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Valuation Process: Deal Pricing and Financial Reporting

When one financial institution acquires another, there are two aspects of the valuation process. These are deal pricing and financial reporting. Deal pricing involves performing financial and operational due diligence used to assess the value of the target. This involves evaluating the following key inputs:

  • Credit risk in the loan portfolio,
  • Quality of earnings,
  • Potential cost savings,
  • GAP and net interest margin positions and
  • Capital requirements to support future growth.

All of these will be inputs into forecasting the future cash flows of the target.  These cash flows are then discounted to present value using a risk adjusted discount rate that reflects the investors’ required returns. Performing sensitivity analyses around these key inputs, you develop a range of values that allow for negotiating the transaction price.

Deal pricing is not the only valuation consideration during the transaction life cycle. The other workstream, financial reporting, involves assessing the fair values of the financial and intangible assets to be acquired.  In addition, the fair value adjustments provide insights into whether the deal is accretive or dilutive to the consolidated earnings of the acquiring entity, which can also be important in the deal pricing phase.

In understanding the purchase accounting impact of a transaction, it is dependent upon the facts and circumstances surrounding the target, but also often involves determining the fair values of the:

  • Loan portfolio (credit and interest rate marks),
  • Core deposit intangible,
  • Fixed maturity deposits and other borrowings,
  • Above and below market rate leases,
  • Servicing rights and
  • Other intangibles (trust and wealth management relationships, tradenames, not-compete agreements, etc.).

The financial reporting valuation process can be every bit as important as the deal pricing phase. It will receive significant scrutiny from the acquiring entity’s audit firm as well as bank regulators and possibly the Securities and Exchange Commission. It is critical to use well tested and documented valuation methods to avoid future challenges that could require restating previously issued financial statements.

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