Credit unions face a number of advantages, disadvantages in bank acquisitions

Credit unions face a number of puts and takes when it comes to acquiring banks.

U.S. bank M&A is surging back after historically low levels last year, but credit union acquisitions of banks are still dragging from a record number in 2019. This year has seen two credit union-bank deals so far, compared to six in 2020 and 14 in 2019.

The complexity of these deals and the need to pay a premium to compensate the selling bank for a "double taxation" issue could be contributing to the decline, industry observers said. Ensuring the credit union can acquire the bank's customers into its field of membership and juggling various regulatory approvals from the National Credit Union Administration and the bank's primary regulators can also prove to be a challenge. But credit unions also enjoy several advantages when it comes to M&A. They tend to have extra cash on hand given their tax-exempt status, and there are no shareholders or analysts scrutinizing the financial metrics of a deal, allowing them to focus on strategy.

"These transactions are relatively complex," Douglas Winn, president of Wilary Winn LLC, said in an interview. "I don't think that the credit union industry always understood just how complex these transactions can be from a tax and regulatory approvals standpoint. So we've actually seen a slowdown in these transactions."

'Double taxation' issue

Credit unions typically have to pay up to acquire a bank because the deals are structured as a purchase and assumption of assets and liabilities. If the selling bank is legally structured as a C-corporation, the deal will be taxed twice — once at the corporate level and again at the shareholder level. Traditional bank M&A deals are typically structured as a sale of stock, avoiding the double taxation.

"The double taxation can be a hindrance for a C-corporation to sell to a credit union," said Paul Sirek, a partner with Eide Bailly LLP who works with banks that sell to credit unions, said in an interview. "But if the price is right and the after-tax return on the deal for the shareholders makes sense, I mean, a lot of the times, you just have to look out for your shareholders and get the best deal that is available for that. So it may be a credit union, may be a bank."

Banking industry groups gripe that community banks cannot compete with credit unions' bids in M&A given the high prices they pay, pointing to their tax-exempt status. But the high prices are mostly driven by double taxation, Rick Childs, partner in advisory services at Crowe LLP, said in an interview.

"Sometimes when you look at a credit union deals and you think that price is high, many times, it's high because they have to cover that level of tax that the company will pay at the corporate level before they distribute to the shareholders," Childs said.

Advantages for credit unions

But a bank can avoid the corporate level tax if it has net operating loss, or NOL, carryforwards. This could be the case for VyStar CU's announced acquisition of Heritage Southeast Bancorp. Inc., potentially making the deal even more financially attractive than it looks on paper, Childs said.

VyStar plans to acquire the bank's assets and liabilities for $27 per share, an 80% premium from the March 31 closing price. The price values the bank at 183.5% of its tangible book value. In its 2019 annual report, Heritage Southeast reported federal NOL carryforwards of $45.5 million at Dec. 31, 2019, which start expiring in 2029.

"They may be able to escape that corporate level tax, which would make the price even more resounding in terms of the value," Childs said. "That makes the 183% of tangible book value, even that more powerful of a price."

In addition to the purchase price, VyStar will pay about $50 million for Heritage Southeast's unconsolidated debt and anticipated interest payments, about $19 million for the bank's expected tax liability for 2021 net income and the gain on sale associated with the transaction and about $1 million for the cost to liquidate the bank following the close of the transaction.

While credit unions may have to pay up to offset double taxation, their tax-exempt status enables higher bids, experts said. And credit unions are able to pursue those higher bids for strategic reasons without as much concern over financial metrics that might be scrutinized by investors or analysts.

"Where credit unions have an advantage is they can do some strategic things and not have to answer to a quarterly earnings call or an analyst," said Charles McQueen, president and CEO of McQueen Financial Advisors.

In traditional bank deals, the Street typically zeroes in on multiples such as earnback period, price to TBV and TBV dilution. When credit unions are evaluating deals, they focus on more strategic considerations.

"Credit unions are trying to build economies of scale, and they're more concerned about ... the strategy and pro forma combined statements coming out of it as opposed to specifically thinking about the deal metrics," said Matt Erickson, a managing director at Wilary Winn LLC. "Strategy comes first."

That focus on strategy allows credit unions to take a longer earnback period, McQueen said. Many credit unions are comfortable with a five-year earnback period, said DD&F Consulting Group Principal Tom Rudkin. Analysts have said investors typically expect a three-year earnback.

"In a transaction, they have the advantage, or at least an internal accounting advantage, to use a five- to five-and-a-half-year payback period," Rudkin said in an interview. "That also allows them to pay a slightly higher price or higher price than a bank purchaser."

Other metrics credit unions look at include the bank's earnings on a pretax basis, credit quality and cost saves, Rudkin said.

The number of credit union acquisitions of banks could surge again following a recent move by the NCUA that could bolster these types of acquisitions. A final rule passed on Dec. 17, 2020, will expand the number of credit unions eligible to issue subordinated debt by including "complex" credit unions, defined as those with more than $500 million in assets.

"When this opens up, it certainly will benefit the credit unions ... and probably, in some cases, allow for more M&A transactions where credit unions will be able to acquire more banks or merge with other credit unions," Rudkin said.