Bank M&A and Merger Model Questions Flashcards
Why would a bank buy another bank?
Because it believes that the Purchase Price of the other bank is less than the Present Value of the other
bank’s future cash flows.
In practice, most banks acquire other banks to expand geographically, diversify their businesses, realize significant Cost Synergies, or strengthen their Regulatory Capital positions.
How is a merger model different for commercial banks?
You still combine the financial statements of the Buyer and Seller, adjust for acquisition effects, create Goodwill, and calculate EPS accretion/dilution.
However, the specifics of the model are quite different.
For example, most banks must use primarily Debt or Stock to fund deals since they need Cash to cover Deposit withdrawals.
Also, acquirers must mark targets’ Balance Sheets to market value and amortize these adjustments. Acquirers also write down targets’ Allowances for Loan Losses as part of that process.
“Core Deposit Intangibles,” which represent the funding advantage of the bank’s most stable Deposits, also get created in bank M&A deals and are amortized over time.
The acquirer may have to divest some of the target’s Deposits for regulatory reasons, and even if the acquirer can realize significant Cost Synergies, it will have to spend a significant amount upfront on Restructuring to do so.
You will also have to recalculate Regulatory Capital, Dividends, and the “balancer” line items (e.g., Federal Funds Sold and Purchased) since the combined company’s Balance Sheet will change.
Finally, you may evaluate bank M&A deals by using alternative accretion/dilution metrics as well as IRR, the NPV of Synergies, and a Contribution Analysis.
Why do banks usually use a high percentage of Stock when acquiring other banks?
Partially, it’s because banks usually can’t use much Cash to fund deals because they need to keep a
certain amount of Liquid Assets available to cover Deposit withdrawals.
Also, most banks are already highly leveraged and cannot necessarily raise significantly more Debt to fund deals.
But the other reason is related to Regulatory Capital: Since the Seller’s Common Shareholders’ Equity is written down in the deal but most of its Risk-Weighted Assets remain, the Combined Company could easily experience a CET 1 shortfall unless the Buyer uses significant Stock to fund the deal.
Why might an acquirer mark a target bank’s Balance Sheet to market value?
Because the fair market values of the target bank’s Assets and Liabilities could easily “drift” from their book values, and banks do not mark everything to market value. For example, they record Loans and Deposits at historical cost less amortization.
The fair market values might change if prevailing interest rates or credit risk change.
For example, if the bank issues 10-year Loans at a 6% coupon rate, market interest rates on similar Loans are also 6%, and there’s no credit risk, the book value and fair market value of the Loans will be the same initially.
But if market interest rates then rise to 7%, and the credit risk of the borrower increases so that there’s
only a 99% chance of repayment, the fair market value of those Loans will decline.
The Acquirer completes this process for all the Assets and Liabilities of the Target that are not already marked to market.
An acquired bank has $1,000 in Gross Loans and $1,200 in Deposits. The Acquirer believes that the fair market value of the Gross Loans is 98% of their book value and the fair market value of the Deposits is 99% of their book value.
The average maturity of the Gross Loans is 5 years, and the average maturity of the Deposits is 2 years.
How will the Acquirer record the amortization of these mark-to-market adjustments on its Income Statement?
The Gross Loans decrease by $20 since $20 is 2% of $1,000, and the Deposits decrease by $12 since
$12 is 1% of $1,200.
The acquirer then amortizes the $20 adjustment over 5 years for $4 per year, and it lists this as a positive $4 on the Combined Income Statement.
Then, it amortizes the $12 adjustment over 2 years for $6 per year, and it lists this as ($6) on the Combined Income Statement.
So, in the first two years, the amortization will be ($2) on the Income Statement, and in the last three years, it will be $4.
What do Core Deposit Intangibles (CDI) represent in a bank M&A deal, and how do you calculate them?
Core Deposit Intangibles represent the “funding advantage” of the acquired bank’s most stable, long- term Deposits over other Deposits on which it would have to pay higher rates.
Technically, you could calculate this number by comparing the interest rates on those Deposits to market interest rates and calculating the Present Value of the difference.
But you rarely have enough information to do that, so you normally base the Core Deposit Intangibles on a small percentage of the acquired bank’s “Core Deposits,” which it discloses in its filings.
Why might a Buyer divest a Seller’s Deposits in an M&A deal?
A Buyer might divest a Seller’s Deposits because of regulatory reasons. For example, in some countries, such as the U.S., banks are prohibited from holding more than a certain percentage of Total National Deposits via M&A deals.
So, if the country has $1,000 of Total Deposits, Bank A has $100 of Deposits, Bank B has $50 of Deposits, and a single bank cannot come to hold more than 13% of Total Deposits via M&A, Bank B would need to divest $20 of Deposits.
But a Buyer might also divest some of the Seller’s Deposits if it wants to exit a certain geography or market segment.
In a bank M&A deal, the Buyer has $1 billion of Deposits, and the Seller has $200 million of Deposits. The Total Deposits in the country are $10 billion, and no bank can come to hold more than 11% of Total Deposits via M&A.
The Buyer’s Tax Rate is 40%, and it will receive a 10% premium for the Seller’s Divested Deposits.
The Seller’s Loan / Deposit Ratio is 10%, and its Securities / Deposit Ratio is 90%. Walk me through
the Balance Sheet impact of this Deposit Divestiture.
11% * $10 billion = $1.1 billion, so the Buyer will have to divest $100 million of the Seller’s Deposits.
It will receive a 10% premium for those Deposits, which means $10 million * (1 – 40%) = $6 million after taxes.
On the Balance Sheet, the After-Tax Premium increases the Combined Company’s Cash balance by $6
million, and it increases Retained Earnings by $6 million on the L&E side.
The Combined Company’s Deposits decrease by $100 million after the divestiture, and on the Assets
side, its Loans decrease by $10 million, and its Securities decrease by $90 million.
How do the Purchase Price Allocation and Balance Sheet Combination processes differ in bank merger models?
In the PPA Schedule, you must factor in all the mark-to-market Balance Sheet adjustments, the write-
down of the Seller’s Allowance for Loan Losses, and the new CDI created in the deal.
The other adjustments are all standard: Write down the Seller’s CSE, write down its existing Goodwill and Other Intangibles, create new Goodwill and Other Intangibles, possibly write up its PP&E, and create a new DTL based on the new Intangible and Tangible Write-Ups.
The Balance Sheet Combination reflects all these differences, and you must also include the impact of Deposit Divestitures, including corresponding Loans and Securities divested and premiums received.
You record all the standard items in the Balance Sheet Combination as well: Cash, Debt, and Stock used to fund the deal, and the new Goodwill, Other Intangibles, and other write-ups.
How can you tell if there will be Tangible Book Value per Share (TBVPS) dilution in a bank M&A deal?
TBVPS dilution depends on how the Buyer’s Tangible Book Value changes relative to the change in its share count.
So, anything that results in a lower Tangible Book Value or a higher share count contributes to the dilution.
Dilution is more likely if the Buyer uses significant Debt or Cash to fund the deal, if the Buyer is trading at a lower P / E multiple than the Seller, or if the Buyer pays a low premium over the Seller’s Book Value.
How are Cost Synergies and Restructuring Charges linked in a bank merger model?
Usually, you assume that Cost Synergies represent a percentage of the Seller’s Non-Interest Expenses based on the number of branches the Buyer plans to consolidate or close. The percentage might be anywhere from 5-10% up to 30-40% in very aggressive deals.
You assume that it takes several years to realize these Cost Synergies fully (e.g., 50% realization in Year 1, 75% in Year 2, and 100% in Year 3).
Then, you assume that the Buyer incurs Restructuring Charges that represent some percentage of the fully realized annual Cost Synergies. It usually pays for these Charges upfront in Cash, and the Combined Net Income declines as a result.
Often, you focus on accretion/dilution metrics in years after the company has incurred the Restructuring Charges so that you exclude their impact.
How do you treat Federal Funds Sold and Purchased in a bank merger model?
These items (and other Balance Sheet “balancers”) work the same way in a merger model as they do in a standalone 3-statement model, but you must recalculate them based on the new Balance Sheet.
In other words, you can’t just add together the Buyer and Seller’s figures to determine the combined numbers.
Instead, you must determine the combined numbers by taking the Combined Company’s Assets in Current Period + Fed Funds Sold in Prior Period and comparing that to the Combined Company’s L&E in Current Period + Fed Funds Purchased in Prior Period.
If the Combined Company needs more funding, increase Federal Funds Purchased; if it has excess funding, increase Federal Funds Sold.
You must also factor in the differences in Interest Income and Interest Expense because of how these items change over the standalone numbers from the Buyer + Seller.
How do a bank’s Regulatory Capital and Dividends change after it acquires another bank?
There’s no universal answer because it depends on the Buyer and Seller’s Regulatory Capital and Dividend Payout targets, the transaction funding, and the relative sizes of the Buyer and Seller.
For example, if the Buyer is targeting a higher CET 1 Ratio than the Seller, they both target similar Dividend Payout Ratios, and the Buyer uses 100% Stock to fund the deal, the Buyer may have to cut Dividends initially because the Seller had lower capital before the deal took place.
If the Buyer uses less than 100% Stock, it will have to cut Dividends even more and possibly issue additional Equity.
On the other hand, if the Seller is targeting a higher CET 1 Ratio than the Buyer, and everything else stays the same, then the Buyer might be able to increase its Dividends after the deal closes.
Besides EPS accretion/dilution, how else might you evaluate a bank M&A deal?
You might calculate accretion/dilution of other metrics, such as Dividends per Share, Book Value per Share, Tangible Book Value per Share, or CET 1 per Share.
Also, you might create a Contribution Analysis and assess how much of the Combined Company the Buyer and Seller “should own.” If the actual ownership levels differ significantly, then the Purchase Price might be inappropriate.
You could also evaluate the deal by calculating its IRR and comparing that to the Buyer’s Cost of Equity,
and you could calculate the NPV of Synergies realized in the deal.
The last one is not a strict valuation methodology; it’s a way to gauge how dependent a deal is on
Synergies and how plausible those Synergies are.
Walk me through the IRR calculation in a bank M&A deal.
To set up this analysis, assume that the Equity Purchase Price is the upfront investment, shown with a negative in Excel.
Then, show any Equity Capital Infusions into the target with negatives as well, and calculate Combined Dividends – Buyer Standalone Dividends in each projected year to determine the additional Dividends generated as a result of the deal.
In the final year, capitalize the Seller’s Net Income, after adjustments for Synergies and other Cash
acquisition effects, at a reasonable P / E multiple.
Apply the IRR or XIRR function to this entire series of cash outflows and inflows to determine the IRR.
