Buy Versus Build for Financial Institutions
If I mention “buy versus build” to a bank CFO friend one more time, he’s going to punch me. Why do I keep bringing it up? Because the potential acquisition targets that are available don’t fit his bank’s strategy very nicely. Not even like OJ’s glove. So I ask, did you think about building your own franchise in the geographies that you want?
Talk to the hand.
Acquisition pricing is on the rise. It may be tempered somewhat by the general market decline this year, but the pressure is definitely upward. And would-be acquirers are feeling it. Should they bid high, increasing tangible book dilution, decreasing earnings accretion, and reducing the deal’s internal rate of return? Or should they sit on the sideline and run the risk that all of their potential acquisition partners go to competitors?
And sometimes the targets are not prizes. So I ask, if you could have the franchise you want, in the geographies you want, would you do it?
This, of course, speaks to building one. And I think bankers ought to go through this exercise when considering submitting bids on targets. What would it cost and what would be the return to build it ourselves?
I did a sample analysis with the accompanying table. I used an extended period, 10 years, to reach more mature profit numbers of a build it yourself franchise. I assumed either buying a $1 billion in assets bank, or building a similar franchise in the geographies that were consistent with your strategic plan. All “build” branches, and I assumed 13 of them, would cost $500,000 each in leasehold improvements and FF&E for leased branches.
Now I see why bankers are favoring buy. The buy scenario, because you start with $1 billion in assets spewing earnings, plus the traditional transaction cost savings (I assumed 30% pre-tax), delivers profits immediately and throughout the projection period, delivering far superior NPV.
The build scenario takes a while to get off of the ground.
The NPV and ROI numbers at the bottom of the table should not be the end of the story. When a bank buys another, it typically uses its stock as part of the consideration. The premium in our example is $60 million. But the total consideration is $150 million. If your stock traded at $20, and you used all stock, you would issue 7.5 million shares in the buy scenario. Breaking down profits per share may be a different story. Tangible book dilution would also favor the build scenario.
I should also note that I did not tax effect the Leasehold Improvements and FF&E expenditures. They do count as operating expenses over time but are capitalized and expensed over their useful lives. So I took the conservative approach.
When you build, you select the locations, employees, and markets. Maintaining your culture is easier, as opposed to acquiring an existing culture.
One reason to buy versus build, however, is the accounting treatment. Sad, but true. The transaction expenses are mostly expensed immediately upon transaction consummation, and do not impact the bank in the next quarter or subsequent periods. The premium paid over the target’s book value is mostly put into goodwill on the buyer’s balance sheet and is never expensed so long as the buyer suffers no impairment on the acquired franchise. So any “investment” in an acquired franchise has little tail effects on the acquiror’s income statement, with the exception of the per share numbers, mentioned above.
The build scenario, on the other hand, can be said to inflict pain over multiple periods. Because the investment and operating losses run through the income statement, albeit over time for the leasehold improvements and FF&E. So senior executives tend to favor buying, so they don’t have the long hangover of building it themselves.
Am I missing something?
Do you run a buy versus build analysis when considering a strategic entry into new geographies? Because target prices are getting higher.