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CECL 'double-count' issue could change US bank M&A pricing

A new accounting standard could change how much banks are willing to pay in deals.

When Simmons First National Corp. announced a deal on July 31, management said they wanted to close before year-end because of the accounting standard known as the current expected credit loss, or CECL. Simmons First has an extensive acquisition history, and management said on the deal call that they have no plans to slow down. But CFO Bob Fehlman said in an interview that CECL will affect the price the bank is willing to pay on future deals.

"I do think it will have an impact on our M&A pricing strategy going forward. We don't expect it to take us out of the business, but it will affect our modeling and pricing," Fehlman said. He said the accounting change will require more capital at the time of acquisition, but he does not expect the change to affect Simmons First's acquisition appetite or timing.

Bankers and investors have expressed concern that CECL's treatment of acquired loans will complicate M&A modeling by "double-counting" the credit risk for acquired loans. BB&T Corp. and TCF Financial Corp. raised the issue in comment letters to the accounting board behind CECL, arguing that it reduces transparency and complicates dealmaking.

"It has become a true point of analysis for anyone doing M&A. As opposed to only doing the economic analysis, you have to do this [separate] CECL analysis," said Joe Stieven, president of Stieven Capital Advisors, an investment management firm focused on banks. Stieven also does not expect CECL to prevent a bank from pursuing a deal, but he does expect it to complicate the financial modeling.

The double-count issue is limited to loans that are fully performing. Loans that have already experienced some credit deterioration are classified as purchased assets with credit deterioration, or PCD loans. CECL directs banks to include the credit loss allowance in the purchase price of PCD assets. However, fully performing loans, or non-PCD assets, have to build a credit loss allowance separate from the recorded purchase price.

Bankers say the inclusion of credit risk in both the purchase price and the allowance build creates a double-counting issue. Fehlman described how a hypothetical, fully performing purchased loan with a 5% credit mark would be recorded.

"You buy it at par at 100 [cents on the dollar]. You put a 5% loan discount on it, which is a large number, but let's assume that's what you expected and let's assume a 5% allowance. You'd have it on the books at 90 cents on the dollar. The 5% stays out there in the allowance for credit protection, and the 5% on the loan discount is no longer tied to asset quality — it is just truly like a bond discount. It is going to come back through income over the life of the loan," he said. A PCD loan would only be recorded with the initial credit mark, since its allowance was built into the purchase price.

Because the credit mark is counted twice for fully performing loans, CECL increases the amount of dilution in deal accounting, modestly lengthening the earnback calculation. In recent years, investors have become laser-focused on earnback periods, with steep selloffs for the buyer's stock for deals with earnback periods longer than three years.

"In some preliminary modeling we've done, there's more dilution on the front end," Fehlman said. "If you're looking at a transaction pre-CECL that might have had a three-year earnback, it now might be a 3.1- or 3.2-year earnback."

Chad Kellar, a partner for Crowe LLP who advises financial companies on CECL and M&A, said the new accounting standard could make certain deals more difficult, especially if a bank is considering an out-of-market target. CECL requires banks to use historical data to model the expected performance of loans, so banks will likely have better, more granular data for markets where they have an extensive operating history.

"If it's in an in-market deal, you can likely use your own trends, but if you're acquiring out of market and the institution hasn't started formulating their CECL estimates, you may be left using proxy call report data and simpler modeling techniques for the ongoing CECL estimate," Kellar said.

The standard becomes effective for public banks such as Simmons First on Jan. 1, 2020, at which point banks can adopt the standard by transferring capital to reserves. If the deal closes after the effective date, the reserve build will have to come out of provisioning, significantly reducing that quarter's net income.

Simmons First's desire to close before year-end is solely limited to a preference to build reserves out of retained capital rather than through provisioning. The double-count issue will persist among post-2020 deals, Fehlman said. Since the credit mark is eventually recaptured through income accretion, Fehlman said his concerns around the double-count issue relate more to timing and broader market perception than to the effect on capital.

"Our local newspaper is going to say, 'Oh, Simmons acquired a bank and they had to take a provision and they're losing money.' It's just a headlines issue, but what's sad is all this is being driven not by what's happening to the company or some business decisions, but because of an accounting change," he said. "The accounting rules changed, and it affects the bottom line."