As interest rates rose steadily in recent years, their impact on the fair value of assets in financial institution mergers and acquisitions has been profound. For banking executives, understanding how these shifts influence transaction structures and valuation can make a critical difference in deal outcomes.

High interest rates may not only affect deal volume but also create unique challenges in estimating fair values, particularly for loan portfolios. The recent moves by the Fed to decrease the Fed Funds rate have provided some relief from the larger fair value discounts of recent years, potentially giving a boost to more merger activity.

Declining Deal Volume: The Rise of Mergers of Equals

Rising interest rates created a complex environment for M&A activity. As financial conditions tightened, deal volume slowed, particularly as bank stock prices fell and credit risk heightened in some segments. In recent months, bank stock prices have rebounded, and interest rates have fallen somewhat. While the effect of these changes is yet to be recognized, they are likely to have a profound impact on transaction activity and deal economics.

Over the past several years, the combination of higher interest rates and increased credit risk has driven valuation marks – essentially the market value adjustments (i.e., discount or premium) to assets – downward. Consequently, sellers may experience larger-than-expected discounts, especially in their loan portfolios, which can result in increased goodwill, dilution of tangible book value, increased earn-back periods and several other significant accounting considerations when structuring deals.

In response to these conditions, the industry has seen an increase in mergers of equals, where two banks of similar size and capital come together to reduce costs and build a stronger, merged entity. This type of merger generally offers smaller deal premiums, making it an attractive choice when both parties are interested in minimizing goodwill and dilution and focusing on earnings-per-share accretion.

Executives interested in such structures need to be prepared for careful negotiations around key financial assets and liabilities, particularly loans and deposits, as these are the most affected by current market conditions.

The Loan Portfolio: Yield Marks and Credit Marks

Fair value analysis in M&A requires a reassessment of the loan portfolio’s value to reflect both market conditions, market participant assumptions and credit risk. In a higher interest rate environment, the fair value of a loan portfolio is often lower than its book value, as market-based discount rates typically exceed loan portfolio rates.

Interest rate mark: According to Abrigo’s latest quarterly fair value analysis, the loan portfolio yield discount reached a peak in Q3 2023 as the differential between loan portfolio yields and market-required discount rates expanded dramatically.

However, these discounts began to ease in early 2024 as market rates stabilized and portfolio yields adjusted upward. Later in 2024, the Fed reduced rates in September and December, further aiding in reducing loan discounts. This recent trend illustrates how rapidly changing interest rates can lead to temporary valuation discounts that may ease as conditions moderate.

Credit mark: The fair value credit mark accounts for expected credit losses based on probabilities of default and loss given default assumptions. According to Abrigo’s quarterly fair value analysis, credit marks have been relatively stable over the trailing eight quarters as interest rates had risen. This mirrored what has happened in the economic environment: Despite economic uncertainty, macroeconomic indicators such as unemployment and quarterly GDP growth have remained relatively stable, and inflation remained on a downward trend.

The Core Deposit Premium: A Unique Asset in Rising Rates

When evaluating a potential acquisition, banks must assess the “core deposit intangible” (CDI) asset acquired. This intangible reflects the value of acquiring low-cost core deposits relative to alternative funding sources, like brokered deposits or borrowings from the Federal Home Loan Bank, which may carry substantially higher costs.

As interest rates rise, the value of low-cost deposits grows, providing a distinct financial advantage to the acquiring institution, which in turn drives up the value of the CDI asset. When interest rates are low, banks might only see a marginal spread between the cost of core deposits and alternative funds, leading to decreased economic value of the acquired deposits.

With today’s elevated rates, the difference is more pronounced – core deposits remain relatively low-cost while costs for alternative sources have surged. With the recent decrease in Fed Funds, Abrigo has seen some reductions in calculated core deposit intangible values.

The flip side of higher CDI values is increased amortization expense. Unlike goodwill, identifiable assets like CDI are amortized over a fixed period, decreasing pro forma earnings.

Fair Value and Expected Credit Losses: Long-Term Implications

A critical component of fair value assessment is evaluating and planning for expected credit losses under CECL. In a merger, the acquirer may recognize these losses immediately. The PCD mark can be used to offset a portion of the required CECL reserve, depending on the transaction’s structure.

For loans with credit deterioration, the acquirer can establish a “purchase credit deterioration” allowance, reducing the hit to income post-closing. On the other hand, non-PCD assets get hit with a “double count,” as the non-PCD loans have a fair value credit mark at closing and a hit to the income statement after closing for the life of loan CECL reserve calculation. This bifurcation of PCD vs. non-PCD also has implications for ongoing loan portfolio performance and income recognition since loan discounts get accreted into interest income over time.

Integrating Forward-Looking Assumptions: A Proactive M&A Strategy

Initial fair value determinations early in the due diligence process provide numerous benefits. Asset and liability fair value marks directly impact transaction-related goodwill. Having sound analytics early in the transaction process provides executive management and investment bankers key inputs to their merger models in the determination of resulting goodwill, pro forma capital levels and goodwill earn-back periods under varying purchase prices and transaction structures.

Over the past several years, many institutions have found it beneficial to update their fair value marks as regulatory approvals progress and transactions near closing. With the potential for long delays in closing transactions, especially in high-interest environments, institutions that don’t revise fair values may find themselves facing outdated or inaccurate marks, which could lead to unanticipated goodwill adjustments.

A Teaching Moment: Building a Robust M&A Framework

As interest rates may have peaked, this may be an opportune time to focus on building an acquisition framework that factors in both current rates, expectations of lower rates, and long-term credit expectations. By so doing, bank leaders can position their institutions for accretive transactions, stronger balance sheets, smoother regulatory approvals and a more accurate alignment with regulatory and market expectations.