Successful Community Bank Sale: Is your cost savings worth more than you think?

Let’s look at cost savings from a sale/merger.

An acquisition that leaves all the personnel in place along with little to no operational changes still results in cost savings.

It is important to recognize that there are still redundancies like two data processing contracts, two financial audits, two payroll systems, employee benefits duplication, and so forth.

The two core processing systems can be merged into one.

The two financial audits can be performed by one of the two firms, not both.

Employee benefit plans can be winnowed down to one - perhaps choosing between the two healthcare plan options, the same for dental plans, vision plans and life and disability insurance.

One flexible spending plan will remain.

So, even with all personnel left in place and with little to no changes operationally for the customers, cost savings still results.

The average cost savings are 33%.

This 33% does factor in some headcount reduction, primarily in duplicated back-office roles.

In other words, the median transaction results in a 33% decrease in the seller’s expenses.

The average seller may have an efficiency ratio of 70% before a deal, after the deal that drops to 47%.

Cost reductions create value.

Size creates scalability.

Scalability creates higher earning power.

But you may see that larger banks don’t necessarily have better multiples than smaller banks.

Again, you’ve got to be careful with multiples.

As banks get bigger, their efficiency gets better, and they make more money as a result.

The earnings in the price to earnings ratio (P/E) increases.

As the earnings (denominator) go up, the P/E ratio goes down.

It goes down, not because they are worth less, but because the efficiency savings of a large bank are less than the efficiency savings for a community bank.

If a larger bank was to sell, it would have less savings on a percentage basis to offer a buyer.

Put another way, a target that is less efficient than the median may be added value to a buyer and the savvy seller will push this benefit during negotiations (another great reason to have a seasoned, productive sell-side investment banker alongside).

Here’s some data, from my perspective, which shines some light on this:

As a smaller bank grows, people and technology are typically added in “chunks.”

You add people and technology to take care of the growth and to reduce risk.

You then take a dip in profitability until that growth offsets the additional expense and subsequently, profitability grows to be more than the added expense.

It stays that way for a period of time until, once again, additional growth causes added expense with the addition of more people and more technology.

It is a repetitive process.

This chart says a great deal about what I have just described. If a bank five to seven times your size is typically the buyer, then the buyer for a $225 million bank is approximately $1.1 billion - $1.6 billion.

The efficiency ratio, on average, is going from 70.4% to 61.4%.

Let’s stay with this example and breakdown the purchase further for demonstration.

Let’s look at what the buyer is paying and the earnings the buyer is getting in exchange.

This is hypothetical.

For example, the buyer has agreed to pay $30 million, at least that’s what it says in the press release.

What are they actually paying?

Here is the data the public doesn’t see.

There might be transaction costs of $3 million.

These are priced in and may include data processing costs (we will discuss this further in an upcoming newsletter – “Successful Community Bank Sale: Do you know your Golden Window of opportunity”), Change-In-Control employee contract costs (we discuss this further in an upcoming newsletter – “Successful Bank Sale: Are your people attracting bank buyers?”), sign changes, short-term duplications in costs associated with employee benefits, audit firms, payroll providers.

(Note: if you would like to access the information above rather than waiting for the newsletters to come out, you can find them in my book in Chapter 10 – The Golden Window, and Chapter 9 – Talent. You can get your book by clicking here: https://rebrand.ly/obhzl2o).

Again, this is a hypothetical example but let’s say this is all done for $3 million, in one-time costs.

There might be a $2 million credit adjustment (referred to as a “credit mark”) following the due diligence loan review by the buyer.

Consider it the provision they are adding as a cushion on the loan portfolio. Again, it is being assumed asset quality for the bank is good—this isn’t a troubled bank that’s being purchased.

Let’s say there’s a $2 million fixed asset/interest rate/deposit mark as well.

Those adjustments total $7 million.

That means the announced price tag is $30 million, but it’s a net number and what the seller’s shareholders will receive, but the buyer is really paying $37 million and that is what they are concerned about.

Let’s now look at the earnings the buyer is getting in exchange.

The seller is making a $2 million net profit on its own, but there’s an additional $1 million in after-tax cost savings. This again is the average 33% savings (tax effected, so 50% estimated in after-tax cost savings).

The buyer is therefore getting $2 million, plus another $1 million, for a total of $3 million in earnings.

They are unlocking, in this hypothetical example, 50% higher earnings.

Maybe the scale and the scope will be higher or lower, but this is as straightforward an example as can be made.

This is the reason so many banks are looking at acquisitions.

The combination of the two banks increases profitability.

The efficiency ratio data also seems to show that most banks are trying to grow to the $5 - $10 billion size as the earnings are best in that size range, a 55% efficiency ratio, and $7 billion in total assets would seem to be a “sweet spot” in earnings.

As the bank grows closer to $10 billion in total assets, some of that profit is lost to regulatory compliance costs building up to be where they need to be by crossing over the $10 billion line.

With the efficiency ratio being 55% as an average for the $5 - $10 billion size, that would lead me to believe it’s closer to 50% at around $7 billion in assets.

So, another way of putting it and to summarize the difference scale brings to the picture, it costs a bank below $250 million in total assets 70 cents to bring in $1 of revenue.

It costs a $7 billion bank 50 cents to bring in $1 of revenue.

The increased regulatory burden when crossing over the $10 billion assets level makes the bank less profitable and is what moves the efficiency ratio higher.

It costs that bank 57 cents to bring in $1 of revenue.

The cost savings outlined represent hard dollar savings.

Action plan:

• Audit your efficiency ratio. Where do you fit on the chart included in this newsletter.
• Audit your potential cost savings.
  • List out all redundant systems and the costs associated with them.
  • List out roles within your company that would likely be eliminated. (Don’t get caught up in any sentimentality – this is all hypothetical – you’re just getting your bearings).

There are zero hacks or tricks in this newsletter. Just proven tactics that help you choose the right path for your bank.

Your path will:

• Inform your strategic plan.
• Guide your annual business plan and budget.
• Clarify priorities.
• Define your message so it can be communicated with confidence.

This is how savvy bankers navigate.

They build smart and valuable banks and choose the best time to sell – serving the needs of the shareholders and the board.

I hope you found this short lesson helpful.

What are your thoughts?

I’ll see you next week.