several buyers took the position that open acquisitions would not be feasible without negotiating reduced redemption prices for these securities. In the case of regional or local banks that sold trust preferred securities or subordinated debt into pooled vehicles, navigating procedural obstacles to collective action by holders of these securities has proven particularly problematic. In limited cases, including Pacific Capital and South Financial, buyers have been able to negotiate discounts with Treasury on TARP. There were other innovations in deals using provisions of the Bankruptcy Code with the goal of purchasing the bank both open (i.e., without an FDIC receivership) yet free of holding company liabilities. Such transactions are not without their complexities and uncertainties and are likely to remain niche approaches, limited to a set of unique circumstances.

Despite its Problems, the U.S. Market Remains Attractive. Despite the difficulties of the last two years and some continued sluggishness, the U.S. market remains attractive for banking and financial services firms, particularly when considering the alternatives. European markets, both within and without the EU, have their own serious issues, and many industry observers consider them to be some months or years behind the U.S. in addressing the issues. Together with other markets like Canada, they are also viewed as challenged to produce significant growth to drive future banking business. Markets in Asia that feature relatively robust growth remain politically, legally and culturally challenging. Latin American markets vary greatly. The result is that, at least for the foreseeable future, the U.S. is likely to remain an attractive destination for foreign, as well as domestic, financial institutions looking to expand.

One clear demonstration of this is the level of activity in the U.S. market by Canadian banks in 2010, as both TD Bank and Bank of Montreal made significant moves with institutions such as South Financial, Marshall & Ilsley and Chrysler Financial. Spanish banks, including Banco Santander and BBVA, have traditionally been active and opportunistic in executing acquisitions around the world and are likely to want to selectively expand their already considerable presences in the U.S. The year 2011 may also be the time when strong institutions from countries with strong demographic and economic ties to the US, such as Brazil, that are yet to establish a significant banking presence in the U.S. seek to enter the market through acquisition.

Accordingly, vigorous competition for attractive and substantial U.S. franchises is likely to be the norm going forward. Acquirers wishing to participate will need to stay on their toes, keep their institutions organically strong, ensure the strength of their compliance functions and cultivate strong and open lines of communications with their regulators.

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