Banking and capital markets deals insights: Midyear 2020

Morgan Stanley in February announced a plan to acquire E*TRADE. The news came just a few months after Charles Schwab Corp. entered into a definitive agreement to acquire TD Ameritrade Holding Corp. When announcing the deal, Morgan Stanley forecasted a gain of 5.2 million retail customers with $360 billion in assets and an online bank with $56 billion of deposits. After integrating its acquisition, Morgan Stanley’s key source of profitability would likely be asset and wealth management revenue.

In June, South State Corp. closed on its acquisition of CenterState Bank Corp. The deal, announced in January as a $3.2 billion merger of equals (“MoE”), is expected to deliver more than 20% EPS accretion once cost savings are fully achieved, with minimal dilution of tangible book value. The bank’s forecast $80 million in expected annual net cost savings to be fully phased in by 2022. This represents approximately 10% of projected 2020 combined non-interest expenses. We expect the MoE trend to continue in coming months among regional banks with reasonably achievable synergies, low TBV multiples, and control premiums that are low or zero.

Pacific Premier Bancorp, Inc. in June completed its acquisition of Opus Bank, announced in February. The all-stock transaction was initially valued at $1.1 billion. Pacific Premier Bank said that, with the transaction, its total assets have now risen to roughly $20 biillion.

Transaction multiples fall due to COVID-19

The average P/TBV multiple fell 6% during the first quarter compared with Q4 2019, and another 27% during the second quarter. COVID-19 undercut transaction volumes as its impact spread across the banking sector and the broader economy.

(Note: We excluded the Morgan Stanley/E*TRADE transaction from the average for the first quarter. Given the firm’s operations in both banking and asset management, the implied P/TBV multiple for the transaction does not provide a meaningful comparison with deals only involving banks.)

Bank valuations recover after Q1 slump

Investors had priced in expectations that the Federal Reserve would raise its benchmark interest rate after three cuts in 2019. But as the effects of COVID-19 spread, the Fed cut its main rate to near zero. Bank stocks fell amid investor concerns about shrinking net interest margins, rising unemployment, declining oil prices and turmoil in credit markets. 

Financial institutions with comparatively high exposure to credit or without robust fee businesses —  generally, regional and community banks — suffered the most severe declines. Firms with trading desks endured a milder shock as investors rebalanced their portfolios and adjusted hedging strategies.

Many bank multiples have apparently recovered in response to fiscal and monetary stimulus and signs of improvements in economic data. Yet, for now, markets are still extremely volatile, and valuations are not necessarily on solid ground.

BCM deals outlook

The industry backdrop

Several factors related to COVID-19 jolted banks and capital markets firms and held down dealmaking during the first half of 2020: 

• Record-low interest rates. The reduction in the Federal Reserve’s benchmark rate to a record low has crimped net interest margins and other spreads. Many BCM firms faced profitability pressures even before the onset of the pandemic in March.
• High unemployment. The highest jobless rate in decades, and the time required for workers to find new employment, has slowed a revival in business operations and economic growth. Fed Chairman Jerome Powell, while citing the severity of the downturn, predicted in June that the former jobs for millions of unemployed workers may not return for many years.
• Possible threats to loan portfolios. Some banks are preparing for an increase in loan losses. Relief under government aid such as the Main Street Lending Program and the Paycheck Protection Program blunted the impact on loan portfolios during the first half. When such aid runs out, delinquencies may rise in corporate, consumer and mortgage lending.
• Some industries hit especially hard. REITS, travel/hospitality and some industrial sectors felt the full brunt of the pandemic. Demand also fell in the oil and gas sector, which before March faced oversupply and other difficulties. During the coming months corporate loan losses for these sectors may rise more than usual.

The industry challenge

The pressures described above have prompted BCM firms to consider how they would revise their business models for an extended period of low or negative interest rates. While banks took stock during the first half, many dealmakers decided to take a “wait-and-see” approach to M&A until valuations and opportunities become more clear. A long period of record-low rates would probably accelerate bank transformation through consolidation and other strategic M&A transactions.

A slow recovery — as described in an IMF forecast in June — could increase stress in global finance and spur consolidation and other dealmaking activity. The Fed, when reporting in June that the largest US banks passed an annual stress test, warned that the downturn may eventually lead to significant loan losses. The central bank capped dividend payouts and suspended share repurchases during the third quarter. It also told banks to update and re-submit their capital plans later in 2020 to reflect current pressures.  

As federal aid to borrowers wanes (and if lockdowns in many states ease) BCM firms will likely shift their focus from stabilizing business to identifying strategic opportunities that have emerged during the pandemic, including M&A. Although the road ahead is challenging, the current instability offers BCM firms scope to accelerate transformation and boost growth in the medium to long term.

This will all take some time to play out. For some time, BCM firms will likely continue to face some key drivers for change — and for dealmaking:

• Profitability: We expect that interest rates will remain low for a long period, holding down net interest margins and profits. Volatility in BCM share prices may persist, potentially reducing the price of companies targeted for future acquisition. (At the same time, a slump in share prices may prompt the renegotiation of some deals already announced.) Continued weak demand in the travel, entertainment and retail industries would constrain revenues from payments and ancillary fees. Facing such headwinds, banks would need to redouble cost cutting, including reductions in their real estate footprints. Their options range from reconfiguring their branches and distribution network to reducing the proportion of staff located at central and corporate offices. Any trend in de-urbanization would reinforce such changes.
• Deployment of Capital: Banks would do well to reconsider where they should target capital and the pace at which they do so. They may want to consider which industries will recover quickest and the implications for their customer base and current locations. Their decisions will shape their risk profile, influence their rate of growth and potentially prompt an openness to future M&A activity.
• Digital transformation: The BCM industry for several years has focused on adopting digital capabilities — with mixed results. The industry is overstaffed, operates fragmented technology and fails to make the most of its data. The pandemic has underscored the value of digital acumen and will likely spur further transformation, including acquisition of FinTech firms. Banks that choose to upgrade technology should reevaluate their footprint and branch network. They should keep in mind that demand for in-person transactions is falling as many large cities face the prospect of shrinking populations.

The industry’s way forward: adapting through M&A

Many banks will probably emerge from the COVID-19 crisis very different from the start of 2020. The pandemic and recession have changed many of the demand and supply dynamics and there will be winners and losers across the BCM industry. Many banks need to fully grasp the full dimension of their challenges, stabilize profitability, and assess how to adjust their growth strategies to record-low interest rates. Some banks could emerge from the current instability in distress, creating M&A opportunities for banks with strong balance sheets.

The pace of dealmaking in coming months hinges in part on the credit outlook for borrowers, as well as the degree of stability in credit markets. Uncertainty usually dampens M&A activity; buyers will probably hold back from transactions with banks that are unable to accurately measure the credit quality of their loan portfolios.

Sudden, extreme change may prompt many firms to pursue consolidation. Through acquisitions a firm can gain access to the industries and retail client segments that are most likely to quickly recover from the downturn. While valuations will vary, market volatility may make some target companies more reasonably priced. Partnership and collaboration will likely be crucial for strengthening capabilities and adapting to changing markets at an acceptable cost.