24 Jun, 2024
Capital raises help banks navigate the choppy M&A waters
By Yizhu Wang and Xylex Mangulabnan
Some banks playing offense in the tough deal environment are turning to capital raises as they try to make their pitch even stronger to regulators, investors and the M&A target.
At least five banks announced equity or debt financing at different stages of an M&A process this year as of May 24. One of the more notable was
The recent capital raises come at a time when bank M&A faces prolonged regulatory approval periods, as well as proposed rulemaking around M&A. To help smooth the approval process, banks can be proactive by strengthening capital levels to meet the higher expectations from bank regulators, said Kevin Stein, managing director at Klaros Capital. In the past, regulators might have allowed a certain amount of dilution of capital when a deal is just closed, giving the combined entity more time to digest the transition and earn back the capital, he added.
"In the current environment post March of 2023, I think the expectation on the part of the regulators is you need to be at the pre-deal capital level post deal on day one, not at the end of some future period," Stein said in an interview.
A solution in the high-rate environment
Persistently high interest rates will remain a key driver for banks to consider capital infusions to make M&A more viable, according to industry sources.
The high interest rates have pushed down the value of bonds and left banks with underwater holdings in their securities portfolios. In an M&A deal, the target's securities portfolios have to be marked to market to reflect current market conditions, and any deductions are subtracted from the seller's capital base. The interest rate marks have made it challenging for banks to pursue M&A.
"In general, one of the reasons we saw fewer transactions in 2023 was that the interest rate environment had a detrimental impact on target balance sheets as a result of purchase accounting, and that problem still exists today," said Bill Burgess, co-head of investment banking in the financial services group at Piper Sandler.
Raising fresh capital can be an effective tool to strengthen the capital base that would be weakened by absorbing the target's unrealized losses.
"First, impact of purchase accounting creates a capital need in many prospective deals; and second, to make sure that capital ratios are strong enough to make the likelihood of regulatory support more probable," said Scott Studwell, head of US depositories and co-head of equity capital markets at Stephens.
For UMB, the capital raise in conjunction with the announced acquisition of Heartland Financial USA Inc. was an "offensive" move to further bolster risk-based regulatory capital ratios, even if they would have been well above regulatory minimums, UMB Chairman and CEO Mariner Kemper wrote in an email to S&P Global Market Intelligence. It also provides downside protection, should the fair value of acquired assets decline due to interest rate movements, Kemper wrote.
Trying to execute a capital raise in the current environment is much more realistic than it was a year ago in the aftermath of the liquidity crunch that led to large bank failures and substantially reduced valuations across the industry. Since then, investor sentiment has improved with the stabilization of the sector, and the end of the rate-hiking cycle — even if actual cuts are taking place later than anticipated, said Brennan Ryan, a partner at Nelson Mullins Riley & Scarborough LLP.
"Even if rates aren't going down, the stability overall in financial markets supports getting that financing in place. I don't think that was available nearly to the same degree in the middle of 2023," Ryan said in an interview.
CRE under the spotlight
Still, banks' exposure to commercial real estate (CRE) loans has been under the spotlight, and too much of it on a pro forma basis can increase the need for a capital raise.
Most banks proposing an M&A deal have been trying to keep their CRE concentration ratio below 300%, although the threshold that different institutions target can vary, Burgess said.
If an M&A deal would not reduce the ratio of the combined entity below 300% or it would increase the buyer's ratio, it is more likely that regulators will ask for a capital raise, loan sale or similar de-risking transaction, said Matthew Bisanz, a partner at Mayer Brown.
Banks currently build capital buffers for CRE mainly in a precautionary manner, rather than needing to build credit reserves as commonly seen in the 2008 financial crisis, Ryan said. It places the banks in a better position to build investors' confidence.
But there is still uncertainty in the economic outlook, "so having some additional capital in place will give you a cushion in the event where we did hit a recession or where there was some additional credit stress," Ryan said.
Adding certainty to the unknown
Getting capital committed early in the M&A process adds more certainty to the regulatory approval process and could lead to more favorable pricing for the bank. Issuers can make a stronger case for investors to back a capital raise if they can articulate their need for capital before the regulatory review progresses.
"Longer approval periods can put a company on the sidelines during moments when capital markets windows are open," Studwell said.
The timing of a bank going to market to raise capital has grown in importance after investors witnessed the rapid downfall of Silicon Valley Bank in March 2023, Stein noted. When Silicon Valley Bank needed capital to reposition its securities portfolio, a raise did not come to fruition, and the bank failed two days later. Since the March 2023 turmoil, investors have been more wary of providing capital to banks that need it to put out fires but are more attracted to banks with promising growth plans.
"I think it's a combination of the [elongated] approvals and what everybody learned from Silicon Valley Bank," Stein said.
Currently, private equity investors still have ample dry powder to support banks' growth plans. A cultural fit, the desire to be high performing, and an attractive entry price are among the criteria for banks to attract investors like Castle Creek, said Tony Scavuzzo, managing principal at the bank-focused investment fund. Castle Creek provided capital to support FirstSun and Bancorp 34 Inc.'s M&A strategy.
"Our appetite is ongoing for opportunities to deploy capital into situations where we are adequately rewarded for the risks we are taking," Scavuzzo wrote in an emailed response.
Cost rising for M&A
Issuing debt or equity is expensive, with interest rates remaining high and bank stocks trading at lower valuations. It effectively reduces a bank buyer's capacity to pay a certain price for a target.
"Everyone is now well attuned to the notion that you have to look at supplementing the pro forma capital base with an issuance. The question is going to be — is that cost prohibitive to the deal?" Burgess said.
A compelling strategic rationale is key for banks to move the needle, and strong economics resulting from the merger could offset the cost in the long term. For banks ready to be offensive in their markets, being able to raise capital and execute on a deal can make them more competitive when many others may be deterred from M&A.
"The cost of capital is higher, but it's essential in this case," Studwell said. "If you wait for a better environment, would you have the same opportunity? Or does this environment create the opportunity?"
