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Capital Management

Alternatives and Uncertainties


2013 Acquire or Be Acquired Conference January 28, 2013 Andrew K. Gibbs, CFA, CPA/ABV and Jeff K. Davis, CFA

Contents Handouts: Capital Management - Alternatives and Uncertainties Professional Biographies Whitepaper: Community Bank Mergers - Creating the Potential for Shared Upside Mercer Capitals 2013 Webinar Series

www.mercercapital.com

2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

Capital Management:
Alternatives & Uncertainties
1 Jeff K. Davis, CFA & Andrew K. Gibbs, CFA, CPA // January 28, 2013

Current Challenges
Discerning a reasonable ROE in a zero-rate environment with evolving capital requirements Excess capital for many banks is building given little loan growthwhat to do with it? Is the capital calculus too tough if capital decisions are subject to cost of capital analyses?

MERCER CAPITAL

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2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

Current Challenges
ROE under cyclical and secular pressure
Yield induced NIM compression via the Fed Loan demand weak in most regions Mortgage gains are supporting fee income, but the refi wave will fade Operating leverage is tough to achieve given pressure on revenues and rising compliance expenses Regulatory expectations regarding higher capital ratios (and more common equity within the capital structure)
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Loan Growth
~50% of community banks reported lower loans in 2010 and 2011 Limited improvement in 2012 loan growth reflects C&I growth and 1-4 mortgage retention for some, plus stabilization in CRE/ C&D books for many

Peer group consists of approximately 3,600 banks with assets between $100 million and $5 billion
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2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

Net Interest Margin


61% of the banks had a lower YTD NIM vs. last YTD thru 9/11 More pressure to come given loan pricing competition and low reinvestment rates for bond cash flows, while COF leverage is limited

Peer group consists of approximately 3,600 banks with assets between $100 million and $5 billion

Net Interest Margin


Declining loan yields given current base rates and competitive pressures will weigh on NIMs in 2013 and 2014 Can community banks push deeper into C&I, asset-backed lending?
Assets $300M - $1B YTD C&I Yield CRE Yield 1-4 Secured Total Loans Treasury & Agency MBS Total Securities (TE) COF - IB Deposits Cost of Funds - IBL COF / Earning Assets Net Interest Margin 30-Day LIBOR 5 Year Swap 5.77% 5.63% 5.58% 5.67% 1.80% 2.45% 2.79% 0.79% 0.88% 0.73% 3.84% 0.32% 1.04% LYTD 5.94% 5.77% 5.76% 5.94% 2.16% 3.25% 3.28% 1.07% 1.16% 1.00% 3.87% 0.29% 1.61% -0.17% -0.14% -0.18% -0.27% -0.36% -0.80% -0.49% -0.28% -0.28% -0.27% -0.03% 0.03% -0.57% YTD 4.68% 4.98% 4.72% 5.09% 1.50% 2.78% 2.63% 0.50% 0.69% 0.58% 3.55% Assets > $10B LYTD 4.91% 4.95% 4.90% 5.25% 1.74% 3.34% 2.87% 0.56% 0.75% 0.64% 3.70% -0.23% 0.03% -0.18% -0.16% -0.24% -0.56% -0.24% -0.06% -0.06% -0.06% -0.15% Commerce Bank ($20B) YTD 3.73% 4.35% 4.63% 4.93% 2.57% 2.75% 2.52% 0.22% 0.23% 0.20% 3.46% LYTD 3.67% 4.63% 5.01% 5.14% 4.30% 3.40% 3.08% 0.33% 0.35% 0.30% 3.76% 0.06% -0.28% -0.38% -0.21% -1.73% -0.65% -0.56% -0.11% -0.12% -0.10% -0.30% YTD 3.92% 4.43% 4.33% 3.87% 1.46% 2.88% 2.90% 0.45% 0.49% 0.46% 3.08% KeyBank ($82B) LYTD 4.21% 4.42% 4.48% 4.08% 1.99% 3.21% 3.21% 0.69% 0.70% 0.64% 3.10% -0.29% 0.01% -0.15% -0.21% -0.53% -0.33% -0.31% -0.24% -0.21% -0.18% -0.02%

<> base for C&I loans <> base for 5-year CRE loans

Source: FDIC, Commerce Bancshares and KeyCorp; YTD thru Sep-12; LYTD thru Sep-11

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2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

Efficiency Ratio
Operating leverage is directionally negative postcrisis Small banks are at a competitive disadvantage

Source: Bank Holding Company Performance Reports

Credit Costs
Credit-related costs have trended down, offsetting pressure on PPOI, but Credit leverage is limited going forward
Peer group consists of approximately 3,600 banks with assets between $100 million and $5 billion

MERCER CAPITAL

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2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

Basel III Capital Regulations


Core equity requirements are increasing
Minimum 7.0% tier one common with 2.5% buffer Minimum 8.5% tier one and 10.5% total capital

Push to reduce parent company leverage


Trust preferred phase-out Parent companies to hold more liquidity

Reworking of asset risk weights creates potential issue


Heavier RW for NPAs create pro-cyclical capital requirements Community banks are heavily invested in CRE
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Tangible Common Equity


TCE / TA above pre-crisis levels and is rising given limited loan growth Tier one common / risk weighted assets ranges from 11.7% to 13.3% @ Sep-12 vs. Basel III threshold of 7.0% with buffer

Source: Bank Holding Company Performance Reports

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2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

Return on Equity
ROE has rebounded 70s & 80s saw ROE volatility via three recessions and sharp rate moves 90-06 great moderation

Source: FDIC

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Return on Tangible Equity


YTD through September 2012, ~50% of the bank holding companies surveyed reported ROTE of 0-10%, representing the highest proportion over the 1991 to 2012 period Proportion with negative ROEs fell from 41% in 2009 to 10% in 2012

Data set includes bank holding companies filing Form FR Y-9C with less than $5 billion of assets at September 30, 2012 (approximately 1,000 holding companies)

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2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

Goal Setting
13

Target Return on Equity


What ROE should a community bank target? Potential comparative metrics
Banks ROE history and relative to peers Inflation U.S. Treasuries Corporate Bonds Preferred Stock Yields Cross-Industry Returns

ROE is not the cost of equity capital required by an investor


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2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

Target Return on Equity


Inflation may represent the minimum ROE Between 1991 and 2006, ROEs exceeded the inflation rate by 10%, on average Spread between ROE and inflation in 2012 is 7%
Data set includes bank holding companies filing Form FR Y-9C with less than $5 billion of assets at September 30, 2012 (approximately 1,000 holding companies)

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Target Return on Equity


ROE spread over 10-year UST similar to relative analysis for bonds Wide spread via Greenspans great moderation 90-99 (~7%) and 00-07 (~13%), but lending is a cyclical business 84-12 (5-7%) YTD ROE spread of 6-8% is in-line with long-term history implies 8-9% ROE, which is okay but not great
84-89 Assets > $10B Assets $1-10B Assets $100M-$1B Assets < $100M All Insured Institutions 1.7% -1.7% -4.6% -2.5% -3.0% 90-99 7.4% 7.6% 5.7% 3.8% 7.1% 00-07 13.6% 13.0% 11.6% 8.1% 13.0% 08-12 3.3% -1.5% 0.4% 0.5% 2.2% 00-12 7.6% 6.9% 5.8% 2.9% 7.2% 84-12 7.1% 5.6% 5.0% 2.3% 6.6% YTD ROE 9.1% 9.9% 7.7% 6.2% 9.0% 10Y UST 1.8% 1.8% 1.8% 1.8% 1.8% Current Current Spread vs. 84-12 7.2% 8.1% 5.9% 4.4% 7.2% 0.2% 2.5% 0.9% 2.1% 0.6%

Source: FDIC and Federal Reserves H.15

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2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

Target Return on Equity


2012 yield ranges vs. median ROE for four BHC groups ($500M to > $10B) Tom Garrott (CEO NBC Memphis) rule: ROE vs. prevailing CD rates
Source: Wall Street Journal, SNL Financial and FFIEC

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Target Return on Equity


Preferred stock yields in the 4% to 6% range for floating rate issues and the 5% to 8% range for fixed rate issues

Note: Preferred stock yields calculated as the median of the yields for each issuers outstanding preferred stock issues (an issuer with multiple fixed rate preferred stock issues would be reported once in the chart, for example). Source: SNL Financial

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MERCER CAPITAL

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2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

Target Return on Equity


9% YTD bank ROE compares unfavorably to investment companies, mReits, specialty finance companies, and asset mangers, though mReits face lower ROEs without more leverage
Total Shareholder Returns (Price Appreciation & Dividends)

Non-Bank Financial Services Companies


Specialty Finance Companies - Consumer Emphasis Specialty Finance Companies - Commercial Emphasis Mortgage REITs Investment Companies Property & Casualty Insurers Investment Managers Life & Health Insurers Broker/Dealers

Return on Tangible Equity 17.6% 13.0% 11.4% 10.0% 10.0% 19.7% 6.4% 5.5%

Price / Tangible Book Value 202% 157% 99% 103% 103% 339% 71% 118%

Price / Earnings 10.1 14.5 8.0 8.7 11.2 17.4 12.2 22.8

Dividend Yield 0.0% 0.0% 10.4% 8.8% 2.0% 2.4% 1.7% 1.4%

1 Year 28% 23% 35% 27% 19% 27% 17% 4%

3 Years 93% 63% 51% 72% 44% 28% 22% -24%

5 Years 126% 59% 48% 20% 19% 3% -8% -29%

Publicly Traded Banks


- Assets Less Than $1 Billion - Assets $1 - $10 Billion - Assets > $10 Billion 5.5% 10.4% 10.7% 98% 125% 142% 14.9 13.5 13.8 1.0% 1.9% 1.9% 22% 22% 14% 32% 46% 17% 18% 10% -6%

Broad Market
S&P 500 Russell 2000 Notes: a) Return on equity used if return on tangible equity unavailable b) Publicly traded companies with market capitalizations less than $50 million were excluded from the analysis 16% 17% 37% 42% 17% 34%

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Source: SNL Financial

Public Market Valuation


P/TBV rises +/- with ROTE ROA x Leverage = ROE; ROE x P/E = P/BV Multiple trends up with TCE and fewer NPAs

Source: SNL Financial

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2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

Reactions
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Do Nothing?
For some banks, maybe Banking is a highly cyclical industry given variability of credit losses and leveraging of equity capital Environment with short-rates anchored near zero, loan demand weak and the Fed competing for Agency MBS is unusual and transitory Dodd-Frank and Basel III rules remain to be finalized Capital is king in the public markets with high capital, low NPA banks awarded above average valuations
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2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

ROE / Capital Management Issues


Define ROE and ROTE Target Ranges
How is it achieved? Is it competitive vs. peers, risks taken, etc.?

Capital Targets
Heavy emphasis on tier one common subject to leverage minimum Recognize pro-cyclical impact of NPA treatment in a recession Internal buffer needed for acquirers ROE drag from excess is okay with expectation that it will be deployed to acquire

Deployment of Excess Capital


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ROE / Capital Management


Organic Loan Growth Usually highest return, lowest risk if pricing generates ROE target Higher risk, but can improve buyers growth, returns and exit attractiveness expected return must exceed cost of capital Return on invested capital can be high for asset / wealth managers and insurance agencies, but culture differences tough to navigate Lending diversification and yield pick-up, but culture differences and losses may surprise in a downturn Large banks will aggressively pare ONB-BAC, FNFB/ KEY -HSBC
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Acquire Banks

Acquire Fee Businesses

Acquire Specialty Finance

Branch Acquisitions

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2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

ROE / Capital Management


Divest Free capital by divesting branches, small trust department redeploy or return Usually lifts shares if investors view balance sheet issues as resolved Good use of capital if no M&A plans and if projected IRR > cost of capital usually ++ if price < TBVPS must avoid buying when prices are high No question about value of dividends as $ for $ proposition possible revaluation higher given yield play Does not have to be common-only fixed-rate preferred interesting
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Bulk Sale of NPAs

Repurchase Shares

Special Dividends

Parent Capital Structure

Cost of Capital Optimize Capital


Estimating the cost of capital for acquisitions and capital actions Cost of capital varies based upon risk profile Discount rate is applied to expected interim cash flows & terminal value
Equity Discount Rate Yield to Maturity on Long-Term UST Bonds + Multi-Yr Common Stock Premium x Industry Beta = Beta Adjusted Equity Premium + Small Capitalization Stock Premium + Specific Risk Associated with Subject = Discount Rate and P/E sensitivity to growth Long-Term Sustainable Growth Rate Cap Factor (1 / Discount Rate - Growth) 3.00% 13.6x 5.00% 12.2x 5.00% 10.9x 3.00% 7.6x <> Sustainable growth and P/Es are inversely related 5.37% 1.49x 8.00% 0.00% 0.00% 10.37% 8.00% 2.80% 0.00% 13.17% 8.00% 2.80% 1.00% 14.17% 8.00% 2.80% 3.00% 16.17% <> Per Mercer analyses of Ibbotson <> Cannot easily diversify private cos. Large Cap Public Co 2.37% Small Cap Public Co 2.37% Low Risk Private 2.37% High Risk Private 2.37% <> YTM on 20-year US Treasuries <> Per Mercer analyses of Ibbotson <> Elevated vs. LT history since 2007

Source: Mercer Capital

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2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

Capital Allocation IRR Ranking


IRR from investment should > cost of capital given price and realistic projections M&A risks argue for higher hurdle rate vs. share repurchases and loan growth

Source: Mercer Capital

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Capital Allocation IRR Expectation


Street is focused on managements IRR expectations, but price paid is key
Date May-06 Oct-08 Buyer Wachovia PNC Seller Golden West National City Investors Action M&A M&A Repurchase Price ($M) $26,000 $5,600 $64 $91 $1,768 $737 $3,700 $730 P/TBV 2.8x 0.4x 0.6x 1.5x 1.6x NA 0.8x 0.9x Targeted IRR 17% 15% NA 18% 18% 20% 18% NA Comments WB release noted GDW diversified WB's b/s by adding "higher yielding, lower risk assets" IRR estimate probably conservative given uncertainty that existed post-Lehman FLY repurchased ~25% of its shares @ ~$8.00 p/s. Also, repurchased notes at $86M discount Expansion into Bloomington (college town), subsequent credit marks were higher than initially estimated Strategic acquisition (quasi MOE); Whitney weakened by its 15% exposure to Florida Street panned the deal due to 6.7% premium, ~17% TBVPS dilution and drop in rates for cash investment Street liked deal due to capital accretion for MTB and perceived low-risk deal due to nature of HCBK's b/s CSE repurchased 113M shares (35%) for $6.46 p/s through Sep-12

FY08-11 Fly Leasing Oct-10 Dec-10 Aug-11 Aug-12 Old National Hancock First Niagara M&T

Monroe Bancorp M&A Whitney HSBC Hudson City Investors M&A Branch Sale M&A Repurchase

FY11-12 CapitalSource

Source: Company reports via SNL Financial

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2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

Capital Deployment to Produce Value


Assets ($M) Strong Organic Loan Growth Signature Bank Texas Capital Bancshares Western Alliance Bancorp Heartland Financial USA High Dividend Payout Ratios Trustmark Corporation First Financial Bancorp NBT Bancorp Inc. Share Repurchases CapitalSource Inc. BCB Bancorp Active Acquirers SCBT Financial Corporation Great Southern Bancorp Home BancShares Bank of the Ozarks $1-10B Assets (Median) $4,325 $4,057 $3,888 $3,823 $2,443 0.78% 0.50% 1.59% 1.99% 0.89% 8.0% 5.8% 12.8% 17.1% 8.5% 6.3% 19.2% 6.2% -1.6% 3.5% 3.29% 6.76% 4.50% 1.11% 3.37% 8.4% 7.3% 11.1% 12.3% 8.4% 176% 121% 225% 254% 128% 18.5x 19.0x 15.5x 15.7x 13.3x 1.7% 2.7% 1.5% 1.8% 1.9% 31% 21% 20% 22% 0% 0% 0% 0% 0% 0% 37% 14% 31% 13% 22% 47% 38% 55% 140% 41% 43% 80% 108% 245% -6% $8,677 $1,155 5.34% 0.39% 27.7% 4.8% 17.2% 12.9% 5.07% 7.26% 18.5% 7.2% 107% 96% 4.1x 19.0x 0.5% 5.1% 2% 0% 13% 11% 25% -3% 85% 20% -44% -13% $9,872 $6,235 $6,029 1.18% 1.05% 1.02% 9.2% 9.3% 10.6% -1.2% -4.6% 14.6% 2.77% 2.83% 1.05% 10.1% 10.0% 7.0% 158% 141% 173% 13.3x 13.0x 11.9x 3.9% 7.6% 3.8% 50% 103% 49% 0% 0% 2% -4% -10% -5% 13% 19% 17% 26% 75% 21% $16,459 $9,882 $7,404 $4,593 1.14% 1.36% 0.74% 0.83% 11.8% 17.5% 7.8% 9.8% 34.6% 29.9% 17.8% 13.6% 0.91% 0.91% 5.41% 3.56% 9.6% 7.9% 7.2% 6.2% 220% 240% 182% 157% 20.4x 15.7x 20.2x 14.2x 0.0% 0.0% 0.0% 1.5% 0% 0% 0% 13% 0% 0% 0% 0% 18% 43% 56% 65% 131% 229% 157% 102% 116% 175% -27% 66% LTM ROA LTM ROE Y/Y Loan Growth NPAs/ Loans TCE/ Assets Price/ TBV P/E LTM Div'd Yield LTM Payout LTM Buyback Total Return 1 Year 3 Year 5 Year

Source: Company reports via SNL Financial

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Dividends & Share Repurchases


Publicly traded bank holding companies with assets between $500 million and $5 billion
Increase in aggregate dividends through September 30, 2012, compared to the same period in 2011, represents the first significant increase in dividends since 2007 Analysis does not include effect of special dividends announced by some banks in late 2012 Share repurchases lower in 2012, potentially due to rising stock prices

Source: Company SEC reports via SNL Financial

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2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

Dividends & Share Repurchases


Privately held, OTC bulletin board, and pink sheet bank holding companies with assets between $500 million and $5 billion (S corporations excluded) Share repurchases rising, up 24% in current year-to-date period versus same period in 2011 Aggregate dividends increased by 18% between 2011 and 2012
Source: FR Y-9C filings; SNL Financial

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Dividends & Share Repurchases


Publicly traded bank holding companies with assets between $500 million and $5 billion
Approximately 40% of the banks reported no dividends through the first nine months of 2012, the same as in 2011 31% of banks raised their dividends in 2012, up from 21% in the 2011 period Only 4% lowered their dividend, versus 10% in the 2011 period
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2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

Capital Management
Privately held, OTC bulletin board, and pink sheet bank holding companies with assets between $500 million and $5 billion (S corporations excluded)
Similar to the publicly-traded banks, the number of banks with higher dividends is rising More difficult to analyze for the privately-held banks, because dividend payments may occur annually, instead of quarterly

YTD 9/05 YTD 9/06 YTD 9/07 YTD 9/08 YTD 9/09 YTD 9/10 YTD 9/11 YTD 9/12 vs. YTD 9/04 vs. YTD 9/05 vs. YTD 9/06 vs. YTD 9/07 vs. YTD 9/08 vs. YTD 9/09 vs. YTD 9/10 vs. YTD 9/11

# of Banks Paying Higher Dividends # of Banks with Greater Than 10% Dividend Increase Number of Reporting Banks in Both Periods % of Banks with Higher Dividends % of Banks with Greater Than 10% Dividend Increase

379 230 675 56% 34%

315 182 531 59% 34%

327 174 536 61% 32%

254 117 562 45% 21%

144 42 602 24% 7%

166 78 667 25% 12%

233 113 711 33% 16%

294 165 765 38% 22%

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Final Thoughts
#1 determinant of return that investors and buyers control is the purchase price Price cures price margin of safety matters Industry is forever cyclical Some excess capital = capital flexibility and an ability to buy when others have to sell

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2013 Acquire or Be Acquired Capital Management

Andy Gibbs gibbsa@mercercapital.com Je Davis jedavis@mercercapital.com

Questions?
Andrew K. Gibbs, CFA, CPA/ABV
Senior Vice President, Financial Institutions Group gibbsa@mercercapital.com 901.685.2120

Jeff K. Davis, CFA


Managing Director, Financial Institutions Group jeffdavis@mercercapital.com 615.345.0350

Mercer Capitals Financial Institutions Group


Mercer Capital's ability to understand and determine the value of a financial institution is the cornerstone of the firm's services and has been its core expertise since its founding.
The Financial Institutions Group of Mercer Capital provides a broad range of specialized advisory services to the financial services industry. Mercer Capital has 30 years of experience assisting financial institutions with significant corporate valuation, transactions and other strategic decisions. Mercer Capital provides hundreds of sound, well-documented financial analyses and valuation opinions for financial institutions large and small. In addition, we have a wealth of transaction experience helping clients with mergers, acquisitions, recapitalizations and other substantial transactions. Valuation Advisory & Opinions Corporate Transactions Financial Reporting Employee Benefit Plans Tax Compliance and Reporting Litigation Support Financial Advisory Corporate and Strategic Advisory Mergers and Acquisitions Fairness Opinions

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Andrew K. gibbs
Phone Email Position Designations Education 901.322.9726 gibbsa@mercercapital.com Senior Vice President CFA, CPA/ABV BA, Rhodes College; MS, Rhodes College

Andrew K. Gibbs, senior vice president, is the leader of Mercer Capitals Depository Institutions Group. Andy provides valuation and corporate advisory services to financial institutions for purposes including mergers and acquisitions, employee stock ownership plans, profit sharing plans, estate and gift tax planning and compliance matters, corporate planning and reorganizations.

has analyzed the potential value that the institution may receive upon a sale, assisted in locating potential buyers, and participated in negotiating a final transaction price and merger agreement. Andy has also participated in projects in a litigated context, including tax disputes, dissenting shareholder actions, and employee stock ownership plan related matters. Andy has co-authored the books The Bank Directors

Andy has experience working with financial institutions in merger and acquisition advisory engagements. He has assisted buyers in evaluating the attractiveness of acquisition candidates, determining a price for the target institution, structuring the transaction, and evaluating different forms of financing. For sell-side clients, Andy

Valuation Handbook: What Every Director Must Know About Valuation, with James D. Wilson, Jr., as well as Acquiring a Failed Bank: A Guide to Understanding, Valuing, and Accounting for Transactions in a Distressed Environment, published by Peabody Publishing, LP.

Selected Publications
Co-Author, The ESOP Handbook for Banks, Peabody Publishing (2011) Co-Author, Acquiring a Failed Bank, Peabody Publishing (2010) Co-Author, The Bank Directors Valuation Handbook, Peabody Publishing (2009) Co-Author, ESOP Valuation, Chapter 7, ESOP Valuation for Banks and Bank Holding Companies, National Center of Employee Ownership (2005) Co-Author, Valuation for Impairment Testing, Peabody Publishing (2001) 5100 Poplar Avenue, Suite 2600 Memphis, Tennessee 38137 901.685.2120 (p) www.mercercapital.com

Jeff K. Davis
Phone Email Position Designations Education 615.345.0350 jeffdavis@mercercapital.com Managing Director CFA BA, Rhodes Collega, MBA; Vanderbilt University

Jeff K. Davis is the Managing Director of Mercer Capitals Financial Institutions Group. Founded in 1982, Mercer Capital is a national valuation and financial advisory firm. Financial services represents Mercer Capitals largest sector concentration. Clients include private and public companies, financial institutions and high-net worth families that are located throughout the U.S. The Financial Institutions Group works with banks, thrifts, asset managers, insurance companies and agencies, BDCs, REITs, broker-dealers and financial technology companies. Prior to rejoining Mercer Capital, Davis spent 13 years as a sell-side analyst providing coverage of publicly traded banks and specialty finance companies to institutional investors evaluating common equity and fixed income investment opportunities. Jeff was most recently Managing Director of Guggenheim Securities, LLC, and was previously head

of the Financial Institutions Group at FTN Equity Capital Markets. While at Mercer Capital in the 1990s, Jeff led the firms financial institutions practice, providing valuation and transaction advisory services. Jeff is a speaker at industry gatherings, including SNL Financial/University of Virginias annual analyst training seminar, the ABA, various state banking meetings as well as security industry gatherings. Additionally, he regularly makes presentations to boards of directors and executive management teams. He is a periodic guest on CNBC, Bloomberg TV and Bloomberg Radio and is quoted in the American Banker, the Wall Street Journal, Reuters, Forbes and other media outlets. Presently, he is an editorial contributor to SNL Financial.

Professional Associations
The CFA Institute The Financial Consulting Group 5100 Poplar Avenue, Suite 2600 Memphis, Tennessee 38137 901.685.2120 (p) www.mercercapital.com

Community Bank Mergers


Creating the Potential for Shared Upside

www.mercercapital.com

January 2013

Community Bank Mergers


Creating the Potential for Shared Upside
In this whitepaper we review financial issues arising when community banks merge or sell to a larger, public institution. It is not intended to answer every question and, in some instances, our intention is to raise questions for directors and managers to evaluate. In a series of follow-up papers and webinars we will address specific topics that merit further scrutiny.

The bank M&A market has defied predictions since 2010 of a broad-based consolidation wave, but M&A activity nonetheless remains steady. A confluence of factors, which could be derailed by a slump in the economy and/or capital markets, ensure in our view that significant consolidation will occur even though the pace is uncertain. In time we expect upwards of one-half of institutions with less than $1 billion of assets to merge. As of September 30, 2012, there were 7,181 commercial banks and thrifts according to the FDIC, compared to 8,534 at year-end 2007 when the financial crisis began unfolding. There were about 18,000 institutions when the June 1985 Supreme Court decision Northeast Bancorp, Inc. v. Board of Governors of Federal Reserve upheld regional interstate banking compacts. Would-be buyers among public institutions seem to be coalescing around 2014 as the year that activity will become more pronounced as regulators write more rules to codify Dodd-Frank. Also, valuation challenges created by credit marks presumably will be less of an issue to the extent real estate values firm a bit and sellers have another year to mark credits themselves. Still, one catalyst has to be overcome to see a pick-up in activity: would-be sellers resistance to the reality of todays pricing, which is a function of lower profitability relative to the pre-crisis era. While circumstances can change, much of the industry may see ROE ease further in coming years in spite of another round of cost cutting initiatives. For buyers, the most important controllable variable that determines the return on investment is the price paid.

Mercer Capitals largest industry concentration is financial institutions. The unifying element of Mercer Capitals services for financial institutions is its in-depth industry knowledge, gleaned from 30 years of experience and over 1,000 engagements.

Jeff K. Davis, CFA 615.345.0350 jeffdavis@mercercapital.com

Andrew K. Gibbs, CFA, CPA/ABV 901.685.2120 gibbsa@mercercapital.com

Unlike the frantic activity of the 1990s and to a lesser extent the years leading up to the financial crisis, we believe bank M&A will be dominated by the merger of privately held small banks with each other rather than large-scale, roll-up activity by regional banks. That is not to say regional banks will not be active, but most have a minimum asset threshold of $500 million to $1 billion of assets that precludes acquisition of broad swaths of small institutions. Only 559 of the 7,181 FDIC-insured institutions as of September 30, 2012 had assets greater than $1 billion. This trend is reflected in M&A metrics for 2012 in which there were 239 non-assisted acquisitions of banks and thrifts, which was the highest number since 2007 when 323 transactions occurred; however, aggregate acquired assets of $142 billion was the second lowest total in the past ten years, eclipsed only by the $95 billion of assets acquired in non-assisted deals during 2009. The aggregate deal value was modest too at $14 billion in 2012 as shown in Figure 1.

Figure 1: Non-Assisted Bank & Thrift Acquisitions 1990-2012


600 566 550 500 481 450 Bank & Thrift Transactions 400 350 305 300 250 200 217 280 261 272 283 278 216 215 233 $100 399 357 309 323 $150 504 463 458 463 $250 $300

$200 Deal Value ($B)

232 177 175

150
100 50 0 $0 $50

Bank & Thrift Transactions

Deal Value

Source: SNL Financial

As for large bank deals, public policy now explicitly discourages the largest banks from getting biggerat least until the next crisis. Even Capital One Financial (COF) had trouble getting regulatory approval for its February 2012 acquisition of ING Direct, which had $77 billion of internet-based deposits compared to $128 billion for Capital One. The combination of the two was hardly the next JP Morgan Chase (JPM). Many bank M&A attorneys regularly remark that the current regulatory environment is the toughest they have ever seen. There also appear to be too few banks rated 2 or better to have a robust M&A market with plenty of

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buyers, though perhaps the exam cycle over the next 12 to 18 months will entail a notable migration of 3 rated banks to 2 with improving asset quality and credit metrics.

Catalysts for Community Bank M&A Activity


Buying and selling will not be the appropriate action for many community banks, but we think boards should ask the basic question, What if we do nothing? Even if the bank in which an individual has an interestas a manager, director, or shareholderdoes nothing, competitors may not adopt the same philosophy. We do not see a return to the high deal prices that drove M&A activity in the late 1990s and mid-2000s being a catalyst in the current wave of consolidation. Rather, we think six forces are going to push returns for many banks to unacceptably low levels, even though minimal credit costs in the next few years may mask the erosion in core profitability, thereby creating conditions ripe for industry consolidation. How long such conditions may persist is unknown. Worse, in our view, the lack of a public market for privately held banks means there is no price signal to indicate that returns are unacceptable. In some instances, boards and significant shareholders may fill the markets role of highlighting the issue, but our experience is that this is usually not the case. Many boards are not fully informed about industry and market conditions, while management may not be inclined to highlight the issue. The catalysts that increasingly will weigh on returns are: 1. Net interest margin (NIM) pressure from the Feds policies of keeping short rates anchored near zero and bond buying to suppress intermediate- and long-term rates; 2. Tepid loan demand for a variety of reasons, though some areas of the country such as the existing and recently emerged energy belts are faring better; 3. 4. Higher compliance costs; Reduced profitability of branch networks due to less value attributable to core deposits in the current rate environment and technological transformation as transactions migrate to electronic venues; 5. 6. Declining mortgage refinancing volumes and (most likely) gain-on-sale margins; and Requirements that institutions hold more equity capital, while reworked risk-weighted asset formulas under Basel III penalize residential mortgages, home equity and CREassets that community banks are heavily exposed to. Overlaid upon economic factors are issues involving CEO succession and shareholder need for liquidity that always have been a consideration in bank M&A. The Feds interest rate policies are of particular note. The financial press tends to focus on the shape of the yield curve as a key determinant of NIMs. While that is largely true for Wall Street and wholesale-oriented banks, community and regional bank NIMs reflect a combination of bank-specific factors, including the types of loans; loan spreads over LIBOR; the mix of core deposits; and the amount, type and duration of securities and wholesale funding. As of year-end 2012, the spreads of 5-year Treasuries to the Federal funds rate and of 10-year Treasuries to 2-year Treasuries were 0.55% and 1.48%, respectively, compared to 20-year averages of 1.05% and 1.15%. One might

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infer that the direction of NIMs should not be a major factor in pressuring profitability; however, we believe the NIM issue will become increasingly severe over the next few years, absent a change in Fed policy. The industrys fundamental problem is that the cost of funds is near a floor, but yields continue to ease. Bond cash flows are being reinvested at 1-2% at most institutions vs. portfolio yields that in many instances that are closer to 3% than 2%. Though it is not clear from Call Report data, we suspect reinvestments are occurring at longer durations, too. Furthermore, super-regional banks have pushed C&I loan yields below 4%, while income-CRE loan terms increasingly entail terms of up to ten years and rates in the vicinity of 4%. These rates compare to yields reported in the Uniform Bank Performance Report for peer group #2 (assets of $1-3 billion) of 5.48% and 5.51%, respectively, for C&I and commercial real estate loans for the year-to-date period ended September 30, 2012. Community banks can choose not to follow market rates set by larger playersand maybe multi-year fixed-rate commitmentsbut the cost will be a loss of loans at a time when balance sheets are liquid and bond investments are unappealing.

Figure 2: Large Banks Eventually Will Pressure Small Bank Loan Yields
Assets $300M - $1B YTD C&I Yield CRE Yield 1-4 Secured Total Loans 5.77% 5.63% 5.58% 5.67% LYTD 5.94% 5.77% 5.76% 5.94% -0.17% -0.14% -0.18% -0.27% YTD 4.68% 4.98% 4.72% 5.09% Assets > $10B LYTD 4.91% 4.95% 4.90% 5.25% -0.23% 0.03% -0.18% -0.16% Commerce Bank ($20B) YTD 3.73% 4.35% 4.63% 4.93% LYTD 3.67% 4.63% 5.01% 5.14% 0.06% -0.28% -0.38% -0.21% YTD 3.92% 4.43% 4.33% 3.87% KeyBank ($82B) LYTD 4.21% 4.42% 4.48% 4.08% -0.29% 0.01% -0.15% -0.21%

Total Securities (TE) COF - IB Deposits Net Interest Margin 30-Day LIBOR 5-Year Swap

2.79% 0.79% 3.84% 0.32% 1.04%

3.28% 1.07% 3.87% 0.29% 1.61%

-0.49% -0.28% -0.03% 0.03% -0.57%

2.63% 0.50% 3.55%

2.87% 0.56% 3.70%

-0.24% -0.06% -0.15%

2.52% 0.22% 3.46%

3.08% 0.33% 3.76%

-0.56% -0.11% -0.30%

2.90% 0.45% 3.08%

3.21% 0.69% 3.10%

-0.31% -0.24% -0.02%

<> base for C&I loans <>base for 5-year CRE loans

Source: FDIC; Commerce Bank Kansas City (2011 Treasury & Agency yield impacted by TIPS income); KeyBank Cleveland

Against a backdrop of yield-induced NIM pressure is an uncompetitive cost structure for many community banks. According to the FDIC, the efficiency ratio in the third quarter of 2012 for banks with less than $100 million of assets was 76%, while banks with $100 million to $1 billion of assets reported a 70% ratio. The NIMs for these two groups approximated 3.80% compared to 3.33% for banks with assets greater than $10 billion. If the NIM for the smaller banks declines by 20bp to about 3.60%, then the efficiency ratios for the less than $100 million and $100 million to $1 billion asset groups would increase to 78% and 72%, assuming constant expenses. The median efficiency ratio for banks with more than $10 billion of assets was 59%. And, while the largest banks face additional NIM pressure, we suspect it will be less than what small banks face because loan yields for large banks have less room to fall. For smaller banks, the cost disadvantage is not a function of excessive branches or pay; rather, it reflects the much lower operating leverage that comes with scale. Also, larger banks typically generate operating earnings from wealth management, mortgage banking, and for some, insurance agencies on a scale that small banks do

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not come close to replicating. Absent actions by bank management, we think the cost structure and therefore the ROE gap will widen between small and large banks.

Figure 3: Small Banks Cost Structure (Efficiency Ratio) is Uncompetitive

80% 75% 70% 65% 60% 55% 50% 45% 40% Assets > $10B Assets $1-10B Assets $100M-$1B Assets < $100M

1998
Source: FDIC

2005

2012

Returns on Equity: Cause & Effect


The preceding litany of factors challenging the profitability of banks in general and community banks in particular is crystallized in the return on equity. As Figure 4 illustrates, while ROEs have improved as credit costs have waned from improving asset quality, ROEs remain well below the averages reported through the 1990s and the first half of the 2000s. Further, there are no evident drivers of community banking profitability that would cause ROEs to revert to the historical level.

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Figure 4: Return on Equity 1984-2012


18% 16% 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% -12% Assets > $10B Assets $1-10B Assets $100M-$1B
84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Source: FDIC; institutions with assets of less than $100 million are not shown

What is an acceptable return? It depends upon whom you ask. An academic answer probably would describe an institution that produces returns on invested capital equal to or above its cost of capital, which is estimated using some variation of the Capital Asset Pricing Model (CAPM). Although results will vary, most community banks will have a cost of capital that is in the low to mid-teens. If an institution is seeking new capital, chances are an informed institutional investor is going to heavily discount a potential investment, relative to book value, where the return on capital does not exceedmuch less approachthe cost of capital. Stated differently, there may be a large gap in the bid-ask spread between the bank and investor. By discounting the potential investment, the investor assures that his or her return reaches the cost of capital deployed.

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Figure 5: Estimating the Cost of Equity Capital


Large Cap Public Co 2.37% 5.37% 1.49x 8.00% 0.00% 0.00% 10.37% 8.00% 2.80% 0.00% 13.17% 8.00% 2.80% 1.00% 14.17% 8.00% 2.80% 3.00% 16.17% <> Per Mercer analyses of Ibbotson <> Cannot easily diversify private cos. Small Cap Public Co 2.37% Low Risk Private 2.37% High Risk Private 2.37% <> YTM on 20-year US Treasuries <> Per Mercer analyses of Ibbotson <> Elevated vs. LT history since 2007

Equity Discount Rate Yield to Maturity on Long-Term UST Bonds + Multi-Yr Common Stock Premium x Industry Beta = Beta Adjusted Equity Premium + Small Capitalization Stock Premium + Specific Risk Associated with Subject = Discount Rate and P/E sensitivity to growth Long-Term Sustainable Growth Rate Cap Factor (1 / Discount Rate - Growth)

3.00% 13.6x

5.00% 12.2x

5.00% 10.9x

3.00% 7.6x

<> Sustainable growth and P/Es are inversely related

Source: Mercer Capital

Another view of what constitutes an acceptable return can be triangulated from relative returns, similar to how fixed income investors evaluate a bond relative to other bonds. Returns on common equity can be compared to returns on other capital instruments, moving up the capital structure (e.g., common vs. preferred vs. subordinated debt, etc.) and then transitioning to government bonds. Spread relationships are intuitive, though they do not necessarily answer the question of how much return is appropriate for the investment. Also, each institutions credit risk, interest rate management, and operational strategies create unique risks that relative returns may not fully explain. Nevertheless, relative returns are a starting point for boards when thinking about their institutions. We calculated the spread between quarterly ROE as reported by the FDIC and that quarters average 10-year U.S. Treasury yield. The results are summarized in Figure 6, grouped by asset size as segregated by the FDIC.

Figure 6: ROE Spread Over 10-Year U.S. Treasury


84-89 Assets > $10B Assets $1-10B Assets $100M-$1B Assets < $100M All Insured Institutions 1.7% -1.7% -4.6% -2.5% -3.0% 90-99 7.4% 7.6% 5.7% 3.8% 7.1% 00-07 13.6% 13.0% 11.6% 8.1% 13.0% 08-12 3.3% -1.5% 0.4% 0.5% 2.2% 00-12 7.6% 6.9% 5.8% 2.9% 7.2% 84-12 7.1% 5.6% 5.0% 2.3% 6.6% YTD ROE 9.1% 9.9% 7.7% 6.2% 9.0% 10Y UST 1.8% 1.8% 1.8% 1.8% 1.8% Spread 7.2% 8.1% 5.9% 4.4% 7.2% vs. 84-12 0.2% 2.5% 0.9% 2.1% 0.6%

Source: FDIC (ROE) and Federal Reserve H.15 (10-year UST)

The analysis indicates a base ROE on the order of 5-6% over 10-year Treasury yields for banks with $100 million to $10 billion of assets, measured over the entire period from 1984 to 2012. The data is based upon banks rather than

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holding companies, so holding companies may produce a slightly better spread than their operating subsidiaries given the use of debt and preferred equity to leverage the parents common equity. Nevertheless, the historical spread data implies management and boards of institutions in the $100 million to $10 billion asset groups should be thinking about minimum ROEs in the 7-8% range given the 10-year yield that is below 2%. A threshold ROE of 7-8% may not pass the smell test given average spreads of nearly 8% during 1990-1999 and 13% during 2000-2007 for banks with $1-10 billion of assets; however, the 5-6% spread observed over the 1984-2012 period encompasses two major credit crises and one minor credit cycle in 2001. In any event, we think many community banks are not earning their cost of capital. By not doing so, we do not believe a line is breached that implies a board needs to sell the bank; however, it does imply that if the condition persists shareholders will be earning sub-optimal risk-adjusted returns.

Valuation Impact of Lower Returns on Equity


Every industry has a rule of thumb, or a benchmark that allows for comparing pricing through time. For depositories, the common metric is tangible book value (TBV). It is a logical metric because the basic banking model entails leveraging capital to fund loans and securities on which a spread is generated. Further, the public markets today have a bias toward banks with excess capital, though we think this reflects some crediting of such institutions with future earnings that will be generated once the excess capital is used to acquire assets. In effect, high capital ratios and low nonperforming assets (NPAs) can be equated to strategic flexibility. If TBV multiples are how buyers and, especially, sellers quote bank pricing, then it is important to understand the components of this multiple that impact valuation. Broadly, value can be expressed as the product of profitability, leverage and the earnings multiple (P/E).

(Net Income / Assets) x (Assets / Tangible Equity) = (Net Income / Tangible Equity); or, ROA x Leverage = ROTE and (Price / Net Income) x (Net Income / Tangible Equity) = (Price / Tangible Equity); or, P/E x ROTE = P/TBV

While the board and management of would-be sellers intuitively understand that returns in the industry have declined post-crisis, some may not understand how much returns have compressed and why it matters so much in terms of a rule-of-thumb valuation. Ultimately, acquirers are buying assets (and deposits) that will produce earnings that equal or exceed the buyers cost of capital. It is easy to see how two banks with similar capitalization will produce differing P/TBV multiples if profitability (ROA) differs materially before considering qualitative factors. Because bank earnings tend to be highly cyclical based upon the credit cycle, P/Es can be inflated or deflated for a given period based upon credit quality, and earning power may thus provide better perspective based upon

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through-the-cycle profitability. Over time, bank P/Es are positively correlated with consistent growth, earnings consistency, franchise attractiveness, and the amount of earnings derived from asset management and other noncapital intensive activities. Also, P/Es are negatively correlated with investor perceptions of the riskiness of lending and the degree of reliance on non-core funding. P/TBV multiples therefore tend to be derived from the buyers valuation process rather than being a starting point for assessment. Figure 7 presents a hypothetical bank that experienced a contracting loan portfolio, tightening net interest margin, and weaker efficiency ratio between 2006 and 2012. The 2006 performance, with a return on assets of 1.15%, implies a price/tangible book value multiple in the 2.00x range. Weaker returns in 2012, coupled with lower price/ earnings multiples attributable to the weaker growth outlook for banks, implies a price/tangible book value multiple only in the 125% range in 2012.

Figure 7: Pre-Crisis vs. Post Crisis Multiple Math


FDIC $100M - $1B Assets 2006 Securities Loans Earning Assets Total Assets Equity $275,000 650,000 925,000 994,624 100,306 2012 $325,000 600,000 925,000 994,624 97,454 Change 18.2% -7.7% 0.0% 0.0% -2.8% 10.0x 12.5x 15.0x 17.5x 20.0x 2006 P/TBV Math (ROA and P/E Variables) 0.75% 74% 93% 112% 130% 149% 0.90% 89% 112% 134% 156% 178% 1.05% 104% 130% 156% 182% 208% 1.20% 119% 149% 178% 208% 238%

Net Interest Income Fee Income Total Revenues Operating Expenses Operating Income Loan Loss Provision Pre-Tax Income Taxes @ 30% Net Income

$37,278 12,234 49,511 31,499 18,012 1,705 16,307 4,892 $11,415

$34,873 11,538 46,410 32,255 14,155 3,157 10,998 3,300 $7,699

-6.5% -5.7% -6.3% 2.4% -21.4% 85.1% -32.6% -32.6% -32.6%

2012 P/TBV Math (ROA and P/E Variables) 0.50% 10.0x 12.5x 15.0x 17.5x 20.0x 50% 62% 74% 87% 99% 0.65% 64% 81% 97% 113% 129% 0.80% 79% 99% 119% 139% 159% 0.95% 94% 118% 141% 165% 188%

NIM Fees / Assets Efficiency Ratio Net Charge-Offs Provision / NCOs Op Income / Assets ROA ROE

4.03% 1.23% 63.6% 0.16% 164.0% 1.81% 1.15% 11.38%

3.77% 1.16% 69.5% 0.57% 92.3% 1.42% 0.77% 7.90%

-0.26% -0.07% 5.88% 0.41% nm -0.39% -0.37% -3.48%

Source: Mercer Capital and the FDIC (for operating metrics for banks with $100 million - $1 billion of assets)

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Public Market Perspective


For community bankers, not all is glum. Larger community and regional banks face similar revenue and cost pressure at a time when capital is building. Further, with somewhat better valuations, buyers have stronger acquisition currencies. As a result, most of these institutions eventually will have a reason and capacity to acquire, just as many smaller institutions have a reason to sell. One question comes to mind: if banks are cheap, then would it not be better to wait to sell? Maybe, but the reality of todays public and M&A market is that banks are only cheap vs. history based upon P/TBV multiples. That cannot be said for P/E multiples, excluding the largest banks that trade for 10-11x earnings. Further, it is our view that public market investors largely have transitioned back to valuing banks based upon near-term earnings, perceptions of earning power in the current rate environment, and P/E multiples rather than P/TBV multiples now that most institutions have seen credit costs drop. Community and regional banks presently trade for approximately 14x the latest 12-month (LTM) earnings and about 12x FY13 consensus estimates. Given the high likelihood that estimates are too high across the board, P/Es based upon FY13 estimates probably approximate LTM multiples as earnings growth likely will be flat for the two groups.

Figure 8: Public Market Pricing P/Es Near Long-Term Average

22.0x 20.0x 18.0x 16.0x 14.0x 12.0x 10.0x 8.0x 6.0x 4.0x 2.0x 0.0x

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Jan-13

$100 Million - $1 Billion

$1 Billion - $10 Billion

> $10 Billion

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But Public Market P/TBV Multiples Remain Below Long-Term Average, Especially Small Banks
325% 300% 275% 250% 225% 200% 175% 150% 125% 100% 75% 50% 25% 0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Jan-13

$100 Million - $1 Billion

$1 Billion - $10 Billion

> $10 Billion

Source: SNL Financial

It is possible that valuations could further improve, but we think that outcome requires a stronger economy. If one were to focus on widely quoted bank indices, such as the Philadelphia Bank Index (BKX), one would conclude it was a banner year for bank stocks. The BKX rose 28% for the year; however, the BKX, as is the case with most indices, is weighted based upon market capitalization. With a recovery in housing, declining NPAs, and a Fed-induced boom in mortgage banking, big uglies had a banner year. Bank of America, which has the second largest market cap among U.S. banks, rose 105% in 2012. Community and regional bank stocks had a good year, but not a banner year. The SNL Small Cap and Mid Cap U.S. bank indexes rose 12% and 8%, respectively. Assuming share prices remain relatively stable, the potential for these banks to be more active acquirers is better than it was in 2011 when stocks (i.e., acquisition currencies) plummeted during the third quarter following the debt ceiling debacle in D.C. and the seizure in the intra-European bank funding markets. Given this backdrop, we think market conditions are supportive for many community and regional banks to engage in M&A. Institutional investors, who face the prospect of owning positions in companies that are not growing, can be expected to be highly supportive of reasonably priced acquisitions that add to potential growth and earning power and that are not excessively dilutive to capital and tangible book value per share.

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M&A Market Perspective


By historical standards, acquisition P/TBV multiples at 117% look low relative to pre-crisis history, as is the case with public market multiples; however, P/E multiples are higher than in the past, which reflects weak earnings. The 2012 median P/E for bank deals (i.e., excluding thrifts) was 28x, which compares to the 2003-2007 average of 25x. Including thrifts, the median 2012 P/E is 34x. If profitability for sellers improves notably over the next few years, then we would expect acquisition P/E multiples to moderate, while P/TBV multiples increase. Given the Feds zero interest rate policy and a sluggish economy, that outcome seems unlikely for the time being, although the mix of acquisition targets may change in favor of fewer distressed sellers. Again, we emphasize that the most important variable that buyers (and all investors) control in determining the return on an investment is the entry price. Absent buyer conviction that industry profitability is going to improve there is no reason to pay up, other than for trophy institutions.

Figure 9: M&A Multiples - P/E and Price/TBV


55x 50x 45x 40x 35x Price / Earnings 30x 25x 20x 15x 10x NM 5x 0x 25% 0% 275% 250% 225% 200% 175% 150% 125% 100% 75% 50% Price / TBV
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Price / Earnings

Price / TBV

Source: SNL Financial

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Conclusion
Our intent is not to guide management and directors into thinking that buying or selling is the only way to create value for shareholders; however, we believe many community banks risk destroying value by not partnering with another institution because prospective returns have been impaired by an interest rate and regulatory environment that is beyond the institutions control. Broadly, we would think about the issue in terms of a window with uncertainty as to how long and how wide it will be open. In light of this uncertainty, we believe directors and managers should ask the following questions: Has the board made a realistic assessment of the banks historical performance, measuring performance relative to peers and relative to potential (i.e., what was the propensity to positively perform or underperform vs. expectations over the years)? Has a comparable forward-looking assessment beyond a one-year budget been made? How does it compare to the past history and peers, and what does it imply for shareholders? What is the trend in branch traffic and transactions? What is the outlook for the local and regional economy? What is the institutions competitive position and how has it evolved over the past few years? Can the institution generate loan growth? The lack of lending in a zero-rate environment can be equated with a lack of revenue growth. Has executive management succession been addressed? To the extent the board is considering selling (or partnering), what is the time horizon to do so? If there is contemplation of selling/merging within a few years, are management and the board prepared for an extension of the timeline to do so if the economy and/or the bank suffer a setback? Who are the logical acquirers or partners, and what is their interest level? What is the risk that they will move on to other opportunities or sell? If the conclusion is to sell or merge, then the next question should be with whom and under what terms? For institutions that have a strong strategic position and a number of potential larger suitors, the process may be straightforward if there is a desire to sell for cash. The acquirer should be the institution that can pay the highest price with certainty of being able to close the transaction.

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Case Study #1
Mercer Capital has represented a number of prospective buyers and sellers over the firms history and the decision of what type of consideration (cash, stock, or some combination) to receive in the transaction is often a tricky one for sellers. About 15 years ago, we represented a southeast-based community bank where the majority shareholder made a decision to sell to diversify the familys assets. There were a number of interested parties, which ranged in size from publicly traded community banks to regional banks with market capitalizations that comfortably exceeded $1 billion. After receiving initial expressions of interest, the buyer list was narrowed to a couple of institutions. Ultimately one institution was clearly interested in paying the most to obtain our client. But, a wrinkle occurred when the dominant shareholder informed us that he wanted cash, not common stock. This was when pooling of interests was the primary means to account for an acquisition, and pooling required that the consideration consist primarily of common stock. Our response was that asking for 100% cash would require accepting a haircut to the price. Our client did not care. He did not trust bankers generally and the buyer in particular. Ultimately, the buyer agreed to a cash deal, but at a 25% discount to the stated value of a stock swap. It was a good call, and the cash price was near 3x tangible book value. The negotiations occurred in 1998 when banks were trading at a multi-generational high that has not been seen since, including in 2005. Our client could have accepted the buyers shares based upon a price that was close to 4x tangible book value and then leaked the shares into the market under 144/145 restrictions; he had no such interest. Cash to him was important for estate planning reasons, and it was a value that was not subject to debate. In his mind, he discounted the buyers NYSE-traded shares. Unfortunately, most bank boards that elect to sell in the coming years will not have the option of selling for all cash, or even selling predominantly for cash. And, boards can forget about 3x tangible book valueand all but the most desirable, profitable banks in growing MSAs can forget about 2x tangible book value, too. Although excess capital is building, most buyers of community banks will be larger community and small regional banks, and in most instances, these institutions will not want to see their capital ratios dip too much for a given transaction. Hence, we think in most instances stock will be dominant form of consideration given. Stated transaction multiples may entail just a modest premium to tangible book value, but credit marks can result in significant goodwill being created. Plus, the Federal Reserves modus operandi, at least for larger institutions, has been for buyers to maintain stout capital immediately after a transaction closes without crediting capital for asset discounts that will be accreted into capital over a relatively short period of time.

The Community Bank Merger Alternative


With all cash transactions becoming more scarce for all but the smallest community banks, due to rising capital expectations, and fewer natural publicly traded acquirers of size targeting smaller community banks, privately held community banks may turn to an alternative, merging with another privately-held institution. There are many factors to consider in a merger whereby the primary consideration is common shares. Aside from entering a transaction in which both parties are fully informed about the financial position of their respective partner, we believe the number one objective should be shared upside rather than price and deal multiples. Generally, such transactions will reflect relative ownerships that approximate relative contributions of capital, core deposits, pre-tax/pre-provision income and the like. (See Figure 10 below.) If one party has an attribute that the other does not (e.g., significant earnings from a higher-earnings multiple business such as trust or lowermultiple business such as mortgage banking), then ownership percentages may differ from a first pass of relative

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contributions. Nevertheless, the intent is to create a situation whereby both parties share in the upside from expense saves and possible revenue synergies. Further, certain other less quantifiable enhancements to the franchise can result from a combination such as a more attractive footprint and/or a more diversified loan and deposit mix. We recognize that it is hard for the seller (or junior merger partner) to accept such an approach over price, but investors typically have responded well to such deals involving larger, publicly traded entities.

Figure 10: Relative Contribution Summary


Junior Bank $ Securities Loans Earning Assets Total Assets Core Deposits Borrowings Tangible Common $300,000 625,000 925,000 1,000,000 735,000 170,000 95,000 % 30% 24% 26% 26% 23% 52% 27% Senior Bank $ $700,000 2,000,000 2,700,000 2,919,000 2,500,000 156,290 262,710 % 70% 76% 74% 74% 77% 48% 73% Combined Bank $1,000,000 2,625,000 3,625,000 3,919,000 3,235,000 326,290 357,710 (150,000) (150,000) (150,000) Shared Synergies ($150,000) Pro Forma Bank $850,000 2,625,000 3,475,000 3,769,000 3,235,000 176,290 357,710

Net Interest Income Service Charges Mortgage Banking Trust Other Fee Income Total Revenues Operating Expenses Operating Income Loan Loss Provision Security Gain/(Loss) Other Pre-Tax Income Taxes @ 30% Net Income

$37,000 7,350 3,125 8,000 3,000 21,475 58,475 42,102 16,373 4,688 0 0 11,686 3,506 $8,180

27% 25% 24% 67% 50% 36% 29% 31% 26% 27% nm nm 25% 25% 25%

$101,250 22,000 10,000 4,000 3,000 39,000 140,250 92,565 47,685 13,000 0 0 34,685 10,406 $24,280

73% 75% 76% 33% 50% 64% 71% 69% 74% 73% nm nm 75% 75% 75%

$138,250 29,350 13,125 12,000 6,000 60,475 198,725 134,667 64,058 17,688 0 0 46,371 13,911 $32,459

($1,500)

$136,750 29,350

(3,000) 500

10,125 12,500 6,000

(2,500) (4,000) (15,000) 11,000

57,975 194,725 119,667 75,058 17,688 0 0

11,000 3,300 $7,700

57,371 17,211 $40,159

ROA ROE Op Income / Assets NIM Efficiency Ratio Provision / Loans Loans / Assets Tangible Equity / Assets

0.82% 8.6% 1.64% 4.00% 72% 0.75% 62.5% 9.5%

0.83% 9.2% 1.63% 3.75% 66% 0.65% 68.5% 9.0%

0.83% 9.1% 1.63% 3.81% 68% 0.67% 67.0% 9.1%

1.07% 11.2% 1.99% 3.94% 61% 0.67% 69.6% 9.5%

Source: Mercer Capital

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Perhaps the best example of a well-executed merger-of-equals (MOE) was the 1994 merger when Southern National and BB&T entered into an MOE that today is a top-performing, super-regional bank. Among the keys to the transaction was clarity as to who would be running the combined company (Southern National management). Others were panned by the market, such as the 1994 merger of Cleveland-based Society National and Albanybased KeyCorp. The combined company struggled with a bloated cost structure and a blended management team that reflected very different operating styles. Boards that choose to sell to a larger institution or enter into a transaction that is more akin to an MOE in which the consideration received consists of the buyers common shares face a valuation question. For the selling bank (or junior merger partner), the first question to be answered is: what is our institution worth? The second question to be answered is: what is the value of the buyers shares? And the third question is: what is the value of the buyers shares on a pro forma basis including our institution, assuming the seller will constitute more than an inconsequential amount of the buyer? Ideally, the seller will conduct an evaluation to gauge a range of value for the institution with the caveat that factors such as the number of interested buyers, type of consideration (i.e., cash vs. stock), market conditions, and the like can lead to a fairly wide range. If a board then moves forward with some form of an auction or even limited market check in which a few potential buyers are contacted, the analysis gains more credence. The pre-auction/ market check should ground board expectations in the reality of the current market. If the targeted partner is publicly traded, on the surface the value of the buyers shares is known; however, many publicly traded banks are thinly traded and have little, if any, institutional ownership. In such instances the board should take a skeptical view of accepting the publicly traded value at face value. A detailed analysis similar to what the seller performed prior to starting the process might lead to a conclusion that the buyers shares are undervalued or over-valued vis--vis peers and relative to its historical and prospective performance. If the buyer (or larger merger partner) is privately held, the valuation analysis is all the more important. The basic premise remains the same: assessing the value of the shares and the value of the proposed consideration. Mergers based upon adjusted book-to-book multiples may not reflect significant earning power differences between two institutions. The third piece of the analysis entails valuing the pro-forma organization. As noted, we think the primary objective for two banks that are merging in todays tough environment should be shared upside. If the transaction is properly structured and executed, both sides potentially will see an increase in value. The analysis should consider each institution as a stand-alone entity, including the value of the organization, vs. each partys pro forma position in the new company and claim on pro forma value. The analysis should entail more than comparing earnings per share, tangible book value per share and dividends per share, though these are important measures to compare to stand-alone metrics. Other considerations include: Profitability relative to peers, history of each organization and projected profitability once expense saves are fully realized; Diversity in the loan portfolio by type and geography; Issues that may exist in the loan portfolios as a result of the credit evaluation of both portfolios, though only the sellers portfolio will be marked;

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The ability to optimize funding; Improved liquidity in the shares given a larger shareholder base and larger institution that may merit interest by institutional shareholders; and

Capacity to engage in additional transactions as a larger institution with improving liquidity for its shares.

In theory, the increase in value will be equal to the present value of after-tax expense savings and, possibly, revenue synergies. If the market judges the transaction to be successful, not only should value increase by the present value of the after-tax enhancement to earnings, but a pro forma organization that is perceived as being larger, stronger, having better growth potential, and the like may experience multiple expansion too. This is particularly true for community banks that have a propensity to be modestly valued. We think the merger route oftentimes will create a win-win situation for both parties, but navigating the process and each sides expectations is usually a difficult proposition.

Figure 11: Shared Upside of Profitability and Multiple Expansion


150%

140%

Pro Forma Bank


+ Net expense saves + P/E Expansion = Large P/TB Expansion

Price / Tangible Book Value (%)

130%

120%

Senior Bank

110%

100%

Junior Bank
90%

80%

70%

60% 9.0x 9.5x 10.0x 10.5x 11.0x 11.5x 12.0x 12.5x 13.0x 13.5x 14.0x

Price / Earnings (x) Multiple


Source: Mercer Capital

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Case Study #2
One example of a well-executed merger-of-equals (MOE) that benefited both community banks involved Signature Bancshares, Inc. and City Bancorp, Inc. In late 2003, the two institutions announced a transaction that could be characterized as a merger-of-equals since the relative financial contributions between City and Signature were fairly similar and the primary consideration was common shares. For the twelve months ended December 31, 2003, Signature reported $325 million in assets, $22 million in tangible equity, $2.3 million in net income while City reported $262 in assets, $21 million in tangible equity, and $1.9 million in net income. Certain benefits of the transaction for both City and Signature included the following: Absent the merger, asset and deposit growth of this magnitude would potentially take a number of years for each institution individually. While the two banks separate deposit market shares ranked them near the middle of the community bank competitive set in the Springfield, Missouri market, the combined entity ranked first among its community bank competitors by mid-2005. The post-merger entity was a better candidate for a public offering or future sale than either bank on a stand-alone basis. Merger synergies and expense savings allowed for an improvement in return on equity and operating leverage as measured by the efficiency ratio. Following the merger-of-equals transaction in early 2004, the surviving entity (City Bancorp, Inc.) received an unsolicited offer from a third party in mid-2006. City then was marketed for sale more broadly, multiple bids were received, and Citys board elected to pursue a transaction with BancorpSouth, Inc. (BXS) in a deal that closed in the first quarter of 2007. The consideration paid for City by BancorpSouth, Inc. was $170 million in the form of 50% cash and 50% stock. At announcement, the consideration paid represented approximately 3.0x tangible book value and 20x earnings. While pricing levels for banks may not return to those levels experienced in the mid-2000s, the transaction demonstrates the potential value that can be created for shareholders through a wellexecuted merger of equals. Mercer Capital was retained by Signature Bancshares, Inc. to provide financial advisory services related to the initial transaction and by City Bancorp, Inc. to provide similar services for the BancorpSouth transaction.

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About Mercer Capital


Mercer Capital assists banks, thrifts, and credit unions with significant corporate valuation requirements, transactional advisory services, and other strategic decisions. Mercer Capital pairs analytical rigor with industry knowledge to deliver unique insight into issues facing depositories. These insights underpin the valuation analyses that are at the heart of Mercer Capitals services to depository institutions. For more information about Mercer Capital, visit www.mercercapital.com.

Mercer Capitals Financial Institutions Group


Jeff K. Davis, CFA 615.345.0350 jeffdavis@mercercapital.com Andrew K. Gibbs, CFA, CPA/ABV 901.685.2120 gibbsa@mercercapital.com

HEADQUARTERS 5100 Poplar Avenue, Suite 2600 Memphis, Tennessee 38137 901.685.2120 (p) 901.685.2199 (f) www.mercercapital.com

Mercer Capitals

2013 webinar series


The Financial Institutions Group of Mercer Capital works with hundreds of depository institutions annually providing a broad range of specialized advisory services. Join us in 2013 for a series of short, topical, and targeted webinars on issues important to your institution given todays current banking environment. The first four webinars are listed below. Notice of future webinars will be posted to our website.

Tuesday, February 12, 2013 12:00 - 12:30pm Central

The Outlook for M&A in 2013


Our expectations for bank M&A in 2013, which follows a modest pick-up in activity in 2012 vis--vis 2011, are presented. Investors are anxious for M&A to increase given the earnings outlook, but seller expectations and regulatory actions are acting as a governorat least for the now.

Tuesday, March 12, 2013 12:00 - 12:30pm Central

How to Profit on a Distressed Transaction


Buyers have been leery of acquiring troubled banks in non-assisted deals. With a slowly recovering economy, we take a look at the opportunities and pitfalls or making an acquisition of a turnaround bank.

Thursday, February 28, 2013 12:00 - 12:30pm Central

Thursday, February 28, 2013 12:00 - 12:30pm Central

Understand the Deal Considerations That Impact You


Key issues that we see when banks combine as it relates to valuing and evaluating a combination are reviewed. This is particularly critical when the consideration consists of shares issued by a buyer (or senior merger partner) whose shares are either privately held or are thinly traded.

Are You a Potential Buyer?


The #1 factor that a buyer controls in determining the return is the price paid. Deals occurring later in a credit cycle tend to entail a higher price and worse outcome for the buyer. We review price and other issues from the buyers perspective that we think matter in ensuring a successful merger.

Jeff K. Davis, Managing Director of Mercer Capitals Financial Institutions Group, will be the featured speaker for these four webinars. Prior to joining Mercer Capital, Jeff spent 13 years as a sell-side analyst providing coverage of publicly traded banks and specialty finance companies to institutional investors evaluating common equity and fixed income investment opportunities. Presently, he is an editorial contributor to SNL Financial.

To register for these complimentary webinars: www.mercercapital.com/insights/2013bankwebinarseries/


For more information, contact: Jeff K. Davis, CFA Andrew K. Gibbs, CFA, CPA/ABV Managing Director Senior Vice President 615.345.0350 901.685.2120 jeffdavis@mercercapital.com gibbsa@mercercapital.com

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