As financial industry specialists and readers of “Too Big to Fail” will know, Rodgin Cohen, a longtime corporate lawyer with Sullivan & Cromwell, is one of the preeminent authorities on banking and financial services M&A in the United States. So, a chance to hear his thoughts on the state of the current M&A environment, as it relates to U.S. banking, was not to be missed. The following summarizes the basic points of Mr. Cohen’s recent speech we attended in New York City.
As we have written previously, it is our expectation that U.S. bank consolidation will accelerate, predominately within the 350+ publicly traded small and mid-cap banks. The Hamilton Capital U.S. Mid-Cap Financials ETF (USD) (ticker: HFMU.U) has exposure to more than 30 U.S. mid-cap banks, accounting for ~65% of NAV, while the Hamilton Capital Global Bank ETF (ticker: HBG) is invested in 20+ U.S. mid-cap banks, accounting for ~50% of exposure.
Mr. Cohen believes there are eight primary drivers of M&A expectations in U.S. banking today:
- The warm reaction to the low/no premium bank deals with low tangible book value (“TBV”) dilution. Specifically, the transactions announced by BB&T and Suntrust, and Chemical Financial and TCF Financial – both mergers of equals (“MOEs”) – were met positively by markets and have encouraged speculation of more such deals to come.
- A change in the regulators’ attitudes to M&A. Specifically, Mr. Cohen cited the shift to supervisory first (vs. enforcement) and the shortened timeframe to close (from an average of 7.5 months to a more recent 4.5 month average).
- The competitive threats from OUTSIDE the banking sector. Everyone is well aware of the various fintech firms, large and small, attempting to crack into different parts of the financial sector. However, investors are likely less aware of the spate of small bank transactions initiated by credit unions in recent years seeking to build scale.
- The competitive threat from WITHIN the banking sector. Deposits, specifically core deposits, are the lifeblood of banks, allowing them to cheaply borrow money that they then lend out. The competition for deposits is incredibly hot today, with internet banks (i.e., online banks without physical locations, including those launched in recent years by Ally, Capital One and Goldman Sachs) and the mega-caps with their nationwide branch networks drawing in a disproportionate share.
- Desire for greater scale. Mr. Cohen cited this as the most important factor for all banks. Scale allows businesses to reduce costs and spread others over a large base within their competitive markets. It also, as Mr. Cohen noted, can allow a bank to expand into multiple channels and even to experiment with new products/methods of distribution.
- The increased value of synergies following the tax changes. With a lower tax rate, more of the expense (or revenue) synergies from M&A transactions drop to the bottom-line.
- Pent up demand. Cohen noted that there are several historical acquirers – primarily large regionals – that have not announced a deal, particularly of a meaningful size, in years.
- Congress’s May 2018 enactment of the Economic Growth, Regulatory Relief and Consumer Protection Act. One of the clear objectives of this legislation was to reduce the regulatory burden on small and mid-cap banks. The bill rolled back several key provisions on the Dodd-Frank Act, including size thresholds on regulations, some of which had hindered deal activity.
Notwithstanding the various drivers of M&A, Mr. Cohen noted a couple of possible headwinds, including a lack of foreign buyers and the market reaction to recent deals. High premiums deals, despite being the more historical norm in terms of structure, have been met negatively by markets. Why? Mr. Cohen cited the market’s focus on TBV earnback1.
In contrast, MOEs have received a favourable market reaction. However, MOEs have a limited history of success in actually creating value, largely owing to the social issues around combining two banks equally making management teams more circumspect.
As we have written in the past, we believe the U.S. banking sector remains very fragmented (with more than 4,600 banks as of Q1 2019). For that reason, as well as the points noted by Mr. Cohen, it is our view that M&A will be one of several key investment themes for U.S. bank investors over the near and medium-term. Moreover, accelerating M&A activity favours the small and mid-cap banks, since they are most likely to participate and benefit from the synergies generated. As noted above, the Hamilton Capital Global Bank ETF (HBG) and the Hamilton Capital U.S. Mid-Cap Financials ETF (USD) (HFMU.U) hold ~50% and 65% of NAV respectively in this category, with an emphasis on higher GDP growth markets.
A word on trading liquidity for ETFs …
HBG and HFMU.U are highly liquid ETFs that can be purchased and sold easily. ETFs are as liquid as their underlying holdings and the global banking and the U.S. mid-cap financial services sectors have combined market cap of ~US$7 trillion and ~US$4 trillion, respectively.
How does that work? When ETF investors are buying (or selling) in the market, they may transact with another ETF investor or a market maker for the ETF. At all times, even if daily volume appears low, there is a market maker – typically a large investment bank – willing to fill the other side of the ETF order (at net asset value plus a spread). The market maker then subscribes to create or redeem units in the ETF from the ETF manager (e.g., Hamilton Capital), who purchases or sells the underlying holdings for the ETF.