Tags: Banking, Banks, Canada, Central Banks, Global Economy, U.S. Banks

Smaller U.S. Regional Banks Fast Becoming Takeover Targets

By , Contributing Writer, Money Morning •

Sharks are circling the beleaguered financial services industry and the upshot may well be a wave of mergers and acquisitions (M&A) that analysts say could lead to higher valuations, especially for smaller, regional banks.

Activity in the financial services industry has been subdued for the past three years as weak loan growth, shrinking profit margins, increased regulation and low valuations kept investors at bay. But now forces pressuring the industry to contract "will create more willingness to sell from bank management teams and board of directors over the next year," and drive consolidation, according to the report by Credit Suisse Equity Research.

Specifically, weak U.S. regional banks could be attractive targets for Canadian banks looking to expand their U.S. holdings, the report said.

With available credit growing and eagerness on the part of private equity funds to put capital to work, deal volume in the second half of this year could reach $20 billion, topping 2009's meager $14.8 billion, according to a report assembled by Freeman & Co, a leading independent advisor to the financial services industry.

Why Smaller Banks Are Attractive Now

There are three big reasons why regional banks look more appealing than larger firms.

  • Healthier books of business - Smaller, regional banks are forced to practice diligent underwriting policies because they usually end up owning and servicing the loans. In fact, many of these small and mid-cap financial service firms have always been profitable, even during the Great Recession.
  • Better value - Small banks' price/earnings (P/E) ratios tend to be smaller and their dividend yields tend to be higher.  The fact that they remain attractive from a security price perspective underlines the long-term value they can offer investors.
  • Very little rescue funding - Despite all of the financial reforms that may hinder the growth prospects of bigger banks, smaller banks continued to conduct business as usual and most didn't receive government bailout funds. Taxpayers will be more inclined to support and patronize these healthier, smaller firms because they're seen as community firms.

Although there is still risk, these financial services firms are better positioned in their communities and in the banking realm to not only profit from an economic recovery, but from tighter banking regulations as well.

As a result, many of these banks will become a first choice solution for borrowers, making regionals more attractive, especially when they are compared to their larger counterparts.

Private Equity Firms on the Hunt

Over the past 18 months, there has been a gradual healing in the banking sector.

The banking industry recorded earnings of $21.6 billion in the second quarter of 2010, the highest quarterly profit since 2007, reversing a $4 billion loss in the corresponding quarter of 2009, according to the Federal Deposit Insurance Corporation (FDIC).

Over the past two years, the 19 largest U.S. banks raised approximately $205 billion of private capital, and redeemed $220 billion of preferred shares issued under the Treasury's Capital Assistance Program.

Meanwhile, the credit environment for private equity firms has undergone a structural change since the deal boom in 2004-2007. After two years of extremely tight credit, banks are beginning to lend again. 

Not surprisingly, the financial services sector has been getting more attention from the private equity industry as the credit crisis eases. And while fundraising continues to slide - private equity firms raised just $76 billion in the first half of the year - private equity firms still have huge amounts of unspent capital.

So far in 2010, there have been 41 completed or announced investments in the financial services industry, totaling over $3 billion, according to PitchBook. That's well above 2009 investment levels when only 30 deals were completed in the entire second half of the year.

Deal volume increased 17% year-over-year in the first half of 2010, Freeman & Co. said in its recent annual report.  Also, high yield bond issuance was up 125% in the first half of 2010, compared to the same period last year.

"Deal volumes collapsed during the crisis," Freeman & Co. managing director Eric Weber said in a press release, "but we now see deal activity accelerating, driven by sales of non-core assets by banks, a more stable economic environment and the re-emergence of the debt financing markets."

Financial sponsors like Carlyle Group, which spent $500 million in a deal with Bank of Butterfield, are now paying more attention to smaller banks. W.L. Ross & Co. has been a repeat investor in community banks.

In the latest deal, Patriot Financial Partners - a private equity firm focused on investing in community banks, thrifts and other financial service related companies - agreed to invest between $20 million and $25 million in TIB Financial Corp. (Nasdaq: TIBB). The investment is part of a $150 million capital raising effort by the southwest Florida bank.

Canadian Banks Jump Aboard

Foreign banks looking for U.S. exposure have also found small and mid-sized regional banks enticing.

U.S. regional banks make particularly good takeover targets for stronger Canadian banks, which are experiencing weak loan growth and have to operate under tight regulation. Other problems for Canadian banks include pressure on net interest margins and low valuation relative to other financials.

"Canadian banks are motivated by a desire to add scale in specific regions at attractive valuation levels," Credit Suisse Group AG (ADR NYSE: CS) said in a research report.

Canadian banks are trading at 93% premiums to U.S. regional banks, up from an average of 23% in the last 10 years, the report noted.

First Niagara Financial Group Inc.'s (Nasdaq: FNFG) $1.5 billion takeover of New Haven, Conn.-based New Alliance Bankshares Inc. (NYSE: NAL)  in August may have started the trend, the analysts said. First Niagara characterized the acquisition as "playing offense" by entering new markets that will enable profit growth.

"We will be able to do even more for the community as a larger, stronger institution," First Niagara said in a statement. "This is another very positive step forward for both our Main Street and Wall Street constituents."

Additionally, the Basel Committee on Banking Supervision earlier this month changed the definition of capital in a way that presented Canadian banks an opportunity to expand, Credit Suisse analyst Nick Stogdill told MarketWatch.

"It gives banks more certainty in deploying capital," he said.

The report points to two Canadian banks, Toronto Dominion Bank and the Bank of Montreal (NYSE: BMO), as potential buyers. 

Potential U.S. targets include TCF Financial Corp. (NYSE: TCB) in the Midwest, and Regions Financial Corp. (NYSE: RF) and Synovus Financial Corp. (NYSE: SNV). Toronto Dominion, Canada's second-biggest lender, operates banks in the eastern U.S. and may buy Synovus, based in Columbus, Georgia, according to the CS report.

BMO and Chicago-based Harris Bank "make an attractive combination," the report said.

Investors looking to capitalize might also follow certain private equity firms for clues.  Lightyear Capital, Stone Point Capital and J.C. Flowers & Co LLC have been some of the most active investors in the industry this year.

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