1. practicallaw.com / October 2014 / PLC Magazine 19
M&AINBANKING
M&A IN BANKING SERIES
Valuing a business is as much an art as a
science, and no single figure will represent
the correct value of a business. The value will
vary according to the perspective of the buyer
and will depend on the relative weight given
toavarietyoffactors,andthosefigureswillbe
linkedtoanunderlyingvaluationmethodology.
It is therefore important, in all types of
mergers and acquisitions (M&A), that legal
advisers understand the methodology used,
as this enables them to establish how best
to draft the contractual protection in order
to support the applicable valuation drivers.
It can also assist an adviser in identifying
priorities for the negotiation process (and
issues of lesser significance which may
therefore potentially be traded).
This article, the second in a three-part series,
explores how the characteristics of different
banks determine the appropriate valuation
method liable to be used, how the nature of
the business and the regulatory environment
in which such institutions operate influences
whether (and if so, how) pricing should be
adjusted for changes between signing and
completion, and the mechanics which have
been used to address these issues.
Traditional valuation methods
Whenitcomestovaluingfinancialinstitutions,
there are some common problems with using
standard valuation methodologies:
Cash-free/debt-freeandnormalisedworking
capital. This basis includes valuing the fixed
assets and a normal level of working capital
excluding any cash and debt (the enterprise
value), with cash and debt being adjusted for
on a pound for pound basis. At closing, the
cash and debt in the business is calculated
and in addition to the enterprise value, the
buyer pays for any cash less any debt (further
adjustments can be made if working capital
fallsshortof,orexceeds,thenormalisedlevel).
However, cash and debt are regarded very
differently by financial institutions because
customer deposits and other types of funding
are debt, but are also the raw materials used
in the bank’s business. Cash-free/debt-free
priceadjustmentsarethereforeinappropriate.
EBIT(DA). Valuation using a multiple of
net earnings, or EBIT/EBITDA represents
earnings before interest, taxes, depreciation
and amortisation. For banks, interest paid
on their debts is essentially the cost of raw
materials, and is typically their biggest
single expense; interest earned on loans is
also a high percentage of a typical bank’s
revenue. Removing interest is therefore
inappropriate.
Locked-box.This is a contractual mechanism
where a valuation is locked in at a particular
point in time (the locked-box date) before the
executionoftransactiondocuments.Theseller
warrants the financial position of the target
as at the locked-box date, and the seller also
indemnifies the buyer for any leakage, that is,
payments that are made to the seller (or its
group) since the locked-box date.
This mechanism does not take account of
any fluctuation of the value of the target up
to signing or closing and is not commonly
used for a bank because of the uncertainty
of the market conditions in which many
banks are operating, and also because of
the extended period between signing and
closing that is typically required to obtain
regulatory approvals.
Common approaches
Parties in transactions involving banks have
adopted alternative valuation (and often also
price adjustment) mechanics that are better
suited to the industry.The methodology used
will largely depend on the nature of the
financial institution and the assets it holds
(see box “Valuing financial institutions”).
Mind the gap
The transfer of a bank will usually require
consentfromatleastoneregulator.Inevitably,
this leads to a gap between signing and
closing, which is typically between three to
six months (depending on the jurisdiction(s)
involved) but could be much longer.
There are a number of ways to reduce this
delay, but in the event of any gap (other than
a de minimis one) the question of dealing with
a fluctuation in value of the target needs to
be addressed (see the first article in the series
“M&A in banking: managing completion risk”,
www.practicallaw.com/8-578-8306).The gap
is of particular concern to buyers purchasing
banks for the following reasons:
Volatility of assets. Banks tend to hold
financial instruments (such as shares, bonds,
or more exotic products such as contracts
for difference and units in exchange traded
funds), whose value is volatile.The true value
of these assets is often very different to the
book value recorded in the target’s accounts.
Even firms which account using mark to
market principles are unlikely to reflect the
true value of their assets, as the value is
likely to have changed since the mark was
last taken. In an M&A transaction where a
material part of a target’s assets is made up
of financial instruments, it will be crucial for
the parties to deal with fluctuations between
signing and closing.
Effect of the announcement. The business
of all banks is built on reputation and public
perception, and so the announcement of a
change of ownership can significantly affect
this. The financial standing of the new owner
is often important as the bank’s clients would
be concerned about long-term solvency and
may withdraw their deposits, or cease trading
with the firm, if concerns persist. For some
banks, the personal relationship between
the firm’s employees and their key clients
and trading partners is of critical importance
and announcing a change of ownership could
worry customers and trading partners that
these relationships are about to change.This
will be particularly relevant to private banks
and asset managers.
The loss of key clients is a concern against
which a buyer would often seek protection.
However, a seller may be equally reluctant
to give any protection to the buyer as a loss
of clients would arguably be as a result of
the buyer’s identity and reputation, and so
should, the seller would contend, be the
buyer’s risk.
Fast changing environments. External
events affect every industry, but current
focus on the financial services industry by
M&A in banking: valuing financial institutions

2. PLC Magazine / October 2014 / practicallaw.com20
governments, regulators and the press,
means that the operating environment for
financial institutions is particularly uncertain.
Dealing with the gap
There are therefore a number of factors that
push buyers towards insisting that a formal
accounting of the financial position of the
target be taken at completion and the price
adjusted in the event of a deviation from the
position at signing. Some examples of how
the different financial institutions might be
affected include:
• The credit experience or composition of a
given loan portfolio may change.
• Levels and composition of assets under
managementwillbeaffectedbyinvestment
decisions and client instructions.
• Balance sheets may fluctuate.
It is therefore common for completion
statements (ranging from full accounts to
spreadsheets of relevant items to be valued)
to be produced as at closing and the price
adjusted accordingly. The target’s usual
accounting principles may be applied, or
specific alternative principles used where
the buyer does not accept that the existing
principles are appropriate (for example, to
value the target’s loan book).
In a deal involving an asset management
business, the buyer may also be concerned
about any withdrawal of funds as a result of
the deal. In that situation, the buyer may push
for price adjustment mechanisms that provide
for a post-closing adjustment in the event
of a significant withdrawal of client funds.
However, it is important to note that sellers
often strongly resist such adjustments as they
are outside of the seller’s control and they
may be concerned that any withdrawals may
be driven by the buyer’s identity and actions.
The completion adjustment mechanism
will typically be supported by sector-
specific restrictions on the conduct of the
business in the period between signing and
completion, and by warranties focused on the
key valuation drivers (and risk factors) of the
type of financial institution being dealt with.
Gordon Low is a partner, and Ron Kirschner
is a senior associate, at Baker & McKenzie
LLP.
Valuing financial institutions
DetailsApproach
Why use it? Useful for banks with multiple business lines and a variety of
assets (for example, commercial banks). Because interest revenue is
typically a high percentage of the overall revenue, the loan and deposit
figures (balance sheet items) are key, and price adjustment mechanisms
that take these into account are popular.
Mechanics. A multiple or fraction is applied to the net asset value to
calculate an appropriate price.
Why use it? Where the bank’s assets are made up of financial instruments
(for example, a hedge fund): The value of those instruments is determined
at the moment they are transferred to the buyer; or if different, the
moment that the risk of fluctuation in their value is transferred to the
buyer. For complex and/or illiquid instruments, parties need to determine
a tailored methodology.
Mechanics. The only people with sufficient expertise to value the
instruments may well be the employees who created them. Both parties
may be cautious about accepting a valuation determined by the target’s
employees.
The buyer may require full disclosure of the valuation methodology
applied in valuing the target’s assets in its last audited accounts (or, if
more recent, the accounts on which the valuation is based).
Parties can negotiate the methodology to value the instruments in any
completion account valuation, and any restrictions on the target entering
into types of instrument between signing and closing.
Regarding valuation at a future point (such as completion), the parties
also need to develop a mechanism for valuation in the event of a dispute.
Use of a third-party expert is most common solution, But where the
instruments being valued are particularly esoteric and complex it may be
difficult to find a qualified expert. The parties can test the expert before
agreeing on the expert mechanism by asking them to value some sample
instruments.
High costs and uncertainties of outcome associated with implementing the
expert valuation may well encourage the parties to agree on the valuations
amongst themselves, rather than trigger the tie-breaking mechanism.
Why use it? For many financial institutions, such as banks, mutual lenders
(such as building societies) and credit card companies their main asset is
their loan portfolio, comprising consumer or commercial loans,
mortgages, and credit cards.
In the current economic environment, it is highly likely that not all loans
will be repaid in full. As such, the price of a loan book would normally be
discounted to reflect the risk.
Mechanics. Loan portfolios, can be split into different categories and a
different discount can be applied to each category to determine its price.
Why use it? Many banks generate income from the funds that they hold on
behalf of clients. For example, by receiving fees for managing client funds
(as in the case of asset managers and private banks).
Mechanics. If the target’s business is managing client funds, valuation is
often based on a percentage of the value of the assets under
management.
Why use it? Buyers that are nervous of particular risks, such as breaches of
regulations and resulting fines or law suits will seek indemnities for such
risks from sellers.
Mechanics. Indemnities offer a good compromise in negotiations,
particularly if the alternative is that the buyer discounts the price to
accommodate the risk, which may not be an acceptable solution.
Negotiations focus on: the scope of the indemnity; limitations applicable
to it; and control of the conduct of the matters to which the indemnity
relates (where balancing the concern of the seller that it should not be
treated as having written a “blank cheque” for the risk underlying the
indemnity needs to be balanced against the buyer’s desire to be in control
of the target’s ongoing relationship with all its regulators).
Net asset
value
Valuing
financial
instruments
Loan portfolio
Deposits and
assets under
management
Indemnities