Rising interest rates have set back European bank mergers and acquisitions by at least two years, dealmakers warn, as a punitive feature of accounting rules means a long-awaited consolidation in the sector faces even higher hurdles.
Dealmakers had bet higher rates would provide more cash for acquisitions as banks benefited from better margins and a boost to their share prices as profitability improved.
Many had also hoped UBS’s state-sponsored rescue of Credit Suisse could spark similar deals between other national champions.
However, banks across the continent have vast stocks of corporate and consumer loans, as well as government debt, that were sold in a much lower-rate environment. As part of any acquisition, those assets would have to be marked to market and valued significantly lower than newer loans issued at more lucrative rates.
“Accounting rules and their impact on capital are a big hindrance for M&A at the moment,” said Dirk Lievens, head of the European financial institutions group at Goldman Sachs.
Under international accounting rules, once a takeover is complete, the acquired company’s assets and liabilities are reappraised at market rates under a process that is known as the purchase price allocation.
If a company is bought for less than the value of its assets — as most European banks are traded — the acquirer benefits from an accounting gain known as negative goodwill, or badwill. But that gain can be wiped out if the asset values drop as part of the purchase price allocation process.
“With rates rising, you have negative fair value adjustment when marking assets to market upon acquisition and part of the badwill evaporates,” said Lievens.
He added: “If you are buying a bank at a discount to book value and the purchase price allocation reduces that, what you thought was capital — ie badwill — is not capital any more. You would then have to top up the capital, which makes doing bank deals more complicated at the moment.”
The speed of the increases in the UK and Europe have also contributed to the accounting issues. A slower pace would have meant a higher proportion of the loans books would have been refinanced over time, easing the capital impact.
For more than a decade, almost every major European lender has traded at a discount to the book value of their assets as they struggle with high costs and low profitability.
Investors, regulators and politicians all called for consolidation in the fragmented industry with multiple combinations explored, from UniCredit buying Société Générale or Deutsche Bank absorbing its domestic rival Commerzbank.
But none made it over the line until UBS’s enforced takeover of Credit Suisse in March. That deal was subject to a $13bn fair value adjustment, reducing UBS’s badwill gain, the bank reported this month.
“The combination of rapidly rising rates and fair value accounting treatment has created a near-term obstacle to bank M&A,” said Andreas Lindh, co-head of the Emea financial institutions group at JPMorgan.
“Accounting rules stipulate that acquirers have to make fair value adjustments to targets’ assets and liabilities at the time of acquisition, an issue that is particularly pronounced for long-dated loans and hold to maturity securities written or acquired at significantly lower rates.
“The negative fair value adjustments creates an upfront capital headwind for the acquirer making the M&A maths less appealing.”
One of the few major deals that had been struck in Europe is foundering for this reason.
In June 2021 — when the ECB rate was zero — US private equity group Cerberus agreed to buy HSBC’s French consumer business for a token €1.
However, last month the bank warned Cerberus may pull out of the deal because “significant, unexpected” rate rises to 3.5 per cent meant “related fair value accounting treatment on acquisition . . . will significantly increase the amount of capital required”.
The major issue is long-dated consumer loans, particularly 30-year mortgages, that make up the bulk of the €21.5bn lending book, said a person familiar with the matter.
Cerberus would have to mark to market the mortgages that were issued with base rates at zero, leaving them valued considerably lower than those currently being issued at higher rates of interest.
Therefore in order to secure regulatory approval for the deal, it would have to inject more capital on day one. While over time the mortgage book would become more lucrative as it is refinanced and repriced, the steep initial impact could cause Cerberus to withdraw.
The two sides are in negotiations to see if there is some way to mitigate the capital impact for Cerberus with an alternate deal structure, but a person involved described the deal as “in the balance”.
While the logic for combinations remains the same, the rise in rates mean most executives are opting to use their excess capital not for deals, but to pay dividends and repurchase their own stock.
UniCredit chief executive Andrea Orcel — a career dealmaker who made his reputation facilitating huge mergers during the financial crisis 15 years ago — has eschewed several potential deals both domestically and internationally, saying that in the current environment “no deal makes sense”.
Instead, with UniCredit’s stock trading at a 40 per cent discount to its book value, Orcel has instead been repeatedly increasing a share buyback programme.
While a “deal would not derail UniCredit’s buyback capacity in the near-term given [its] strong starting position . . . [b]uybacks remain a low-risk way for UniCredit to deploy capital. Management’s disciplined approach to date provides comfort,” said Jefferies analyst Benjie Creelan-Sandford.
Source: Financial Times