Bank Buyout and Growth Equity Questions Flashcards
Why are traditional leveraged buyouts rare for commercial banks?
They’re rare because of regulatory reasons and deal math. If a PE firm acquires over 20-25% of a bank, it will be classified as a “bank holding company” in many countries, and it will have to comply with Regulatory Capital and other requirements.
Also, most commercial banks are highly leveraged already and cannot take on additional Debt to fund deals; that restriction makes it difficult for traditional LBOs to work.
How can PE firms avoid these problems and invest in commercial banks anyway?
Most firms avoid these issues by purchasing minority stakes in banks, investing in something other
than Equity, or doing “club deals” with multiple PE firms such that all the firms own small percentages
of the bank’s Equity.
How do PE firms generate returns from minority-stake investments or buyouts of banks?
The main returns sources are Tangible Book Value Growth, P / TBV Multiple Expansion, and Dividends.
There’s no real difference between the returns sources in a minority deal vs. a 100% buyout deal, but
you’re more likely to see strategies such as add-on acquisitions and divestitures in true buyouts.
Unlike in traditional LBOs, Debt Paydown and Cash Generation is not a source of returns because banks
use Debt differently than traditional companies and don’t necessarily “repay it” over time.
Your firm acquires a $100 Tangible Book Value bank for 2.0x P / TBV, and it plans to sell the bank in 5 years for 3.0x P / TBV. The bank will not issue any Dividends during the holding period.
By how much must its TBV grow for your firm to realize a 25% IRR?
A 25% IRR over 5 years means that your firm must triple its Invested Equity in that time frame. Since your firm purchases the bank for an Equity Value of $200, it must sell it for an Equity Value of $600.
Since $600 / 3x = $200, the bank’s TBV must increase to $200.
How does your answer change if the bank issues $5 in Dividends each year?
These Dividends will reduce the required Exit TBV slightly because of the time value of money.
It’s hard to do this math in your head because IRR is a polynomial function, but one simple way to estimate it is to say that $5 in Dividends per year = $25 in Total Dividends.
Therefore, you won’t need all $600 in Equity back at the end; you need more like ($600 – Slightly More Than $25). You could say that “slightly more than $25” means $30, so the required Exit Equity Value is around $570.
$570 / 3x = $190, so the bank’s TBV must increase to $190. If you do the math in Excel, the actual number is $189.7.
Your firm acquires a $200 Tangible Book Value bank for 2.0x P / TBV, and it plans to hold it for 3 years. The firm’s Cost of Equity is 10%, its ROTCE is 15%, and its Net Income Growth Rate is 5%. Its TBV is projected to grow to $250 over 3 years. The bank does not plan to issue any Dividends.
Is it plausible for your firm to realize a 25% IRR in this deal?
To realize a 25% IRR over 3 years, your firm must double its money in that time. It pays an Equity Purchase Price of $400 for the bank, so it must get an Exit Equity Value of $800 at the end.
If the firm’s TBV is $250 in Year 3, the Exit P / TBV must be $800 / $250 = 3.2x.
Initially, the purchase P / TBV = 2.0x because (ROTCE – NI Growth) / (Cost of Equity – NI Growth) = (15% – 5%) / (10% – 5%) = 2.0x.
So, to reach a 3.2x multiple, the bank must earn a higher ROTCE, reduce its Cost of Equity, or grow its Net Income more quickly.
Of those, it’s most plausible for the bank to increase its ROTCE and Net Income Growth. If its ROTCE were 21% instead of 15%, the Exit P / TBV would be 16% / 5% = 3.2x.
Or, if its Net Income Growth were 7.7% instead of 5%, the Exit P / TBV would also be 3.2x. These increases are possible, but not particularly easy, especially if the bank is already mature.
So, we would say the deal is plausible but a bit of a stretch unless there’s a really good reason to assume higher ROTCE or Net Income Growth over several years.
What type of result from a Returns Attribution Analysis would make you reluctant to support a bank buyout deal?
An analysis that indicates that the deal is overly dependent on Multiple Expansion (e.g., 80% of returns come from there) would make us reluctant to support a bank buyout deal because Multiple Expansion is inherently speculative.
It’s better if the majority of the returns come from TBV Growth, with a portion also coming from Dividends.
How might you evaluate a growth equity deal for a bank?
Growth equity deals are primarily about P / TBV Multiple Expansion and TBV Growth, so you would create projections for the bank and evaluate the growth potential for both of those.
For example, if a bank’s P / TBV Multiple is at all-time lows, and you believe its financial performance will improve, it might be a good growth equity candidate since Multiple Expansion is plausible.
The TBV Growth assumptions must also be grounded in reality. For example, if the required TBV Growth means that a bank must grow its Loans at 3x the rate of GDP growth, the deal is probably not feasible in a developed country.
You would look at the deal in different scenarios and decide whether or not it’s plausible to achieve
your targeted IRR and MoM Multiple in each case; if it is, you might recommend the deal.
Walk me through a buyout model for a bank.
First, make assumptions for the Purchase P / TBV Multiple or Purchase Premium if the bank is public. Then, create the Sources & Uses and Purchase Price Allocation Schedules, and adjust the bank’s
Balance Sheet for acquisition effects, such as new Goodwill & Other Intangibles, the write-down and replacement of Common Shareholders’ Equity, and so on.
Next, project the bank’s Balance Sheet and Income Statement based on your assumptions for Loan/Deposit Growth, Yields and Interest Rates, and other factors, and “back into” the Dividends based on the bank’s targeted CET 1 Ratio.
At the end, assume a reasonable range of Exit P / TBV Multiples, and calculate the IRR and MoM Multiple based on the Equity Purchase Price, Dividends, and Exit Proceeds.
How do you estimate the Exit Multiple when investing in a bank?
You could calculate it with the formula that relates P / TBV to ROTCE, Net Income to Common Growth, and the Cost of Equity.
However, the bank’s financial metrics may not stabilize by the end of the holding period, so you may get nonsensical results with this formula.
If that happens, you may have to determine the range of Exit Multiples based on the Public Comps or the bank’s trading history (e.g., find a time when its ROTCE was similar to its Exit Year ROTCE, and use its P / TBV from that time).
How might you decide whether or not to invest in a bank?
You can make an investment decision by creating operational scenarios for the bank and determining whether or not you could achieve your targeted IRRs and multiples in the different cases. For example, you might target a 1.2x multiple in the Downside Case, a 20% IRR in the Base Case, and a 30% IRR in the Upside Case.
If you can’t achieve those numbers, you should lean against an investment in the bank.
If you can, you then look into the qualitative criteria that might support or refute the deal. For example, is the bank a clear market leader, or does it have many similar competitors?
If the qualitative factors support the deal, then you’ll keep moving toward a recommendation. Finally, you need to examine the risk factors and determine whether or not they’re serious problems
and how you might be able to mitigate them.
If you can do all that, you might recommend an investment in the bank.
The hardest part of this process is coming up with reasonable numbers in the different scenarios. To do that, you might review data from peer companies on Loan Growth, Interest Rates and Spreads, and other assumptions.
To get the numbers in the Downside case, you might go back to the last recession or look at underperforming peer companies.
What are the main risk factors when investing in a bank? How could you mitigate them?
The biggest risk factors are Multiple Contraction and a lack of TBV Growth. You can evaluate the risk of both by looking at the bank’s historical trading multiples and growth rates and the same data for peer companies.
Other risk factors include the bank needing to raise additional Equity Capital in the future, which would dilute your firm, and changes in the regulatory environment.
You can’t do much to mitigate these risks in a buyout for 100% of a bank, but you can find a bank that
might be able to divest Assets or otherwise change its business to respond.
- How might you evaluate whether or not divestitures or add-on acquisitions are worth it in a bank buyout deal?
You have to calculate their impact on the bank’s CET 1, TBV, and other financial metrics and ratios and see if the benefits of these deals outweigh their drawbacks (such as reduced CET 1 or an increased Investor Equity contribution from the sponsor).
For example, if a bank divests Non-Performing Loans (NPLs), and its CET 1 and TBV fall significantly due to Realized Losses, the bank needs to generate a significantly higher TBV by the end of the holding period to make up for that.
It might be able to do that by earning higher Loan Yields or boosting its Revenue and Net Income, but it may or may not be enough to boost the IRR and MoM Multiple to acceptable levels.
