August 5th, 2013

By Dominic Fracassa, Daily Journal Staff Writer

PacWest Bancorp's Large Deal Is Rare, As Fewer Transactions Have Closed

When PacWest. Bancorp Inc. acquired fellow Los Angeles bank Capital Source Inc. last month in a $2.3 billion deal ? becoming the ninth largest bank in California ? some viewed it as a sign of a whetted appetite for dealmaking amongst California banks.

And with the worst of the economy's downturn now in the rearview mirror, banking industry analysts and transactional attorneys believe that financial institutions are poised once again to engage in tactical dealmaking instead of scrambles for survival.

However, most experts agree that deals the size of PacWest's will be the exception. Instead, they expect smaller financial institutions to be the likely targets for acquisitions for the rest of this year and beyond.

Statistics show the predicted uptick hasn't yet begun. In fact, dealmaking among California banks was significantly slower in the first half of 2013 than in the year-earlier period. The number of deals to close dropped from eight to five, and valuations on those deals dropped from a collective $1.6 billion to under $200 million, according to data intelligence service Mergermarket.

Mergermarket's global financial services head Mark Eissman said he views the lull this year as a sign that target banks are lying in wait, biding their time in hopes of maximizing their worth now that the broader macroeconomic landscape is on sound footing.

"What last year shows is reflective of the fact that there are some deals being done for strategic reasons," Eissman said. "The reason we had fewer deals is the sellers. The market has stabilized some ... and it's made sellers more willing to want to get their price."

During and after the recession, many banks were forced to remain on the sidelines for different reasons - they struggled to evaluate the quality and quantity of their remaining holdings, according to Stanley F. Farrar, of counsel at Sullivan & Cromwell LLP in Los Angeles.

Now, as smaller and community banks decide whether to grow organically or look for a buyer, attorneys said they're focused on two factors that have evolved in the post-recession economy: a shift in regulatory burdens and the long-term compression of net interest margins.

James M. Rockett, a partner at Bingham McCutchen LLP in San Francisco, said that in recent years, bank regulators have shifted much of their attention away from mortgage and quality reviews and are instead focusing on more traditional compliance issues, such as the Bank Secrecy Act and other anti-money laundering reporting requirements that "had been somewhat marginalized during the economic downturn."

Rockett observed, "Banks haven't devoted sources to regulatory compliance issues, and it's being cited by regulators as problematic. Regulators ... have found that banks have either ignored or not kept up with the level of concerns in those areas, the consequence of which is that they now have to deploy resources to those areas and it's expensive."

Those expenses typically come from the purchase of pricey software suites, which are meant to help banks compile the data they need to present to regulators, and the hiring of additional full-time staff to operate it.

Regulatory and compliance costs associated with the Dodd-Frank Act of 2010 are also weighing heavily on small banks' growth prospects - a significant consideration for a business thinking about becoming a target for acquisition, according to California Bankers Association President Rod Brown.

"There's a kind of a base level of regulation - requirements that extend to all commercial banks. That base level is so significant that it is more burdensome to smaller community banks than it is to larger financial institutions," Brown said. "The regulatory burdens are compelling boards of directors and management teams to consider if they can continue to deliver a return to shareholders or are better served in finding a partner."

King, Holmes, Paterno & Berliner, LLP partner Keith T. Holmes agrees that regulatory compliance costs are playing a considerable role in determining whether a bank has enough capital to continue alone. But he sees years of historically low interest rates as a "far more potent" issue, directly impeding the ability of small banks to profit from loans and deposits at a time when it's crucially needed.

"Particularly since the zero-interest rate policy of the [Federal Reserve Bank], you've had huge compression of net interest margins," Holmes said. "Community banks aren't in the securitization business. They're not in the wealth management business. They're lenders - that's where they earn their money. When the yield curve gets compressed they have a harder time making money." In a near-zero interest rate environment, Holmes said, "community banks do not do well."

Holmes said he and his firm have represented six banks on M&A transactions so far this year, all of which had assets between $100 million and $2.5 billion. Several of those were announced in July, including the sale of the Private Bank of California to First PacTrust Bankcorp Inc.

He expects the market in California to buck the national trend going forward.

"Right now, bank M&A is relatively slow but not in this state - particularly in Southern California," said Holmes, who practices in Los Angeles. "It's still a very vibrant market from the standpoint of financial opportunity."