Strategies for M&A Due Diligence and Integration Planning

The market for financial services organizations’ mergers and acquisitions (M&A) has shown signs of picking up, which means now is the time to get ready for future M&A activity. In our last article, we covered five steps to help financial services organizations set their M&A strategy, including assessing their own readiness, defining their strategy and success metrics, and identifying targets that align with that strategy. Once the strategy is set and a target is identified, organizations can start with due diligence and integration planning. Our specialists offer some strategies that can help organizations with effective due diligence and integration planning for prospective deals.

Assess strategic fit before the M&A due diligence process begins. Assessing the target’s financial health, regulatory standing, strategic fit, and quality of assets is critical. Even before the detailed due diligence can begin, financial services organizations should have already assessed a target’s fit based on the M&A strategy they’ve created, preliminary assumptions, and initial risks identified. Once plans are set to move to next steps with a target, the organization should confirm initial assumptions that made the target an attractive fit and critically evaluate risks.

With more regulatory scrutiny and fewer deals closing per year than a decade ago, it is more important than ever that organizations confirm that a target aligns with their strategy to increase the likelihood of a successful deal. Even though a target might have solid financials, if it does not ultimately help an organization meet its strategic goals, it is not a worthwhile target to pursue. It’s better to confirm that a target is the right strategic fit before spending precious time and resources in an intensive due diligence process.

Begin the M&A due diligence process as early as possible. Once a target aligned to the organization’s strategy has been identified and signed a letter of intent, the organization can begin a more detailed financial analysis and due diligence process. This analysis is a critical step in understanding the target’s true financial condition, risks, and operations. Making sure the M&A due diligence is robust and well documented can better position the organization for success and help with the future regulatory application process.

A key area of scrutiny is the target’s financial health from multiple lenses, including examining accounting policies and treatment, profits, interest margins, deposit costs, loan yields, potential losses, and efficiency ratios. Analyzing asset quality and the duration of assets and liabilities is also paramount in gauging underlying risks. Organizations can also use financial due diligence to verify preliminary assumptions about profitability, cost savings, and that business risks identified are adequately addressed.

Expand M&A due diligence beyond financial health. Due diligence isn’t just about financials and asset quality. Organizations should also consider five critical areas of risk (the five C’s) in a bank acquisition or merger: credit quality, compliance management, cybersecurity, consumer protection, and culture. In practice, this consideration could look like scrutinizing operational risks, compliance programs, and any past issues or concerns, especially in areas such as consumer protection, Bank Secrecy Act, and anti-money laundering (AML). It is also important to further evaluate cultural fit and the strength of the management team of the target.

Organizations should consider stakeholder alignment between their own stakeholders and those of the target to evaluate if there is any misalignment in terms of strategic vision, timelines, deal structure, or expectations regarding securing additional capital. Performing regulatory compliance, credit, tax, and technology due diligence in addition to financial due diligence can help organizations evaluate risks, inform the deal structure, influence negotiations, quantify cost savings, and plan for integration – or to walk away, if needed.

Examine the target’s credit. It’s also vital to conduct credit due diligence that critically evaluates the target’s credit portfolio. Doing so helps organizations thoroughly understand the financial health and risks associated with the target portfolio, starting with data analytics on the portfolio and diving deeper into individual relationships and loans. This part of the due diligence process allows organizations to examine the credit portfolio fit, concentrations, risk ratings, and preliminary loss expectations. Additionally, this process allows organizations to understand the financial outlook of outstanding loans, look for hidden pockets of risk, and determine whether the target’s reserves are adequate.

This detailed evaluation is crucial for estimating the impact of the current expected credit loss reserve on the pro forma model and informing the credit mark in the loan valuation. Furthermore, it is essential to define the purchase credit deteriorated (PCD) criteria and align the credit and accounting teams to consider the interplay of PCD identification, credit due diligence, and purchase accounting.

Identify and quantify the synergies and merger expenses. There are a variety of potential synergies to consider for the combined organization – from unlocking meaningful cost savings by consolidating redundant branches and IT systems to employing increased scale to manage regulatory requirements. Each organization’s prioritization of synergies will be different, but it’s important to take a clear-eyed, detailed approach to assessments and ground assumptions in realistic, achievable targets for synergies and cost savings that can be quantified and tracked.

Employing sophisticated benchmarking analyses and drawing on deep industry expertise is critical to maximizing and validating synergy estimates and pressure-testing their underlying premises. With synergies so pivotal to M&A success, organizations cannot afford to be overly optimistic in this crucial area. Specific identification of synergies and cost savings, anchored by target-specific and industry analysis on vendor selection, contract negotiation, and performance and staffing benchmarks, can help set up the combined organization for success.

Organizations also should assess anticipated merger expenses – including those that will be required throughout integration, from system conversions to branch signage – so that they are prepared when the deal closes and integration execution begins.

Prepare detailed pro forma financials. Financial services organizations should model what the day one combined pro forma balance sheet and income statement will look like after the transaction closes, analyzing key metrics and capital ratios of the merged entity to assess if the deal math works. Sophisticated pro forma modeling allows organizations to evaluate the purchase accounting effects, pinpoint issues, and stress test assumptions to determine whether the proposed M&A transaction is financially viable.

Pro forma modeling is more impactful when going through estimates and assumptions line-by-line with detailed analysis rather than back of the envelope estimates. If the pro forma modeling reveals concerns, organizations can reassess assumptions, explore other ways to structure the deal, revisit negotiations, or decide if it’s time to walk away. Organizations can also use pro forma modeling to prepare for accounting treatment of acquired assets and liabilities, assess capital needs, and guide the deal structure.

Obtain preliminary valuation estimates. Obtaining preliminary valuation estimates ahead of close, and even prior to announcement, can be pivotal for organizations to have an accurate assessment of the financial impact of purchase accounting. By obtaining these early estimates, organizations can enhance their pro forma modeling, which can help ensure the most accurate estimates within the opening balance sheet as well as the modeled accretion and amortization calculations of purchase accounting marks from day two onward.

This approach provides a stronger foundation for management to conduct scenario analyses, which are essential when it comes to stress testing the assumptions built into the pro forma model. Additionally, it’s crucial for organizations to proactively identify intangible assets that might emerge from the transaction and to navigate any complex accounting treatments that might arise from the deal. Assessing these elements early on can significantly benefit the organization through a more reliable depiction of the overall impact on the combined organization’s financials and strategic positioning in its internal modeling, investor and stakeholder communication, and materials submitted to regulators.

Identify any third-party capital needs. In some cases, acquiring organizations might consider bringing in third-party investors to shore up the balance sheet and meet regulatory capital requirements. If that’s a worthwhile option, financial services organizations should consider whether additional due diligence is needed to develop a comprehensive understanding of their financial position with and without additional investments.

Survey the regulatory landscape. Heightened regulatory scrutiny, particularly regarding capital requirements and expanded regulatory oversight of M&A transactions, is a driving force behind delays or pain points during many recent M&A deals in financial services. As one indication of the heightened regulatory scrutiny, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency recently tightened policies for bank merger applications and expanded the factors they will take into consideration during review.

This increased regulatory oversight means financial services organizations must be more prepared than ever before when pursuing M&A opportunities. It’s vital for organizations to understand what regulators will expect to review with the deal. Organizations should also stay current on the regulatory landscape to understand which targets offer the best fit while still complying with regulatory obligations.

Assess other areas of compliance. Beyond capital considerations, organizations should also assess the target’s compliance programs regarding consumer protection, AML, fair lending, and other areas. Any deficiencies or lapses could draw regulatory scrutiny and threaten deal approval.

Using the regulatory compliance due diligence performed, organizations should develop a detailed plan for a combined compliance program, a combined risk and control taxonomy, a strategy to address any vulnerabilities, and an approach to remediate any issues identified, including timelines. Taking these proactive steps can help make the deal process run more smoothly. Organizations should also assess the cost of compliance when establishing a plan.

Maintain open communication with regulators. Transparency regarding the deal rationale, financial projections, compliance integration plans, and mitigation strategies for any concerns can build trust and help facilitate approval with regulators. Organizations must be prepared to clearly articulate their plan for regulatory compliance with the combined organization.

Develop an integration road map. Successful M&A deals require meticulous planning to integrate systems, processes, people, and cultures into a unified organization – or, conversely, to decide which parts should not be integrated. This part of the process might include performing vendor or system assessments, analyzing contracts, branch consolidation, and benchmarking decisions. M&A transactions include many moving parts with many stakeholders, and creating an integration road map can help manage the process.

A road map can help financial services organizations prioritize critical areas and activities, such as core banking platform conversions, customer data, risk management frameworks, and operational workflows, to help maintain business continuity and minimize disruptions. The plan should also establish clear accountability measures with dedicated teams and leaders to help the organization effectively execute the integration and align to regulatory expectations, as regulators will expect to see a robust governance structure. A road map also allows organizations to lay the groundwork for long-term synergy realization.

Establish an integration management office. M&A affects all aspects of a business, which means it’s essential to proactively facilitate coordination among stakeholders throughout the organization, maintain the integration road map, manage prioritization, and track risks, actions, issues, and decisions via the RAID log throughout the M&A life cycle. An integration management office (IMO) can do just that by steering the M&A integration process while facilitating and supporting the integration execution. Throughout the M&A life cycle, the IMO can serve as a communication hub, helping to keep all processes, third-party advisers, and key stakeholders aligned and on track; prevent extraneous tasks; avoid costly bottlenecks, delays, and redundancies; and track success metrics, synergies, and costs.

Contracting with a third party that has extensive experience in financial services organizations and M&A activity to run the IMO for the deal can help the entire process run more smoothly.

Pay attention to culture. A cultural match might be one of the most overlooked parts of an M&A transaction, but it’s crucial to success. Cultural issues often are difficult to assess since many tend not be readily measurable metrics. Clashing cultures can derail even the most financially sound deal, so the organization should outline strategies for fostering a cohesive organizational culture, assess risk and compliance cultural alignment, address potential resistance, and align values, behaviors, and ways of working across the combined entity.

It’s important to consider the target’s management team and what the management of the combined organization might look like. Having a strong and ethical management team with a solid ability to execute on the strategic vision is critical. Organizations might ask questions such as:

• Have target management leaders demonstrated an ability to execute on strategy?
• Are they meeting their budgeted objectives?
• Are they effectively planning for the future?
• What are their strategic goals?

Just because an organization might be acquired doesn’t mean its goals go away. In fact, a strong alignment in values, culture, and strategy might contribute to why an organization is identified as the right target in the first place.

Prioritize communications and employee engagement. M&A deals can often breed anxiety about job security, cultural fit, and operational changes. While determining the right group of people to be “under the tent” during the due diligence stage is important, it also important for organizational leadership to craft clear internal messaging upon announcement that outlines the rationale for the deal, anticipated timelines, and how employee roles and responsibilities might be affected. Effective communication can also help to identify the critical roles and top performers who are essential for continuity and to reach out specifically to those individuals to answer any questions. It is also important to establish effective communication with investors, customers, and the community.

Due diligence and integration planning are essential steps for financial services organizations considering an M&A, and these steps require an organizationwide effort. For some organizations, involving a third-party with extensive expertise in M&A for financial services organizations can be a helpful way to conduct due diligence and integration planning in a way that considers both the specific needs of the organization and the overarching market and regulatory environment.