Jeff K. Davis

Strong performance of U.S. equity markets in 2024 combined with narrowing credit spreads in the high yield bond, leverage loan and private credit markets are powerful stimulants for M&A activity. According to the Boston Consulting Group, U.S. M&A activity based upon deal values rose 21% though September 30 compared to the same period in 2023 after Fed rate hikes during 2022 and 1H23 weighed on deal activity.Deal activity measured by the number of announced deals is less compelling as deal activity has been dominated by a number of large transactions in the energy, technology and consumer sectors.While large company M&A may continue, the broadening rally in the equity markets (Russell 2000 +13% YTD through October 16; S&P 400 Midcap Index +14%) suggests that deal activity by “strategic” buyers may increase. If so, deals where publicly-traded acquirers issue shares to the target will increase, too, because M&A activity and multiples have a propensity to increase as the buyers’ shares trend higher.It is important for sellers to keep in mind that negotiations with acquirers where the consideration will consist of the buyer’s common shares are about the exchange ratio rather than price, which is the product of the exchange ratio and buyer’s share price.When sellers are solely focused on price, it is easier all else equal for strategic acquirers to ink a deal when their shares trade at a high multiple. However, high multiple stocks represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be obvious even when the buyer’s shares are actively traded.Our experience is that some if not most members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved, there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to, “value.”A fairness opinion is more than a three- or four-page letter that opines as to fairness of the consideration from a financial point of a contemplated transaction. The opinion should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated.Key questions to ask about the buyer’s shares include the following:Liquidity of the Shares.What is the capacity to sell the shares issued in the merger? SEC registration and NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently. OTC traded shares should be heavily scrutinized, especially if the acquirer is not an SEC registrant. Generally, the higher the institutional ownership, the better the liquidity. Also, liquidity may improve with an acquisition if the number of shares outstanding and shareholders increase sufficiently.Profitability and Revenue Trends. The analysis should consider the buyer’s historical growth and projected growth in revenues, EBITDA and net income as well as trends and comparisons with peers of profitability ratios.Reported vs Core Earnings. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated (preferably over the last five years and last five quarters) with particular sensitivity to a preponderance of adjustments that increase core earnings.Pro Forma Impact. The analysis should consider the impact of a proposed transaction on the pro forma balance sheet, income statement and capital structure in addition to dilution or accretion in EBITDA per share, earnings per share and tangible book value per share both from the seller’s and buyer’s perspective.Shareholder Dividends. Sellers should not be overly swayed by the pick-up in dividends from swapping into the buyer’s shares; however, multiple studies have demonstrated that a sizable portion of an investor’s return comes from dividends over long periods of time. Sellers should examine the sustainability of current dividends and the prospect for increases (or decreases). Also, if the dividend yield is notably above the peer average, the seller should ask why? Is it payout related, or are the shares depressed?Share Repurchases. Does the acquirer allocate some portion of cash flow for repurchases? If not, why not assuming adequate cash flow to do so?Capex Requirements. An analysis of capex requirements should focus on whether the business plan will necessitate a step-up in spending vs history and if so implications for shareholder distributions.Capital Stack.Sellers should have a full understanding of the buyer’s capital structure and the amount of cash flow that must be dedicated to debt service before considering capex and shareholder distributions.Revenue Concentrations. Does the buyer have any revenue or supplier concentrations? If so, what would be the impact if lost and how is the concentration reflected in the buyer’s current valuation.Ability to Raise Cash to Close.What is the source of funds for the buyer to fund the cash portion of consideration? If the buyer has to go to market to issue equity and/or debt, what is the contingency plan if unfavorable market conditions preclude floating an issue?Consensus Analyst Estimates.If the buyer is publicly traded and has analyst coverage, consideration should be given to Street expectations vs. what the diligence process determines. If Street expectations are too high, then the shares may be vulnerable once investors reassess their earnings and growth expectations.Valuation. Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles.Share Performance.Sellers should understand the source of the buyer’s shares performance over several multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Strategic Position. Assuming an acquisition is material for the buyer, directors of the selling board should consider the strategic position of the buyer, asking such questions about the attractiveness of the pro forma company to other acquirers?Contingent Liabilities. Contingent liabilities are a standard item on the due diligence punch list for a buyer. Sellers should evaluate contingent liabilities too.The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. We at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business.

Rising regulatory burdens contributed to the stunning growth in private equity the last two decades and private credit in recent years. PE investors ultimately require liquidity, however.Subdued M&A and IPO markets since mid-2022 have spurred growth for private equity secondaries, which mostly consists of GP-initiated transactions for continuation funds and LP-initiated transactions for portfolio interests.As shown in Figure 1, secondary transactions rose to $109 billion in 2023 from $102 billion in 2022 based upon data compiled by Lazard as volume soared 57% in 2H23 to $67 billion following depressed activity of about $43 billion in 2H22 and 1H23. Lazard expects secondary volume will improve further in 2024 and 2025 as the investor base for secondaries expands and buoyant markets support narrower bid-ask spreads. The need for LP liquidity also has driven the rise of NAV lending in which the GP arranges for a fund-level loan to fund distributions and/or acquisitions.Figure 1Lazard reports that LP secondaries of buyout funds realized ~88% of NAV whereas LPs realized only ~60% of NAV for interests in funds focused on early stage venture capital assuming NAV was not materially overestimated. LPs averaged 85% for interest in private credit funds, which is less than we would have guessed.LP investors can decide whether it makes sense to transact at a price that is less than NAV and thereby convey to the buyer additional return from investing in an illiquid asset. The LP investor will weigh the cost against the expected return from the current investment, the need for liquidity, and the opportunity to deploy the returned capital in new ventures.GP-led transactions for continuation funds create a corporate governance can of worms because the GP sits on both sides of the transaction as adviser to the fund that is selling an asset and as adviser to the fund that will buy it. LPs can choose liquidity on the terms offered, or they can roll their interest into the continuation fund. Whether a single asset or multi asset investment, presumably the GP is using a continuation vehicle because the exit price for an attractive asset is presently unattractive.The SEC addressed the issue through adopting Rule 211(h)(2)-2 in August 2023 which requires the GP adviser to: (a) obtain a fairness opinion or valuation from an independent valuation firm; and (b) disclose any material business relationships between the GP and opinion provider. Given the increase in GP-led secondaries to $31 billion in 2H23 from $17 billion in 1H23, the SEC governance requirement has not slowed the market.Although not mandated by law, fairness opinions for significant corporate transactions effectively have been required since 1985 when the Delaware Supreme Court ruled in Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985) that directors were grossly negligent for approving a merger without sufficient inquiry. The Court suggested directors could have addressed their duty of care (informed decision making) by obtaining a fairness opinion.The SEC rule takes aim at the corporate duty of loyalty, which with the duty of care and good faith form the triad that underpins the Business Judgement Rule in which courts defer to the decision making of directors provided they have not violated one of their duties. As far as we know, there has been no widespread finger pointing that GP-led transactions have intentionally disadvantaged LPs. Nonetheless, the SEC rule is a regulatory means to address the issue of loyalty.Fairness opinions involve a review of a transaction from a financial point of view that considers value (as a range concept) and the process the board followed. Due diligence work is crucial to the development of the opinion because there is no bright line test that consideration to be received or paid is fair or not.Mercer Capital has over four decades of experience as an independent valuation and financial advisory firm in valuing illiquid equity and credit, assessing transactions and issuing fairness opinions. Please call if we can be of assistance in valuing your funds private equity and credit investments or evaluating a proposed GP-led transaction.Originally featured in Mercer Capital's Portfolio Valuation Newsletter: Summer 2025

The other significant industry news from the first quarter was the $1.05 billion equity investment in New York Community Bank (NYSE: NYCB) by an investor group led by former Secretary of the Treasury Steve Mnuchin. The investment was necessary to boost loss absorbing capital and to shore up confidence to stem a possible deposit run after its share price collapsed during February following a surprise fourth quarter loss that was later revised higher for a $2.4 billion goodwill write-off.The initially reported 4Q23 loss of $252 million was not catastrophic, especially considering the company reported net income of $2.4 billion excluding the goodwill write-off as a result of the bargain gain from the purchase of the failed Signature Bank; however, the fourth quarter loss that arose from a $538 million provision for loan losses highlighted investor concerns about NYCB’s sizable exposure to NYC rent-controlled apartments and offices.The figure on the right presents our proforma analysis of the transaction and its impact on the consolidated company (NYCB), the parent company in which the group invested, and wholly owned Flagstar Bank, N.A. The adage that capital is exorbitantly expensive if available at all when it must be raised comes to mind here with NYCB.Source: Mercer Capital, NYCB SEC filings, and S&P Global Market IntelligenceWe note the following:The investor group paid $1.05 billion for 525 million common share equivalents consisting of 59.8 million common shares for $2.00 per share and $930 million of Series B and C preferred stock with a 13% dividend that is convertible into 465 million common shares at $2.00 per share.Tangible book value per share (“TBVPS”) declined by about one-third from $10.03 per share as of year-end 2023 to $6.65 per share on a proforma basis.Inclusive of 315 million seven-year warrants with a $2.50 per share strike price, diluted proforma TBVPS is ~$5.80 per share.The 525 million common shares represent ~40% of the 1.25 billion proforma shares while dilution to existing shareholders exceeds 50% inclusive of the warrants.The capital injection boosted the Company’s consolidated leverage ratio by ~80bps to 8.6% and total risk-based capital ratio by ~120bps to 13.0%.NYCB will generate ~$1.4 billion of pretax, pre-provision operating income in 2024 and 2025 based upon consensus analyst estimates that will supplement the new capital to absorb loan losses.Given NYCB’s shares are trading around 50% to 60% of proforma TBVPS, investors are questioning the magnitude of loan losses to be recognized; whether more capital will be required; and long-term earning power.Our additional thoughts on the transaction can be found HERE, and a link to NYCB’s investor deck announcing the transaction can be found HERE.If we can assist your board with a capital raise or other significant transaction, please call us.Originally appeared in the March 2024 issue of Bank Watch.

At this time last year, we thought bank M&A would be described as a second year of “gaining altitude” after 2020 was spent on the tarmac following the short, but deep recession in the spring of 2020. Our one caveat was that bank stocks would have to avoid a bear market following a strong performance in 2021 because bear markets are not conducive to bank M&A.The caveat was correct. Bear markets developed in both bank stocks and fixed income that included the most deeply inverted U.S. Treasury curve since the early 1980s. Among the data points:The NASDAQ Bank Index declined 19% through December 28;The Fed raised the Fed Funds target rate 425bps to 4.25% to 4.50%;The yield on the 10-year US Treasury rose 236bps to 3.88%; andCredit spreads widened, including 150bps of option adjusted spread (OAS) on the ICE BofA High Yield Index to 4.55% from 3.05%.The outlook for deal making in 2023 is challenged by significant interest rate marks (i.e., unrealized losses in fixed-rate assets), credit marks given a potential recession, soft real estate values, and the bear market for bank stocks that has depressed public market multiples. For larger deals, an additional headwind is the significant amount of time required to obtain regulatory approval.However, core deposits are more attractive for acquirers than in a typical year given rising loan-to-deposit ratios, the high cost of wholesale borrowings and an inability to sell bonds to generate liquidity given sizable unrealized losses. A rebound in bank stocks and even a modest rally in the bond market that lessens interest rate marks could be the catalysts for an acceleration of activity in 2023 provided any recession is shallow.A Recap of 2022As of December 28, 2022, there have been 167 announced bank and thrift deals compared to 216 in 2021 and 117 in 2020. During the halcyon pre-COVID years, about 270 transactions were announced each year during 2017-2019.As a percentage of charters, acquisition activity in 2022 accounted for 3.5% of the number of banks and thrifts as of January 1. Since 1990, the range is about 2% to 4%, although during 2014 to 2019 the number of banks absorbed each year exceeded 4% and topped 5% in 2019. As of September 30, there were 4,746 bank and thrift charters compared to 4,839 as of year-end 2021 and about 18,000 charters in 1985 when a ruling from the U.S. Supreme Court paved the way for national consolidation.Also notable was the lack of many large deals. Toronto-Dominion’s (NYSE: TD)pending $13.7 billion cash acquisition of First Horizon (NYSE: FHN) represents 61% of the $23 billion of announced acquisitions this year compared to $78 billion in 2021 when divestitures of U.S. operations by MUFG and BNP and several larger transactions inflated the aggregate value.Pricing—as measured by the average price/tangible book value (P/TBV) multiple—was unchanged compared to 2021. As always, color is required to explain the price/earnings (P/E) multiple based upon reported earnings.The median P/TBV multiple was 154% in 2022. As shown in Figure 1, the average transaction multiple since the Great Financial Crisis (GFC) peaked in 2018 at 174% then declined to 134% in 2020 due to the impact of the short but deep recession on economic activity and markets.The median P/E in 2022 eased slightly to 14.6x from 15.3x in 2021; however, buyers focus on pro forma earnings with fully phased-in expense saves that often are on the order of 7x to 8x unless there are unusual circumstances. Accretion in EPS is required by buyers to offset day one dilution to TBVPS and to recoup the increase in TBVPS that would be realized on a stand-alone basis as investors expect TBVPS payback periods not to exceed three years.Figure 1 :: 1990-2022 National Bank M&A MultiplesClick here to expand the image abovePublic Market Multiples vs Acquisition MultiplesFigure 2 compares the annual average P/TBV and P/E for banks that were acquired for $50 million to $250 million since 2000 with the average daily public market multiple each year for the SNL Small Cap Bank Index.1Among the takeaways are the following:Acquisition pricing prior to the GFC as measured by P/TBV multiples approximated 300% except for the recession years of 2001 and 2002 when the average multiples were 248% and 267%.Since 2014, average P/TBV multiples have been in the approximate range of 160% to 180% except for 2020.The reduction in both the public and acquisition P/TBV multiples since the GFC reflects a reduction in ROEs for the industry since the Fed adopted a zero-interest rate policy (ZIRP) other than 2017-2019 and 2022.Since pooling of interest accounting ended in 2001, the “pay-to-trade” multiple as measured by the average acquisition multiple relative to the average index multiple has remained in a relatively narrow range of roughly 0.9 to 1.15 other than during 2009 and 2010.P/E multiples based upon unadjusted LTM earnings have approximated or exceeded 20x prior to 2019 compared to 14-18x since then.Acquisition P/Es have tended to reflect a pay-to-trade multiple of 1.25 since the GFC but the pay-to-trade multiples are comfortably below 1.0x to the extent the pro forma earnings multiple is 7-8x, the result being EPS accretion for the buyer.Figure 2 :: 2000-2022 Acquisition Multiples vs Public Market MultiplesClick here to expand the image aboveFigure 3 :: 2000-2022 M&A TBV Multiples vs. Index TBV MultiplesClick here to expand the image abovePremium Trends SubduedInvestors often focus on what can be referred to as icing vs the cake in the form of acquisition premiums relative to public market prices. Investors tend to talk about acquisition premiums as an alpha generator, but long-term performance (or lack thereof) of the target is what drives shareholder returns.As shown in Figure 4, the average five-day premium for transactions announced in 2022 that exceeded $100 million in which the buyer and usually the seller were publicly traded was about 20%, a level that is comparable to recent years other than 2020. For buyers, the average reduction in price compared to five days prior to announcement was 2.5%. There are exceptions, of course, when investors question the pricing (actually, the exchange ratio), day one dilution to TBVPS and earn-back period. For instance, Provident Financial (NASDAQ: PFS) saw its shares drop 12.5% after it announced it would acquire Lakeland Bancorp (NASDAQ: LBAI) for $1.3 billion on September 27, 2022.Figure 4About Mercer CapitalM&A entails a lot of moving parts of which “price” is only one. It is especially important for would be sellers to have a level-headed assessment of the investment attributes of the acquirer’s shares to the extent merger consideration will include the buyer’s common shares. Mercer Capital has 40 years of experience in assessing mergers, the investment merits of the buyer’s shares and the like. Please call if we can help your board in 2023 assess a potential strategic transaction.

The U.S. bond market is undergoing its worst bear market in decades. Barclays U.S. Aggregate Bond Market Index produced a total return of negative 14.5% through September 30, 2022 and negative 16.0% through November 8, 2022. Excluding coupon income, the year-to-date loss was 17.2% which speaks to how low coupon income is given the nominal difference between price change and total return.Click here to expand the image aboveAs shown in the figure below, U.S. commercial banks have suffered unrealized losses in their bond portfolios equal to roughly 10% of the cost basis of both AFS and HTM classified portfolios as of September 30, which compares to a price reduction of 15.6% in the Barclay’s index as of quarter end.The less-worse performance by U.S. banks likely reflects less duration than the index, which has an effective duration of 6.25 years and weighted average maturity of 8.25 years. Our observation is that for the most part outsized losses among U.S. banks reflect an outsized position in municipals and/or MBS. The index composition is heavily skewed to U.S. Treasuries and U.S. Agency obligations given the heavy issuance of government backed debt the past 15 years or so.While management and directors at most banks are unhappy with their bond portfolios, institutional investors have taken a more nuanced view of the impact of rising rates based upon the tenor of third quarter earnings calls and the reaction of most stocks upon the release of earnings. Rising rates have supported bank earnings even though fixed-rate loan and bond portfolios are slow to reprice as floating-rate loans have repriced and banks have lagged deposit rates.Investor concern is more focused on liquidity risks. Some (or many) banks eventually may have to raise deposit rates sharply to stem outflows and/or fund loan growth because selling bonds is not a viable option given the magnitude of unrealized losses that if realized will reduce regulatory capital.Our prior commentary on bank bond portfolios following the release of the first and second quarter Call Reports can be found here and here.

The August Bank Watch looks at unrealized losses in bank bond portfolios based upon Call Report data as of June 30, 2022. Our review of unrealized losses as of March 31 can be found here.Fed Chair Powell gave a short 8-minute speech on August 26 at the annual Jackson Hole, Wyoming economic summit that is hosted by the Federal Reserve Bank of Kansas City. The gist of Powell’s speech is that the Fed is solely focused on reducing inflation. Powell’s speech in 2021 discussed “transitory” inflation and the timing of when the Fed might begin to reduce its monthly purchase of $120 billion of U.S. Treasuries (“UST”) and Agency MBS. At the time consumer prices were then advancing around 5% vs 9% now.Last year, equity markets liked what it heard from Powell at Jackson Hole regarding the liquidity spigot; not so this year as the S&P 500 declined 3.4% and the NASDAQ declined 3.9% the day Powell spoke. The NASDAQ Bank Index declined 2.4% and is down 12.8% year-to-date through August 26.Interestingly, UST yields did not move much even though Powell said it would not be appropriate to stop hiking at a “neutral” rate. As such, bank bond portfolios did not incur additional losses. In fact, the peak loss for most bank bond portfolios was in mid-June when the yield on the 10-year UST rose to 3.49% compared to 2.98% on June 30 and 3.04% on August 26.Based upon our review of bank second quarter earnings calls and analysts’ write-ups, investors seem to be taking the losses in stride given solid growth in spread revenues as NIM expansion has been dramatic. Last spring that was not the case when the ~150bps increase in intermediate- and long-term rates produced significant losses in bond portfolios given little coupon to cushion the higher term structure.As shown in Figure 1, the Fed has hiked the Funds target rate much faster and by a greater magnitude than it did in 1994 when the Fed waylaid the bond market with 300bps of hikes. Bond portfolios were hammered as the hikes and an upturn in inflation drove longer-term rates higher by ~275bps. The curve became flatter but never inverted as investors assumed a recession would not develop.1Figure 1: 1994 Bond Bear Market vs 2022 Bond Bear Market Powell’s comments last week imply short-term policy rates may go as high as 4% by next Spring based upon futures markets. Given little movement in UST yields, bond investors are pricing in slowing economic activity and possibly lower yields to come. If so, the inverted UST curve prospectively will become more inverted if the Powell Fed can stomach the seemingly probable fallout as it pushes short rates higher. Figure 2: Unrealized Bond Portfolio Losses vs Cost Basis and Tier 1 CapitalClick here to enlarge the image aboveFigure 3: Unrealized Bond Portfolio Losses vs Cost Basis and Tier 1 CapitalClick here to enlarge the image aboveAs shown in Figure 2, unrealized losses as of June 30 were significant though losses and gains are excluded from regulatory capital for all but the largest banks.Unrealized losses in available-for-sale (“AFS”) designated portfolios ranged from an average of 5.7% of cost for banks with less than $100 million of assets to 8.0% for banks with $1 billion to $3 billion of assets. As a percent of tier one capital the range was from 11.3% for banks with $100 billion to $250 billion of assets to 22.5% for banks with $100 million to $500 million of assets.Figure 3 provides the same data as of year-end 1994 when the ten-year UST was near a cyclical peak of ~8%. The bear market of 2022 is far worse than the 1994 bear market. Unlike 1994, portfolios today have little coupon to cushion the impact of rising rates. Also, duration may be longer today.The “coupon issue” today is reflected in low portfolio yields. As an example, the average taxable equivalent portfolio yield for banks with $1 billion to $3 billion of assets was only 1.96% in 2Q22 compared to 1.80% in 4Q21 immediately before the Fed began to hike. By way of comparison, the yield on one-month T-bills as of August 26 was 2.21% and 30-day LIBOR was 2.49%. Cash yields more than bond portfolios and prospectively will yield much more if the Fed pushes the Funds target to 4% by next spring.The good news is that portfolio cash flow should be reinvested at much higher yields to the extent it is not used to fund loan growth or deposit run-off. The same applies to fixed rate loans, which are not marked-to-market but may have comparable losses given both higher rates and wider credit spreads.The exceptionally good news is that non-interest-bearing (“NIB”) deposits, which are the core of core deposits, are driving NIM expansion and growth in spread revenues. Rate hikes this year are inflating the value of NIB deposits. There is no mark-to-market report for a board to see this; rather, the value is in the income statement.The unknowable question is if the Fed can push short-term rates higher without producing a sharp downturn or serious credit event that forces the Fed to blink again. The downturn in bank stocks this year primarily reflects investor expectations about the potential impact a recession would have on credit costs next year; it is not about unrealized losses in bond portfolios. Figure 4: Credit Spreads WidenClick here to enlarge the image aboveAbout Mercer CapitalMercer Capital is a national valuation and transaction advisory firm that has advised banks for 40 years through bear and bull markets. Please call if we can be of assistance.1 The Fed rate hiking campaigns of 2004-2006 (425bps of cumulative hikes to 5.25%) and 2015-2018 (225bps to 2.50%) did not produce as great of losses as the current cycle and 1994. The curve was exceptionally steep in 2004 such that long-term UST rates rose less than 100 bps (Greenspan called it a “conundrum”) while it took a couple of years for long-term yields to peak in 2018 around 3% vs the “all-at-once” episode this year.

This is the eighth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. Directors are periodically asked to make tough decisions about the strategic direction of a company. Major acquisitions are usually one of the toughest calls boards are required to make. A board’s fiduciary duty to shareholders is encapsulated by three mandates:Act in good faith;Duty of care (informed decision making); andDuty of loyalty (no self-dealing; conflicts disclosed). Directors are generally shielded from courts second guessing their decisions by the business judgment rule provided there is no breach of duty to shareholders. The presumption is that non-conflicted directors made an informed decision in good faith. As a result, the burden of proof that a transaction is not fair and/or there was a breach of duty resides with the plaintiffs. An independent fairness opinion helps demonstrate that the directors of an acquiring corporation are fulfilling their fiduciary duties of making an informed decision. Fairness opinions seek to answer the question whether the consideration to be paid (or received from a seller’s perspective) is fair to a company’s shareholders from a financial point of view. Occasionally, a board will request a broader opinion (e.g., the transaction is fair). A fairness opinion does not predict where the buyer’s shares may trade in the future. Nor does a fairness opinion approve or disapprove a board’s course of action. The opinion, backed by a rigorous valuation analysis and review of the process that led to the transaction, is just that: an opinion of fairness from a financial point of view.Delaware, the SEC and FairnessFairness opinions are not required under Delaware law or federal securities law, but they have become de rigueur in corporate M&A ever since the Delaware Supreme Court ruled in 1985 that directors of TransUnion were grossly negligent because they approved a merger without adequate inquiry and expert advice. The court did not specifically mandate the opinion be obtained but stated it would have helped the board carryout its duty of care had it obtained a fairness opinion regarding the firm’s value and the fairness of the proposal.The SEC has weighed in, too, in an oblique fashion via comments that were published in the Federal Register in 2007 (Vol. 72, No. 202, October 19, 2007) when FINRA proposed rule 2290 (now 5150) regarding disclosures and procedures for the issuance of fairness opinions by broker-dealers. The SEC noted that the opinions served a variety of purposes, including as indicia of the exercise of care by the board in a corporate control transaction and to supplement information available to shareholders through a proxy.Dow’s Sour PickleBuy-side fairness opinions have a unique place in corporate affairs because the corporate acquirer has to live with the transaction. What seems fair today but is deemed foul tomorrow, may create a liability for directors and executive officers. This can be especially true if the economy and/or industry conditions deteriorate after consummation of a transaction.For instance, The Dow Chemical Company (“Dow”), a subsidiary of Dow Inc. (NYSE: DOW), agreed to buy Rohm and Haas (“RH”) for $15.4 billion in cash on July 10, 2008. The $78 per share purchase price represented a 75% premium to RH’s prior day close. The ensuing global market rout and the failure of a planned joint venture with a Kuwait petrochemical company led Dow to seek to terminate the deal in January 2009 and to cut the dividend for the first time in the then 97 years the dividend had been paid.Ultimately, the parties settled litigation and Dow closed the acquisition on April 1, 2009 after obtaining an investment from Berkshire Hathaway (NYSE: BRK.A) and seller financing via the sale of preferred stock to RH’s two largest shareholders.Dow was well represented and obtained multiple fairness opinions from its advisors (Citigroup, Merrill Lynch and Morgan Stanley). One can question how the advisors concluded a 75% one-day premium was fair to Dow’s shareholders (fairness is a mosaic and maybe RH’s shares were severely depressed in the 2008 bear market). Nonetheless, the affair illustrates how vulnerable Dow’s Board of Directors or any board would have been absent the fairness opinions.Fairness and ElonBefore Elon Musk reneged on his planned acquisition of Twitter, Inc. (NYSE: TWTR) on July 8, 2022, one of the most recent contentious corporate acquisitions was the 2016 acquisition of SolarCity Corporation by Tesla Inc. (NASDAQGS: TSLA). Plaintiffs sought up to $13 billion of damages, arguing that (a) the Tesla Board of Directors breached its duty of loyalty, (b) Musk was unjustly enriched (Musk owned ~22% of both companies and was Chairman of both); and (c) the acquisition constituted waste.Delaware Court of Chancery Judge Joseph Slights ruled in favor of Tesla on April 27, 2022. Slights noted courts are sometimes skeptical of fairness opinions; however, he was not skeptical of Evercore’s opinion, noting extensive diligence, the immediate alerting of the Tesla Board about SolarCity’s liquidity situation and the absence of prior work by Evercore for Tesla. Tesla Walks the Entirely FairLine with SolarCityDownload Presentation

Equity investors define a bear market as a 20% or greater reduction in price from the most recent high price. There is no consensus for fixed income. A bond’s maturity and coupon are key variables in determining the sensitivity of price except when overlaying credit and prepayment variables when applicable.A simple definition might be when the price falls more than three times the annual income for any bond with a maturity greater than five years. If so, it is a low bar when coupons are as low as they are. Definitions aside, the bond market is in a bear market.Figure 1 :: 1994 Bear Market vs 2022 Bear Market The yield on the 10-year U.S. Treasury note (“UST”) was 3.21% on June 27, up from 1.51% as of year-end. Ignoring the impact of the intervening six months for what would be a bond with 9.5 years to maturity, the increase in yield has produced a ~14% loss in value. The last bond bear market that was brutal occurred in 1994 when the Fed raised the Fed Funds target rate from today’s aspirational rate of 3.0% beginning in February to 6.0% by February 1995. The yield on the 10-year UST rose from 5.19% on October 15, 1993 to a peak of 8.05% on November 7, 1994 once the market could see the last few Fed hikes to come. The 286bps increase in yield pushed the price of the 10-year UST down by 17%, which modestly exceeds the 14% loss this year. Coupons matter. Fixed income investors entered the current rising rate environment with little coupon to cushion rising yields unlike in the years immediately after the Great Financial Crisis when the Fed first implemented a zero-interest rate policy (“ZIRP”). Worse, banks entered the current bear market with much bigger securities portfolios given the system was inundated with excess deposits because of actions taken by the Fed and government to offset the COVID-19 recession. To get a sense of the damage in bank bond portfolios consider Figures 2 and 3 where we have compared the unrealized losses in bank bond portfolios as of March 31 with the unrealized losses as of year-end 1994, which roughly corresponded to the bottom of the 1994 bear market. The data reflects averages. Figure 2 :: Unrealized Losses in Bank Portfolios as of March 31, 2022Figure 3 :: Unrealized Losses in Bank Portfolios as of December 31, 1994 We make the following observations for banks with $1 billion to $3 billion of assets: Banks are better capitalized with average leverage and tier one capital ratios of 10.6% and 17.0% as of March 31, 2022 compared to 8.3% and 12.9% as of year-end 1994.Securities classified as available-for-sale (“AFS”) and held-to-maturity (“HTM”) averaged 19.0% and 2.5% of assets as of March 31, 2022 compared to 11.2% and 14.6% as of year-end 1994.The unrealized loss in the AFS portfolio equated to 4.7% of the cost basis and 11.3% of tier one capital (excludes the deferred tax asset adjustment) as of March 31, 2022 compared to 2.8% and 5.7% as of year-end 1994. 1 Unrealized losses in HTM portfolios in Figure 2 may appear too small even though many banks classify long-dated municipals as HTM because these illiquid bonds had not been adequately marked yet to reflect a rapidly declining market.Unrealized losses will increase once June 30 data is available because UST rates have risen ~75bps since March 31. Banks are sitting on large unrealized losses today. Investors know that. The bear market in bank stocks (the NASDAQ Bank Index is down ~19% YTD) primarily reflects investor expectations about the potential impact a recession would have on credit costs next year even though NIMs will increase this year (excluding the impact of PPP loan fees) and next provided the Fed does not pivot and reduce rates. The current equity bear market is not about unrealized losses in bond portfolios; it is about the economic outlook. From a valuation perspective, we primarily look to the impact of rising (or falling) rates on a bank’s earnings rather than how changes in rates have impacted the value of the bond portfolio and tangible book value. Assuming an efficient market, the unrealized losses represent the opportunity cost of holding bonds with coupons below the current market rate. If the underwater bonds are sold and immediately repurchased, then the bonds repurchased will produce enough extra income over the life of the bonds to recoup the loss (assuming an efficient market). Further, the AFS securities portfolio is the only asset for most banks that is marked-to-market other than mortgage loans pending sale. Fixed rate residential and CRE loans would have sizable losses, too, if subjected to mark-to-market. Rates have risen, prepayment speeds have slowed and in the case of CRE credit spreads have widened. Also not marked-to-market are deposits. Though a liability, core deposits are the key “asset” for commercial banks. Value for deposits—especially non-interest-bearing deposits—are soaring given a low beta to changes in market interest rates when loan-to-deposit ratios are low. The monthly report that really matters is not the bond report but the asset-liability model (“ALM”). Banks manage net interest margin (price) and assets (volume) to drive earnings; and earnings (or cash flow) drive stocks over time. Earnings also build book value to the extent earnings are retained. Rising rates—gradually rather than rapid—are a positive development given the commercial bank business model, assuming that credit quality does not deteriorate. Having said that, we cannot completely dismiss the unrealized losses in the bond portfolios. Some investors focus on tangible book value, though we view it as a proxy for earning power because tangible book value is levered to produce net interest income. Also, M&A is more challenging because day one dilution to tangible BVPS is greater to the extent unrealized bond losses are recognized via fair value marks applied to all assets. Of course, earnings then increase from accreting the discounts as additional yield. Aside from the soaring value of core deposits, the glass half full view is bonds and fixed rate loans eventually mature. In the interim, cash flows should be reinvested to produce better yields.About Mercer CapitalMercer Capital is a national valuation and transaction advisory firm that has advised banks for 40 years through bear and bull markets. Please give one of our professionals a call if we can be of assistance.

Evaluating Fairness of the Tesla Motors, Inc. and SolarCity Corporation MergerIn March 2016, Jonathan Goldsmith retired from a long advertising stint for Dos Equis beer as the Most Interesting Man in the World with a final commercial in which he was sent on a one-way trip to Mars. The same month Elon Musk, arguably the most interesting man in global business then and now, was laying the ground work for the merger of Telsa, Inc. (NASDAQ: TSLA) and SolarCity Corporation of which he owned about 22% of both companies.Fairness as an adjective means what is just, equitable, legitimate and consistent with rules and standards. As it relates to transactions, fairness is like valuation in that it is a range concept: transactions may not be fair, a close call, fair or very fair.This presentation looks at the issues raised by plaintiffs who alleged Musk orchestrated the deal to bail-out SolarCity, and how the Delaware Court of Chancery ruled on the issues on April 27. 2022 under the entire fairness standard rather than deferential business judgment rule.

In this week's Family Business Director, we feature Jeff K. Davis, CFA, Managing Director of Mercer Capital’s Financial Institutions Group, a veteran banking analyst, and an editorial contributor to SNL Financial. He regularly is featured in American Banker, Bloomberg News, and other industry outlets.Barring a change in the economic backdrop, the availability of debt financing for most family businesses in 2022 should be good; however, the cost of borrowing probably will rise in 2022. Market participants are highly certain the Fed will raise short-term policy rates to address high inflation that massive growth in monetary aggregates since March 2020 unleashed on financial markets initially and now the broader economy.As shown in the chart below, the yield on two-year and ten-year US Treasury (“UST”) notes have been trending higher for some time. The two-year note is sensitive to short-term policy rates the Fed sets (e.g., the rate the Fed pays banks for reserves that are deposited with it). It has rapidly increased in yield (i.e., the price has declined) since last September when it became obvious that inflation was not “transitory” and the Fed faced a political as well as economic issue of having not acting sooner. Click here to expand the chart below.Source: Market Yield on U.S. Treasury Securities at 2-Year Constant Maturity (DGS2) | FRED | St. Louis Fed (stlouisfed.org)The yield on the 10-year UST is not directly tied to where the Fed sets short-term policy rates. Theoretically, the rate reflects economic growth expectations, inflation, and a term premium for long lending. If short-term policy rates are kept too low, then all else equals the yield on the 10-year would be expected to increase as growth and inflation expectations rise. Conversely, once the Fed starts hiking, long-term UST rates initially tend to rise less than the Fed hikes and later often decline as investors wager the Fed will hike until something breaks.This is what occurred in 2018. The yield peaked in October and fell sharply as investors concluded the anticipated December rate hike would be ill-advised. The yield on the 10-year continued to trend lower in the first half of 2019 before the Fed was forced to reduce short-term policy rates three times to about 1.50% during the third quarter.Since late March 2020, short-term policy rates have been near zero when the Fed cut rates to address illiquidity in markets and the economic shock from policy actions taken in response to the COVID-19 pandemic.It is these short-term policy rates that are now poised to increase, which in turn impact short-term benchmark rates banks and other lenders use as a base rate to charge businesses, most notably 30-day and 90-day LIBOR and now the secured overnight funding rate (“SOFR”) for floating rate borrowings. (Note: LBIOR is in the process of being phased out and will be replaced by SOFR, AMERIBOR, and other less well-known overnight borrowing rates.)Even with rising rates, competition will likely remain intense and preclude much if any increase in the margin over the base rate in 2022.Fixed borrowing rates that track UST and swap rates for various maturities have already begun to rise somewhat and will increase further in 2022 provided UST yields continue to track higher.Competition among lenders determines the margin over the base rate whether short-term floating or intermediate-term fixed the borrower will be charged. Even with rising rates, competition will likely remain intense and preclude much if any increase in the margin over the base rate in 2022.As shown below, market participants are pricing in about four 25bps hikes in short-term policy rates by the Fed given about 100bps of increase in 30/90-day LIBOR based upon rates that are observed in the highly liquid Eurodollar market. Likewise, the forward SOFR curve also is pricing in about 100bps of increase over the next year. Over the next two years, the market is pricing in about 175bps of hikes, which would equate to seven 25bps hikes by the Fed compared to nine during the last hiking cycle that ended in December 2018.If market expectations are fully realized, borrowing rates for family businesses should remain very low by historical standards, just not as low as 2020 and 2021. Our sense is that most businesses will not be materially impacted given the market projects' low terminal rate. Higher rates will only be an issue if the borrower’s industry or broader economy falls into recession.An unanswered question is whether financial markets can stand the prospective increase given the massive leverage employed for speculation and to fund “carry trades” in which leverage is used to increase the amount of income produced from low-yielding bonds. If markets cannot tolerate much increase, then the question will become at what point will the “Fed put” or “Powell put” be triggered in which further hikes are precluded or even reversed?No one knows, but this link provides an interesting perspective on the accuracy of forwarding curves. Since the Fed experimented with very low policy rates in the early 2000s when the Fed Funds rate was set at 1%, market participants have projected hikes would commence sooner than occurred. Also, once hiking cycles began, market participants projected less hiking than occurred.In effect, investors believed rates were too low once reduced to near zero; and once the hiking began, the Fed did not have as much latitude as it thought it had to raise rates given the build-up of debt in the economy and markets.

At this time last year, bank M&A could be described as “on the runway” as economic activity accelerated following the short, but deep recession in the spring. Next year, activity should gain altitude. Most community banks face intense earnings pressure as PPP fees end, operating expenses rise with inflation, and core NIMs remain under pressure unless the Fed can hike short-term policy rates more than a couple of times. Good credit quality is supportive of activity, too.Should and will are two different verbs, however.One wildcard that will impact activity and pricing is the public market multiples of would be acquirers. Consideration for all but the smallest sellers often includes the issuance of common shares by the buyer. When bank stocks trade at high multiples, sellers obtain “high” prices though less value than when public market multiples are low and sellers receive low(er) prices though more value.If bank stock prices perform reasonably well in 2022, after a fabulous 2021 in which the NASDAQ Bank Index increased 40% through December 28, then activity probably will trend higher as more community banks look to sell. MOEs may be easier to negotiate, too. If bank stocks are weak for whatever reason, then activity probably will slow.A Recap of 2021As of December 17, 2021, there have been 206 announced bank and thrift deals compared to 117 in 2020. During the halcyon pre-COVID years, about 270 transactions were announced each year during 2017-2019.As a percent of charters, acquisition activity in 2021 accounted for about 4% of the number of banks and thrifts as of January 1.Since 1990, the range is about 2% to 4%, although during 2014 to 2019 the number of banks absorbed each year exceeded 4% and topped 5% in 2019. As of September 30, there were 4,914 bank and thrift charters compared to 9,904 as of year-end 2000 and about 18,000 charters in 1985 when a ruling from the U.S. Supreme Court paved the way for national consolidation.Pricing—as measured by the average price/tangible book value (P/TBV) multiple—improved in 2021. As always, color is required to explain the price/earnings (P/E) multiple based upon reported earnings.The national average P/TBV multiple increased to 155% from 135% in 2020, although deal activity was light in 2020. As shown in Figure 1, the average transaction multiple since the Great Financial Crisis (GFC) peaked in 2018 at 174% then declined to 158% in 2019 as the Fed was forced to cut short-term policy rates three times during 3Q19 in an acknowledgment that the December and probably September 2018 hikes were ill-advised.Earnings—rather than tangible book value — drive pricing as do public market valuations of acquirers who issue shares as part of the seller consideration. Nonetheless, drawing conclusions based upon unadjusted reported earnings sometimes can be misleading.As an example, the national median P/E for banks that agreed to be acquired in 2018 approximated 25x, in part, because many banks that are taxed as C corporations wrote down deferred tax assets at year-end 2017 following the enactment of corporate tax reform. Plus, forward earnings reflected a reduction in the maximum federal tax rate to 21% from 35%.Also, the median P/E in 2021 fell to about 15x from 17x in 2019 and 2020 in part because the earnings of many sellers included substantial PPP-related income that will largely evaporate after this year.Buyers focus on the pro forma earnings multiple with all expense savings in addition to EPS accretion and the amount of time it takes to recoup dilution to tangible BVPS. Our take is that most deals entail a P/E based upon pro forma earnings with fully phased-in expense saves of 7x to 10x unless there are unusual circumstances.Public Market Multiples vs Acquisition MultiplesClick here to expand the image aboveFigure 2 compares the annual average P/TBV and P/E for banks that were acquired for $50 million to $250 million since 1997 with the SNL Small Cap Bank Index average daily multiple for each year. Among the takeaways are the following:Acquisition pricing as measured by the P/TBV multiple peaked in 1998 (when pooling-of-interest was the predominant accounting method) then bottomed in 2009 (as the GFC ended) and trended higher until 2018.Since pooling ended in 2001, the “pay-to-trade” multiple as measured by the average acquisition P/TBV multiple relative to the average index P/TBV multiple, has remained in a relatively narrow range of roughly 0.9 to 1.15 other than during 2009 and 2010.The reduction in both the public and acquisition P/TBV multiples since the GFC corresponds to the adoption of a zero interest rate policy (ZIRP) by the Fed during 2008 that has been in place ever since other than 2017-2019.P/E multiples based upon LTM earnings have shown little trend with a central tendency around 20x other than 1998 (1990s peak), 2018 (tax reform implementation) and 2020-2021 (COVID distortions).Acquisition P/Es have tended to reflect a pay-to-trade multiple of 1.25 since the GFC but as noted what really matters is the P/E based upon pro forma earnings with expense saves. To the extent the pro forma earnings multiple is 7-10x, the pay-to-trade earnings multiples typically are below 1.0 to the extent buyers are trading above 10x forward earnings.Click here to expand the image aboveClick here to expand the image abovePremium Trends SubduedPublic market investors often focus on what can be referred to as icing vs the cake in the form of acquisition premiums relative to the pre-announcement prices. Investors tend to talk about acquisition premiums as an alpha generator, but long-term performance (or lack thereof) of the target is what drives shareholder returns. Sometimes the market is suprised by acquisitions with an outsized premium, but in recent years premiums often have been modest.As shown in Figure 4, the average one-day premium for transactions announced in 2021 that exceeded $100 million in which the buyer and seller were publicly traded was about 9%, a level that was comparable to the prior few years excluding 2020. For buyers, the average day one reduction in price was less than 1%, though there are exceptions when investors question the pricing (actually, the exchange ratio). For instance, First Interstate (NASDAQ: FIBK) saw its shares drop 7.4% after it announced it would acquire Great Western for about $2 billion on September 16, 2021.About Mercer CapitalM&A entails a lot of moving parts of which “price” is only one. It is especially important for would be sellers to have a level-headed assessment of the investment attributes of the acquirer’s shares to the extent merger consideration will include the buyer’s common shares. Mercer Capital has roughly 40 years of experience in assessing mergers, the investment merits of the buyer’s shares, and the like. Please call if we can help your board in 2022 assess a potential strategic transaction.

Last July I gave a presentation to the third-year students attending the Consumer Bankers Association’s Executive Banking School. The presentation, which can be found here, touched on three big valuation themes for bank investors: estimate revisions, earning power and long-term growth.Although Wall Street is overly focused on the quarterly earnings process, investors care because of what quarterly results imply about earnings (or cash flow) estimates for the next year and more generally about a company’s earning power. Earning beats that are based upon fundamentals of faster revenue growth and/or positive operating leverage usually will result in rising estimates and an increase in the share price. The opposite is true, too.For U.S. banks that have largely finished reporting third quarter results, questions about all three—especially earning power—are in flux more than usual. Industry profitability has always been cyclical, but what is normal depends. Since the early 1980s, there have been fewer recessions that have resulted in long periods of low credit costs. Monetary policy has been radical since 2008. What’s normal was also distorted in 2020 and 2021 by PPP income that padded earnings but will evaporate in 2023.Most banks beat consensus EPS estimates, largely due to negligible credit costs if not negative loan loss provisions as COVID-19 related reserve builds that occurred in 2020 proved to be too much; however, there was no new news with the earnings release as it relates to credit.Investors concluded with the release of third and fourth quarter 2020 results that credit losses would not be outsized. Overlaid was confirmation from the corporate bond market as spreads on high yield bonds, CLOs and other structured products began to narrow in the second quarter of 2020 as banks were still building reserves.As of October 28, 2020, the NASDAQ Bank Index has risen 78% over the past year and 39% year-to-date.Much of that gain occurred during November (October 2020 was a strong month, too) through May as investors initially priced-in reserve releases to come; and then NIMs that might not fall as far as feared as the yield on the 10-year UST doubled to 1.75% by late March. Bank stocks underperformed the market during the summer as the 10-year UST yield fell. Since late September banks rallied again as investors began to price rate hikes by the Fed beginning in 2022 rather than 2023.No one knows for sure; the future is always uncertain. For banks, two key variables have an outsized influence on earnings other than credit costs: loan demand and rates. In other industries the variables are called volume and price. If both rise, most banks will see a pronounced increase in earnings as revenues rise and presumably operating leverage improves. Street estimates for 2022 and 2023 will rise, and investors’ view of earning power will too.We do not know what the future will be either.Loan demand and excess liquidity have been counter cyclical forces in the banking industry since banks came into being.The question is not if but how strong loan demand will be when the cycle turns. Interest rates used to be cyclical, too, until governments became so indebted that “normal” rates apparently cannot be tolerated.Nonetheless, at Mercer Capital we have decades of experience of evaluating earnings, earning power, multiples and other value drivers. Please give us a call if we can assist your institution.

Depository M&A activity in the U.S. has accelerated in 2021 from a very subdued pace in 2020 when uncertainty about the impact of COVID-19 and the policy responses to it weighed on bank stocks. At the time, investors were grappling with questions related to how high credit losses would be and how far would net interest margins decline. Since then, credit concerns have faded with only a nominal increase in losses for many banks. The margin outlook remains problematic because it appears unlikely the Fed will abandon its zero-interest rate policy (“ZIRP”) anytime soon.As of September 23, 2021, 157 bank and thrift acquisitions have been announced, which equates to 3.0% of the number of charters as of January 1. Assuming bank stocks are steady or trend higher, we expect 200 to 225 acquisitions this year, equivalent to about 4% of the industry and in-line with 3% to 5% of the industry that is acquired in a typical year. During 2020, only 117 acquisitions representing 2.2% of the industry were announced, less than half of the 272 deals (5.0%) announced in pre-covid 2019.To be clear, M&A activity follows the public market, as shown in Figure 1. When public market valuations improve, M&A activity and multiples have a propensity to increase as the valuation of the buyers’ shares trend higher. When bank stocks are depressed for whatever reason, acquisition activity usually falls, and multiples decline.Click here to expand the image aboveThe rebound in M&A activity this year did not occur in a vacuum. Year-to-date through September 23, 2021, the S&P Small Cap and Large Cap Bank Indices have risen 25% and 31% compared to 18% for the S&P 500. Over the past year, the bank indices are up 87% and 79% compared to 37% for the S&P 500.Excluding small transactions, the issuance of common shares by bank acquirers usually is the dominant form of consideration sellers receive. While buyers have some flexibility regarding the number of shares issued and the mix of stock and cash, buyers are limited in the amount of dilution in tangible book value they are willing to accept and require visibility in EPS accretion over the next several years to recapture the dilution.Because the number of shares will be relatively fixed, the value of a transaction and the multiples the seller hopes to realize is a function of the buyer’s valuation. High multiple stocks can be viewed as strong acquisition currencies for acquisitive companies because fewer shares are issued to achieve a targeted dollar value.However, high multiple stocks may represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be obvious even when the buyer’s shares are actively traded.Our experience is that some, if not most, members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved, there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to “value.”A fairness opinion is more than a three or four page letter that opines as to the fairness from a financial point of a contemplated transaction; it should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated.Key questions to ask about the buyer’s shares include the following:Liquidity of the Shares - What is the capacity to sell the shares issued in the merger? SEC registration and NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently. OTC traded shares should be scrutinized, especially if the acquirer is not an SEC registrant. Generally, the higher the institutional ownership, the better the liquidity. Also, liquidity may improve with an acquisition if the number of shares outstanding and shareholders increase sufficiently.Profitability and Revenue Trends - The analysis should consider the buyer’s historical growth and projected growth in revenues, pretax pre-provision operating income and net income as well as various profitability ratios before and after consideration of credit costs. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated. This is particularly important because many banks’ earnings in 2020 and 2021 have been supported by mortgage banking and PPP fees.Pro Forma Impact - The analysis should consider the impact of a proposed transaction on the pro forma balance sheet, income statement and capital ratios in addition to dilution or accretion in earnings per share and tangible book value per share both from the seller’s and buyer’s perspective.Tangible BVPS Earn-Back - As noted, the projected earn-back period in tangible book value per share is an important consideration for the buyer. In the aftermath of the GFC, an acceptable earn back period was on the order of three to five years; today, two to three years may be the required earn-back period absent other compelling factors. Earn-back periods that are viewed as too long by market participants is one reason buyers’ shares can be heavily sold when a deal is announced that otherwise may be compelling.Dividends - In a yield starved world, dividend paying stocks have greater attraction than in past years. Sellers should not be overly swayed by the pick-up in dividends from swapping into the buyer’s shares; however, multiple studies have demonstrated that a sizable portion of an investor’s return comes from dividends over long periods of time. Sellers should examine the sustainability of current dividends and the prospect for increases (or decreases). Also, if the dividend yield is notably above the peer average, the seller should ask why? Is it payout related, or are the shares depressed?Capital and the Parent Capital Stack - Sellers should have a full understanding of the buyer’s pro-forma regulatory capital ratios both at the bank-level and on a consolidated basis (for large bank holding companies). Separately, parent company capital stacks often are overlooked because of the emphasis placed on capital ratios and the combined bank-parent financial statements. Sellers should have a complete understanding of a parent company’s capital structure and the amount of bank earnings that must be paid to the parent company for debt service and shareholder dividends.Loan Portfolio Concentrations - Sellers should understand concentrations in the buyer’s loan portfolio, outsized hold positions, and a review the source of historical and expected losses.Ability to Raise Cash to Close -What is the source of funds for the buyer to fund the cash portion of consideration? If the buyer has to go to market to issue equity and/or debt, what is the contingency plan if unfavorable market conditions preclude floating an issue?Consensus Analyst Estimates - If the buyer is publicly traded and has analyst coverage, consideration should be given to Street expectations vs. what the diligence process determines. If Street expectations are too high, then the shares may be vulnerable once investors reassess their earnings and growth expectations.Valuation - Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles.Share Performance - Sellers should understand the source of the buyer’s shares performance over several multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Strategic Position - Assuming an acquisition is material for the buyer, directors of the selling board should consider the strategic position of the buyer, asking such questions about the attractiveness of the pro forma company to other acquirers?Contingent Liabilities - Contingent liabilities are a standard item on the due diligence punch list for a buyer. Sellers should evaluate contingent liabilities too.The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. The professionals at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business. Give us a call to discuss your needs in confidence.

It may seem an odd time for some publicly traded companies to consider cash-out merger transactions because broad equity market indices are at or near record levels. Nonetheless, the changing market structure means some boards may want to consider it.Among a small subset of public companies that may are those that are traded on OTC Markets Group’s Pink Open Market (“Pink”), the lowest of three tiers behind OTCQB Venture Market and OTCQX Best Market. Pink is the successor to the “pink sheets” which was published by a quotation firm that was purchased by investors who rechristened the firm OTC Markets Group.Today, OTC Markets Group is an important operator in U.S. capital markets because it facilitates capital flows for 11,000 US and global securities that range from micro-cap and small-cap issuers across all major industries to ADRs of foreign large cap conglomerates. Many issuers are SEC registrants, too.The issue that may cause some boards of companies traded on Pink to contemplate a cash-out merger or other transaction to reduce the number of shareholders is an amendment by the SEC to Rule 15c2-11, which governs the publication of OTC quotes and was last amended in 1991. Since then, markets and the public participation in markets have increased significantly as trading costs have declined and information has become more widely disseminated. The amendment applies only to Pink listed companies because those traded on OTCQB and OTCQX already meet the new requirements.Because of a quirk in how the rule was written in conjunction with a “piggyback exception” for dealers, financial information for some Pink issuers is not publicly available. The amended rule, which goes into effect September 28, 2021, prohibits dealers from publishing quotes for companies that do not provide current information including balance sheets, income statements and retained earnings statements. OTC Markets Group requires companies to comply with the rule through posting information to the issuer’s publicly available landing page that it maintains.While the disclosure requirement presumably is not burdensome, not all companies want to disclose such information, especially to competitors. Companies that choose not to comply with amended Rule 15c2-11 will no longer be eligible for quotation. Because shareholders of these companies historically have had the option to obtain liquidity, boards may want to evaluate an offer to repurchase shares or a cash-out merger transaction that reduces the number of shareholders.1Also, some micro-cap and small-cap companies whether traded on an OTC market or a national exchange may not obtain as many advantages compared to a decade or so ago.Given the rise of passive investing in which upwards of 50% of US equities are now held in a passively managed fund, companies that are not included in a major index such as the S&P 500, Russell 1000, NASDAQ or Russell 2000 are at a disadvantage given the amount of capital that now flows into passive funds. In some instances, it may make sense for these companies to go private, too.Cash-out transactions can be particularly attractive for companies that have a high number of shareholders in which a small number of shareholders have substantial ownership. Cash-out merger transactions require significant planning with help from appropriate financial and legal advisors. The link here provides an overview of valuation and fairness issues to consider in going private and cash-out transactions for companies whether privately or publicly held.Mercer Capital is a national valuation and financial advisory firm that works with companies, financial institutions, private equity and credit sponsors, high net worth individuals, benefit plan trustees, and government agencies to value illiquid securities and to provide financial advisory services related to M&A, divestitures, capital raises, buy-backs and other significant corporate transactions.1 Cash-out merger transactions are also referred to as freeze-out mergers or squeeze-out mergers in shareholders owning fewer than a set number of shares receive cash for their shares while those holding more than the threshold amount will be continuing shareholders.

Going Private 2023 presentation by Mercer Capitals’, Jeff K. Davis, CFA, that provides an overview of issues surrounding a decision to take an SEC-registrant private.Pros and Cons of Going PrivateStructuring a TransactionValuation AnalysisFairness Considerations

Evaluating a Buyer’s Shares From the Seller’s PerspectiveM&A activity in North America (and globally) is rebounding in 2021 after falling to less than $2.0 trillion of deal value in 2020 for just the second time since 2015 according to PitchBook; however, deal activity has accelerated in 2021 and is expected to easily top 2020 assuming no major market disruption due to a confluence of multiple factors.Most acquirers whose shares are publicly traded have seen significant multiple expansion since September 2020;Debt financing is plentiful at record low yields;Private equity is active; and,Hundreds of SPACs have raised capital and are actively seeking acquisitions. The rally in equities, like low borrowing rates, has reduced the cost to finance acquisitions because the majority of stocks experienced multiple expansion rather than material growth in EPS. It is easier for a buyer to issue shares to finance an acquisition if the shares trade at rich valuation than issuing “cheap” shares. As of June 3, 2021, the S&P 500’s P/E based upon trailing earnings (as reported) was 44.9x compared to the long-term average since 1871 of 16x. Obviously trailing earnings were depressed by the impact of COVID-19 on 2020 earnings, but forward multiples are elevated, too. Based upon consensus estimates for 12 months ended March 31, 2022, the S&P 500 is trading for 21x earnings. High multiple stocks can be viewed as strong acquisition currencies for acquisitive companies because fewer shares have to be issued to achieve a targeted dollar value. As such, it is no surprise that the extended rally in equities has supported deal activity this year. However, high multiple stocks may represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be as obvious as it seems, even when the buyer’s shares are actively traded. Our experience is that some if not most members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to, “value.” A fairness opinion is more than a three or four page letter that opines as to the fairness from a financial point of a contemplated transaction; it should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated. Key questions to ask about the buyer’s shares include the following:Liquidity of the Shares - What is the capacity to sell the shares issued in the merger? SEC registration and even NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently. Generally, the higher the institutional ownership, the better the liquidity. Also, liquidity may improve with an acquisition if the number of shares outstanding and shareholders increase sufficiently.Profitability and Revenue Trends - The analysis should consider the buyer’s historical growth and projected growth in revenues, operating earnings (usually EBITDA or EBITDA less capital expenditures) in addition to EPS. Issues to be vetted include customer concentrations, the source of growth, the source of any margin pressure and the like. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated.Pro Forma Impact - The analysis should consider the impact of a proposed transaction on revenues, EBITDA, margins, EPS and capital structure. The per share accretion and dilution analysis of such metrics as earnings, EBITDA and dividends should consider both the buyer’s and seller’s perspectives.Dividends - In a yield starved world, dividend paying stocks have greater attraction than in past years. Sellers should not be overly swayed by the pick-up in dividends from swapping into the buyer’s shares; however, multiple studies have demonstrated that a sizable portion of an investor’s return comes from dividends over long periods of time. If the dividend yield is notably above the peer average, the seller should ask why? Is it payout related, or are the shares depressed? Worse would be if the market expected a dividend cut. These same questions should also be asked in the context of the prospects for further increases.Capital Structure - Does the acquirer operate with an appropriate capital structure given industry norms, cyclicality of the business and investment needs to sustain operations? Will the proposed acquisition result in an over-leveraged company, which in turn may lead to pressure on the buyer’s shares and/or a rating downgrade if the buyer has rated debt?Balance Sheet Flexibility - Related to the capital structure should be a detailed review of the buyer’s balance sheet that examines such areas as liquidity, access to bank credit, and the carrying value of assets such as deferred tax assets.Ability to Raise Cash to Close - What is the source of funds for the buyer to fund the cash portion of consideration? If the buyer has to go to market to issue equity and/or debt, what is the contingency plan if unfavorable market conditions preclude floating an issue?Consensus Analyst Estimates - If the buyer is publicly traded and has analyst coverage, consideration should be given to Street expectations vs. what the diligence process determines. If Street expectations are too high, then the shares may be vulnerable once investors reassess their earnings and growth expectations.Valuation - Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles.Share Performance - Sellers should understand the source of the buyer’s shares performance over several multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Strategic Position - Assuming an acquisition is material for the buyer, directors of the selling board should consider the strategic position of the buyer, asking such questions about the attractiveness of the pro forma company to other acquirers?Contingent Liabilities - Contingent liabilities are a standard item on the due diligence punch list for a buyer. Sellers should evaluate contingent liabilities too. The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. We at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business.

Barring another recession or material reduction in bank stock valuations in the public markets, M&A activity should improve as 2021 progresses.However, some boards that would like to sell may have a hard time accepting a lower price versus what was obtainable a couple of years ago.One way to bridge the bid-ask gap is to consider transactions with more rather than less consideration consisting of the buyer’s common shares. Cash deals “cash-out” shareholders who then reinvest after-tax proceeds. Stock deals allow the target’s shareholders to remain invested in a sector that still trades cheap to longer-term valuations.This session, presented as part of the 2021 Acquire or Be Acquired Conference sponsored by Bank Director, addresses these issues.Click here to view the video!

A long-time Wall Street saying speaks to the availability of credit for mid-size and larger family businesses that seek to raise debt capital in 2021:If the ducks are quacking, feed them.Barring a change in the economic backdrop, as uncertain as it is, the availability of debt financing for most family businesses in 2021 is good. Further, the cost of credit will be low and most likely the terms will be lenient by historical standards.There are exceptions, of course. Hotels, retail CRE, restaurants, and tourism-related businesses face greater scrutiny. Retail malls and strip centers without a grocery or other essential business are tough financing propositions. Trepp, which tracks the commercial mortgage-backed security (“CMBS”) market, reports that it is not uncommon for servicers to sell troubled retail CRE loans at huge discounts and to auction large albatross retail properties in which no one shows up to bid.At the other extreme are companies such as Carnival Corporation, which operates multiple cruise lines. Carnival raised $3.5 billion on February 10 via a 5.75% senior unsecured offering due March 2027. Demand was sufficiently robust to boost the offering from a planned $2.5 billion. During July 2020 Carnival sold $775 million senior secured second priority notes due February 2026 with a 10.50% coupon.Four Options to Obtain Debt CapitalFamily businesses have four broad options to obtain debt capital:Commercial banksNon-bank commercial finance companiesPrivate credit fundsCorporate bond market Each financing option has its pluses and minuses.Commercial BanksHistorically, commercial banks offered the cheapest source of funding to family businesses albeit with plenty of covenants and perhaps personal guarantees compared to more expensive unsecured long-term financing available from the bond market. Those precepts are changing in a yield-starved world in which investors (and banks) accept lower yields with fewer covenants (i.e., “covenant-lite” is now a standard for syndicated leverage loans).Non-Bank Commercial Finance CompaniesNon-bank commercial finance companies differ from banks in that they do not have deposit funding, are less levered than commercial bank and generally charge higher rates than banks to produce a competitive ROE. Commercial finance companies offer deep expertise in a given asset class to be financed, and the subject asset rather than a blanket lien on the firm’s assets and cash flow serves as the collateral.Private Credit FundsPrivate credit, which runs the gamut from publicly traded BDCs to funds sponsored by private equity firms, has existed in its current form for a few decades; however, private credit has exploded as a major source of financing since the 2008 recession because leverage lending by banks was restricted somewhat by regulators and because investors can earn attractive yields on capital that is levered by the manager. Plus, the sponsors earn management fees on the assets in addition to the coupon on their capital. Family businesses may find credit funds to be expensive, but generally, they can move quickly and will allow for more leverage than a commercial bank that originates loans for its balance sheet. There also is an advantage to having an ongoing dialogue with the fund that can make decisions to modify a loan or advance additional funds, unlike a bond offering.Corporate Bond MarketFor financing needs that are sufficiently large, a corporate bond offering that is broadly distributed or privately placed with a few investors offers family businesses multi-year fixed rate financing at historically low rates though not as low as short-term commercial bank borrowings. Also, corporate bonds usually entail interest only payments until the bond matures at which point the issue will have to be refinanced or repaid with existing corporate liquidity. Among the downsides of a corporate bond financing is limited flexibility should something go awry at the company whereas a loan from one or a few banks will entail more flexibility to renegotiate terms.Are We Currently in a Borrower's Market?There is so much capital available for lending, yet loan demand is weak because the U.S. is (or was) in a recession.Loans in the commercial banking system declined for the first time in a decade in 2020 and only the second time in 28 years while deposits increased over 20%. Some of the reduction reflected corporate customers tapping the bond market to raise cheap long-term capital to refinance existing indebtedness. Further, banks have tightened commercial and CRE loan standards since last March based upon the Federal Reserve’s quarterly survey of senior lenders.Tighter standards at commercial banks notwithstanding, there is a basic reason why the ability to obtain financing in 2021 should be a borrower’s market: cash and near-cash equivalents yield nothing while government and corporate bonds yield little. Banks and investors are sitting on sizable cash piles that must be lent to produce a return.To get a sense of the pressure on yields, consider high yield corporate bonds (rated BB+/Ba1 or lower). The ICE BofA High Yield Index yielded 4.10% on February 10, well below prior lows seen in mid-2014 and early 2020 of ~5.25%. The peak yield of ~22% occurred in November 2008. This time around, yields grew to approximately 9% in late March 2020 before the Fed announced a plan to buy corporate credit and thereby restore liquidity to what had become a very illiquid market.Also, the yield investors demand over comparable duration U.S. Treasuries (i.e., the option adjusted spread) is near a record low.Investors are all-in, and our assumption is that commercial banks will not be willing to sit too long on excess deposits because revenue pressures are intense at banks amid an extremely low yield environment.ConclusionWe conclude with two final points for family businesses about what the bond market is saying about credit.First, the message of the U.S. Treasury market yield curve conveys is positive (assuming the Fed has not completely distorted market pricing). Typically, the shape of the yield curve points to investor expectations about future economic activity. A steeper curve as measured by the spread between market determined long-term rates and short-term rates that are heavily influenced by Fed policy rates points to a stronger economy in 12-18 months. Since Pfizer made the first vaccine announcement the curve has steepened. A flatter or inverted curve indicates a slowing or recessionary environment.Second, Fed Chair Powell has been emphatic the Fed will not raise short-term policy rates until after 2023, even if inflation takes off. Following the 2008 recession, the Fed first raised rates in December 2015, seven years after the zero-interest rate policy (“ZIRP”) was adopted. The futures market for Eurodollars, one of the most liquid markets in the world that settles based upon 90-day LIBOR, has priced in only 75-100bps of an increase by the mid-2020s. For family business directors, 2021 is an opportune time to evaluate financing needs to support growth investments and shareholder redemptions, and diversification needs.

Maybe not for the best of reasons, the stars have aligned for bank investors who have significant interests in banks to undertake robust estate planning this year. Bank stock valuations are depressed as a result of the recession that developed from the COVID-19 policy responses, including a return to a zero interest rate policy (“ZIRP”) that is now known as the effective lower bound (“ELB”). The result is severe compression in net interest margins (“NIMs”), while the extent of credit losses will not be known until 2021 or perhaps even 2022.As shown in Figure 1, bank stocks have produced a negative total return that ranges from -27% for the twelve months ended September 25, 2020 for the SNL Large Cap Bank Index to -36% for the SNL Mid Cap Bank Index. At the other extreme are tech stocks. The NASDAQ Composite has produced a one-year total return of 35%–a 70% spread between the two sectors.Valuations for banks are depressed and are comparable to lows observed on March 24, 2020 when market panic and forced selling by levered investors peaked and March 9, 2009 when investors feared a possible nationalization of the large banks. Price-to-tangible book value (“P/TBV”) multiples are presented in Figure 2, while price-to-earnings (“P/E”) ratios based upon the last 12-month (“LTM”) earnings are presented in Figure 3.(Note—while P/TBV multiples are little changed from March 24, 2020, P/E ratios have increased because reserve building and reduced NIMs have reduced LTM earnings).No one knows the future, but assuming reversion to the mean eventually occurs bank stocks could rally as earnings improve once credit costs decline even if NIMs remain depressed, resulting in higher earnings and multiple expansion. Relative to ten-year average multiples based upon daily observations, banks are 30-40% cheap to their post-Great Financial Crisis trading history. In effect, current gifting and other estate planning could lock in significant tax benefits assuming a Japan and Europe scenario does not develop in the U.S. where banks are “re-rated” and underperform for decades.A second reason to consider significant estate planning transactions this year is the potential change in Washington if 2021 sees a Biden Administration backstopped with a Democrat-controlled Senate and House.Vice President Biden’s proposed estate tax changes include the elimination of basis step-up, significant reductions to the unified credit (the amount of wealth that passes tax-free from estate to beneficiary) and gift tax exemption, and increasing current capital gains tax rates to ordinary income levels for high earning households.The cumulative effect of these changes is a substantial increase in high net worth clients’ estate tax liabilities if Biden’s current proposals become law.Basis step-up is a subtle but important feature of tax law.Unusual among industrialized nations, in the United States the assets in an estate pass to heirs at a tax value established at death (or at an alternate valuation date).Even though no tax is collected on the first $11.6 million per person, the tax basis for the heir is “stepped-up” to the new value established at death.Other countries handle this issue differently, and Biden favors eliminating the step-up in tax basis.Further, he prefers taxing the embedded capital gain at death.Canada, for example, does this – treating a bequest as any other transfer and assessing capital gains taxes to the estate of the decedent.Fortunately, there are several things bank shareholders can do now to minimize exposure to these potential tax law changes.Taking advantage of the current high-level of gift tax exemptions ($11.58 million per individual or $23.16 million per married couple) could save millions in taxes if Biden’s proposed lower exemption of $3.5 million per individual becomes law. Other options include the formation of trusts or asset holding entities to transfer wealth to the next generation in a tax-efficient manner.Proper estate planning can mitigate the adverse effects of higher taxes on wealth transfers, but the window to do so may be closing if we have a regime change later this year. Further, the demand (and associated cost) for estate planning services may go up significantly in November, so you need to apprise your clients of these potential changes before it’s too late.In the 1990s, the unified credit (the amount of wealth that passes tax-free from estate to beneficiary) was only $650 thousand, or $1.3 million for a married couple.The unified credit was not indexed for inflation, and the threshold for owing taxes was so low that many families we now consider “mass-affluent” engaged in sophisticated estate tax planning techniques to minimize their liability.Then in 2000, George W. Bush was elected President, and estate taxes were to be phased out.Over the past decade, the law has changed several times, but mostly to the benefit of wealthier estates.That $650 thousand exemption from estate taxes is now $11.6 million.A married couple would need a net worth of almost $25 million before owing any estate tax, such that now only a sliver of bank stock investors require heavy duty tax planning.That may all be about to change. Vice President Biden has more than gestured that he plans to increase estate taxes by lowering the unified credit, raising rates, and potentially eliminating the step-up in basis that has long been a feature of tax law in the United States.Talk is cheap. But investors take heed; now may be the time to execute rather than plan. Originally appeared in Mercer Capital’s Bank Watch, September 2020.

U.S. M&A activity slowed sharply in the second quarter due to the economic shock resulting from the COVID-19 pandemic. Activity – especially involving lower-to-middle market businesses – is expected to remain muted for the duration of 2020 and throughout 2021 unless more effective therapeutics and/or vaccines are developed that facilitate a more bullish sentiment than currently prevails.Although evidence is currently obscure, M&A markets appear to reflect wider bid-ask spreads among would-be sellers and buyers. Sellers are too fixated on what their business might have transacted for in 2019 while buyers expect to pay less as a result of declining performance and higher uncertainty regarding the magnitude and duration of the current economic malaise.Numerous industries lack sufficiently motivated strategic buyers willing to overlook concerns for their existing businesses to say nothing of the integration of new business. On the other hand, certain financial buyers seem to have returned to the market looking to deploy capital at attractive valuations when and where acquisition financing is available at reasonable terms and pricing.Would-be sellers face a dilemma: sell now for a seemingly compromised valuation; or wait for a recovery in market appetite that is not guaranteed to occur in the foreseeable future.Sellers are also faced with weighing the potential dilution of their future transaction proceeds if political regime/legislative change threatens the currently favorable tax environment.A modest consolation in the near-term for certain sellers may extend from the forgiveness of PPP loans under the CARES Act.As an aside from the current topical focus, sellers are advised to study the requirements and documentation for PPP forgiveness under change of control transaction events.We believe that in the current environment, contingent payments (e.g., earnouts and/or clawbacks) and seller financing will be employed to a greater extent than in the past in order to bridge a widening bid ask gap in deal value.Contingent deal consideration is typically structured such that a portion of transaction consideration is contingent upon the buyer’s achievement of specified post-transaction performance thresholds.The current environment requires careful seller scrutiny of such terms.When reasonably structured and negotiated, contingent consideration results in a symmetrical risk for buyers and sellers.While the economics can vary, earnouts often provide an incremental tranche of deal value that reconciles to that debated 0.5x to perhaps 2.0x turn that comprises the typical bid-ask spread (usually EBITDA based).For the buyer, contingent consideration acts as an insurance policy to insulate against downside future performance. For the seller contingent consideration can deliver deal consideration over and above that at the closing table, thus facilitating upfront liquidity while allowing for potential upside versus a straight all-cash closing. Sellers are advised to be careful about their unwillingness to entertain contingent consideration in the current environment because doing so can be a signal to the buyer of the seller’s concerns about near-term performance (i.e., actions speak louder than words).As always, every transaction is unique, requiring careful assessment of contingent consideration for purposes of productive negotiation.In theory, sellers may have to provide more financing in the post-COVID environment in order to achieve acceptable terms and pricing. We use the qualifier “in theory” because the high yield and leverage loan markets that are an important source of acquisition financing improved sharply as the third quarter progressed with more capital being raised at tighter spreads than the second quarter.An additional concern that has slowed M&A activity is execution.Conducting due diligence during a pandemic is inherently difficult and fraught with its own complications.It is easy to imagine how due diligence would have ground to a complete halt in an era before electronic data rooms and Zoom Video meetings. Nonetheless, travel prohibitions and social distancing protocols have stymied due diligence as most buyers require site visits and face-to-face meetings in order to consummate a purchase agreement.However, issuing a non-binding LOI remains quite doable, and some buyers are eager to secure the optionally and potential exclusivity obtained by an LOI submission.M&A in most industries is pro-cyclical. Challenges notwithstanding, M&A activity should gradually improve if the economy continues to do so and as buyers and sellers adjust expectations to the current environment and business earnings “normalize” in 2021 or 2022.

Mercer Capital is a national valuation and financial/transaction advisory firm. The Neiman Marcus Chapter 11 bankruptcy filing raises multiple valuation questions:Fraudulent conveyance (asset stripping) and solvency related to pre-filing asset distributionsLiquidation vs going concern valueValue of the company once it emerges from Chapter 11Allocation of enterprise value to secured and unsecured creditorsFresh start accounting Neiman Marcus Group, Inc. (“Neiman Marcus” or “Company”) is a Dallas, Texas-based holding company that operates four retail brands: Neiman Marcus, Bergdorf Goodman, Last Call (clearance centers), and Horchow (home furnishings). Unlike other department store chains, such as JCPenney and Macys that cater to the mass market, Neiman Marcus’s target market is the top 2% of U.S. earners. Among the notable developments over the last 15 years were two private equity transactions that burdened the Company with a significant debt load and one well-timed acquisition. The debt and acquisition figured prominently in the May 7, 2020 bankruptcy filing in which the company sought to reorganize under Chapter 11 with the backing of most creditors.Iconic Luxury Retailer to Indebted MorassHistoryThe iconic Neiman Marcus department store was established in 1907 in Dallas. Over the ensuing decades, the Company prospered as oil wealth in Texas fueled demand for luxury goods. Neiman Marcus merged with Broadway-Hale Stores (later rechristened Carter Hawley Hale Stores, Inc.) in the late 1960s. Additional stores were opened outside of Texas in Atlanta, South Florida, and other wealthy enclaves around the U.S. except for New York where Bergdorf Goodman (acquired in the 1970s) operated two stores.In 1987, Neiman Marcus along with Bergdorf Goodman was partially spun out as a public company with the remaining shares spun in 1999.In 2005, the Company was acquired via a $5 billion LBO that was engineered by Texas Pacific Group and Warburg Pincus.  Once the economy rebounded sufficiently from the Great Financial Crisis, the PE-owners reportedly sought to exit via an IPO in 2013. However, the IPO never occurred. Instead, the Company was acquired for $6 billion by Ares Management and the Canada Pension Plan Investment Board (“CPPIB”).In 2014 Neiman Marcus acquired MyTheresa, a German luxury e-commerce retailer with annual revenues of $130 million, for $182 million of cash consideration. During 2018, the entity that held the shares of MyTheresa (MyT Holding Co.) was transferred via a series of dividends to the Neiman Marcus holding company directly controlled by Ares and CPPIB and thereby placed the interest out of the reach of Company creditors.Neiman Marcus filed an S-1 in 2015 in anticipation of becoming a public company again; however, the registration statement was withdrawn due to weak investor demand.Although Neiman Marcus’ common shares had not been publicly traded since 2005, the Company filed with the SEC because its debt was registered. During June 2019, the Company deregistered upon an exchange of new notes and preferred equity for the registered notes. S&P described the restructuring as a selective default because debt investors received less than promised with the original securities.Review of FinancialsFigure 1 below presents a recent summary of the company’s financial performance and position one year prior to the bankruptcy filing. Of note is the extremely high debt burden that equated to 12.4x earnings before interest taxes, depreciation, and amortization (“EBITDA”) for the last twelve months (“LTM”) ended April 27, 2019. Although definitions vary by industry, federal banking regulators consider a company to be “highly levered” if debt exceeds EBITDA by 6x.Moody’s downgraded the Company’s corporate credit rating to B3 from B2 in October 2013 with the acquisition by Ares and CPPIB. Moody’s also established an initial rating of Caa2 for unsecured notes issued to partially finance the acquisition. By the time the notes were deregistered, Moody’s had reduced the corporate rating to Caa3 and the notes to Ca.Moody’s defines Caa as obligations that “are judged to be of poor standing and are subject to very high credit risk,” and Ca as obligations that are “highly speculative and are likely in, or very near, default, with some prospect of recovery in principal and interest.” Neiman Marcus has struggled with a high debt load since the first LBO in 2005, which has been magnified by the disruptive impact that online retailing has had on department stores.  EBITDA declined from $665 million in FY2015 to $400 million in the LTM period ended April 27, 2019; the EBITDA margin declined by over a third from 13.1% to 8.5%, over the same time. By April 2019, debt equated to 12.4x LTM EBITDA and covered interest expense by 1.2x. By way of reference, the debt/EBITDA and EBITDA/interest ratios for Ralph Lauren (NYSE: RL) for the fiscal year ended March 30, 2019, were 1.0x and 47.1x, while the respective ratios for Dillard’s (NYSE: DDS) were 1.2x and 9.9x for the fiscal year ended February 2, 2019. At the time of bankruptcy, Neiman Marcus generated about one-third of its sales (about $1.5 billion) online. MyTheresa generated approximately $500 million of this up from $238 million in 1Q17 when certain subsidiaries that held MyTheresa were designated “unrestricted subsidiaries” by the Company. While MyTheresa’s sales increased, the legacy department store business declined as the Company struggled to connect with younger affluent customers who favored online start-up boutiques and had little inclination to shop in a department store. As shown in the chart below, ecommerce sales as a portion of total retail sales have doubled over the last five years to about 12% in 2019. The move to work from home (“WFH”) and social distancing practices born of COVID-19 in early 2020 have accelerated the trend such that the pre-COVID-19 projection of e-commerce sales rising to 15% by 2020 will likely prove to be significantly conservative. Bankruptcy FilingNeiman Marcus filed on May 7, 2020 for chapter 11 bankruptcy protection. The COVID-19 induced shutdown of the economy was the final nail in the coffin, which forced major furloughs and the closing of its stores in accordance with various local shelter-in-place regulations.  Other recent retail bankruptcies include Lord & Taylor, Men’s Warehouse, Ann Taylor, Brooks Brothers, Lucky Brands, J. Crew with many more expected to file.The initial plan called for creditors to convert $4 billion of $5 billion of debt into equity. The plan does not provide for mass store closures or asset sales, although the Last Call clearance stores will close.As noted, the bankruptcy filing follows a restructuring in June 2019 that entailed:An exchange of all but $137 million of $960 million of 8.0% cash pay and $656 million of 8.75%/9.50% PIK Toggle unsecured notes for $1.2 billion of (i) 8.0% and 8.75% third lien Company notes and (ii) $250 million of Series A preferred equity in MyT Holding Co., a US-based entity that holds the German corporate entity that operates MyTheresa;The issuance of $550 million of new second-lien 6% cash pay/8.0% PIK notes due 2024 with a limited senior secured claim of $200 million from MyT Holding Co. and other MyT affiliates;A partial paydown of the first-lien term loan facility at par with the proceeds of the second lien notes; andAn exchange for the remaining $2.2 billion first-lien credit facility with a new facility and an extension of the maturity to October 2023. The restructuring did not (apparently) materially impact the Company’s $900 million asset-based credit facility of which $455 million was drawn as of April 2019; or the first lien $125 million debentures due in 2028. As shown in Figure 4, market participants assigned little value to the $1.2 billion of third lien notes that were trading for around 8% of par when the bankruptcy filing occurred and 6% of par in late August 2020. The binding Restructuring Support Agreement (“RSA”), dated May 7, 2020, included commitments from holders of 99% of the Company’s term loans, 100% of the second line notes, 70% of the third line notes, and 78% of the residual unsecured debentures to equitize their debt.  Also, certain creditors agreed to backstop $675 million in debtor-in-possession (“DIP”) financing and to provide $750 million of exit financing which would be used to refinance the DIP facility and provide incremental liquidity. DIP financing is often critical to maintain operations during the bankruptcy process when the company has little cash on hand. DIP financing is typically secured by the assets of the company and can rank above the payment rights of existing secured lenders. DIPs often take the form of an asset-based loan, where the amount a company borrows is based on the liquidation value of the inventory, assuring that if the company is unable to restructure, the loan can be repaid from the liquidation of the retailer’s assets.Bankruptcy Path: Chapter 7 vs. Chapter 11Federal law governs the bankruptcy process. Broadly, a company will either reorganize under Chapter 11 or liquidate under Chapter 7.A Chapter 7 filing typically is made when a business has an exceedingly large debt combined with underlying operations that have deteriorated such that a reorganized business has little value. Under Chapter 7, the company stops all operations. A U.S. bankruptcy court will appoint a trustee to oversee the liquidation of assets with the proceeds used to pay creditors after legal and administrative costs are covered. Unresolved debts are then “discharged”, and the corporate entity is dissolved.Under Chapter 11, the business continues to operate, often with the same management and board who will exert some control over the process as “debtor in possession” operators. Once a Chapter 11 filing occurs, the debtor must obtain approval from the bankruptcy court for most decisions related to asset sales, financings, and the like.Most public companies and substantive private ones such as Neiman Marcus file under Chapter 11.  If successful, the company emerges with a manageable debt load and new owners. If unsuccessful, then creditors will move to have the petition dismissed or convert to Chapter 7 to liquidate.Most Chapter 11 filings are voluntary, but sometimes creditors can force an involuntary filing. Normally, a debtor has four months after filing to propose a reorganization plan. Once the exclusivity period ends creditors can propose a competing plan.Usually, the debtor continues to operate the business; however, sometimes the bankruptcy court will appoint a trustee to oversee the business if the court finds cause to do so related to fraud, perceived mismanagement and other forms of malfeasance.The U.S. Trustee, the bankruptcy arm of the Justice Department, will appoint one or more committees to represent the interests of the creditors and stockholders in working with the company to develop a plan of reorganization. The trustee usually appoints the following:The “official committee of unsecured creditors”Other creditors committee representing a distinct class of creditors such as secured creditors or subordinated bond holders; andStockholders committee. Once an agreement is reached it must be confirmed by the court in accordance with the Bankruptcy Code before it can be implemented. Even if creditors (and sometimes stockholders) vote to reject the plan, the court can disregard the vote and confirm the plan if it believes the parties are treated fairly. Neiman Marcus pursued a “prepackaged” or “prepack” Chapter 11 in which the company obtained support of over two-thirds of its creditors to reorganize before filing. Under the plan, the Company would eliminate about $4 billion of $5.5 billion of debt. The creditors also committed a $675 million DIP facility that will be replaced with a $750 million facility once the plan is confirmed by the court.The Role of Valuation in BankruptcyValuation issues are interwound in bankruptcy proceedings, especially in Chapter 11 filings when a company seeks to reorganize. Creditors and the debtor will hire legal and financial advisors to develop a reorganization plan that maximizes value and produces a reorganized company that has a reasonable likelihood of producing sufficient cash flows to cover its obligations.There are typically three valuation considerations for companies restructuring through Chapter 11 Bankruptcy.Companies must prove that a Chapter 11 Restructuring is in the “best interest” of its stakeholders;A cash flow test must prove that post-reorganization the debtor will be able to fund obligations; and,“Fresh Start Accounting” must be adopted in which the balance sheet is restated to fair value. Sometimes as is the case with Neiman Marcus there is a fourth valuation-related issue that deals with certain transactions that may render a company insolvent. Fraudulent ConveyanceA side story to Neiman Marcus relates to the 2018 transaction in which the shares of MyTheresa were transferred in 2018 to bankruptcy-remote affiliates of PE owners Ares and CPPIB. Under U.S. bankruptcy law, transferring assets from an insolvent company is a fraudulent transaction.During 2017, Neiman Marcus publicly declared the subsidiaries that held the shares were “unrestricted subsidiaries.” Once the distribution occurred in September 2018, creditors litigated the transaction. All but one (Marble Ridge) settled in 2019 as part of the previously described debt restructuring.Since the bankruptcy filing occurred, the unsecured creditors commissioned a valuation expert to review the transaction to determine whether Neiman Marcus was solvent as of the declaration date, immediately prior to the distribution and after the distribution. As shown in Figure 5, the creditors’ expert derived a negative equity value on all dates. If the court accepted the position, then presumably Ares and CPPIB would be liable for fraudulent conveyance.At the time the distribution occurred, Neiman Marcus put forth an enterprise valuation of $7 billion and relied upon the opinion of two national law firms that it was within its rights to execute the transaction. Since filing, the PE owners have commissioned one or more valuation experts whose opinion has not been disclosed. On July 31, 2020, the committee of unsecured creditors and the Company reached a settlement related to the fraudulent conveyance claims arising from the MyTheresa transaction. Ares and CPPIB agreed to contribute 140 million MyTheresa Series B preferred shares, which represent 56% of the B class shares, to a trust for the benefit of the unsecured creditors. The Company also agreed to contribute $10 million cash to the trust. A range of value for the series B shares of $0 to $275 million was assigned in a revised disclosure statement filed with the bankruptcy court. Marble Ridge, which served on the committee, did not view the settlement as sufficient as was the case in 2019 when it did not participate in the note exchange as part of the 2018 litigation settlement. During August, it became known that Marble Ridge founder Dan Kamensky pressured investment bank Jeffrey’s not to make a bid for the shares that were to be placed in a trust because it planned to bid, too (reportedly 20 cents per share compared to 30 cents or higher by Jeffrey’s). The anti-competitive action was alleged to have cost creditors upwards of $50 million. Marble Ridge subsequently resigned from the creditors committee and announced plans to close the fund. Kamensky was arrested on September 7th and charged with securities fraud, extortion, wire fraud, extortion, and obstruction of justice, according to the U.S. Attorney’s Office for the Southern District of New York. Best Interest TestA best interest test must show that the reorganization value is higher than the liquidation value of the company, to ensure that the creditors in Chapter 11 receive at least as much under the restructuring plan as they would in a Chapter 7 liquidation. In the case of Neiman Marcus, the liquidation vs. reorganization valuation analysis was a formality because most unsecured creditors and the Company agreed to a prepackaged plan subject to resolution of such items as the MyTheresa shares. Nonetheless, we summarize both for illustration purposes. Liquidation AnalysisA rough calculation of Neiman Marcus’ liquidation value is included below, based on balance sheet data from April 2019 as these are the most current figures available. Substantial value in a liquidation analysis depends upon what an investor would be willing to pay for the rights to the Neiman Marcus name as well as its customer lists and proprietary IP code. The recovery ratio applied to Neiman Marcus’ inventory is higher than expected recovery ratios across the broader apparel industry since much of Neiman’s inventory is designer goods. Nonetheless, the analysis implies creditors would face a significant haircut in a Chapter 7 liquidation scenario. Reorganization (Going Concern) AnalysisThe reorganization value represents the value of the company once it has emerged as a going concern from Chapter 11 bankruptcy. Typically, the analysis will develop a range of value based upon (i) Discounted Cash Flow (“DCF”) Method; (ii) Guideline Public Company Method; and (iii) Guideline Transaction Method.Both guideline methods develop public company and M&A “comps” to derive representative multiples to apply to the subject company’s earnings and cash flow.  Market participants tend to focus on enterprise value (market value of equity and debt net of cash) in relation to EBITDA. Secondary multiples include enterprise value in relation to EBIT, EBIT less ongoing Capex, and revenues.As it relates to Neiman Marcus, we note that Lazard Freres & Co. (“Lazard”) as financial advisor focused on adjusted EBITDA for the LTM period ended February 1, 2020 and the projected 12 months ended February 1, 2022. In doing so, Lazard looked past 2020 and 2021 as excessively abnormal years due to the COVID19 induced recession. Our observation is that this treatment (for now) is largely consistent with how many market participants are treating various earning power measures in industries that were severely impacted by the downturn.A DCF analysis for Neiman Marcus that assumes the Company emerges from bankruptcy in the fall of 2020 will incorporate the impact of the adverse economy as reflected in presumably subpar operating performance in the first year or two of the projections. More generally, the DCF method involves three key inputs: the forecast of expected future cash flows, terminal value, and discount rate.Forecast of Expected Future Cash Flows: Valuation practitioners typically develop cash flow forecasts for specific periods of time, ranging anywhere from three to ten years, or as many periods as necessary until a stable cash flow stream can be realized. Key elements of the forecast include projected revenue growth, gross margins, operating costs, and working capital and capital expenditure requirements. Data from other publicly traded companies within similar lines of business can serve as good reference points for the evaluation of each element in the forecast.Terminal Value: The terminal value represents all cash flow values outside of the discrete forecast period. This value is calculated through capitalizing cash-flow at the end of the forecast period, based on expectations of long-term cash flow growth rate and discount rate. Alternatively, a terminal value can be determined through the application of projected or current market multiples.Discount Rate: The discount rate is essential in estimating the present value of forecasted cash flows. A proper discount rate is developed from assumptions about costs of equity and debt capital, and capital structure of the new entity. For costs of equity capital, a build-up method is used with long-term risk-free rate, equity premia, and other industry/company-specific factors as inputs. Cost of debt capital and new capital structure can be based on benchmark rates or comparable corporations. The discount rate should reflect the financial risks that come with the projected cash flows of the restructured entity. The sum of the present values of all forecasted cash flows indicates the enterprise value of the emerging company for a set of forecast assumptions. Reorganization value is the total sum of expected business enterprise value and proceeds from the sale or disposal of assets during the reorganization.Cash Flow TestThe second valuation hurdle Neiman Marcus will have to jump is a cash flow test. The cash flow test determines the feasibility of the reorganization plan and the solvency of future operations. Since a discounted cash flow analysis is typically used to determine reorganization value, the projected cash flows from this analysis are compared to future interest and principal payments due.Additionally, the cash flow test details the impact of cash flows on the balance sheet of the restructured entity, entailing modeling changes in the asset base and in the debt obligations of and equity interests in the company. Therefore, the DCF valuation and cash flow tests go together because the amount of debt that is converted to equity creates cash flow capacity to service the remaining debt. If the cash flow model suggests solvent operations for the foreseeable future, the reorganization plan is typically considered viable.Fresh-Start AccountingWhen emerging from bankruptcy in the case of going concern, fresh-start accounting could be required to allot a portion of the reorganization value to specific intangible assets. The fair value measurement of these assets requires the use of multi-period excess earnings method or other techniques of purchase price allocations.ConclusionNeiman Marcus plans to eliminate about $4 billion of over $5 billion of debt and $200 million of annual interest expense in a reorganization plan that was approved by U.S. bankruptcy judge David Jones in early September. The plan will transfer the bulk of ownership to the first lien creditors, including PIMCO, Davidson Kempner Capital Management and Sixth Street Partners. PIMCO will be the largest shareholder with three of seven board seats.Other creditors will receive, in effect, a few pennies to upwards of one-third of what they were owed depending in part on the value of MyTheresa Class B preferred shares that were contributed to a trust for the benefit of unsecured creditors. Also, the Company’s term loan lenders, second lien and third lien note holders waived their right to assert deficiency claims and thereby eliminated upwards of $3.3 billion of additional claims in the general unsecured claims pool (now limited to $340 to $435 million).Lazard estimated the value of the reorganized Company upon exit from bankruptcy to approximate $2.0 billion to $2.5 billion on an enterprise basis with the equity valued at $800 million to $1.3 billion.Creditors and the Company negotiated a plan that has presumably maximized (or nearly so) value to each creditor class based upon the priority of their claims. We are not privy to the analysis each class produced and how their views of the analyses, relative negotiating strength and the like drove the settlement.Ultimately, the performance of the reorganized Neiman Marcus will determine the eventual amount recovered by creditors to the extent shares are not sold immediately. Some creditors would be expected to sell the shares immediately, while others who have flexibility to hold equity interests and have a favorable view of the reorganized company’s prospects may wait to potentially realize a greater recovery.In Figure 9 we have constructed a waterfall analysis which we compare with the actual settlement. We assume a range of enterprise values based upon multiples of projected FY22 EBITDA, or $342 million, and compare the residual equity after each claimant class is settled to provide perspective on the creditors’ recovery.This waterfall implies that class 5 through 7 debt, which for our purposes here is more or less pari passu, should receive the bulk if not all of the equity given $2.4 billion of debt owed to the three classes. Because ~10% of the equity was allocated to subordinated creditors, the senior lenders may have been willing to cede some ownership in order to reach a settlement more quickly.Per the settlement, ~90% of the equity was allocated to the 2019 senior secured term loan (~$2.3 billion; 87.5%), 2013 residual senior secured loan ($13 million) and first lien debentures ($129 million; 2.8%).Recovery for the 2019 senior secured creditors was estimated in the Disclosure Statement to approximate 33% compared to about 19% for the first lien debentures.Interests in MyTheresa also impacted projected recoveries for the junior and unsecured creditors, a byproduct of the litigation to settle the fraudulent conveyance claims related to the 2018 transaction.The second lien noteholders ($606 million) would obtain (i) 1.0% equity interest; (ii) seven-year warrants to purchase up to 25% of the reorganized equity at an agreed upon strike price; (iii) participation rights in the exit loan and associated fees; and (iv) an economic interest in MyTheresa in the form of $200 million of 7.5% PIK notes.The disclosure statement indicates the recovery equates to less than 2% of what is owed to the second lien note holders, which appears to exclude whatever value is attributable to the PIK notes because 1% of the Newco equity would equate to $800 thousand to $1.3 million of value based upon a range of equity value of $800 million to $1.3 billion.1The third lien noteholders ($1.3 billion) would obtain (i) 8.5% equity interest; (ii) participation rights in the exit loan and associated fees; and (iii) a 50% economic and 49.9% voting interest in the common equity of MyTheresa.The disclosure statement indicates the recovery to be 5.6% of the claim, which also appears to exclude the value of the MyTheresa common shares if the equity interest is equal to $68 million to $110 million based upon an aggregate equity value of $800 million to $1.3 billion.The issuance of $200 million of PIK notes and transfer of 50% of the common equity interest in MyTheresa to the second and third lien noteholders appears to be a result of the 2019 debt restructuring and settlement of the 2018 litigation surrounding the 2018 transfer of MyTheresa to the parent company and out of the reach of creditors.The final wrinkle in the disputed MyTheresa saga involved an agreement reached in late July 2020 in which Ares and CPPIB agreed to allocate 140 million (56%) MyTheresa Series B preferred shares to a trust established for unsecured creditors. Neiman Marcus as debtor also agreed to contribute $10 million cash to the trust.At the time the settlement was announced in late July, the value attributed to the preferred shares was $162 million; however, the August 3 Disclosure Statement assigned a range of value of $0 to $275 million. Marble Ridge reportedly had planned to bid 20 cents per share to provide certain unsecured creditors (e.g. unpaid vendors) immediate liquidity before the fracas with Jeffrey’s occurred. Neiman Marcus emerged from Chapter 11 by September 30, 2020 in a streamlined process via the prepackaged negotiations that will leave the Company with significantly less debt in its capital structure.  As outlined in this article, valuation is an important factor in the bankruptcy process. 1 The issuance of $200 million of PIK notes and transfer of 50% of the common equity interest in MyTheresa to the second and third lien noteholders appears to be a result of the 2019 debt restructuring and settlement of the 2018 litigation surrounding the 2018 transfer of MyTheresa to the parent company and out of the reach of creditors. 2 The projected 1.4% recovery rate for the second lien notes apparently excludes the MyTheresa PIK notes, while the projected 5.6% recovery rate for the third lien notes likewise appears to exclude the 50% common equity interest in MyTheresa.

March 2020 probably will prove to be among the most dramatic months for financial markets in US history.Likewise, the fallout for banks may take a year or so to fully appreciate.Nonetheless, in this issue of BankWatch, we offer our initial thoughts as it relates to the industry.Market Performance U.S. equity markets have entered a bear market, the definition of which is a drop of at least 20%.As of March 27, 2020, the S&P 500 had declined 21% year-to-date and the Russell 2000 was down 32%.Not surprisingly banks have fared worse with the SNL Large Cap Bank Index falling 39% given the implications for credit because of the government’s mandated shutdown of broad swaths of the economy due to COVID-19.Bear markets vary in length and depend upon the severity of the economic downturn, the value of assets before the downturn started, and policy responses among other factors.The 2001 recession, which was shallow, started in March and ended in November according to government statisticians; however, the bear market for equities as measured by the S&P 500 was brutal (-49%) that ran from March 2000 to November 2002. Banks trended modestly higher during 2000-2002 because they entered the downturn cheap to their late 1990s valuations and because real estate values did not fall. The Great Financial Crisis (“GFC1”) that ran from August 2007, when the Bear Stearns hedge funds failed, through year-end 2009 entailed a bear market that saw a 57% reduction in the S&P 500 between October 2007 and the bottom on March 9, 2009.Economists tell us the recession occurred from year-end 2007 throughJune 30, 2009.Unlike 2000-2002, banks were a disaster for investors because credit losses were high, and many had to raise equity at low prices to survive.We do not know how much further bank stocks may fall if at all from late March in what we are taking liberty to define as GFC2.Figure 1 provides perspective on how banks—here defined as SNL’s Small Cap US Bank Index—performed in the two-year period ended March 9, 2009, and March 27, 2020. During GFC1 the bank index fell almost 70% to when the bear market ended. (March 9 was near the date when FASB eased mark-to-market rules and the Obama Administration signaled it would not nationalize the banks.)By contrast the bank index traded sideways between March 2018 and early 2020 before plummeting about 40% at the lowest point in March as investors rushed for the exits as economic activity crashed. Massive intervention in the markets by the Fed has arrested the decline in financial assets for now, but in doing so the important market function of price discovery and therefore capital allocation has been distorted. Revaluation of BanksRelative to history banks are cheap, but that does not mean they cannot get cheaper.Alternatively, valuation multiples may rise because EPS and TBVPS fall more than share prices fall or even trade sideways or higher from here.Presumably GFC2 will be like GFC1 and most bear markets in which prices fall in anticipation of earnings that will decline later as the market discounts fundamentals that are expected to prevail 6-18 months in the future.As of late March, bank stocks were cheap to long-term average multiples with small cap banks trading for 9.4x trailing 12-month earnings and 105% of TBV compared to 7.9x and 122% for the large cap bank index.Dividend yields around 4% are enticing, too, but the downturn could be sufficiently severe to force widescale dividend cuts.We do not know and will not know until the future arrives. Interestingly, small cap banks as of March 27 were trading below the March 9, 2009, bottom at 105% of TBV vs. 118% nine years ago.Net Interest Margins—Lower for LongerPerhaps one of the more depressing expectations for banks is not that credit losses will increase but the Fed promise that short-term rates will remain anchored near zero for the foreseeable future.As shown in Figure 3, the market expects 30/90 day LIBOR to fall from current distressed levels in excess of 1.0% to around 0.3% within a few months and remain anchored there for a couple of years.Those who follow the forward curves know that forward rate expectations can change quickly.Nonetheless, the market today expects LIBOR benchmark rates (and SOFR) to fall toward the Fed Funds target range.Our expectation is that NIMs may fall below the last cycle low of ~3.5% recorded in 1H09 because asset yields are much lower today than in 2008 when the GFC1 was gathering steam.Likewise, deposit rates can be cut somewhat but they, too, are much lower now than was the case in 2008.By way of comparison the NIM for banks with $1 billion to $10 billion of assets in 4Q06 was 3.74% according to the FDIC.By 1H09 the NIM for the group had declined to less than 3.4%.As of 4Q19 the NIM was 3.67%.Credit—Regulatory Forbearance PossibleWe do not know how high credit costs will go.According to the FDIC, losses approximated 2% of loans in 2009 for banks with $1 billion to $10 billion of assets and 3% for banks with $10 billion to $250 billion of assets.Losses were especially high in C&D portfolios because residential mortgage was the epicenter of the last downturn.This time more asset classes look to be at risk because a deflationary shock has been unleashed on the global economy. The hardest hit sectors within most bank loan portfolios will be hotels and restaurants as part of the travel and leisure industry that has been impacted the most by COVID-19.Among a subset of banks in the Southwest, Dakotas and Appalachia potentially will be sizable losses in energy-related credits as oil and gas are at the epicenter of this deflationary shock. Retail CRE will see more problem assets, too, as the shutdown accelerates the shift to digital commerce. An unknown element is how shifts in consumer and business behaviors may impact credit losses.One surprise from the last recession was the move by consumers to pay auto and credit card loans while defaulting on mortgages in order to commute to work and maintain access to revolving credit.Previously consumers would default on other borrowings to save the home. The behavior was an admission by many consumers that they overpaid for houses and were willing to return to renting. In this downturn maybe consumers will let auto loans go because the average auto loan is much larger and has a longer duration than a decade ago, and ride sharing lessens the need for a car.Businesses may decide that much less office space is needed as employees become more adept at working remotely.In short, it is easy to construct a scenario in which credit losses are higher than those experienced during 2008-2010, but it is too early to know for certain.One interesting market data point arguing perhaps not is high yield bonds.The option-adjusted spread (“OAS”) on the ICE BofA High Yield Index peaked on March 23 at 1087bps versus 1988bps in November 2008.If credit losses are notably higher than what was experienced in 2008 then an informal form of regulatory forbearance may be allowed in which losses are slowly recognized to protect capital.Past precedence includes the Lesser Developed Country (“LDC”) crisis of the early and mid-1980s in which money center banks took 5-6 years to write-off large exposures to LDCs as a result of a collapse in oil and commodity prices.Capital and DividendsAs shown in Figure 5, US banks are much better capitalized today than at year-end 2006 immediately before GFC1 began.Ironically, the severely adverse scenario in the DFAST-mandated stress tests will be tested given the magnitude of the economic shut-down.All 18 large-cap banks that were subjected to the Fed’s 2019 test passed with leverage ratios bottoming over an eight-quarter period in the vicinity of 6-7%.Results can be found at the following link http://mer.cr/2JswW1d.A secondary issue is the outlook for common and preferred dividends.We expect first quarter and perhaps second quarter dividends to be paid; however, beginning in the third quarter dividend reductions and omissions are possible if not probable once a better estimate of losses is developed.Aside from written agreements with regulators that preclude payments we assume sub debt coupon payments will continue to be made because a missed coupon payment is an event of default unlike trust preferred securities that provided issuers 20 quarters to miss a payment without tripping a default.M&A—Down but Eventual UpturnFinally, M&A will become more imperative among commercial banks as NIMs go much lower.Executives of Truist Financial Corporation likely are relieved that the respective boards of directors of SunTrust and BB&T had the courage to combine to extract significant cost savings on what will be a lower run-rate of revenues than originally envisioned.As for investors and M&A participants, the challenge as always will be first to think about earning power rather than next year’s estimate and what is a reasonable valuation in terms of earning power.That, of course, is easier said than done when markets are rapidly repricing for a new order. Originally published in Bank Watch, March 2020.

Bank fundamentals, which are discussed in more detail below, did not change a lot between 2018 and 2019; however, bank stock prices and the broader market posted strong gains as shown in Table 1 following a short but intense bear market that bottomed on Christmas Eve 2018. Our expectation is that 2020 will not see much change in fundamentals either, while bank stocks will require multiples to expand to produce meaningful gains given our outlook for flattish earnings.Fed Drives the Market ReboundThe primary culprit for the 4Q18 plunge and subsequent 2019 rebound in equity prices was the Fed, which has a propensity to hike until something breaks according to a long standing market saw. A year-ago the Fed had implemented its ninth hike in short-term policy rates that it controls despite the vocal protests of the President and, more importantly, the credit markets as reflected in widening credit spreads and falling yields on Treasury bonds and forward LIBOR rates.One can debate how much weight the Fed places on equity markets, but it has always appeared to us that they pay close attention to credit market conditions. When the high yield bond and leverage loan markets shutdown in December 2018, the Fed was forced to pivot in January and back away from rate hikes after forecasting several for 2019 just a few months earlier. Eventually, the Fed was forced to reduce short rates three times and resume expansion of its balance sheet in the fourth quarter after halting the reduction (“quantitative tightening”) in mid-year.Markets lead fundamentals. Among industry groups bank stocks are “early cyclicals,” meaning they turn down before the broader economy does and tend to turn up before other sectors when recessions bottom. One take from the price action in banks is that the economy in 2020 will be good enough that credit costs will not rise dramatically. Otherwise, banks would not have staged as strong a rebound as occurred.Likewise, somewhat tighter spreads on B- and BB-rated high yield bonds relative to U.S. Treasuries (option adjusted spread, “OAS”) since the Fed eased is another data point that credit in 2020 will not see material weakening. The stable-to-tighter spreads in the high yield market today can be contrasted with 2007 when OAS began to widen sharply even after the Fed began to cut rates and the U.S. Treasury curve steepened as measured by the spread between the yield on the two-year and 10-year notes.Bank FundamentalsBank fundamentals are in good shape even though industry net income for the first three quarters of 2019 increased nominally to $181 billion from $178 billion in the comparable period in 2018. On a quarterly basis, third quarter earnings of $57 billion were below the prior ($63 billion) and year ago ($62 billion) quarters. Not surprisingly, earnings pressure emerged during the year as what had been expanding NIMs during 2017 and 2018 began to contract due the emergence of a flat-to-inverted yield curve, a reduction in 30/90-day LIBOR which serves as a base rate for many loans, and continuation of a highly competitive market for deposits. Also, loan growth slowed in 2019—especially for larger institutions.As shown in Table 2, core metrics such as asset quality and capital are in good shape, while profitability remains high. Our outlook for 2020 is for profitability to ease slightly due to incrementally higher credit costs and a lower full year NIM although stabilization seems likely during 2H20. Nonetheless, ROCE in the vicinity of 10- 11% and ROTCE of 13-14% for large community and regional banks seems a reasonable expectation.EPS growth will be lacking, however. Wall Street consensus EPS estimates project essentially no change for large community and regional banks, while super regional banks are projected to be slightly higher at 3%. Money center banks (BAC, C, GS, JPM, MS, and WFC) reflect about 6% EPS growth, which seems high to us even though the largest banks tend to be more active in repurchasing shares relative to smaller institutions where excess capital is allocated to acquisitions, too.The Fed—Presumably on HoldIn the December 2018 issue of Bank Watch we opined it was hard to envision the Fed continuing to raise short-term rates even though the Fed forecasted further hikes. We further cited the potential for rate cuts. Our reason for saying so was derived from the market rather than economists because intermediate- and long-term rates had decidedly broken an uptrend and were heading lower.As the calendar turns to 2020, the Fed has indicated no changes are likely for the time being. The market reflects a modest probability that one more cut will be forthcoming, but to do so in an election year probably would require long rates to fall enough to meaningfully invert the Treasury curve unlike the nominal inversion which occurred in mid-2019.As it relates to bank fundamentals, the impact on NIMs will depend upon individual bank balance sheet compositions. Broadly, however, a scenario of no rate hikes implies NIMs should stabilize in 2H20 as higher cost CDs and wholesale borrowings rollover at lower rates. Also, if the Fed continues to expand its balance sheet (presently it is doing so through only purchasing T-bills through support of the repo market) then assets may remain well bid. All else equal, stable to rising prices in the capital markets usually are supportive of credit quality within the banking system.Bank Valuations—Rebound from Year-End 2018 “Bargains”A synopsis of bank valuations is presented in Table 3 in which current valuations for the market cap indices are compared to year-end 2018 and year-end 2017 as well as multi-year medians based upon daily observations over the past 20 years. The table illustrates the important concept of reversion to the mean. Valuations were above average as of year-end 2017 due to policy changes that occurred with the November 2016 national elections that culminated with the enactment of corporate tax reform in late 2017. One year later valuations were “cheap” as a result of the then bear market that reflected concerns the Fed would hike the U.S. into a recession. Despite the rebound in prices and valuation multiples during 2019, bank stocks enter 2020 with moderate valuations provided the market (and us) have not miscalculated and earnings are poised to fall sharply. Money center and super-regional banks are trading for median multiples of about 10x and 11x consensus 2020 earnings. Regional and large community banks, which include many acquisitive banks, trade for respective median multiples of 12x and 13x. An important point is that valuation is not a catalyst to move a stock; rather, valuation provides a margin of safety (or lack thereof) and thereby can provide additional return over-time as a catalyst such as upward (or downward) earnings revisions can cause a multiple to expand or contract. Looking back to last year one might surmise the rebound in valuations reflects the market’s view that the Fed avoided hiking the U.S. into recession. Bank M&A—2020 Potentially a Great yearM&A activity has been robust with bank and thrift acquisitions since 2014 exceeding 4% of the industry charters at the beginning of each year. It appears once the final tally is made, upwards of 275 institutions will have been acquired in 2019, which would represent almost 5% of the industry. With only a handful of new charters granted since the financial crisis the industry is shrinking fast. As of Sept. 30, there were 5,256 U.S. banks and thrifts, down from about 18,000 in 1985.While activity was steady at a high level in 2019, the most notable development was market support for four merger-of-equals (“MOE”) in which the transaction value exceeded $1.0 billion. The largest transaction closed Dec. 9 when BB&T Corp. and SunTrust merged to form Truist Financial Corp. Others announced this year include tie-ups between TCF Financial Corp./Chemical Financial Corp., First Horizon National Corp./IBERIABANK Corp., and Texas Capital Bancshares Inc./Independent Bank Group Inc. Although not often pursued, we believe MOEs are a logical transaction that if well executed provide significant benefits to community bank shareholders.The national average price/tangible book multiple eased to 157% from 173% in 2018, while the median price/earnings (trailing 12 months as reported) declined to 16.8x from 25.4x (~21x adjusted for the impact of corporate tax reform). The reduction was not surprising given low public market valuations that existed at the beginning of 2019 because acquisition multiples track public market multiples with a lag.We see 2020 shaping up as a potentially great year for bank M&A. The backdrop is an M&A trifecta: buyer and seller earnings will likely be flattish primarily due to sluggish loan growth and lower NIMs; asset quality is stable; and stock prices are higher, meaning buyers can offer better prices (but less value) to would-be sellers. Also, the capital markets remain wide open for banks to issue subordinated debt and preferred equity at very low rates to fund cash consideration not covered by existing excess capital.Summing it UpThis year appears to be the opposite of late 2018 in which a strong market for bank stocks is predicting continuation of solid fundamentals and possibly better than expected earnings. Nonetheless, an environment in which earnings growth is expected to be modest at best likely will result in limited gains in bank stocks given the rebound in valuations that occurred in 2019.Originally published in Bank Watch, December 2019.

A Look at WeWork’s Failed IPOIn last quarter’s issue of Portfolio Valuation we raised the issue as to whether public market investors are more critical (or discerning) in establishing value than private equity investors.The evidence this year largely is, yes—at least for companies where there is skepticism as to whether meaningful profitability can be achieved. Lyft, SmileDirectClub and Uber are examples of unicorns that saw share prices marked sharply lower after the IPO (Lyft, SDC) or during the roadshow (Uber); and The We Company’s planned IPO never occurred due to pushback by investors. At the other extreme is Beyond Meat, which as of early October had risen about six-fold from its May IPO.The We Company’s (formerly “WeWork” and will be refered to in this article as WeWork) valuation journey is interesting (maybe even fascinating).WeWork, which was founded in 2010, is a real estate company that signs long-term leases for pricey real estate that it refurbishes then releases the space short-term. The company describes itself somewhat differently as a “community company committed to maximum global impact.” The S-1 disclosed not only massive losses, but also significant corporate governance issues.Year-to-date revenues through June 30, 2019 doubled to $1.5 billion from the comparable period in 2018, but the operating loss also doubled to $1.4 billion.EBITDA for the six months was negative $511 million, while capex totaled $1.3 billion. That is a big hole to fill every six months before factoring in rapid growth to be financed.Cash as of June 30 totaled $2.5 billion, while the capital structure entails a lot of debt and negative equity. From a valuation perspective, WeWork is problematic because operating cash flows are deep in the red with little prospect of turning positive anytime soon. Nonetheless, the increase in value private equity investors placed on the company was astounding. The company pierced the unicorn threshold in early 2014 when affiliates of JPMorgan invested $150 million in the fourth funding at a post-raise $1.5 billion valuation. T. Rowe Price and Goldman Sachs invested $434 million in late 2014, which resulted in a post raise valuation of $10 billion. The 7th and 8th funding rounds are where the valuation really gets interesting.In August 2017 SoftBank Vision Fund invested $3.1 billion, which implied a valuation of $21 billion.SoftBank Group Corp., which sponsors the Vision Fund, invested $4.0 billion in January 2019 at an implied valuation of $47 billion. When the underwriters were forced to pull the plug on the IPO the targeted post-raise valuation reportedly was $10 billion to $15 billion—a value the company apparently was willing to accept because it needs the cash.We do not know exactly how private equity investors valued the company.Presumably discounted cash flow (DCF), guideline public company and guideline transaction methods were used, perhaps overlaid with a Monte Carlo simulation.The valuation history raises an important question: how was a stupendous valuation achieved in the private markets by a cash incinerator such as WeWork? A similar question could be asked about many high-profile PE-backed investments.The short answer is that Softbank thinks the valuation increased significantly even though the company’s fundamentals argue otherwise. Prospective investors such as the public ones who were offered WeWork shares in an IPO could prepare their own DCF forecast to value the company.They also could examine past transactions in the company for relevant valuation information. Likewise, they could examine capital transactions in similar companies.Both sets of data fall under the guideline transaction method. A transaction in a privately held company infers a meaningful data point about value to investors, but there are a couple of caveats.One is an assumption that both parties are fully-informed and neither is forced to transact.Great values were realized by those willing to buy during the 2008 meltdown because there were so many forced sellers that ran the gamut from levered credit investors forced to dump bonds to the likes of Wachovia Corporation and National City Corporation. The price data was legitimate, but many sellers faced margin calls and had to dump assets into an illiquid market.Is the valuation data relevant if “normal” market conditions prevail?The second issue relates to private equity valuation generally, but especially those where start-up losses and ongoing capital requirements can be huge.The valuation issue relates to using transaction data from investments in other money losing enterprises.Is it always valid to apply multiples paid by investors in a funding round of a money-losing business to value another money-losing business? The valuation data may be factual, but it may be nonsense when weighed against the business’ operating and financial performance.One can question Softbank’s motives.Did Softbank need a higher valuation to offset losses in other parts of the portfolio in order to maintain investor and lender confidence? Was a higher valuation necessary to support upcoming capital raises? We do not know, but prospective public investors were dismissive of Softbank’s valuations and they appear to be dismissive of the prior two raises given how low the price talk had fallen by the time the IPO was pulled. We at Mercer Capital respect markets and the pricing information that is conveyed.The prices at which assets transact in private and public markets are critical observations; however, so too are a subject company’s underlying fundamentals, especially the ability to produce positive operating cash flow and a return on capital that at least approximates the cost of capital provided.Mercer Capital can assist with the valuation of your portfolio companies.We value hundreds of debt and equity securities of privately held companies every year and have been doing so for nearly four decades.Please call if we can assist in the valuation of your portfolio companies.Originally published in Mercer Capital’s Portfolio Valuation Newsletter:Third Quarter 2019

The IPO market is hot thanks to the intersection of investor enthusiasm and a new crop of venture capital-backed, and in some instances traditional private equity-backed, firms that have gone public. Unicorns (pre-IPO valuation of $1 billion or more) in particular have caught investors’ attention. There is nothing new about a hot IPO cycle in the U.S. IPO activity waxes and wanes with markets. The last massive wave occurred in 1999 when a mania swept through markets as then internet and other technology-focused companies captured investors’ imaginations.1999 vs. 2019Why has 2019 become the year of the unicorn IPO? It could be a matter of timing and monetary policy. After a nearly ten-year bull market, private equity is monetizing while the IPO window remains open after it more or less closed in the fourth quarter of 2018. Also, easy money policies the past decade arguably have incented investors to shower capital on growth-focused tech companies. With the Fed likely to begin cutting rates again in 2019, capital flows may intensify again.Nonetheless, the current IPO wave is different from 1999 and other peaks on three related counts. One is the length of time most venture-backed companies have remained private before going public. The other is the staggering amount of losses incurred even on an “adjusted” basis before going public. The link between the two differences has been the willingness of deep-pocketed investors, such as SoftBank, to fund losses through multiple capital raises. The link gives rise to the third difference: staggeringly large private market valuations for some.Looking at how several of the big name public offerings have fared this year, we can’t help but wonder:Do current losses matter to public market investors?Did the private market overvalue these unicorns?What does all of this mean for other unicorns planning to go public in 2019?The short answers are: perhaps, probably, and hurry.Sentiment Toward Recent UnicornsPublic investors seemingly have been more discerning about losses than private investors who pushed valuations higher for many companies with successive funding rounds. Price performance in the post-IPO market has been uneven as would be expected, but it points to less tolerance among public market investors to the extent big money losers such as Lyft and Uber have much lower valuations today than expected when their IPO roadshows were launched. Blue Apron is a poster child for a disaster post-IPO stock, but it is not alone.Lyft and Uber point to the more critical view public investors have taken of each company’s business model as it relates to future earnings. Lyft priced near the high end of the range targeted initially by lead underwriter JPMorgan and then saw strong first day performance; however, it now trades about 15% below the IPO price.Uber has traded down modestly from the IPO price, but lead underwriter Morgan Stanley had to sharply reduce the IPO price from when the roadshow started with price talk of a $90 billion to $100 billion post-raise valuation compared to about $73 billion presently.Uber and Lyft posted the highest revenue growth over the prior three years, but also the largest losses. The losses didn’t prohibit the companies from going public, but the uncertainty of a future path to profitability has led to disappointing performance relative to the hype that has surrounded the companies. Perhaps investors see a better outlook for Slack Technologies, which went public via a direct listing on the NYSE in mid-June. Although the company is not yet profitable, the shares rose nearly 50% on the first day of trading as either investors see a path to profitability or too few shares were floated. On the other hand, both Tradeweb and Zoom among a number of newly minted tech companies have performed well since their respective IPOs. Both were profitable in the year prior to the IPO, which is more in line with the kind of pre-offering financials that public investors are used to seeing. The market has rewarded the two companies accordingly. The next big name to test investors’ willingness to fund sizable losses is The We Company. The company confidentially filed for an IPO at the end of 2018 and is expected to begin a roadshow soon. The We Company may be the ultimate unicorn to test the market. It is minting losses. Only through the company’s defined term “community adjusted” EBITDA, which is akin to a twice-adjusted EBITDA, does the company post positive EBITDA. Also, the company has a huge $45 billion valuation based upon its last fundraising round; yet, its business model may be suspect in that it entails acquiring expensive real estate that generally is leased under short-term arrangements. Presumably, in a recession, lease rates would plummet as vacancies soar.Some have raised legitimate questions about valuation processes employed by private equity and VC firms and whether private market valuations are too high. Others have noted investors can, in effect, mark-up the value of prior investments by investing in follow-on capital raises for a given company at a higher valuation. ConclusionWe do not mean to disparage anyone with the issues raised in this article. We respect markets and the pricing information that is conveyed. The prices at which assets transact in private and public markets are critical observations; however, so too are a subject company’s underlying fundamentals, especially the ability to produce positive operating cash flow and a return on capital that at least approximates the cost of capital provided.At Mercer Capital we have been valuing private equity and private credit securities for nearly four decades and have deep experience in most industries. If we can help you establish the value of securities held in your fund or offer a second opinion, please call. We would be glad to assist. Stock Performance Since IPO (Pricing as of 6/20/19)Three Year Financial PerformancePrivate vs. Public Valuation (Pricing as of 6/20/19)Originally published in Mercer Capital’s Portfolio Valuation Newsletter: Second Quarter 2019

It has been 34 years since the Delaware Supreme Court ruled in the landmark case Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985) and thereby made the issuance of fairness opinions de rigueur in M&A and other significant corporate transactions. The backstory of Trans Union is the board approved an LBO that was engineered by the CEO without hiring a financial advisor to vet a transaction that was presented to them without any supporting materials.Why would the board approve a transaction without extensive review? Perhaps there were multiple reasons, but bad advice and price probably were driving factors.  An attorney told the board they could be sued if they did not approve a transaction that provided a hefty premium ($55 per share vs a trading range in the high $30s).Although the Delaware Supreme Court found that the board acted in good faith, they had been grossly negligent in approving the offer. The Court expanded the concept of the Business Judgment Rule to include the duty of care in addition to the duties to act in good faith and loyalty.  The Trans Union board did not make an informed decision even though the takeover price was attractive. The process by which a board goes about reaching a decision can be just as important as the decision itself.Directors are generally shielded from challenges to corporate actions the board approves under the Business Judgement Rule provided there is not a breach of one of the three duties; however, once any of the three duties is breached the burden of proof shifts from the plaintiffs to the directors.  In Trans Union the Court suggested had the board obtained a fairness opinion it would have been protected from liability for breach of the duty of care.The suggestion was consequential.  Fairness opinions are now issued in significant corporate transactions for virtually all public companies and many private companies and banks with minority shareholders that are considering a take-over, material acquisition, or other significant transaction.When to Get a Fairness OpinionAlthough not as widely practiced, there has been a growing trend for fairness opinions to be issued by independent financial advisors who are hired to solely evaluate the transaction as opposed to the banker who is paid a success fee in addition to receiving a fee for issuing a fairness opinion.While the following is not a complete list, consideration should be given to obtaining a fairness opinion if one or more of these situations are present:There is only one offer for the bank and competing bids have not been solicitedCompeting bids have been received that are different in price and structure (e.g., cash vs stock)The shares to be received from the acquiring bank are not publicly traded and, therefore, the value ascribed to the shares is open to interpretationInsiders negotiated the transaction or are proposing to acquire the bankShareholders face dilution from additional capital that will be provided by insidersVarying offers are made to different classes of shareholdersThere is concern that the shareholders fully understand that considerable efforts were expended to assure fairness to all partiesWhat’s Included (and What’s Not) in a Fairness Opinion A fairness opinion involves a review of a transaction from a financial point of view that considers value (as a range concept) and the process the board followed. The financial advisor must look at pricing, terms, and consideration received in the context of the market for similar banks. The advisor then opines that the consideration to be received (sell-side) or paid (buy-side) is fair from a financial point of view of shareholders (particularly minority shareholders) provided the analysis leads to such a conclusion. The fairness opinion is a short document, typically a letter.  The supporting work behind the fairness opinion letter is substantial, however, and is presented in a separate fairness memorandum or equivalent document. A well-developed fairness opinion will be based upon the following considerations that are expounded upon in an analysis that accompanies the opinion:A review of the proposed transaction, including terms and price and the process the board followed to reach an agreementThe subject company’s capital table/structureFinancial performance and factors impacting earningsManagement’s current year budget and multi-year forecastValuation analysis that considers multiple methods that provide the basis to develop a range of value to compare with the proposed transaction priceThe investment characteristics of the shares to be received (or issued), including the pro-forma impact on the buyer’s capital structure, regulatory capital ratios, earnings capacity, accretion/dilution to EPS, TBVPS, DPSAddress the source of funds for the buyer and any risk funding may not be available It is important to note what a fairness opinion does not prescribe, including:What the highest obtainable price may beThe advisability of the action the board is taking versus an alternativeWhere a company’s shares may trade in the futureHow shareholders should vote a proxyThe reasonableness of compensation that may be paid to executives as a result of the transaction Due diligence work is crucial to the development of the fairness opinion because there is no bright line test that consideration to be received or paid is fair or not.  Mercer Capital has nearly four decades of experience in assessing bank (and non-bank) transactions and the issuance of fairness opinions.  Please call if we can assist your board. Originally appeared in Mercer Capital's Bank Watch, April 2019

What a difference a year makes. A year ago corporate tax reform had been enacted that lowered the top marginal tax rate to 21% from 35%. Banks were viewed as one of the primary beneficiaries through a reduction in tax rates and a pick-up in economic growth. Now investors are questioning whether bank stocks and other credit investments are canaries in the U.S. economic coalmine.As 2018 draws to a close, bank fundamentals are very good; however, bank stock prices have tanked. SNL Financial’s small-, mid-, and large-cap bank indices have fallen by more than 20% since August 31, which meets the threshold definition of a bear market (i.e., down 20% vs. 10% for a correction). Markets, of course, lead fundamentals, and corporate credit markets lead equity markets. Among industry groups, bank stocks are “early cyclicals”, meaning they turn down before the broader economy does and tend to turn up before other sectors when recessions bottom. Large cap banks peaked in February while the balance of the industry peaked in the third quarter after having a fabulous run that dates to the national elections on November 8, 2016. The downturn in bank stock prices corresponds with weakening home sales, widening credit spreads in the leverage loan and high yield bond markets, a ~40% reduction in oil prices, and a nearly inverted Treasury yield curve. To state the obvious: markets—but not fundamentals so far—are signaling 2019 (and maybe 2020) will be a more challenging year than was assumed a few months ago in which the economy slows and credit costs rise. The key question for 2019 then is: how much and is a slowdown fully priced into stocks? Our next issue of Bank Watch will entail a deep dive into credit, but for this issue, we observe that a global unwind of leverage is underway as the Fed extracts liquidity from the system. Bond buying (QE) and ultra-low rates helped drive asset prices higher. The reverse is proving true, too. Bank FundamentalsBank fundamentals are in good-to-great shape. During the third quarter all FDI-Cinsured institutions reported aggregate net income of $62 billion, up 29.3% from 3Q17. Excluding the impact of lower taxes, 3Q18 pro forma net income would have been about $55 billion, up 13.9% from 3Q17. The data is more nuanced once the industry is segregated by asset size, however.As shown in Figure 3, ROA and ROE have nearly rebounded to the last pre-crisis year of 2006. Importantly, capital has increased significantly and, thereby, provides an additional buffer whenever the next downturn develops. As it relates to 2019, bank fundamentals are not expected to change much other than credit costs are expected to increase from a very low level in which current loss rates in all loan categories are below long-term averages. Wall Street consensus EPS estimates project mid-single digit EPS growth for the largest banks, primarily as a result of share repurchases and a slightly higher full year NIM, while regional and community bank consensus estimates reflect upper single digit EPS growth from the same factors and somewhat better loan growth. However, credit and equity markets imply the consensus is too high given the sharp widening in credit spreads and drop in bank stock prices the past several months. Although markets lead fundamentals, market signals about magnitude are less clear. Given continuing growth in the U.S. economy that on balance will be helped by lower oil prices, it seems reasonable that an increase in credit costs the market is forecasting will be modest, and as a result, bank profitability will not be meaningfully crimped in 2019. The Fed: 2019 Rate Hikes Seem UnlikelyWhenever the Fed embarks on an extended rate hiking campaign, the saying goes the Fed hikes until something breaks. The market is signaling that the December rate hike—the ninth in the current cycle—that pushed the Fed Funds target from 2.25% to 2.50% when the yield on the 10-year UST bond was ~2.8% may be one of those moments. What’s unusual about the current tightening cycle is it represents an attempt by the Fed (but not the BOJ, ECB or SNB) to extract itself from radical monetary policies in which the Fed is raising short-term rates and shrinking its balance sheet at the same time. Given the flat yield curve, it is hard to see how the Fed will hike the Fed Funds another couple of times as planned for 2019, unless the Fed wants to invert the yield curve or unless intermediate- and long-term rates reverse and trend higher. Presumably the $50 billion a month pace in the reduction of its US Treasury and Agency MBS portfolio will continue. Alternatively, perhaps the Fed will bow to the market and not raise rates in 2019 and slow or even halt the reduction in its balance sheet to stabilize markets. As it relates to bank fundamentals, the impact on net interest margins will depend upon individual bank balance sheet compositions. Broadly, however, a scenario of no rate hikes implies less pressure to raise deposit rates, and rising wholesale borrowing rates should stabilize. The result, therefore, should be a little bit better NIMs than a slight reduction if the Fed continues to hike given that deposit rate betas for many institutions are well over 50% now. More important for banks if the Fed pauses vs continues to hike would be the impact on asset values (higher all else equal) and, therefore, credit costs. Bank Valuations: Support but Never a Stand-Alone CatalystA synopsis of bank valuations is presented in Figure 4 in which current valuations for the market cap indices are compared to the approximate market top around August 31, November 8, 2016 when the national election occurred, and multi-year medians based upon daily observations. An important point is that valuation is not a catalyst to move a stock; rather, valuation provides a margin of safety (or lack thereof) and thereby can provide additional return over time as a catalyst such as upward (or downward) earnings revisions can cause a multiple to expand or contract.Bank stocks—particularly mid-cap and large-cap banks—enter 2019 relatively inexpensive to history. The stocks are cheap relative to 2019 consensus earnings with large cap banks trading around 8x and small cap banks at 10x; however, the market’s message is that the estimates are too high. It is hard to envision that estimates are dramatically too high as proved to be the case in 2008 unless the economy is poised to roll-over hard, which seems unlikely. Assuming no recession or a shallow recession, then, the modest valuations may result in bank stocks having a good year even if fundamentals weaken and analysts cut estimates because the limited downside in earnings had been adequately priced into the stocks by late December.Bank M&A: Slowing Activity for 2019 LikelyOutwardly, 2018 has been another good year for bank M&A even though activity slowed in the fourth quarter. There were few notable deals other than Fifth Third’s pending acquisition of Chicago-based MB Financial valued at $4.8 billion at announcement and Synovus Financial’s pending acquisition of Boca Raton-based FCB Financial Holding valued for $2.8 billion at announcement. Even before bank stocks rolled over the shares of both Fifth Third and Synovus severely underperformed peers as investors questioned the exchange ratios, cost saving assumptions, credit risk (especially at FCB), and whether the buyers could keep the franchises intact as key personnel defected elsewhere.The national average price/tangible book multiple expanded to 173% from 166% in 2017 and about 140% in 2014, 2015 and 2016 before the sector was revalued in the wake of the national election. The median P/E of 25x was within the five-year range of 21x to 28x.The total number of bank and thrift transactions through December 24 totaled 261, which equated to 4.4% of the commercial bank and thrift charters as of year-end 2017. During 2014–2018, the number of acquisitions exceeded 4% each year except for 2016 when activity at the beginning of the year was hampered by weak stock prices as a result of a slowing economy that was marked by a collapse in oil prices and sharply wider credit spreads. Weak bank stock prices crimp the ability to negotiate deals because most sellers are focused on absolute price rather than relative value when taking the buyer’s shares as consideration; and, buyers usually are unwilling to increase the number of shares being offered given a limitation on minimum acceptable EPS accretion and maximum acceptable TBVPS dilution. A notable late year exception occurred when Cadence Bancorporation opted to increase the number of shares it will issue to State Bancorp by 9.6% because the double trigger in the merger agreement signed during May when Cadence’s share price was much higher came into play. Although there is no change in the driver of consolidation such as succession issues, shareholder liquidity needs, and economies of scale, a slowdown in M&A activity in 2019 is likely because bank stocks will enter the year depressed. Deals that entail some amount of common share consideration will be tough to structure unless sellers will be willing to take less, which most will not do with operating fundamentals in good shape for now. All cash deals will be impacted less, but all cash deals are more prevalent among very small institutions in which pricing usually occurs at a discount to those that entail some proportion of common shares. Summing It UpThe market is shouting fundamentals will weaken in 2019 after a long period of gradual improvement following the Great Financial Crisis, which most likely will be reflected in sluggish loan growth and modestly higher credit costs; however, bank stocks may surprise to the upside as they did to the downside in 2018 provided a) there is no recession or a shallow one; and, b) the Fed relents and does not hike further and potentially slows the run-off of its excess bonds (and liability reserves). For clients of Mercer Capital who obtain year-end valuations, rising stock prices since the presidential election may be reversed partially, given the compression in market price/earnings and price/tangible book value multiples that occurred in 2018.

The extensive use of core versus reported earnings by public companies has been a widespread phenomenon for at least 25 years. During the past decade, the practice also has become widespread among companies (and their bankers who market deals) that are issuing debt in the leverage loan and high yield markets.The practice is controversial. The SEC periodically will crack down on companies it thinks are pushing the envelope. Bank regulators have raised the issue of questionable adjustments to borrowers’ EBITDA for widely syndicated leverage loans.Investors are aware of the issue, too, but have not demanded the practice to stop. In mid-2017, I attended a conference on private credit. One session dealt exclusively with adjusted EBITDA. One panelist offered that adjustments in the range of 5-10% of reported EBITDA were okay, but the consensus was the adjustments were out of control. Covenant Review reported that as of mid-2017 the average leverage for middle market LBOs over the prior two years was 5.5x based upon the target’s adjusted EBITDA compared to reported EBITDA of ~7x. The issue is no better, and perhaps worse, in 2018 judging from market sentiment.If investors are solely relying upon company defined adjusted EBITDA, then they may be vacating their fiduciary duties when investing capital. That said, an analysis of core versus reported earnings is a critical element of any valuation or credit assessment of a non-early stage company with an established financial history.Table 1 below provides a sample overview of the template we use at Mercer Capital. The process is not intended to create an alternate reality; rather, it is designed to shed light on core trends about where the company has been and where it may be headed.AdjustmentsAdjustments typically consist of items that are non-recurring, unusual, and infrequent. They also may entail elements for a change in business operations, such as the addition of a new product or the discontinuation of a division. This is where judgment is particularly important because we have noticed a trend among some investors to credit businesses with future earnings for initiatives such as stepped-up hiring of revenue producers in which a favorable outcome is highly uncertain.Minority vs. ControlAdjustments considered should take into account whether the valuation is on a minority interest or controlling interest basis. An adjustment for an unusual litigation expense will not be impacted by the level-of-value; however, other potential adjustments—particularly synergies a buyer could reasonably be expected to realize would only apply in a control valuation.Core Trends vs. PeersThe development of the adjusted earnings analysis should allow one to identify the source of revenue growth and the trend in margins through a business cycle. The process also will facilitate comparisons with peers both historically and currently to thereby make further qualitative judgments about how the business is performing.Out Year Budget vs. Adjusted HistoryThe adjusted earnings history should create a bridge to next year’s budget, and the budget a bridge to multi-year projections. The basic question should be addressed: Does the historical trend in adjusted earnings lead one to conclude that the budget and multi-year projections are reasonable with the underlying premise that the adjustments applied are reasonable?Core Earnings vs. Ongoing Earning PowerCore earnings differ from earning power. Core earnings represent earnings after adjustments are made for non-recurring items and the like in a particular year. Earning power represents a base earning measure that is representative through the firm’s (or industry’s) business cycle and, therefore, requires examination of adjusted earnings ideally over an entire business cycle. If the company has grown such that adjusted earnings several years ago are less relevant, then earning power can be derived from the product of a representative revenue measure such as the latest 12 months or even the budget and an average EBITDA margin over the business cycle.Platform Companies/Roll-UpsCompanies that are executing a roll-up strategy can be particularly nettlesome from a valuation perspective because there typically is a string of acquisitions that require multiple adjustments for transaction related expenses and the expected earnings contribution of the targets. The math of adding and subtracting is straightforward, but what is usually lacking is seasoning in which a several year period without acquisitions can be observed in order to discern if past acquisitions have been accretive to earnings. Public market investors struggle with this phenomenon, too, but often the high growth profile of roll-ups will trump questions about earning power and what is an appropriate multiple until growth slows.Income and Market-Based Valuation ApproachesIn addition to providing insight into how a business is performing, the adjusted earnings statement will “feed” multiple valuation methods. These include the Discounted Cash Flow and Single Period Earning Power Capitalization Methods that fall under the Income Approach, and the Guideline (Public) Company and Guideline (M&A) Transaction Methods that constitute Market Approaches.It may be obvious, but we believe an analysis of adjusted (and reported) earnings statements for a subject company over a multi-year period is a critical, if not the critical element, in valuing securities that are held in private equity and credit portfolios. Mercer Capital has nearly 40 years of experience in which tens of thousands of adjusted earnings statements have been created. Please call if we can help you value investments held in your portfolio.Originally published in Mercer Capital’s Portfolio Valuation Newsletter: Fourth Quarter 2018

After a slow start, M&A activity among U.S. commercial banks and thrifts picked up to the point where 2018 should look like recent years. Historically, approximately 2% to 4% of the industry is absorbed each year via M&A. Since 2014, the pace has been at or slightly above 4% as a well performing economy, readily available financing, rising stock prices for bank acquirers, and strong asset quality and earnings of would be sellers have supported activity.There were 140 announced transactions according to S&P Global Market Intelligence through early July, which equates to 2.4% of 5,913 FDIC-insured institutions that existed as of year-end 2017. The average assets per transaction based upon YTD activity was $656 million, which is below the 28 year average of $1.1 billion. Pricing has trended higher as measured by the average price/tangible book value (P/TBV) multiple, which increased to 172% in 2018 from 164% in 2017 and about 140% in 2014-2016 before the sector was revalued after the national election on November 8, 2016. The median P/E based upon trailing 12 month earnings increased to 26x in 2018 from 23x in 2017 and 21x in 2016; however, the 2018 P/E based upon trailing 12 month earnings does not reflect a full year impact of the reduction in the top marginal federal tax rate to 21% from 35% that occurred on January 1. The adjusted P/E assuming the lower tax rate was in effect for 2017, too, is around 20-22x. Lower tax rates notwithstanding, it appears that buyers are still paying roughly 9-13x pro forma earnings assuming all expense savings are fully realized, a level of pricing that we believe has existed for many years excluding periods when industry fundamentals are stressed. For example, Fifth Third Bancorp (FITB) estimates the $4.6 billion consideration to be paid to MB Financial (MBFI) shareholders equates to 16.4x consensus 2019 earnings and 9.6x assuming all expense savings realized in 2019 (which will not be the case due to the phase-in lag). Cash Deals vs. Mix/Stock DealsDig deeper and, of course, there is more to the pricing story. The reduction in tax rates has had a material impact on profitability. Depending upon the index bank stocks rose 25-30% in the three months after the national election on November 8, 2016, on the expectation of what has mostly played out: a reduction in corporate tax rates, less regulation, higher short rates and faster economic growth. The improvement in public market multiples has supported expansion of M&A multiples when the majority of the consideration consists of the buyer’s common shares. As shown in Table 1, the median P/TBV and P/E ratios for transactions announced in the 20 months since the election were 173% and 23.0x compared to 147% and 20.3x for the 20 months ended November 8, 2016. Multiple expansion is even more pronounced when only 2018 deals are considered because the YTD median P/TBV and P/E multiples are 193% and 25.4x. Not surprisingly (to us), the median multiples for cash deals did not rise as much, increasing to 141% after the election compared to the 20 month pre-election median of 123%. Cash did not inflate in value over this period like public market bank stock valuations; hence, the only meaningful factor that drove the limited improvement in cash acquisition multiples was the increase in ROE. In addition, cash activity slowed post-election because buyers and sellers waited to see if would be sellers’ earning power would increase from a reduction in corporate tax rates, which was not confirmed until late 2017. Transactions in which the primary form of consideration consisted of the buyer’s common shares did not have to wait for the tax issue to be resolved because buyer and seller both faced the issue. Small Deals, Larger Deals, and Perhaps Big DealsM&A is largely a story of the consolidation of the small banks by large community and small regional banks. Two decades ago the theme was the same, but overlaid was the formation of the nationwide and multi-region franchises through mega-mergers such as NCNB/Bank of America and Wells Fargo/Norwest.Since the financial crisis, activity has mostly been confined to small deals with deal values a fraction of the pre-crisis and especially pre-2000 amounts. Annualized year-to-date deal value is $33 billion, which compares to approximately $26 billion annually during 2015-2017. By comparison, the value of announced transactions in 1997 and 1998 were many multiples greater at $97 billion and $289 billion, respectively.During the past five years, there only have been 10 deals that exceeded $2 billion of consideration and 22 deals in which the consideration exceeded $1 billion. As shown in Table 2, the two largest transactions involved Canadian banks, while three involved the large Ohio-based banks. Change may be afoot, however. Fifth Third’s $4.6 billion pending acquisition of MB Financial is its first bank acquisition since 2008, and it was announced a couple of days before President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act. Among other things, the financial deregulation law moved the SIFI asset threshold from $50 billion to $100 billion and provided significant relief for institutions such as Fifth Third that fall within the $100 billion to $250 billion asset bucket. Notably, during the past five years only CIT Group crossed the prior $50 billion SIFI threshold via acquisition, and apparently did so at the urging of regulators who wanted CIT to shore up its deposit funding. We look for more activity among mid-sized regional banks that are near or over $50 billion of assets; however, deal activity among the very largest banks is off the table given the $250 billion asset threshold for the global SIFI designation and the 10% nationwide deposit market share cap if pierced via acquisition. The potential fly in the ointment to the robust bank M&A environment is the flattening yield curve and the attendant underperformance of bank stocks this year. If bank stocks lag and valuations compress further, then it may be difficult for buyers to meet inflated seller expectations that rarely take into account downward moves in buyers’ share prices. How We Can HelpThe adage banks are sold rather than bought is largely true, meaning most banks transact when the sellers are ready to do so. Sometimes that occurs after years of planning; sometimes it occurs unexpectedly when another institution makes a casual inquiry.Mercer Capital has over three decades of experience as a financial advisor helping institutions navigate the process as buyer and seller. Even if your board has no interest in selling (or buying) we would be happy to present an overview to your board about the lay of the land as it relates to the public market, M&A market and what actions your board might consider to enhance value. Please call if we can be of assistance.Originally published in Bank Watch, July 2018.

Viewed from the prism of “fairness” in which a transaction is judged to be fair to shareholders from a financial point of view, many transactions are reasonable; some are very fair; and some are marginally fair. Transactions that are so lopsided in favor of one party should not occur absent a breach of corporate duties by directors (i.e., loyalty, care and good faith), bad advice, or other extenuating circumstances. Obtaining competent financial advice is one way a board exercises its duty of care in order to make an informed decision about a significant corporate transaction.The primary arbiter of fairness is the value of the consideration to be received or paid relative to indications of value derived from various valuation methodologies. However, the process followed by the board leading up to the transaction and other considerations, such as potential conflicts, are also important in the context of “entire” fairness.A tough fairness call can occur when a transaction price appears to be low relative to expectations based upon precedent transactions, recent trading history, management prognostications about a bright future, and/or when the value of the consideration to be received is subject to debate. The pending acquisition of commercial finance lender NewStar Financial, Inc. (“NewStar”; Nasdaq-NEWS) is an example where the acquisition price outwardly seems to be low, at least until other factors are considered.NewStar ExampleOn October 16, 2017, NewStar entered into a merger agreement with First Eagle Holdings, Inc. (“First Eagle”) and an asset purchase agreement with GSO Diamond Portfolio Holdco LLC (“GSO”). Under the merger agreement, NewStar will be acquired by First Eagle for (a) $11.44 per share cash; and (b) non-transferable contingent value rights (“CVR”) that are estimated to be worth about $1.00 per share if the transaction closes before year-end and $0.84 per share if the transaction closes in 2018. The CVR reflects the tax benefit associated with the sale of certain loans and investments at a discount to GSO for $2.37 billion.Also of note, the investment management affiliate of First Eagle is majority owned by an entity that is, in turn, partially owned by Corsair Capital LLC, which is the largest shareholder in NewStar with a 10.3% interest.Acquisition PriceAs shown in Figure 1, the acquisition price including all of the CVR equates to 83% of tangible book value (“TBV”), while the market premium is nominal. Although not relevant to the adequacy of the proposed pricing, NewStar went public in late 2006 at $17.00 per share then traded to around $20 per share in early 2007 before sliding to just about $1.00 per share in March 2009. “Feel” is a very subjective term; nonetheless the P/TBV multiple that is well below 100%, when combined with the nominal market premium, feels light. NewStar is not a troubled lender. Non-performing assets the past few years have been in the vicinity of 3% of loans, while net charge-offs have approximated 1% other than 2015 when losses were negligible. Further, the implied haircut applied to the loans and investments that will be acquired by GSO is modest.Transaction MultiplesWhile the P/TBV multiple for the transaction is modest, the P/E multiple is not at 26.5x (the latest twelve month (“LTM”) earnings) and 18.4x (the consensus 2018 estimate). The P/E could be described as full if NewStar were an average performing commercial bank and very full if it was a typical commercial finance company in which low teen P/Es are not unreasonable.What the P/TBV multiple versus the P/E multiple indirectly states is that NewStar has a low ROE, which has been less than 5% in recent years. The culprit is a highly competitive market for leveraged loans, a high cost of funds absent cheap bank deposit funding and perhaps excess capital. Nonetheless, management’s projections incorporated into the recently filed proxy statement project net income and ROE will double from $20 million/3% in the LTM period ended September 30 to $41 million/6% in 2020.In spite of a doubling of projected net income, the present value (assuming NewStar is worth 18.4x earnings in 2020 discounted to September 30 at a discount rate of 13%) is about $507 million, or about the same as the current transaction value to shareholders. Earnings forecasts are inherently uncertain, but one takeaway is that the P/TBV multiple does not appear so light in the context of the earnings forecast.Additional perspective on the transaction multiples is provided in Figure 2 in which NewStar’s P/TBV multiple based upon its public market price consistently has been below 100% the last several years while the P/E has been around 20x or higher due to weak earnings.Performance and TimingAs for the lack of premium there outwardly did not appear to be wide-spread expectation that a transaction was imminent (as was thought possible in 2013 when Bloomberg reported the company was shopping itself). There were no recent media reports; however, the shares fell by 17% between May 2–May 19 following a weak first quarter earnings report. The shares subsequently rebounded 19% between June 6–June 14. Both the down and then up moves were not accompanied by heavy volume. Trading during most of this time frame fell below the approximate 100 thousand daily average shares.Measured from June 14–October 17, the day after the announcement, NewStar’s shares rose about 10% compared to 8% for the SNL Specialty Finance Index. Measured from May 19, when the shares bottomed following the weak first quarter results the shares rose 34% compared to 12% for the index through October 17. The market premium relative to recent trading was negligible, but it is conceivable some premium was built into the shares for the possibility of a transaction given the sharp rebound during mid-June when negotiations were occurring.Other Support for the TransactionFurther support for the transaction can be found in the exhaustive process that led to the agreements as presented in the proxy statement. The proxy confirmed the Bloomberg story that the board moved to market the company in 2013. Although its investment bankers contacted 60 potential buyers, only two preliminary indications of value were received, in part because U.S. banking regulators tightened guidelines in 2013 related to leverage lending by commercial banks. The two indications were later withdrawn.During 2016 discussions were held with GSO regarding a going-private transaction, in addition to meetings with over 20 other parties to solicit their interest in a transaction. By the spring of 2017, consideration of a going-private transaction was terminated. Discussions then developed with First Eagle/GSO, Party A and Party B that eventually led to the announced transaction. Given the experience of trying to sell NewStar in 2013 and go private in 2016, the board elected not to broaden the marketing, calculating the most likely bidders would be alternative asset managers (vs. banks with a low cost of funding).Fairness considerations about the process were further strengthened through a “go-shop” provision in the merger agreement that provided for a 30-day “go-shop” period in which alternative offers could be solicited. If a superior offer emerged and the agreements with First Eagle and GSO were terminated a modest termination fee of $10 million (~2.5%) would be owed. Conversely, if NewStar terminates because GSO cannot close, then a $25 million termination fee will be owed to NewStar.The go-shop provision was activated, but to no avail. More than 50 parties were contacted and seven other unsolicited inquiries were received. NewStar entered into confidentiality agreements with 22 of the parties, but no acquisition proposals were received.Financial AdvisorsOther elements of the agreements that are notable for a fairness opinion include the use of two financial advisors, financing, and director Thornburgh, who was recused from the deliberations given his association with 10% shareholder Corsair, which holds, with Blackstone, a majority interest in First Eagle. Financing was not a condition to close on the part of the buyers because GSO secured $2.7 billion of debt and equity capital to finance the asset purchase. First Eagle will use excess funds from the asset purchase and existing available cash to fund the cash consideration to be paid at closing to NewStar shareholders. While two financial advisors cannot make an unfair deal fair, the use of two here perhaps gave the board additional insight that was needed given the four-year effort to sell, take the company private, or affect some other corporate action to increase value.The Lesson from the NewStar ExampleWhile the transaction price for NewStar seems low, there are other factors at play that bear consideration. When reviewing a transaction to determine if it is fair from a financial viewpoint, a financial advisor has to look at the entire transaction in context. Some shareholders will, of course, focus on one or two metrics to support a view that is counter to the board’s decision.ConclusionEvery transaction has its own nuances and raison d’etre whether the price “feels right” or not. Mercer Capital has significant experience helping boards sort through valuation, process and other issues to determine what is fair (or not) to shareholders from a financial point of view. Please call if we can help your board make an informed decision.Originally published in Mercer Capitals Portfolio Valuation: Private Equity Marks Newsletter: Fourth Quarter 2017

Sometimes deals can go horribly wrong between the signing of a merger agreement and closing. Buyers can fail to obtain financing that seemed assured; sellers can see their financial position materially deteriorate; and a host of other “bad” things can occur. Most of these lapses will be covered in the merger agreement through reps and warranties, conditions to close, and if necessary, the nuclear trigger that can be pushed if negotiations do not produce a resolution: the material adverse event clause (MAEC). And MAEC = litigation.Bank of America’s (BAC) 2008 acquisition of Countrywide Financial Corporation will probably be remembered as one of the worst transactions in U.S. history, given the losses and massive fines that were attributed to Countrywide. BAC management regretted the follow-on acquisition of Merrill Lynch so much that the government held CEO Ken Lewis’ feet to the fire when he threatened to trigger MAEC in late 2008 when large swaths of Merrill’s assets were subjected to draconian losses. BAC shareholders bore the losses and were diluted via vast amounts of common equity that were subsequently raised at very low prices.Another less well-known situation from the early crisis years is the acquisition of Charlotte-based Frist Charter Corporation (FCTR) by Fifth Third Bancorp (FITB). The transaction was announced on August 16, 2007 and consummated on June 6, 2008. The deal called for FITB to pay $1.1 billion for FCTR, consisting 30% of cash and 70% FITB shares with the exchange ratio to be set based upon the five day closing price for FITB the day before the effective date. At the time of the announcement FITB expected to issue ~20 million common shares; however, 45 million shares were issued because FITB shares fell from the high $30s immediately before the merger agreement was signed to the high teens when it was consummated. (The shares would fall to a closing low of $1.03 per share on February 20, 2009; the shares closed at $25.93 per share on July 14, 2017.) The additional shares were material because FITB then had about 535 million shares outstanding. Eagerness to get a deal in the Carolinas may have caused FITB and its advisors to agree to a fixed price / floating exchange ratio structure without any downside protection.A more recent example of a deal that may entail both buyer and seller regrets is Canadian Imperial Bank of Commerce’s (CIBC) now closed acquisition of Chicago-based Private Bancorp Inc. (PVTB). A more detailed account of the history of the transaction can be found here. The gist of the transaction is that PVTB entered into an agreement to be acquired by CIBC on June 29, 2016 for 0.3657 CIBC shares that trade in Toronto (C$) and New York (US$), and $18.80 per share of cash. At announcement the transaction was valued at $3.7 billion, or $46.20 per share. As U.S. bank stocks rapidly appreciated after the November 8 national elections, institutional investors began to express dismay because Canadian stocks did not advance. In early December, proxy firms recommended shareholders vote against the deal. A mid-December shareholder vote was then postponed.CIBC subsequently upped the consideration two times. On March 31, 2017, it proposed to acquire PVTB for 0.4176 CIBC shares and $24.20 per share of cash. On May 4, CIBC further increased the cash consideration by $3.00 to $27.20 per share because its shares had trended lower since March as concerns intensified about the health of Canada’s housing market. On May 12, shareholders representing 66% of PVTB’s shares approved the acquisition. Figure 1 highlights the trouble with the deal from PVTB shareholders’ perspective. While the original deal entailed a modest premium, the performance of CIBC’s shares and the sizable cash consideration resulted in little change in the deal value based upon the original terms. On March 30 the deal equivalent price for PVTB was $50.10 per share, while the market price was $59.00 per share. The following day when PVTB upped the consideration the offer was valued at $60.11 per share; however, the revised offer would have been worth nearly $69 per share had CIBC’s shares tracked the SNL U.S. Bank Index since the agreement was announced on June 29. On May 11 immediately before the shareholder vote the additional $3.00 per share of cash offset the reduction in CIBC’s share price such that transaction was worth ~$60 per share, while the “yes-but” value was over $71 per share had CIBC’s shares tracked the U.S. index since late June. Fairness opinions do not cover regret, but there are some interesting issues raised when evaluating fairness from a financial point of view of both PVTB and CIBC shareholders. (Note: Goldman Sachs & Co. and Sandler O’Neill & Partners provided fairness opinions to PVTB as of June 29 and March 30. The registration statement does not disclose if J.P. Morgan Securities provided a fairness opinion as the lead financial advisor to CIBC. The value of the transaction on March 30 when the offer was upped the second time was $4.9 billion compared to CIBC’s then market cap of US$34 billion.)Fairness is a Relative ConceptSome transactions are not fair, some are reasonable, and others are very fair. The qualitative aspect of fairness is not expressed in the opinion itself, but the financial advisor conveys his or her view to management and a board that is considering a significant transaction. When the PVTB deal was announced on June 29, it equated to $46.35 per share, which represented premiums of 29% and 14% to the prior day close and 20-day average closing price. The price/tangible book value multiple was 220%, while the P/E based upon the then 2016 consensus estimate was 18.4x. As the world existed prior to November 8, the multiples appeared reasonable but not spectacular.Fairness Does not Consider 20-20 Hindsight VisionFairness opinions are qualified based upon prevailing economic conditions; forecasts provided by management and the like and are issued as of a specific date. The opinion is not explicitly forward looking, while merger agreements today rarely require an affirmation of the initial opinion immediately prior to closing as a condition to close. That is understandable in the context that the parties cut a deal that was deemed fair to shareholders from a financial point of view when signed. In the case of PVTB, the future operating environment (allegedly) changed with the outcome of the national election. Banks were seen as the industry that would benefit from a combination of lower corporate tax rates, less regulation, faster economic growth, and higher rates as part of the “reflation trade.” A reasonable deal became not so reasonable if not regrettable when the post November 8 narrative excluded Canadian banks. Time will tell if PVTB’s earning power really will improve, or whether the move in bank stocks was purely speculative.Subtle Issues Sometimes MatterAlthough not a major factor in the underperformance of CIBC’s shares vis-à-vis U.S. banks, the Canadian dollar weakened from about C$1.30 when the merger was announced on June 29 to C$1.33 in early December when the shareholder meeting was postponed. When shareholders voted to approve the deal on May 12 the Canadian dollar had eased further to C$1.37. The weakness occurred after the merger agreement was signed and the initial fairness opinions were delivered on June 29. Sometimes seemingly small financial issues can matter in the broad fairness mosaic, but only with the clarity of hindsight.Waiting for a Better Deal is not a Fairness ConsiderationAlthough a board will consider the business case for a transaction and strategic alternatives, a fairness opinion does not address these issues. The original registration statement noted that Private was not formally shopped. The deal was negotiated with CIBC exclusively, which twice upped its initial offer before the merger agreement was signed in June. It was noted that the likely potential acquirers of PVTB were unable to transact for various reasons. The turn of events raises an interesting look-back question: should the board have waited for a better competitive situation to develop? We will never know; however, the board is given the benefit of the doubt because it made an informed decision given what was then known.The Market Established a Fair PriceInstitutional shareholders had implicitly rejected what became an unfair deal by early December when PVTB’s shares traded well above the deal price. The market combined with the “no” recommendation of three proxy firms forced PVTB to delay the special meeting. The increase in the consideration in late March pushed the deal price to a slight premium to PVTB’s market price. CIBC increased the cash consideration an additional $3.00 per share in early May to offset a decline in CIBC’s shares that had occurred since the consideration was increased in March. The market had in effect established its view of a fair price. While CIBC could have declined to up its offer yet again, it chose to offset the decline.Relative Fairness from CIBC’s Perspective FluctuatedWhat appeared to be a reasonable deal from CIBC’s perspective in June became exceptionally fair by early December, if the market is correct that the earning power of U.S. commercial banks will materially improve as a result of the November 8 election. CIBC’s financial advisors can easily change assumptions in Excel spreadsheets to justify a higher price based upon better future earnings than originally projected, but would doing so be “fair” to CIBC shareholders whether expressed euphemistically or formally in a written opinion? So far the evidence of higher earning power is indirect via the market placing a higher multiple on current bank earnings in expectation of much better earnings that will not be observable until 2018 or 2019. That as a stand-alone proposition is an interesting valuation attribute to consider as part of a fairness analysis both from PVTB’s and CIBC’s perspective.ConclusionHindsight is easy; predicting the future is a fool’s errand. Fairness opinions do not opine where securities will trade in the future. Some PVTB shareholders may have regrets that CIBC was not a U.S. commercial bank whose shares would have out-performed CIBC’s after November 8. CIBC shareholders may regret the PVTB acquisition even though U.S. expansion has been a top priority. The key, as always in any M&A transaction, will be execution over the next several years rather than the PowerPoint presentation. Higher rates, a faster growing U.S. economy and the like will help, too, if they occur.We at Mercer Capital cannot predict the future, but we have over three decades of experience in helping boards assess transactions as financial advisors. Sometimes paths and fairness from a financial point of view seem clear; other times they do not. Please call if we can assist your company in evaluating a transaction.This article originally appeared in Mercer Capital's Bank Watch, July 2017.

Last year was a volatile year for credit and equity markets that saw price moves that more typically play out over a couple of years. The year began with a broad-based sell-off in risk assets that got underway in late 2015 due to concerns about the impact of the then Fed intention to raise short-term rates up to four times, widening credit spreads, and a collapse in oil prices. Credit (i.e., leverage loans and high yield debt) and equities rebounded in March and through the second quarter after market participants concluded that media headlines about potentially sub $20 oil were ridiculous and that the Fed probably would not raise rates four times; or, stated differently—the U.S. economy was not headed for recession. Markets staged the second strong rally of the year immediately following the national elections on November 8th with the surprise election of Donald Trump as the next POTUS, and Republicans holding Congress.Not surprisingly, the heavily regulated financial sector outperformed the broader market, with bank stocks (as represented by the SNL U.S. Bank Index) gaining 23% versus 5% for the S&P from November 8th through the end of the year. Most of the return for the bank index was realized after the election given the full year total return of 26%. Banks in the $1 to $5 billion and $5 to $10 billion groups led the way in 2016 with total returns on the order of 44% for the year.The magnitude of the rally in bank stocks was notable because the U.S. economy was not emerging from recession – when bank earnings are near a cyclical trough, poised to turn sharply higher as credit costs fall and loan demand improves. Last year was a great year for most bank stock investors. Bank returns averaged around 40% in 2016, with 30% of the U.S. banks analyzed (traded on the NASDAQ, NYSE, or NYSE Market exchanges for the full year) realizing total returns greater than 50%. The returns reflected three factors: earnings growth, dividends (or share repurchases that were accretive to EPS), and multiple expansion. As shown in Figure 4, the median P/E for publicly-traded banks expanded about 30% to 20.6x trailing 12-month earnings at year-end from 15.9x at year-end 2015. Likewise, the median P/TBV multiple expanded to 181% from 140%. While bank stocks closed the year at the highest P/E level seen this century, P/TBV multiples remain below the pre-crisis peak given lower ROEs (ROTCEs), which in turn are attributable to higher capital and lower NIMs. Figure 5 summarizes profitability by asset size. Banks with assets between $5 and $10 billion were the most profitable on an ROA basis and realized the highest total returns for the year. This group stands to benefit the most from regulatory reform if the Dodd-Frank $10 billion threshold (and $50 billion for SIFIs) is raised. In the most optimistic scenario, the market appears to be discounting that banks’ profitability will materially improve with lower tax rates, higher rates, and less regulation. The corollary to this is that the stocks are not as expensive as they appear because forward earnings will be higher provided credit costs remain modest. Based upon our review, most analysts have incorporated lower tax rates into their 2018 estimates, which accounts for much more modest P/Es based upon 2018 consensus estimates compared to 2017 consensus estimates. 2016 M&A TrendsOn the surface, 2016 M&A activity eased modestly from 2014 and 2015 levels based upon fewer transactions announced; however, when measured relative to the number of banks and thrifts at the beginning of the year, 2016 was consistent with the long-running trend of 2-4% of institutions being acquired each year. The 246 announced transactions represented 3.8% of the 6,122 chartered institutions at the beginning of the year compared to 4.5% for 2014 and 4.2% for 2015. As for pricing, median multiples softened a little bit, but we do not read much into that. Last year, the median P/TBV multiple for transactions in which deal pricing was disclosed eased to 136% compared to 142% in 2015; the median P/E based upon trailing 12 month earnings as reported declined to 21.2x versus 24.4x in 2015. Elevated public market multiples since the national election have set the stage for higher M&A multiples in 2017 as publicly-traded buyers can “pay” a higher price with elevated share prices (Figure 8). The impact of this was seen among some larger transactions announced after the national election compared to when LOIs were announced earlier in the Fall. Activity may not necessarily pick-up with higher nominal prices, however, if would be sellers decide to wait for higher earnings as a result of anticipated increases in rates and lower taxes and regulations. In effect, some may wait for even better values or decide not to sell because ROEs improve sufficiently to justify remaining independent. Time will tell. Figure 9 shows the change in deal multiples from announcement to closing and compares the change between deals announced and closed pre-election to those closed post-election. With the run-up in pricing, P/E and P/TBV multiples increased 12% and 9% from announcement to close compared to 4% and a decline of 1% pre-election. 2017 OutlookNo one knows what the future holds, although one can assess probabilities. An old market saw states “buy the rumor; sell the news” which means stocks move before the expected news comes to pass. As of the date of the drafting of this note (February 7), bank stocks are roughly flat in 2017. The stocks have priced in the likelihood of some roll-back in Dodd-Frank, higher short-term and long-term rates, lower tax rates, and a generally more favorable economic backdrop that supports loan growth and asset quality. The magnitude of these likely – but not preordained – outcomes and the timing are unknown. Following a big rally in 2016, returns for bank stocks may be muted in 2017 even if events in Washington and the Fed prove to be favorable for banks.That said, higher stock prices and investor demand for reasonable yielding sub-debt from quality issuers implies the M&A market for banks should be solid. The one caveat is that there are fewer banks, so a healthy M&A market for banks could still entail fewer transactions than were recorded in 2016.Mercer Capital is a national business valuation and financial advisory firm. Financial Institutions are the cornerstone of our practice. To discuss a valuation or transaction issue in confidence, feel free to contact us.This article originally appeared in Mercer Capital's Bank Watch, February 2017.

Culture trumps everything.  A big part of RIA consolidators’ pitch to target firms is that they can trade paper, give the sellers access to their administrative and marketing infrastructure, but keep their unique culture.  We’ll hear more about this as Focus Financial gets closer to their IPO. MOEs (mergers of equals) are a different animal, and not just because “some of us are more equal than others” (ask Tom Hiddleston).  When firms of similar size join forces to get a bigger footprint, solve leadership issues, stop advisors from competing with each other, etc. – realizing those benefits is the easy part.  The hard work happens because different firms have different histories, and different histories create different cultures.  Blending cultures can be awkward.  My father was on a business trip in Asia at Christmastime 30 years ago.  He walked into a large mainline department store in Tokyo and was stunned at the holiday display just inside the front door: Santa Claus on a cross (!).I don’t know that Pathstone Federal Street is going to have quite as difficult a time merging in Convergent Wealth Advisors, but no doubt there will be moments.   If it works, others will want to follow suit.  If it doesn’t, it will be a cautionary tale we’ll talk about for some time.  For now, it might be helpful for RIA managers considering MOEs to read the following piece written by one of our colleagues, Jeff Davis.  Jeff usually works with depository institutions, but no doubt his checklist of dos and don’ts for MOEs will ring true in the investment management community as well.– Matthew R. Crow, ASA, CFA When asked about his view of a tie years before the NCAA instituted the playoff format in the 1990s, Coach Bear Bryant famously described the outcome as “kissing your sister.” If he were a portfolio manager holding a position in a company that entered into a merger of equals (MOE), his response might be the same. Wall Street generally does not like MOEs unless the benefits are utterly obvious and/or one or both parties had no other path to create shareholder value. In some instances, MOEs may be an intermediate step to a larger transaction that unlocks value. National Commerce Financial Corporation CEO Tom Garrott once told me that part of his rationale for entering into a $1.6 billion MOE with CCB Financial Corp. in 2000 that resulted in CCB owning 47% of the company was because bankers told him he needed a bigger retail footprint to elicit top dollar in a sale. It worked. National Commerce agreed to be acquired by SunTrust Banks, Inc. in 2004 in a deal that was valued at $7 billion.Kissing Your Sister?MOEs, like acquisitions, typically look good in a PowerPoint presentation, but can be tough to execute. Busts from the past include Daimler-Benz/Chrysler Corporation and AOL/Time Warner. Among banks the 1994 combination of Cleveland-based Society Corporation and Albany-based KeyCorp was considered to be a struggle for several years, while the 1995 combination of North Carolina-based Southern National Corp. and BB&T Financial Corporation was deemed a success.The arbiter between success and failure for MOEs typically is culture, unless the combination was just a triumph of investment banking and hubris, as was the case with AOL/Time Warner. The post-merger KeyCorp struggled because Society was a centralized, commercial-lending powerhouse compared to the decentralized, retail-focused KeyCorp. Elements of both executive management teams stuck around. Southern National, which took the BB&T name, paid the then legacy BB&T management to go away. At the time there was outrage expressed among investors at the amount, but CEO John Allison noted it was necessary to ensure success with one management team in charge. Likewise, National Commerce’s Garrott as Executive Chairman retained the exclusive option to oust CCB’s Ernie Roessler, who became CEO of the combined company, at the cost of $10 million if he chose to do so. Garrett exercised the option and cut the check in mid-2003 three years after the MOE was consummated.Fairness Opinions for MOEsMOEs represent a different proposition for the financial advisor in terms of rendering advice to the Board. An MOE is not the same transaction as advising a would-be seller about how a take-out price will compare to other transactions or the company’s potential value based upon management’s projections. The same applies to advising a buyer regarding the pricing of a target. In an MOE (or quasi-MOE) both parties give up 40-50% ownership for future benefits with typically little premium if one or both are publicly traded. Plus there are the social issues to navigate.While much of an advisor’s role will be focused on providing analysis and advice to the Board leading up to a meaningful corporate decision, the fairness opinion issued by the advisor (and/or second advisor) has a narrow scope. Among other things a fairness opinion does not opine:The course of action the Board should take;The contemplated transaction represents the highest obtainable value;Where a security will trade in the future; andHow shareholders should vote. What is opined is the fairness of the transaction from a financial point of view of the company’s shareholders as of a specific date and subject to certain assumptions. If the opinion is a sell-side opinion, the advisor will opine as to the fairness of the consideration received. The buy-side opinion will opine as to the fairness of the consideration paid. A fairness opinion for each respective party to an MOE will opine as to the fairness of the exchange ratio because MOEs largely entail stock-for-stock structures. Explaining the benefits of an MOE and why ultimately the transaction is deemed to be fair in the absence of a market premium can be challenging. The pending MOE among Talmer Bancorp Inc. (45%) and Chemical Financial Corp. (55%) is an example. When the merger was announced on January 26, the implied value for Talmer was $15.64 per share based upon the exchange ratio for Chemical shares (plus a small amount of cash). Talmer’s shares closed on January 25, 2016 at $16.00 per share. During the call to discuss the transaction, one analyst described the deal as a “take under” while a large institutional investor said he was “incredibly disappointed” and accused the Board of not upholding its fiduciary duty. The shares dropped 5% on the day of the announcement to close at $15.19 per share. Was the transaction unfair and did the Board breach its fiduciary duties (care, loyalty and good faith) as the institutional shareholder claimed? It appears not. The S-4 notes Talmer had exploratory discussions with other institutions, including one that was “substantially larger”; yet none were willing to move forward. As a result an MOE with Chemical was crafted, which includes projected EPS accretion of 19% for Talmer, 8% for Chemical, and a 100%+ increase in the cash dividend to Talmer shareholders. Although the fairness opinions did not opine where Chemical’s shares will trade in the future, the bankers’ analyses noted sizable upside if the company achieves various peer-level P/Es. (As of mid-July 2016, Talmer’s shares were trading around $20 per share.) Fairness is not defined legally. The Merriam-Webster dictionary defines “fair” as “just, equitable and agreeing with what is thought to be right or acceptable.” Fairness when judging a corporate transaction is a range concept. Some transactions are not fair, some are in the range—reasonable, and others are very fair. The concept of “fairness” is especially well-suited for MOEs. MOEs represent a combination of two companies in which both shareholders will benefit from expense savings, revenue synergies and sometimes qualitative attributes. Value is an element of the fairness analysis, but the relative analysis takes on more importance based upon a comparison of contributions of revenues, earnings, capital and the like compared to pro forma ownership.Investment Merits to ConsiderA key question to ask as part of the fairness analysis: are shareholders better off or at least no worse for exchanging their shares for shares in the new company and accepting the execution risks? In order to answer the question, the investment merits of the pro forma company have to be weighed relative to each partner’s attributes.Profitability and Revenue Trends. The analysis should consider each party’s historical and projected revenues, margins, operating earnings, dividends and other financial metrics. Issues to be vetted include customer concentrations, the source of growth, the source of any margin pressure and the like. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated.Expense Savings. How much and when are the savings expected to be realized. Do the savings come disproportionately from one party? Are the execution risks high? How does the present value of the after-tax expense savings compare to the pre-merger value of the two companies on a combined basis?Pro Forma Projected Performance. How do the pro forma projections compare with each party’s stand-alone projections? Does one party sacrifice growth or margins by partnering with a slower growing and/or lower margin company?Per Share Accretion. Both parties of an MOE face ownership dilution. What is obtained in return in terms of accretion (or dilution) in EBITDA per share, (for non-banks) tangible BVPS, EPS, dividends and the like?Distribution Capacity. One of the benefits of a more profitable company should be (all else equal) the capacity to return a greater percentage of earnings (or cash flow) to shareholders in the form of dividends and buybacks.Capital Structure. Does the pro forma company operate with an appropriate capital structure given industry norms, cyclicality of the business and investment needs to sustain operations? Is there an issue if one party to an MOE is less levered and the other is highly levered?Balance Sheet Flexibility. Related to the capital structure should be a detailed review of the pro forma company’s balance sheet that examines such areas as liquidity, funding sources, and the carrying value of assets such as deferred tax assets.Consensus Analyst Estimates. This can be a big consideration in terms of Street reaction to an MOE for public companies. If pro forma EPS estimates for both parties comfortably exceed Street estimates, then the chances for a favorable reaction to an MOE announcement improve. If accretion is deemed to be marginal for the risk assumed or the projections are not viewed as credible, then reaction may be negative.Valuation. The valuation of the combined company based upon pro forma per share metrics should be compared with each company’s current and historical valuations and a relevant peer group. Also, while no opinion is expressed about where the pro forma company’s shares will trade in the future, the historical valuation metrics provide a context to analyze a range of shareholder returns if earning targets are met under various valuation scenarios. This is particularly useful when comparing the analysis with each company on a stand-alone basis.Share Performance. Both parties should understand the source of their shares and the other party’s share performance over multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Liquidity of the Shares. How much is liquidity expected to improve because of the MOE? What is the capacity to sell shares issued in the merger? SEC registration and even NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently.Strategic Position. Does the pro forma company have greater strategic value as an acquisition candidate (or an acquirer) than the merger partners individually?ConclusionThe list does not encompass every question that should be asked as part of the fairness analysis for an MOE, but it points to the importance of vetting the combined company’s investment attributes as part of addressing what shareholders stand to gain relative to what is relinquished. We at Mercer Capital have over 30 years of experience helping companies and financial institutions assess significant transactions, including MOEs. Do not hesitate to contact us to discuss a transaction or valuation issue in confidence.

When asked about his view of a tie years before the NCAA instituted the playoff format in the 1990s, Coach Bear Bryant famously described the outcome as “kissing your sister.” If he were a portfolio manager holding a position in a company that entered into a merger of equals (MOE), his response might be the same. Wall Street generally does not like MOEs unless the benefits are utterly obvious and/or one or both parties had no other path to create shareholder value. In some instances, MOEs may be an intermediate step to a larger transaction that unlocks value. National Commerce Financial Corporation CEO Tom Garrott once told me that part of his rationale for entering into a $1.6 billion MOE with CCB Financial Corp. in 2000 that resulted in CCB owning 47% of the company was because bankers told him he needed a bigger retail footprint to elicit top dollar in a sale. It worked. National Commerce agreed to be acquired by SunTrust Banks, Inc. in 2004 in a deal that was valued at $7 billion.Kissing Your Sister?MOEs, like acquisitions, typically look good in a PowerPoint presentation, but can be tough to execute. Busts from the past include Daimler-Benz/Chrysler Corporation and AOL/Time Warner. Among banks the 1994 combination of Cleveland-based Society Corporation and Albany-based KeyCorp was considered to be a struggle for several years, while the 1995 combination of North Carolina-based Southern National Corp. and BB&T Financial Corporation was deemed a success.The arbiter between success and failure for MOEs typically is culture, unless the combination was just a triumph of investment banking and hubris, as was the case with AOL/Time Warner. The post-merger KeyCorp struggled because Society was a centralized, commercial-lending powerhouse compared to the decentralized, retail-focused KeyCorp. Elements of both executive management teams stuck around. Southern National, which took the BB&T name, paid the then legacy BB&T management to go away. At the time there was outrage expressed among investors at the amount, but CEO John Allison noted it was necessary to ensure success with one management team in charge. Likewise, National Commerce’s Garrott as Executive Chairman retained the exclusive option to oust CCB’s Ernie Roessler, who became CEO of the combined company, at the cost of $10 million if he chose to do so. Garrett exercised the option and cut the check in mid-2003 three years after the MOE was consummated.Fairness Opinions for MOEsMOEs represent a different proposition for the financial advisor in terms of rendering advice to the Board. An MOE is not the same transaction as advising a would-be seller about how a take-out price will compare to other transactions or the company’s potential value based upon management’s projections. The same applies to advising a buyer regarding the pricing of a target. In an MOE (or quasi-MOE) both parties give up 40-50% ownership for future benefits with typically little premium if one or both are publicly traded. Plus there are the social issues to navigate.While much of an advisor’s role will be focused on providing analysis and advice to the Board leading up to a meaningful corporate decision, the fairness opinion issued by the advisor (and/or second advisor) has a narrow scope. Among other things a fairness opinion does not opine:The course of action the Board should take;The contemplated transaction represents the highest obtainable value;Where a security will trade in the future; andHow shareholders should vote. What is opined is the fairness of the transaction from a financial point of view of the company’s shareholders as of a specific date and subject to certain assumptions. If the opinion is a sell-side opinion, the advisor will opine as to the fairness of the consideration received. The buy-side opinion will opine as to the fairness of the consideration paid. A fairness opinion for each respective party to an MOE will opine as to the fairness of the exchange ratio because MOEs largely entail stock-for-stock structures. Explaining the benefits of an MOE and why ultimately the transaction is deemed to be fair in the absence of a market premium can be challenging. The pending MOE among Talmer Bancorp Inc. (45%) and Chemical Financial Corp. (55%) is an example. When the merger was announced on January 26, the implied value for Talmer was $15.64 per share based upon the exchange ratio for Chemical shares (plus a small amount of cash). Talmer’s shares closed on January 25, 2016 at $16.00 per share. During the call to discuss the transaction, one analyst described the deal as a “take under” while a large institutional investor said he was “incredibly disappointed” and accused the Board of not upholding its fiduciary duty. The shares dropped 5% on the day of the announcement to close at $15.19 per share. Was the transaction unfair and did the Board breach its fiduciary duties (care, loyalty and good faith) as the institutional shareholder claimed? It appears not. The S-4 notes Talmer had exploratory discussions with other institutions, including one that was “substantially larger”; yet none were willing to move forward. As a result an MOE with Chemical was crafted, which includes projected EPS accretion of 19% for Talmer, 8% for Chemical, and a 100%+ increase in the cash dividend to Talmer shareholders. Although the fairness opinions did not opine where Chemical’s shares will trade in the future, the bankers’ analyses noted sizable upside if the company achieves various peer-level P/Es. (As of mid-July 2016, Talmer’s shares were trading around $20 per share.) Fairness is not defined legally. The Merriam-Webster dictionary defines “fair” as “just, equitable and agreeing with what is thought to be right or acceptable.” Fairness when judging a corporate transaction is a range concept. Some transactions are not fair, some are in the range—reasonable, and others are very fair. The concept of “fairness” is especially well-suited for MOEs. MOEs represent a combination of two companies in which both shareholders will benefit from expense savings, revenue synergies and sometimes qualitative attributes. Value is an element of the fairness analysis, but the relative analysis takes on more importance based upon a comparison of contributions of revenues, earnings, capital and the like compared to pro forma ownership.Investment Merits to ConsiderA key question to ask as part of the fairness analysis: are shareholders better off or at least no worse for exchanging their shares for shares in the new company and accepting the execution risks? In order to answer the question, the investment merits of the pro forma company have to be weighed relative to each partner’s attributes.Profitability and Revenue Trends. The analysis should consider each party’s historical and projected revenues, margins, operating earnings, dividends and other financial metrics. Issues to be vetted include customer concentrations, the source of growth, the source of any margin pressure and the like. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated.Expense Savings. How much and when are the savings expected to be realized. Do the savings come disproportionately from one party? Are the execution risks high? How does the present value of the after-tax expense savings compare to the pre-merger value of the two companies on a combined basis?Pro Forma Projected Performance. How do the pro forma projections compare with each party’s stand-alone projections? Does one party sacrifice growth or margins by partnering with a slower growing and/or lower margin company?Per Share Accretion. Both parties of an MOE face ownership dilution. What is obtained in return in terms of accretion (or dilution) in EBITDA per share (for non-banks), tangible BVPS, EPS, dividends and the like?Distribution Capacity. One of the benefits of a more profitable company should be (all else equal) the capacity to return a greater percentage of earnings (or cash flow) to shareholders in the form of dividends and buybacks.Capital Structure. Does the pro forma company operate with an appropriate capital structure given industry norms, cyclicality of the business and investment needs to sustain operations? Is there an issue if one party to an MOE is less levered and the other is highly levered?Balance Sheet Flexibility. Related to the capital structure should be a detailed review of the pro forma company’s balance sheet that examines such areas as liquidity, funding sources, and the carrying value of assets such as deferred tax assets.Consensus Analyst Estimates. This can be a big consideration in terms of Street reaction to an MOE for public companies. If pro forma EPS estimates for both parties comfortably exceed Street estimates, then the chances for a favorable reaction to an MOE announcement improve. If accretion is deemed to be marginal for the risk assumed or the projections are not viewed as credible, then reaction may be negative.Valuation. The valuation of the combined company based upon pro forma per share metrics should be compared with each company’s current and historical valuations and a relevant peer group. Also, while no opinion is expressed about where the pro forma company’s shares will trade in the future, the historical valuation metrics provide a context to analyze a range of shareholder returns if earning targets are met under various valuation scenarios. This is particularly useful when comparing the analysis with each company on a stand-alone basis.Share Performance. Both parties should understand the source of their shares and the other party’s share performance over multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Liquidity of the Shares. How much is liquidity expected to improve because of the MOE? What is the capacity to sell shares issued in the merger? SEC registration and even NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently.Strategic Position. Does the pro forma company have greater strategic value as an acquisition candidate (or an acquirer) than the merger partners individually?ConclusionThe list does not encompass every question that should be asked as part of the fairness analysis for an MOE, but it points to the importance of vetting the combined company’s investment attributes as part of addressing what shareholders stand to gain relative to what is relinquished. We at Mercer Capital have over 30 years of experience helping companies and financial institutions assess significant transactions, including MOEs. Do not hesitate to contact us to discuss a transaction or valuation issue in confidence.

Statistics can be deceptive. The bank M&A market in 2015 could be described as steady, bereft of any blockbuster deals. According to SNL Financial 287 depositories (253 commercial banks and 34 thrifts) agreed to be acquired in 2015 compared to 304 in 2014 and 246 in 2013. Since 1990, the peak in M&A transactions occurred in 1994 (566) followed by 1998 (504). For those who do not remember, 1998 was the blockbuster year when NationsBank/Bank of America, Norwest/Wells Fargo, Bank One/First Chicago NBD and SunTrust Banks/Crestar Financial among others agreed to merge (Figure 1). There has been a cumulative impact of M&A activity over the years. As of September 30, 2015, there were 6,270 insured depositories compared to about 18,000 institutions in 1985 when interstate banking laws were liberalized. M&A activity when measured by the number of transactions obviously has declined; however, that is not true on a relative basis. Since 1990, the number of institutions that agreed to be acquired in non-assisted deals ranged between 1.4% (1990) and 4.6% (1998) with an overall median of 3.2%. Last year was an active year by this measure, with 4.4% of the industry absorbed, as was 2013 (4.5%). What accounts for the activity? The most important factors we see are (a) good asset quality; (b) currency strength for many publicly traded buyers; (c) very low borrowing costs; (d) excess capital among buyers; and (e) ongoing earnings pressure due to heightened regulatory costs and very low interest rates. Two of these factors were important during the 1990s. Asset quality dramatically improved following the 1990 recession while valuations of publicly traded banks trended higher through mid-1998 as M&A fever came to dominate investor psychology. Today the majority of M&A activity involves sellers with $100 million to $1 billion of assets. According to the FDIC non-current loans and ORE for this group declined to 1.20% of assets as of September 30 from 1.58% in 2014. The most active subset of publicly traded banks that constitute acquirers is “small cap” banks. The SNL Small Cap U.S. Bank Index rose 9.2% during 2015 and finished the year trading for 17x trailing 12 month earnings. By way of comparison, SNL’s Large Cap U.S. Bank Index declined 1.3% and traded for 12x earnings. Strong acquisition currencies and few(er) problem assets of would-be sellers are a potent combination for deal making. Earnings pressure due to both the low level of rates (vs. the shape of the yield curve) and post-crisis regulatory burdens are industry-wide issues. Small banks do not have any viable means to offset the pressure absent becoming an acquirer to gain efficiencies or elect to sell. Many chose the latter. The Fed may have nudged a few more boards to make the decision to sell by delaying the decision to raise short rates until December rather than June or September when the market expected it to do so. “Lift-off” and the attendant lift in NIMs may prove to be a non-starter if the Fed is on a path to a one-done rate hike cycle. As shown in Figure 2, pricing in terms of the average price/tangible book multiple increased nominally to 142% in 2015 from 139% in 2014. The more notable improvement occurred in 2014 when compared to 2013 and 2012, which is not surprising given the sharp drop in NPAs during 2011-2013. The median P/E multiple was 24x, down from 28x in 2014 and comparable to 23x in 2013. The lower P/E multiple reflected the somewhat better earnings of sellers in which pricing was reported with a median ROA of 0.65% compared to 0.55% in 2014. Although the data is somewhat murky, we believe acquirers typically pay on the order of 10-13x core earnings plus fully-phased-in, after-tax expense savings. Figure 3 provides perspective on pricing based upon size and profitability as measured by LTM ROE. Not surprisingly, larger and more profitable companies obtained better pricing in terms of the P/TBV ratio; however, as profitability increases the P/E multiple tends to decline. That is not surprising because a higher earning bank should have fewer issues that depress current earnings.The other notable development in 2015 was the return of non-SIFI large banks to the M&A market after largely being absent since the financial crisis as management and regulators sorted through the changes that the Dodd-Frank Act mandated. BB&T Corporation, which is among the very best acquirers, followed-up its 2014 acquisitions for Bank of Kentucky Financial Corp. and Susquehanna Bancshares with an agreement to acquire Pennsylvania-based National Penn Bancshares. The three transactions added about $30 billion of assets to an existing base of about $180 billion. Other notable deals included KeyCorp agreeing to acquire First Niagara ($39 billion) and Royal Bank of Canada agreeing to acquire City National Corporation ($32 billion). Also, M&T Bancorp was granted approval by the Federal Reserve to acquire Hudson City Bancorp ($44 billion) three years after announcing the transaction.To get a sense as to how the world has changed, consider that the ten largest transactions in 2015 accounted for $17 billion of the $26 billion of transaction value compared to $9 billion of $19 billion in 2014. The amounts are miniscule compared to 1998 when the ten largest transactions accounted for $254 billion of $289 billion of announced deals that year.Law firm Wachtell, Lipton, Rosen & Katz (“Wachtell”) noted that with the approval of several large deals this year there is more certainty to the regulatory approval process and there is no policy to impede bank mergers x-the SIFI banks. A key threshold for would-be sellers and would-be buyers from a decision process has been $10 billion of assets (and $50 billion) given enhanced regulatory oversight and debit card interchange fee limitation that applies for institutions over $10 billion. Wachtell cited the threshold as an important consideration for National Penn’s board in its decision to sell to BB&T.There were a couple of other nuances to note. While not always true, publicly-traded buyers did not receive the same degree of “pop” in their share prices when a transaction was announced as was the case in 2012 and 2013. The pops were unusual because buyers’ share prices typically are flat to lower on the news of an announcement. Several years ago the market view was that buyers were acquiring “growth” in a no-growth environment and were likely acquiring banks whose asset quality problems would soon fade.Also, the rebound in real estate values and resumption of pronounced migration in the U.S. to warmer climates facilitated a pick-up in M&A activity in states such as Georgia (11 deals) and the perennial land of opportunity and periodic busts—Florida (21). The recovery in the banking sector in once troubled Illinois was reflected in 25 transactions followed by 20 in California.As 2016 gets underway, pronounced weakness in equity and corporate bond markets if sustained will cause deal activity to slow. Exchange ratios are hard to set when share prices are volatile, and boards of sellers have a hard time accepting a lower nominal price when the buyer’s shares have fallen. Debt financing that has been readily available may be tougher to obtain this year if the market remains unsettled.Whether selling or merging, we note for the surviving entity a key goal should be something akin to Figure 4 in which there is shared upside for both the acquirer’s and seller’s shareholders (assuming a merger structured as a share exchange). A well-structured and well-executed transaction can improve the pro forma bank’s profitability and growth prospects. If so, all shareholders may benefit not only from EPS accretion, but also multiple expansion. We at Mercer Capital have over 30 years of experience of working with banks to assess transactions, ranging from valuation to issuing fairness opinions in addition to helping assess the strategic position (e.g., sell now vs. sell later). Please call if we can help your institution evaluate a significant corporate transaction.

August has become the new October for markets in terms of increased volatility and downward pressure on equities and high yield credit. This year has seen similar volatility as was the case in some memorable years such as 1998 (Russian default; LTCM implosion), 2007 (tremors in credit markets), 2008 (earthquakes in credit and equity markets) and 2011 (European debt crisis; S&P’s downgrade of the U.S.). Declining commodity markets, exchange rate volatility and a pronounced widening of credit spreads finally began to reverberate in global equity markets this year.So far the downdraft in equities and widening high yield credit spreads has not slowed M&A activity. Preliminary data from Thomson Reuters for the third quarter indicates global M&A exceeded $1 trillion, which represents the third highest quarter on record and an increase of 11% over the year ago quarter. Activity is less broad-based though as 8,989 deals were announced compared to 10,614 a year ago.Immediately prior to intensified pressure on risk-assets, Thomson Reuters estimated that as of August 13 global M&A was on pace for a record year with $2.9 trillion of announced transactions globally (+40% vs. LYTD) and $1.4 trillion in the U.S. (+62%). Within the U.S., strategic buyer activity rose 53% to $1.1 trillion while PE M&A rose 101% to $326 billion.LBO multiples have been trending higher since 2009. The median LBO EBITDA multiple for broadly syndicated large deals was 10.1x through September, while middle market multiples expanded to 10.3x. Debt to EBITDA multiples for LBOs were 6.0x for large deals YTD and 5.5x for middle market transactions.No one knows what the future holds for markets. Deal activity could slow somewhat; however, a weak environment for organic revenue growth will keep many strategic buyers engaged, while lower prices for sellers if sustained will make more targets affordable for private equity provided debt financing costs do not rise too much. As of October 14, the option-adjusted-spread (OAS) on Bank of America Merrill Lynch’s High Yield Index was 6.31%, up from 5.04% at year-end and 4.83% a year ago.The role of the financial advisor becomes tougher too when markets are declining sharply. Obviously, sellers who do not have to sell may prefer to wait to see how market turmoil will play out while buyers may push to strike at a lower valuation. Questions of value and even fair dealing may be subjected to more scrutiny.Fairness opinions seek to answer the question whether a proposed transaction is fair to a company’s shareholders from a financial point of view. Process and especially value are at the core of the opinion. A fairness opinion does not predict where a security—e.g. an acquirer’s shares—may trade in the future. Nor does a fairness opinion approve or disapprove a board’s course of action. The opinion, backed by a rigorous valuation analysis and review of the process that led to the transaction, is just that: an opinion of fairness from a financial point of view. Nevertheless, declining markets in the context of negotiating and opining on a transaction will raise the question: How do current market conditions impact fairness?There is no short answer; however, the advisor’s role of reviewing the process, valuation, facts and circumstances of the transaction in a declining market should provide the board with confidence about its decision and the merits of the opinion. Some of the issues that may weigh on the decision process and the rendering of a fairness opinion in a falling market include the following:Process vs. Timing. Process can always be tricky in a transaction. A review of fair dealing procedures when markets have fallen sharply should be sensitive to actions that may favor a particular shareholder or other party. A management-led LBO after the market has fallen or a board that agrees to buyback a significant shareholder’s interest when prices were higher are examples. Even an auction of a company may be subject to second guessing if the auction occurred in a weak environment.Corporate Forecasts. Like the market, no one knows how the economy will perform over the next several years; however, consideration should be given to whether declining equity markets and widening credit spreads point to a coming economic slowdown. A baseline forecast that projects rising sales and earnings or even stable trends may be suspect if the target’s sales and earnings typically fall when the economy enters recession. A board should consider the implications of any sustained economic slowdown on the subject’s expected financial performance with follow-through implications for valuation.Valuation. Unless markets experience a sharp drop from a valuation level that reflects a widely held view that multiples were excessive, a sharp pullback in the market will cause uncertainty about what’s “fair” in terms of value. DCF valuations and guideline M&A transaction data may derive indications that are above what is obtainable in the current market. Transactions that were negotiated in mid-2007 and closed during 2008 may have felt wildly generous to the seller as conditions deteriorated. Likewise, deals negotiated in mid-2012 that closed in 2013 when markets were appreciating may have felt like sellers left money on the table. There is no right or wrong, only the perspective provided from the market’s “bloodless verdict” of obtaining a robust market check if a company or significant asset is being sold. It is up to the board to decide what course of action to take, which is something a fairness opinion does not address.Exchange Ratios. Acquisitions structured as share exchanges can be especially challenging when markets are falling. Sellers will tend to focus on a fixed price, while buyers will want to limit the number of shares to be issued. The exchange ratio can be (a) fixed when the agreement is signed; (b) fixed immediately prior to closing (usually based upon a 10 day volume-weighted average price of the buyer); or (c) a hybrid such as when the ratio floats based upon an agreed upon value for the seller provided the buyer’s shares remain within a specified band. Floating exchange ratios can be seen as straightjackets for buyers and lifejackets for sellers in falling markets; rising markets entail opposite viewpoints.Buyer’s Shares. An evaluation of the buyer’s shares in transactions that are structured as a share exchange is an important part of the fairness analysis. Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles. The historical perspective can then be compared with the current down market to make inferences about relative performance and valuation that is or is not consistent with comparable periods from the past.Financing. If consummation of a transaction is dependent upon the buyer raising cash via selling shares or issuing debt, a sharp drop in the market may limit financing availability. If so, the board and the financial advisor will want to make sure the buyer has back-up financing lined-up from a bank. The absence of back-stop financing, no matter how remote, is an out-of-no-where potential that a board and an advisor should think through. Down markets make the highly unlikely possible if capital market conditions deteriorate unabated. While markets periodically become unhinged, a board entering into an agreement without a backstop plan may open itself to ill-informed deal making if events go awry. A market saw states that bull markets take the escalator up and bear markets take the elevator down. Maybe the August sell-off will be the pause that refreshes, leading to new highs, tighter credit spreads, and more M&A. Maybe the October rebound in equities (but not credit, so far) will fade and the downtrend will resume. It is unknowable. What is known is that boards that rely upon fairness opinions as one element of a decision process to evaluate a significant transaction are taking a step to create a safe harbor. Under U.S. case law, the concept of the "business judgment rule" presumes directors will make informed decisions that reflect good faith, care and loyalty to shareholders. The evaluation process is trickier when markets have or are falling sharply, but it is not unmanageable. We at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies engaged in transactions during bull, bear and sideways markets garnered from over three decades of business.

In this 2013 whitepaper we review financial issues arising when community banks merge or sell to a larger, public institution. It is not intended to answer every question and, in some instances, our intention is to raise questions for directors and managers to evaluate. In a series of follow-up papers and webinars we will address specific topics that merit further scrutiny.