Ahead of the Curve: A Banker's Podcast
Ahead of the Curve: A Banker's Podcast
M&A accounting best practices for financial institutions
Bank mergers and acquisitions are on the rise, with institutions looking to expand, scale technology investments, and enhance profitability. But the accounting side of these deals—Day 1 valuation, CECL modeling, and income recognition—can introduce unexpected complexities that impact deal success.
In this episode, Abrigo Advisory’s Neekis Hammond and Derek Hipp bring their accounting expertise to discuss key accounting considerations for M&A transactions, such as common pitfalls and how leveraging data can streamline the transition. Join us to learn best practices for banks preparing for future acquisitions.
Helpful links:
Whitepaper: Valuation and purchase accounting in a dynamic macroenvironment
Webinar: Valuation and purchase accounting: Navigating the changing M&A landscape
Advisory services: Bank Valuation Services - Purchase Accounting Services
This is Ahead of the Curve, a banker's podcast. Bank mergers and acquisitions are on the rise, with institutions looking to expand, scale technology, and enhance profitability. But the accounting side of these deals– day one valuation, CECL modeling, and income recognition– can introduce unexpected complexities that impact deal success. In today's episode, Abrigo Advisors Neekis Hammond and Derek Hipp bring their accounting expertise and break down the key considerations for M&A transactions, like common pitfalls and how leveraging data can streamline the transition. Join us to discuss best practices for banks preparing for future acquisitions. Thank you guys for joining us today. We're going to start pretty big picture on this topic. We are seeing a resurgence in merger and acquisitions interest. We saw that 43% of bank leaders are saying they're likely to buy another bank by 2025. So could you guys tell us what's driving the increase in activity right now?
Neekis Hammond:Yeah, Kate, there's a few factors here that kind of drive in that momentum. I'll hit on a couple. The first one being scale, just, you know, with... with some fixed costs and maybe some regulatory costs. These bigger banks, they can scale better. So merging banks and finding synergies is important. Expanding into new markets. M&A allows somebody to grow into a new market fast, much faster than organically. Another big one is just stock prices. Just like your dollar can go further when it's worth more, these banks' stock prices, when they're worth more, they may be able to purchase more with their stock compared to previous years. So stronger bank stock price is another reason. So I think acquisition interest is high, and banks are comfortable paying a decent tangible book value. I think the biggest thing is what we'll probably talk about next, which is what's constraining M&A.
Derek Hipp:Yeah, the other thing that I would mention is there's a little bit of pent-up demand that I've heard and or seen in the M&A market. If you just look at the overall deal activity from the past couple of years, obviously liquidity and stock valuations were a big problem in and around the bank failures that happened. And there's just been some continuation of that, maybe some regulatory burden that's maybe made people less susceptible to really pursue meaningful mergers. And I think some of that, you know, you expect to lessen. So all those things, I agree with what Neekis is saying there. I think there's also some components of just the overall environment that should be more conducive to deals happening into the future.
Neekis Hammond:Yeah, pent-up demand's a big one. That's a good call out there.
Kate Randazzo:People have been waiting it out. So with that in mind, let's talk about the accounting side. What are some of the biggest financial challenges that banks face when they're integrating a new acquisition?
Neekis Hammond:Yeah, I mean, there's a lot of challenges. I think, you know, focusing in, like you said, on the accounting is something we're particularly good at. But the day one valuation, sometimes that just just kind of go with who's helped them in due diligence or whatever but that's a big one to get right because it follows you forever you know you've got some other items to consider on the accounting side you've now merging two cecil or two banks into one cecil model you don't want to be using two models that tell a different story so you've got to integrate those somehow end up with one the third item is income recognition these You'll have purchase accounting marks, marking these loans and assets to fair value, and you've got to recognize those over time. And so having a model or having an answer for how you're recognizing the accretion or the amortization of those marks in an auditable and transparent way is not easy. And so having an answer for those three items is important. Derek, what did I miss?
Derek Hipp:Yeah, I mean, there's a lot of technicalities to get into. I think from a financial report, I'll expand it from accounting to say maybe financial reporting around business combinations. And those three are kind of the major classifications of where we would see some process flows around them. We've got a pretty good piece of thought leadership content that goes through all the steps on a detailed basis on our website. And we'll talk about, you know, on this, what are some of the key things to think about to be successful in each one of them? You know, the first there that we talked about was the day one valuation or the mark to market of the balance sheet of that target. So there's financial instruments that have to be maintained from a fair value perspective moving forward. And then there's some that you're just carving out intangible separately from goodwill. So if we kind of go down the balance sheet quickly, Generally speaking, cash is cash. You don't have to mark anything on cash. You then get into fixed assets and maybe equipment and things like that, ATMs, computers, all that type of stuff. Generally on the fixed assets, you're going to have a full appraisal that's needed. And there's obviously companies that our banks use to get real estate appraisals. On the equipment side, Pretty straightforward of that. We generally see costs being the best estimate of fair value. And those are all kind of straightforward. And then you start getting into loans, which is a big part of the financial modeling. And there's this concept in accounting of different levels of ways that you can approach fair value. So most people know that, but I'll go back through it just at a high level to explain that. Level one is like Apple stock. There is a very highly liquid market. You know what the value of those assets are because it's traded every day. Level two is less liquid of a market, and I'm just speaking in general terms here to make it easy to understand, where There is a market that exists. It may not be as quickly quoted or as accurately quoted. And then there's level three, which there really isn't an active market. And that's what a lot of this stuff falls into because there's just not an active market of commercial loans that are not securitized in the way that they're set up that you can just go grab a QSIP on or some quoted price. And so the valuation process is really important to get through. And then you keep working down Outside of loans, right, we talked about carving out those intangibles. Generally speaking, a core deposit intangible exists with a bank M&A or a credit union M&A deal because it's just obviously a very valuable customer list. And so it's an intangible that certainly gets carved out. You have to mark time deposits to fair value, pretty straightforward on that in terms of the interest rate marks. The other thing to consider is long-term debt. So if there's any outstanding trust preferred from way back in the day or subordinated debt, that needs to get marked to fair value. And the last one that we generally see is pretty relevant is around leases. And so when we think about leases, there is a concept of favorable or unfavorable arrangements to consider. So went into a lot of weeds there, but the purpose is you kind of work your way down the balance sheet and just make sure you've got a game plan around all of those. And especially on the loan valuation, getting into that next step of how it interacts with CECL is really important because CECL is not fair value and fair value is not CECL, but they're pretty close to one another conceptually. And so because of that, there's a lot of comparative analysis that has to be done when you're working through that process. And so if we kind of step into that next step of these three categories that we're going through, day one valuation, CECL transition and income recognition. The CECL component is kind of exactly what we see with what Neekis said. Generally, you're going to have one surviving CECL process, Kate. We have not seen in the many transactions that we've helped out with at least any reason to continue on with the targets CECL process and the buyer to have their CECL process. When there's a deal where the buyer is significantly larger than the target, Nine times out of 10, maybe more than that, 9.9 times out of 10, the buyer's CECL framework is going to be surviving. Maybe there's some alterations that need to be made to that to make that happen, but that's generally going to be the case. When you have a merger of equals or even a buyer buying a target that is significantly larger, It may call into question the framework that you have. Can it be used for the pro forma combined company? And there may be more work that needs to be done. But there's things you got to think about there. Which methods are both companies using? It could be just something as simple as the buyer is using a forecast regression component for probability default, loss given default, and the target's using kind of a warm model based on historical charge-off activity. Will they even work together? Or maybe the target, as resident auto loans of a specialty that the buyer has no pools or framework set up. So there's alterations there and things you certainly need to be thinking about as you look at the combination of those models and how ultimately they can be used. One major component that probably doesn't get enough attention in that is this concept around PCD assets. And generally during valuation, PCD assets are The term stands for purchase credit deteriorated. And those are generally those that are more risky. More than insignificant credit deterioration is technically what the accounting guidance says. But quite often, those loans will carry very high marks or heavy marks in the allowance process and that mark-to-market day one valuation. And then when you get into your CECL framework, you may not really have a method as to get to those high marks, right? If you just look at your allowance components, it can be quite a difference. And we just talked about earlier where there's some type of comparative analysis that needs to be done. So quite often there is a process that there needs to be some type of calibration to the CECL model to accept those PCD assets. It's one that probably doesn't get enough attention on the front end, and then it's quickly kind of observed. as you're actually trying to create these CECL calculations. And so all of those things we kind of talked about there were more of the policy perspective to consider around CECL. There's also just simple operational things, right? Like if you're running a CECL software, how are you going to get the target's data into that CECL software prior to the full core merge happening? So there's the policy stuff that takes... you know, a little bit more time and documentation to work through. And then there's just procedural steps mechanically to create those. And so working all the way through that, kind of the final step is after you do things, there's a mark to market that exists that has to be accreted into earnings over time. And, you know, that terminology technically is called income recognition. And what we quite often see there is just different ways of going about that. Generally, you have three options that we see, a software product, a vendor software product, you have a spreadsheet maybe you're keeping internally or trying to do it on the core processing system. And one thing to really think about there in that process is these marks generally that are coming onto the balance sheet, especially in the current interest rate environment, can be pretty material to the overall earnings of these companies, Kate. And so they need to be really cognizant of this process. This is one that If it's a smaller deal, maybe people haven't really thought about, or even if it's a larger deal, there's a process that they believe will work for them. But when they start getting into the weeds, you have to realize on mark-to-markets and this concept of running it through 31020 or FAS91, whenever you've got in your originated portfolio, you're making new loans every day and loans are paying off. And so that number is never very big. But if I'm a $10 billion bank doing an MOE with a $9 billion bank, I'm now bringing $9 billion, let's call it $7 billion of loans, onto the balance sheet at one time. So even if the fair value mark's really, really low, I'm still putting all those marks on at one time, right? And it's material regardless if the mark is material or not. And quite often in a lot of scenarios we're seeing right now, right, especially on residential ones, the marks as a percentage are very high. And so that one probably doesn't get as much attention as the other two that we typically see, but it's very relevant and just something to make sure there's a process to be handled around.
Neekis Hammond:And it's kind of, Kate, it's kind of newly relevant also, you know, pre-CECL adoption, you know, there was some more technical accounting behind how you should account for these purchase marks that kind of forced a lot of folks to have a separate process for this.
Kate Randazzo:Yeah.
Neekis Hammond:But now there is a thinking that these can just kind of be thrown onto your core system and accreted accordingly, but these dollars are big, as Derek described, and there's not audit support to go along with that core accretion that's sufficient enough to really dig into some of these anomalies you may see or explain, right? outliers and so or even find them for that matter and so it becomes very important to be able to get the detail behind that income recognition on these marks and it's really challenging to get through a core provider so that's where you know that's where it off we see a lot of um that's often overlooked when we when we talk to customers or experience in m&a with some of our customers
Kate Randazzo:yeah i can see how that'd be easy to do i mean it sounds simple when you break into the three steps, day one valuation, CECL transitioning, but then, you know, you break it down and you end up with just a lot of detail. And I know a lot of banks have turned to Yelp for help in the past couple of years and Abrigo's had some really high profile M&A deals recently. Could you explain how your team's process works with really streamlining all of those transitions?
Derek Hipp:Yeah, we've got a big practice here, you know, and it couples well with our CECL practice as well. But on any given day, year, we're probably working on 40 to 50 deals. There's a press release that we've got out there we generally put out annually. But in 23 and 24, we worked on six of the largest 10 MOEs, did a ton of other activities around smaller deals kind of all across the country. And so we certainly got exposure to it. And we'll go through some of those details of how we can be involved. But The reality of it is you got to make sure that when you're working through these processes that you have a provider or a partner that's thinking through the entire process with each of these because there's a lot of work that can be done out there internally or externally through vendors where it's very much a point solution. And then you've got to fill in the gaps. And so that's definitely something to keep in mind when you're going through these to make sure It's all the way from data ingestion. It's policy documentation around why you're making the decisions you're making, actually doing it, and then reporting off of it as well, because a lot of people can just do it, and then all those other things are just kind of on you. And there's a lot of audit support. There's a lot of going back and forth with these things. We talked about a lot of level three processes, a lot of decisions to be made from a policy perspective, not just operationally. And so because of that, just make sure there's a partner we would generally recommend that is helping you through the entire concept and really being an extension of your team. And that means being on a call with auditors, being on a call to present everything, right? Not sending emails and things like that. It's just not great because of the risk that's there in the amount of detailed analysis. But on that valuation side, how we generally help is the mark-to-markets of of all of those components. And again, on the appraisal side, generally on real estate, there's going to be specifics there to work through. And then the more burdensome valuations that contain a lot of assumptions are the loan inputs and then around CDI from there. Some of the other things are a little bit more straightforward. Secondarily, as we move into that second component of CECL, we help all the way from something as simple as just manually getting data into the system for that target portfolio, all the way to evaluating whether the current CECL framework that the buyer has is sufficient enough to be used for the combined company, or if there's modifications that need to be made. And again, just kind of talking about a lot of the MOEs that we've worked on in those situations, you're really setting up to maybe where there's just some updates. Maybe the full framework doesn't have to be changed, but if you're using a peer group, maybe the peer group's no longer relevant. If you're using a peer group based on a company that's 10 billion in one particular geographic region, and now you're 20 billion operating in a much different geographic region, the current CECL framework may not be relevant. Or if your current CECL framework is using historical losses from your entity only, right? How are you going to bring a whole new portfolio into there and say that those losses are relevant for the combined company? And then finally, it's really just, you know, working through those simulations of whatever that combined framework needs to be, because again, that's really important. So it's okay to think through, you know, considerably what makes sense to use, but Until you actually do dry runs and practices and see what the accounting flow looks like with some of these concepts around PCD, gross ups, et cetera, you might not really know what you're getting into and the decisions that you're making. And then finally, we've got a software product to do income recognition to work through. Got deployed recently in the Brigo user interface. Got a number of customers that use that. It integrates from an allowance perspective as well because the allowance needs to consider those for non-PCD assets. And so we work with a lot of companies and, you know, getting that set up, getting the software running, you know, getting it flowing through CECL properly.
Kate Randazzo:That's great advice. And for banks considering acquisitions in the next few years, what advice would you give them to help them prepare?
Neekis Hammond:Yeah, I mean, Derek's covered a lot of this, but I think I'll try and summarize. But The valuation is important. You have to live with those decisions. It's not just a one and done exercise. And we see a lot of aggregate calculations being pushed down to the loan level. That causes problems down the road. We see a lot of PCD credit loss estimates that are not thinking about how you need to recalculate those into perpetuity as part of a CECL model. We see a lot of valuation providers communicating to their clients that a valuation credit mark is a CECL allowance, and that's not correct. And so the first thing would be very careful about who you work with your valuation. As Derek described, there's a lot of point solutions. It's best to work with somebody that can take you through the entire process rather than just solve one thing, because you're going to have to bring those groups together, and that can be a challenge. The other idea here is just the CECL planning. You need to start it early. You can't wait till close. You need to start building these models early. And the specific thing that I'd give advice on here is you can't just show up to an auditor and say, we threw these loans into our existing allowance model because we have a similar footprint, similar loan pool. You need to prove it. And so the specific thing I'd give advice on there is, you know, We prefer to run an independent calculation for the acquired bank using your model. That way you can show here is following our processes, our procedures, our philosophy on the newly acquired bank. Here's the answer. Here's the answer if you just plug them into our model. What's the delta and why are we comfortable with that delta? In other words, be witting about that decision. Document why. with calculations, it's appropriate for them to live in a pool with your existing loans or why you need to create a new segment for these loans that you've just acquired. So that's a big part of the CECL planning process. There's also setting up purchase credit deteriorated, these PCD segments, they need to be calculated differently. You need to set up those segments. You've got to get your documentation done. Those are all big deals. You need to figure out how those new marks are gonna flow into your CECL model at the end of every reporting period as they change. How are you accounting for those marks in your CECL model out of the valuation? So those are the three key components that Derek went through, valuation, CECL and income recognition, and you can't do one without the other. And so the advice is just talk to somebody that does all three before you advance in your decision, because far too often we're brought in too late. The decision's been made and we can't help. And so just bring us in early. Let's talk, you know?
Kate Randazzo:Definitely. And I did want to point out another thing to our audience, which is just that sometimes just having a third party who has heard from other institutions can be so helpful. And Abrigo has this database of loan data from over, what, 2,000 financial institutions. So you guys have the experience, and I know that you're happy to share those insights and just have exploratory conversations with people who are interested in hearing about help.
Neekis Hammond:Kate, you bring up a good point, which is a lot of these organizations don't have inputs and assumptions that are beyond their own walls. They have data that they have. And so if they need to make an assumption for an institution that's elsewhere in the country or has a different kind of loan, working with somebody that has a strong database to draw analogies from and to provide supportable inputs and assumptions is a big deal because you don't You can't just make up these numbers. Everyone knows that. It's listening. But having strong support behind them is helpful.
Kate Randazzo:Definitely. So a lot of opportunity coming up in the M&A space, but got to get the accounting right. And Abrigo can help you do that. So if you enjoyed this conversation and you want to learn more, I will link in the show notes to some of the resources that Derek mentioned and to our advisory pages if you would like to talk to someone. But Derek Neekis, thank you so much for sharing your expertise today. Yeah,
Derek Hipp:thank you, Kate. Absolutely.
Kate Randazzo:Appreciate it, guys.
