M&A in SVB’s Long Shadow

At Castle Creek Capital, a PE firm based in San Diego that makes minority investments generally in community banks, “the opportunity set for us is expanding and improving,” says Tony Scavuzzo, a managing principal at the firm.

Within the universe of community banks—those with assets of $10 billion or less—the banks that have large bond portfolios and tight liquidity are already feeling pressure from bank regulators. “We’ve had calls with a handful of banks already exploring what capital opportunities may look like,” Scavuzzo says.

Scavuzzo describes Castle Creek as one of only a handful of PE firms that are regularly active in the community bank sector, which accounts for nine out of every 10 banks in the U.S. He adds that Castle Creek is making sure its existing investments in banks are well-capitalized and that its banks are well-equipped to withstand a recession.

On the other hand, the PE firm is preparing to deploy capital and underwrite risk in new opportunities—banks with compelling valuations.

A Bad Year for M&A

Even before the failure of Silicon Valley Bank, rising interest rates and low stock valuations for banks had put a crimp on banking M&A activity. S&P Global reported that the six U.S. bank deals announced in January were the lowest number for the month since 2009. In 2022, at least 10 U.S. bank deals were announced in every month, for a total of 168, down from 204 deals in 2021.

Early in 2023, rising interest rates had pushed down the values of bond portfolios held by banks, which created poor capital metrics for potential deals. The run on SVB and the subsequent takeover of the bank by the FDIC spooked the market, driving double-digit declines in stock valuations across the banking sector, which were unexpected, Scavuzzo says.

“They kind of came out of nowhere,” he says. “It put fear and uncertainty into the sector, and when fear and uncertainty are rising, generally people pause and wait for the dust to settle.” He expects the valuations will continue to have a negative impact on dealmaking in banking. Potential sellers don’t want to make deals when potential buyers are offering prices based on historically low valuations.

While a few banks have had serious problems, most banks are very healthy and the industry seems to have stemmed its previous six to 12 months of outflows of deposits, which were due to rising interest rates, says Nathan Stovall, lead banking analyst for S&P Global Market Intelligence.

“It’s not as if cash has gone to the mattresses; It’s gone into other banks,” he says, and anecdotally it seems that small banks have picked up a modest share of deposits.

Motivations for Dealmaking

Stovall says small banks still have an appetite for M&A for the same reasons they’ve had in recent years: to scale up to be able to invest in technology, modernize, compete with large institutions and realize cost savings, as well as to grow earnings by consolidating back offices, HR departments and other redundant functions. And now, they have the additional incentive to diversify their deposit base among different sectors through M&A—one of the lessons drawn from the failure of Silicon Valley Bank, whose depositors were overly concentrated in the tech sector. “Some of the people we’ve been talking to seem confident that it will happen,” he says.

But he doesn’t expect the pace of bank M&A activity to pick up soon because of low valuations. “The idea that maybe you want to take on somebody new and grow much faster, I think that hesitation is going to remain in the near term,” Stovall says.

Scavuzzo says he expects M&A will return for community banks when interest rate hikes stop. “Once you see inflation in check, and the Fed stops raising rates and starts to cut them to get the yield curve back to a more normal level, then we would start to see bank valuation adjustments and M&A come back,” he adds.

Challenges Create Opportunities

In the meantime, PE firms potentially could find opportunities in government-assisted deals in other banks that are grappling with liquidity and interest rate challenges. And the number of opportunities could grow if the economy enters into a recession or encounters widespread credit stress.

“If we tip into a formal recession or a period of stress, there will be good banks that have problems that need to raise capital to reposition the balance sheet or get rid of bonds that are at losses. In addition, banks may experience credit losses too,” Scavuzzo says.

For now, credit quality remains strong in the banking sector. But as the Fed continues to raise interest rates, some borrowers will have problems, which could spur a credit event or more demand for capital across the banking sector, Scavuzzo says.

A sector-wide opportunity like the Great Recession, when hundreds of banks had to raise capital because of a system-wide need to flush credit losses and strengthen their balance sheets, would draw a much larger supply of private capital, Scavuzzo says. “We’re not there yet, but certainly the events of the last couple of weeks have pushed it much more in that direction.”

For larger banks, M&A may increase because of their need in the current environment to scale up deposits, accumulate talent to better manage risk, or to bring strong operations and technologies in from profitable banks, says Ronak Doshi, a partner with the Everest Group research firm.

“If this is not an isolated event and it becomes systemic, we could start seeing several other banks having similar challenges and start realizing ‘Oh, this is something which we didn’t have capability to manage on our own; we now need to be combining forces,’” Doshi says.

Another factor that could drive bank M&A is the need to diversify revenues or commercial deposit pools, such as for banks that are overly concentrated in the life sciences or healthcare sectors, he says. Meanwhile, banks that don’t have good leadership teams in place could present a red flag to potential acquirers. “You do want to get a good leadership team along with the acquisition,” he adds.