As the COVID-19 pandemic keeps the global economy in shackles, most community banks are not focused on strategic initiatives like M&A. However, there are two camps of banks that must think about M&A during the pandemic: those that completed deals in the last 6 to 12 months, and banks that were recently in early to mid-stage talks with targets.

The first group is likely concerned that its pre-COVID-19 due diligence wasn’t enough to ensure confidence in the new partnership. If a definitive agreement is in negotiation or has just been signed, then these banks may even be looking for exit strategies, which could be extremely costly and time-consuming. Or at minimum, they are nervous and are wondering if they just made a big mistake.

The other camp’s natural inclination is to put everything on hold until some of the uncertainties subside. It is important for these banks to remember that this kind of environment will eventually lead to more deals. For example, in 1990 and 1991, there was an 8-month recession, due to upward oil price shocks and consequences of rapid debt accumulation of the 1980s. In the next few years, bank consolidation sped up at historical rates. There was a similar reaction after the 2008 financial crisis. Banks that were set up to take advantage of opportunities thrived, snapping up failing and troubled banks as the industry consolidated.

As a buyer in this environment, you should be keeping your relationships with targets alive. All banks should be stress testing their loans and capital during the crisis to understand their vulnerabilities. Below are two suggestions for how buyers, no matter their stage in the process, can marry the stress testing they should already be doing with their M&A strategies.

Covering the Bases

You can’t round third base without first rounding second base. Stress testing your own bank is the most important priority right now. Being able to continuously stress test throughout the pandemic will help you keep a close eye on capital and get early warning signals on loans.

Stress testing targets is just as important, so you understand what you are buying (or bought). Being able to identify the weaknesses in a target’s loan portfolio will give you a sense of how to manage the portfolio going forward. You will be better armed to make decisions around renewals and repricing of those acquired credits. Banks that have done deals in the last 6 to 12 months can easily segment the loans by originating bank and then view them as separate buckets in a stress testing analysis.

Even prior to the COVID-19 crisis, it made sense for buyers to stress test their targets’ loan portfolios as soon as loan tapes became available in the data room and prior to signing a definitive agreement. Those that properly did so may still be nervous if they recently entered into a definitive agreement, but they will have far more comfort than the typical acquirer. Unfortunately, most of the community banking market confuses stress testing with the loan review process and fails to stress test target portfolios effectively, if at all.

Banks that have recently closed a deal may need to take things further to get a fully accurate picture of the bank on a post-stress basis. The stress test needs to be run on the consolidated entity to properly account for impacts to capital. If the financials have not yet been integrated, then you need to integrate your pro forma consolidation analysis into the stress test so that the Day 1 balance sheet and P&L take over for your reported financials. This step can be challenging for those without experience, but it is necessary. This is especially true if the transaction is structured with debt financing and the servicing of the debt is dependent upon a recurring dividend from the bank charter to the holding company.

If you are in early stage talks, there are multiple ways you can go about stress testing the target bank.

One suggestion is to communicate directly with the target and offer to have your advisor perform stress testing services under the protection of an NDA. Clearly spell out what the buyer will be able to view and more importantly highlight the value to the target. The goal should be to provide the target with the same value that you would get from stress testing your bank. The target’s management should be able to add this as another tool in its arsenal to combat the COVID-19 crisis.  It can use the stress tests to effectively communicate with all stakeholders, develop contingency plans to protect capital, and concentrate precious resources on working with those borrowers that are most vulnerable and most material to the bottom line. As their prospective buyer, you are essentially offering a value-added service in the spirit of further developing the relationship prior to a potential marriage down the road.

Stress testing the consolidated entity can also apply to a bank that is still shopping for a deal. In this environment it is wise to stress the consolidated entity before purchase. You should have all the necessary ingredients if you can stress each bank individually and have some sense of the purchase pricing/purchase accounting.  Regulatory capital levels under stress especially need to be considered early in the process and well before you even provide the target with a Letter of Intent or bid.

Continuing Negotiations

Stress testing’s role in the M&A process is not just about due diligence. In fact, due diligence is a secondary benefit. Its primary benefit is two-fold: (1) You can further develop your relationship with the target by providing it with a value-added tool as previously mentioned. (2) You can use the information from the stress test to drive the valuation and structuring of the transaction to protect you from downside risk, while also providing the target with a path to realizing its upside.

Creative deal structuring can be a significant competitive advantage as well. This is especially true with bank stock prices trading well below minimum thresholds necessary for buyers to use their equity as currency.  The silver lining is that this scenario once again creates a significant opportunity to those banks that  are farsighted and looking to separate themselves from the rest of the pack.

When the time is right to continue the negotiations, both sides should be in a better place of understanding. Being armed with a target’s stress test as a buyer can help in structuring the transaction so that you are protected against the unknown. For example, you can set certain performance benchmarks in your agreements that allow for future payouts or claw-backs against a “business-as-usual” purchase price. Stress testing is the only tool you have in this environment to get tangible numbers that can be used for this purpose. Items such as unexpected loan losses, NIM compression, and reduced pre-provision earnings all affect the P&L and ultimately the ideal purchase price. This is where buyers start to unlock the true power of stress testing for negotiations. Meanwhile, sellers can realize the ’full value’ of the transaction if unexpected losses triggered by an economic downturn do not materialize.

This is not simply handcuffing the target but rather a practical way to give a target their “business as usual” fair value while protecting the buyer from risks that might slip through the cracks in coming months. These kinds of actions need to be approached thoughtfully but will be essential to taking advantage of opportunities that arise in this environment.

Unfortunately, most investment bankers failed to recognize the importance of stress testing’s role in valuation and structuring following the 2008 financial crisis and are ill-equipped to provide these services.

Conclusion: The Right Tools Illuminate Opportunities

In review, the name of the game is caution when considering strategic initiatives in this market environment. If you stress test your bank and see that your capital is robust in the most severe economic decline, then you should keep an eye open for opportunities. By marrying stress testing with your analysis of strategic opportunities, you can systematically address uncertainties.

Check-the-box stress testing to appease regulators is amateur hour at its finest. The smart banks approach stress testing as a strategic exercise and an immensely powerful tool for M&A, especially now.

— Jared Woods is an Invictus Group senior M&A analyst.