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An in Depth Look at Community Banks and Valuations Presented by Scott Deters, Kent Pummel and Doug Michel

Scott Deters

Doug Michel

Kent Pummel

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Today’s Agenda Community Banks and Valuations - Four primary fair value adjustments to be discussed today: • Fair value of loans receivables and related discounts • Fair value of deposits • Core deposit intangible asset • Goodwill

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A glance into the market • No longer “hypothetical buyer” – there are

actual buyers in the market • Fair value is largely based on research of

previous, similar transactions – What type of premiums are being paid in the

market?

• Sources – Factset Mergerstat Review; Pratt’s Stats (must look at specifics to see total value paid); 10-K’s or other filings from public companies, SNL Data

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Purchase Price Accounting Issues

• Since measurements are to be at fair value, the business valuation professional should be a part of the purchase price accounting team

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Purchase Price Accounting Issues

• Who are the professionals to be included in the purchase price accounting team?

– Investment banker or other primary transaction advisor

– External auditors – Internal auditors, CFO and Controller All should be aware of the assumptions and reporting requirements for fair value calculations

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Purchase Price Accounting Issues

• Assets acquired and liabilities assumed shall be recorded at their fair values as of the acquisition date

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Purchase Price Accounting Issues

• Intangible assets should be identified and recognized at their fair values as of the acquisition date

• An intangible asset is identifiable if it meets two criteria:

– It is possible to separate the asset from the entity – A contract or other specific legal event creates the

asset

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Purchase Price Accounting Issues

• Fair value defined in ASC 805-20-20- glossary as:

– “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

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• Each of these assets are subject to subsequent measurement for impairment, and/ or amortization

Purchase Price Accounting Issues

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What About Goodwill?

• Goodwill is the excess of purchase price paid over assets acquired less liabilities assumed

• Goodwill is subject to impairment testing on an annual basis. (For non-public companies, goodwill may be amortized over 10 years, with the net book value still subject to impairment testing)

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Fair Value of Loans Receivable

• Two methods for Accounting for Acquired loans:

#1 Follow ASC 310-20: Purchase of a loan or group of loans

#2 Follow ASC 310-30: Loans acquired with Deteriorated Credit Quality

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Fair Value of Loans Receivable ASC 310-20: “Contractual Cash Flows” - Results in entire discount or premium being accreted / amortized into income over the contractual term of the loans - No presumption of lost cash flow on the loans acquired - Provision may be needed if loans perform worse than anticipated in fair value model upon acquisition

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Fair Value of Loans Receivable ASC 310-30: “Expected Cash Flows” 1. Must be evidence of credit deterioration since the loan’s origination (hence PCI – Purchased Credit Impaired) 2. Acquirer does not expect to collect all contractual cash flows for the loan

Excess of contractual cash flows over expected cash flows = nonaccretable difference. Amount of expected cash flows that exceeds the initial investment in the loan = accretable yield.

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Fair Value of Loans Receivable ASC 310-30: “Expected Cash Flows” Separating the cash flows on a PCI loan: Contractual payments $9,000 (1,000) Nonaccretable difference Expected Cash flows 8,000 (1,500) Accretable yield Initial investment $6,500 in loan receivable

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Fair Value of Loans Receivable 310-30-35 Subsequent Measurement • Continue to estimate cash flows expected to be

collected over the life of the loan and adjust amounts through accretable yield for improvements in cash flows

• If it is probable the acquirer is unable to collect all cash flows expected, due to changes in estimate after acquisition, the loan shall be measured for additional impairment

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Fair Value of Loans Receivable Note: Most core processing systems do not handle the calculations required for ASC 310-30, and calculations are maintained off-line. As such, interest income recorded through the core system on a loans contractual basis must be reversed, and the calculated accretion booked through a manual entry.

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Deposits

• Demand deposits and savings typically recorded at historical cost

• Time deposits recorded using discounted future cash flows

• Apply market rates to the time deposits as part of the analysis

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Core Deposit Intangible

• Valued using net present value of future income stream from core deposits

• Future income stream is discounted back to purchase date

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Core Deposit Intangible

• Net income stream includes: – Income from net investible assets – Service charge income

• Expenses used to calculate net income include:

– Deposit interest costs – Servicing costs – Income tax

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Core Deposit Intangible Amortization of CDI and Subsequent Measurement:

• CDI is amortized over the estimated useful life of the deposit relationships

• Amortization methods vary, with straight-line being a default method if other methods cannot be determined for the recovery of the asset over the life of the deposit relationships

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Other Considerations

• Mortgage servicing rights – should be consistent with amounts recorded on balance sheet

• Non-compete agreements with key members of management (with and without analysis)

• Service marks or service names – name recognition and customer loyalty associated with acquired bank

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Business Valuations & Due Diligence

• What is the role of Valuators in the due diligence process?

• When should valuation professionals become

involved?

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Role of BV in Due Diligence Process

• Once adjustments have been identified, can determine value to the buyer

• Understand what they are buying and what creates value

• Determine what it could be worth – then the negotiation process begins

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Acquisition Related Costs

• ASC 805-10-25-23 – “Acquisition related costs are costs incurred by the

acquirer to effect a business combination. Generally, those costs are expenses of the acquirer in the period the costs are incurred and the services received.”

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Questions?

Contact: • Scott Deters – sdeters@cshco.com

• Kent Pummel – kdpummel@cshco.com

• Doug Michel – dmichel@cshco.com