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The banking industry has witnessed a significant transformation over the past few decades, with the number of FDIC-insured institutions dwindling from 12,362 in 1995 to a mere 4,568 as of March 31, 2024.

The driving force? Community banks exiting the market.

There are many factors at play in this shift, including succession planning challenges, shareholder liquidity concerns and the ever-increasing costs associated with technology and cybersecurity.

As community banks deal with a complex and ever-changing landscape, many are considering mergers and acquisitions (M&A) as a strategic avenue for growth, survival or exit. With an increasing list of active or receptive sellers heading to market and a discerning pool of potential buyers, a dynamic yet volatile market has emerged.

In this tightening marketplace, buyers are more cautious than ever, carefully evaluating each opportunity to help ensure strategic alignment and long-term viability. Further, nontraditional investors are seeing opportunity and seeking bank charters, throwing yet another wrench into the works.

What’s fueling the shrinking pool of community banks?

The contraction of the community bank industry can be attributed to a confluence of factors, including:

• Lack of a well-defined succession plan: As the current generation of leadership approaches retirement, many institutions find themselves grappling with the challenge of identifying and grooming their next cohort of executives.
• Shareholder liquidity dynamics: Community banks often grapple with shareholder bases that span multiple generations, with some residing far from the bank’s geographical footprint. As these shareholders seek liquidity, the pressure to facilitate stock buybacks or consider outright sale mounts.
• The pursuit of scale: Larger institutions enjoy a distinct competitive advantage, as their scale enables them to leverage their asset base more effectively, translating into higher earnings potential. This pursuit of scale has driven many community banks to explore M&A opportunities as a means to bolster their competitive edge and secure long-term viability.
• The rising costs of technology and cybersecurity: The digital age has ushered in a new era of challenges for community banks, with technology and cybersecurity costs escalating at an unprecedented rate. Institutions must now allocate substantial resources to fortify their defenses against cyberthreats while simultaneously investing in cutting-edge digital offerings to remain competitive. These mounting expenses have left smaller banks struggling to shoulder the financial burden.

Challenges in the competitive landscape

As if the internal pressures weren’t challenging enough, community banks must also contend with a highly competitive external environment. The advent of fintech companies, nonbank lenders and deposit alternatives has disrupted the traditional banking model, forcing institutions to adapt or risk losing market share.

Fintech companies and nonbank lenders have emerged as formidable competitors, offering innovative financial products and services that cater to the evolving needs of consumers and businesses. These agile players leverage cutting-edge technology and lean operations to deliver seamless experiences and competitive pricing, posing a significant threat to traditional banking models.

Additionally, the recent interest rate hikes have exposed another vulnerability for community banks: the allure of deposit alternatives. As rates soared, savvy consumers and businesses sought higher-yielding options, such as money market accounts offered by brokerages and online platforms. This exodus of deposits has compounded the liquidity challenges many community banks face, further intensifying the competitive pressures.

A buyer’s market

Conversely, potential purchasers have become more judicious in their approach, meticulously evaluating each target’s strategic fit, financial health and long-term growth prospects. Gone are the days of indiscriminate acquisitions; today’s buyers are driven by a clear vision and a commitment to creating lasting value for their stakeholders.

Nonbank buyers, such as credit unions and fintech companies seeking to obtain bank charters, add another layer of complexity to the M&A landscape. These entities, often flush with cash and unencumbered by shareholder demands, have disrupted the traditional M&A dynamics, introducing new valuation paradigms and negotiation strategies.

Navigating the selling process

For those community banks embarking on the M&A journey, a litany of challenges awaits, ranging from complex accounting implications to stringent regulatory scrutiny. Navigating these hurdles requires a deep understanding of the nuances involved and a strategic approach to mitigate potential pitfalls.

• AOCI and fair value adjustments: One of the most significant accounting challenges in M&A transactions is the treatment of accumulated other comprehensive income (AOCI) and fair value adjustments. When a bank is acquired, its balance sheet must be marked to fair market value, which can result in substantial adjustments to the value of assets and liabilities, including loan portfolios and bond holdings. These adjustments can have far-reaching implications for regulatory capital ratios and overall profitability, necessitating careful planning and execution.
• Regulatory oversight: Timing and approval processes: M&A transactions in the banking industry are subject to rigorous regulatory oversight, with agencies such as the FDIC and the Federal Reserve closely scrutinizing proposed deals. The approval process can be lengthy and complex, with regulators meticulously examining factors such as capital adequacy, risk management practices and the potential impact on competition and financial stability. Delays or outright rejections can derail even the most carefully planned transactions, underscoring the importance of proactive regulatory engagement and compliance.
• Key contract provisions: At the heart of every M&A transaction lies a complex web of legal agreements and contract provisions, each with the potential to significantly impact the outcome for both parties. From representations and warranties to holdbacks and termination fees, a deep understanding of these provisions is essential for mitigating risk and protecting the interests of all stakeholders.
• Representations and warranties: Representations and warranties form the bedrock of any M&A agreement, with the seller and buyer making legally binding statements about the accuracy and completeness of the information provided. These provisions are critical for establishing trust and accountability, as breaches can result in significant financial consequences and legal liabilities.
• Holdbacks and escrow arrangements: To mitigate the risks associated with potential breaches or undisclosed liabilities, M&A agreements often include provisions for holdbacks or escrow arrangements. A portion of the purchase price is withheld and placed in an escrow account, providing a financial cushion for the buyer in the event of contingencies or disputes arising post-closing.
• Operating covenants and control considerations: Operating covenants are another crucial element of M&A contracts, governing the actions and decisions that the seller can take during the interim period between signing and closing. These provisions aim to prevent the seller from taking actions that could adversely impact the target bank’s value or operations, while also helping to ensure that the buyer does not exercise premature control over the acquired entity.
• Golden parachutes and change of control agreements: For key executives and employees, M&A transactions can have significant implications for their employment and compensation arrangements. Golden parachutes and change of control agreements are designed to provide financial protection and incentives for these individuals to remain with the combined entity post-acquisition. However, these agreements must be carefully structured to comply with regulatory requirements, such as Section 280G of the Internal Revenue Code, which governs the tax treatment of excessive compensation payments.
• Termination fees and breakup provisions: M&A agreements typically include provisions for termination fees and breakup clauses, which outline the financial consequences for either party should they choose to walk away from the transaction. These provisions serve as deterrents against unjustified terminations and provide a measure of protection for the nonbreaching party, helping ensure that the substantial time and resources invested in the deal are not wasted.

The role of trusted advisors

Given the intricate nature of community bank M&A transactions, the guidance of trusted advisors is invaluable. These seasoned professionals possess deep experience in various facets of the process, from valuation and due diligence to legal and regulatory compliance, offering invaluable insights and support throughout the journey.

Accurate valuation is the cornerstone of any successful M&A transaction, helping ensure that both parties receive fair compensation and that the deal makes strategic and financial sense. Valuation professionals bring a wealth of experience and industry-specific knowledge to the table, employing sophisticated methodologies and data-driven analyses to determine the true worth of the target bank.

Additionally, M&A transactions are inherently financial in nature, involving intricate accounting considerations and complex financial modeling. Financial and accounting specialists bring their knowledge to bear, helping to ensure that all aspects of the deal, from purchase price allocations to tax implications, are meticulously analyzed and optimized. Their insights can mean the difference between a successful transaction and a costly misstep.

Beyond the technical aspects of M&A, strategic advisors provide invaluable guidance in aligning the transaction with the broader goals and vision of the parties involved. These advisors help clients evaluate the strategic rationale for the deal, assess potential synergies and risks, and develop a roadmap for successful integration and value creation post-acquisition.

The path forward

As the community banking landscape continues to evolve, those institutions that embrace change and proactively seek opportunities will be best positioned for long-term success. Whether pursuing strategic acquisitions or exploring potential sale options, a proactive and well-informed approach is essential.

For community banks considering acquisitions, a thorough evaluation of the target’s strategic fit and growth potential is paramount. This analysis should encompass factors such as geographic footprint, product offerings, customer demographics and cultural alignment, helping ensure that the combined entity can capitalize on synergies and create lasting value for stakeholders.

On the seller side, community banks must carefully assess the dynamics of their shareholder base and the evolving liquidity needs of their investors. Proactive communication and transparent decision-making processes can help align expectations and facilitate mutually beneficial outcomes, whether through outright sales, strategic partnerships or alternative liquidity solutions.

Perhaps most importantly, community banks must cultivate resilience and adaptability as core organizational competencies. The ability to navigate uncertainty, anticipate and respond to market shifts, and continuously reinvent themselves will be critical to long-term survival and success in this ever-changing industry.

By staying ahead of the curve, fostering strategic partnerships, and leveraging the experience of trusted advisors, community banks can navigate the complexities of the M&A landscape and emerge as stronger, more agile and better positioned to serve their customers and communities for generations to come.

How Wipfli can help

If your bank is considering a sale or just surveying the marketplace, or if you’re thinking about joining the scrum from the buyer’s side, then you need a trusted advocate at your side to walk you through the intricacies. That’s Wipfli. Our team of dedicated professionals understands the industry and the competitive landscape inside and out, and we’re ready to advise you on your next move.

We can help you determine if selling is your best course of action, properly valuate your current business to maximize sale price and advise you through every step of the process. And if you’re looking to buy, we can help identify the right opportunities to maximize your investment. Contact us today for guidance in a tumultuous market.