mergers & the role of internal audit 19 - session 5... · • develop plans to integrate...

Insight. Oversight. Foresight. SMMichigan Texas Florida

Mergers & the Role of Internal AuditSeptember 30, 2019

Presented by:Bill Astrab, CPA, Shareholder

1

Overview

• Industry trends• Merger trends• Merger process• Where IA can provide value in mergers

• Considerations for each phase of merger process• Other topics or questions

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Financial Institutions Group

Return on Assets

• Components of ROA – 2018

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Insight. Oversight. Foresight. SM

Merger Trends

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Merger and Other CU Activity

• Types of Mergers• Voluntary• Unassisted merger• Assisted mergers and Purchase & Assumption (P&A)• Emergency Assisted (danger of insolvency)

• Other Activities• Purchasing entire banks• Bank branches• CU conversions to banks

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Merger and Other CU Activity• Reasons for Mergers

• Strategic– Geographic expansion– Community charter– Branch network – Additional products/services– Increase size

• Efficiencies / economies of scale• Lack of succession planning (retirements)• Insolvency (forced mergers)

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Merger and Other CU Activity

# of Credit Unions:1985 – >15,0002019 – 5,4212038 – projected to be less than 3,000

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Merger Process

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Merger Process

• Merger Strategy• Process can take multiple years

• Due Diligence• Financial and operational

• Merger approval and close• Board, Legal, Regulatory approval

• Post-Merger Integration• People, processes, technology

• Post-Merger Audit• Risk-based for combined organization

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Merger Strategy – Value Proposition

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With what type of partner would your credit union be able to

leverage its own strengths in a merger?

What type of partner would uncover and provide additional opportunities

your credit union could capitalize on?

What threats are your credit union facing and what type of partner

would help mitigate these?

What type of partner would resolvethe weaknesses your credit union

may have?

1 2

3 4

Merger Strategy - Objectives

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Member Value

Proactive vs. Reactive

Sustainability

Philosophy & Culture

Mutual Collaboration

Retain Identity/Voice

Diversification

Merger Strategy - Key Considerations

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Philosophy (e.g. Pricing

Culture

Leadership

Brand / Name

Board Structure

Facilities / Branches

Organizational Structure/Integration

Timing/Event Pacing

Due Diligence

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Summary Components• Accounting and reconciliation • Assess current contracts (liability and

escape clauses – IT & Debit Card)• Human resource policies, staffing,

compensation structure and unrecorded benefit plans

• Review legal to determine potential litigation or contingent liabilities

• Loan evaluation focused on credit, collateral, concentration, and interest rate risk

• Allowance for loan loss analysis and delinquency, charge-off patterns

• Cash and liquidity • Investments-credit & Interest rate risk• Fixed assets and market value • Other assets and liabilities• Members shares and certificates • Equity levels• Fair value of balance sheet • Projected synergies

Due Diligence – Fair Value

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MERGING CONTINUING COMBINEDBook Value Adjustment Fair Value Book Value

A B C = A+B D E = C+DCash & Cash Equivalents 5,000 - 5,000 6,000 11,000

Gross Loans 100,000 (1,400) 98,600 140,000 238,600 Allowance for Loan and Lease Losses (1,000) 1,000 - (2,100) (2,100) Net Loans 99,000 (400) 98,600 137,900 236,500

Total Investments 20,000 (400) 19,600 25,000 44,600

Core Deposit Intangible 5,931 5,931 5,931

Total Other Assets 7,200 875 8,075 19,000 27,075

TOTAL ASSETS 131,200 6,006 137,206 187,900 325,106

LIABILITIES & CAPITALTotal Member Shares/Deposits 105,000 - 105,000 146,851 251,851

Total Liabilities 12,000 - 12,000 22,868 34,868

Total Capital 14,200 6,006 20,206 18,181 38,387 Total Liabilities & Capital 131,200 6,006 137,206 187,900 325,106

Capital Asset Ratio 10.8% 14.7% 9.7% 11.8%

Due Diligence – Projected Synergies

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Dec YTD Full Year Full Year Full Year Full Year Full YearActuals Forecast Forecast Forecast Forecast Forecast

2009 2010 2011 2012 2013 2014

Income StatementLoan IncomeVehicle Loans 3,913 3,764 3,486 3,238 2,996 2,770 Mortgage Loans 2,021 2,017 2,014 2,010 2,006 2,003 Secured Loans 151 160 174 190 205 221 Unsecured Loans 471 443 392 351 321 303 Home Improvement Loans 25 19 10 6 1 (2) Mastercard 655 678 713 750 787 824 Business Loans 557 511 405 338 311 287 Misc. Loans & Participations 62 63 64 65 65 66

Misc. Loans & ParticipationsLoan Income 7,855 7,655 7,258 6,948 6,693 6,472

Total Investment Income (2,015) 346 346 346 353 432

Total Interest Income 5,840 8,001 7,604 7,294 7,046 6,904

Deposit Interest ExpenseDeposit Interest Expense 1,994 2,125 1,269 1,015 842 759

Borrowing Interest Expense - 103 142 85 16 - Interest Expense 1,994 2,228 1,411 1,100 858 759

Net Interest Income Before Provision for Loan Loss 3,846 5,773 6,193 6,194 6,188 6,145 Provision for Loans Losses 3,195 2,683 2,096 1,554 1,053 600 Net Interest Income After Provision for Loan Loss 651 3,091 4,097 4,640 5,135 5,545

Non-Interest IncomeFee Income 1,025 952 810 723 687 653 Other Income 1,542 1,542 1,489 1,445 1,417 1,459

Total Non-Interest Income 2,567 2,494 2,299 2,169 2,104 2,112

Due Diligence – Projected Synergies

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Dec YTD Full Year Full Year Full Year Full Year Full YearActuals Forecast Forecast Forecast Forecast Forecast

2009 2010 2011 2012 2013 2014

Income StatementNon-Interest ExpenseTotal Employee Compensation and Benefits 2,562 2,559 2,468 2,393 2,343 2,411

Cost Reduction - - - (89) (214) (241) Travel and Conference Expense 36 36 35 34 33 34

Cost Reduction - - - (4) (8) (8) Office Occupancy Expense 437 436 421 408 400 411

Cost Reduction - - - - - - Office Operations Expense 915 914 882 855 837 861

Cost Reduction - - - (21) (42) (43) Marketing Expense 71 71 68 66 65 67

Cost Reduction - - - - (13) (13) Loan Servicing Fees 150 150 150 150 150 150

Cost Reduction - - - - - - Professional and Outside Services 686 696 714 733 752 772

Cost Reduction - - - - (38) (39) Other Operating Expense 599 555 522 530 544 559

Cost Reduction - - - (106) (109) (112) Non-Operating Expense 594 814 773 742 717 702

Operating Expense 6,050 6,231 6,033 5,615 5,345 5,440

One-Time Costs - (770) (875) - - - Gains/(Losses) - - - - - -

Net Income / (Loss) (2,832) (1,416) (512) 1,194 1,894 2,218

Merger Approval and Close

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Section Description

1 Detailed explanation of the reason for the merger.

2 Proposed effective date of the merger.

3 Current financial statements for both credit unions.

4 Current delinquent loan summary for both credit unions.

5 Current analysis of the adequacy of the Allowance for Loan and Lease Losses for both credit unions.

6aConsolidated financial statement, including an assessment of the net worth of each credit union before the merger and the net worth of the continuing credit union after the merger.

6b Combined Credit Union Prospective Forecast and Analytics.

↓

Section Description

1 Process and project plan

2 Message and methods of communication

3 Member vote packet

4 Meeting agenda and logistics

5 Member vote tabulation and results submission

Section Contents

1 Notification and Report Form

2Merger Documentationo Explanation and value proposition of the mergero Merger agreemento Executive biographies

3Market Share Informationo Market Concentration—Deposit Analysiso Market Concentration—Loan Analysiso Market Concentration by Countyo Bank and Credit Union Market Share Analysis

4Financial Informationo Fair Valuation of Combined Entities as of 3/31/09o Call reports as of 12/31/09o Combined forecast 2010o 5-year historical financial performance ratios

5 Legal Information

Member Vote

FTCNCUA/State

Merger Considerations

Project Management Group Structure

Merger Integration

Executive Team/Sponsor

Performance Group Leaders

Performance Groups

Merger Considerations

Project Management Group Process

Merger Integration

Use Tools

Decision

Group Leaders

Meetings

Decision

Update ProjectPlan

Executive Team

Meetings

Decision Communication

Post-Merger Audit

• Risk based audit plan of combined entity• Most significant changes in:

• Technology• People• Controls• Processes

• Significant integration challenges• Most apparent culture diversity• Other observations from due diligence

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Where IA Can Provide Value in Mergers

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Participation by Internal Audit

• Ranking of actual participation by IA in Mergers:1. Post-merger audit of combined entity2. Due diligence3. Post-merger integration4. Merger approval and close (very minimal)5. Merger strategy (very minimal)

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Post-Merger Audit

• Accounting for MergersPurchase Accounting Pooling of Interest (no longer permitted)

• Purchase Accounting (ASC 805)Much more complicated – need specialist Acquired credit union - recorded at fair value

• Pooling of InterestLess complicatedBook values of merging credit unions are added together

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Post-Merger Audit

• Purchase Accounting – Determination of Fair ValueRequires expertise - certified valuation analystComponents of fair value Entity value – 1st step Fair value of assets and liabilities Core deposit intangible Goodwill (plug) or gain on acquisition

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Post-Merger Audit

• Purchase Accounting – Determination of Fair ValueEntity value Entity value – fair value of the business (credit union) based on

market assumptionsFair value of assets and liabilities Loans – most complicated calculation

– FV calc for each loan class/type, less:– Credit discount and interest discount or premium

Deposits – adjusting for interest discount or premium Investments Real property – buildings, property Other assets / liabilities – FMV = B.V.

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Post-Merger Audit

• Purchase Accounting – Determination of Fair ValueCore deposit intangible (CDI) Premise is that buyer is willing to pay a premium on deposits

that are less expensive than their cost of funds Fair value – cash flows

Estimated life of the deposits (run-off) Rates vs. market Fee income generated Interest (dividend) expense

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Post-Merger Audit

• Purchase Accounting – Determination of Fair ValueGoodwill vs. bargain gain / gain on acquisition FMV of assets acquired > liabilities = bargain gain FMV of liabilities acquired > assets = goodwill

Goodwill Asset on the balance sheet Analyze for “impairment” Credit unions can amortize over a reasonable period

Bargain gain Recorded as income on the date of the merger Negative equity from a merger does not exist

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Post-Merger Audit

• Purchase Accounting – Example Goodwill

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Post-Merger Audit

• Purchase Accounting – Example Goodwill

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Post-Merger Audit

• Purchase Accounting – Example Bargain Gain

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Post-Merger Audit

• Purchase Accounting – Example Bargain Gain

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Post-Merger Audit

• Pooling No longer permitted (2009)Merger is accounted for at Book Value vs. FMVPotentially can be used if the merged entity is small

(immaterial) Materiality – not necessarily based on asset size, but the

estimated difference between book value and FMV Management’s estimate Inform your CPA firm

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Post-Merger Audit

• Pooling Accounting – Example

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Post-Merger Audit

• Accounting for Mergers – Call ReportingGAAP Financial Statements – Merged equity is recorded at

Entity Value (FMV).Regulatory Reporting – Merged equity is recorded at book

value AND FMV the acquired credit union?? GAAP – RAP difference Capital ratio is calculated based on call

report equity

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Post-Merger Audit

• Accounting for Mergers – Call ReportingBalance Sheet (@ FMV) – Pg#4, Q #37

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Post-Merger Audit

• Accounting for Mergers – Call ReportingNet Worth Calculation – Pg#12

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Post-Merger Audit

• Audit integration process to identify control weaknesses• Report audit findings and other observations to business

owners regarding implementation execution• Investigate whether the specific goals of the acquisition

have been achieved• Prepare lessons learned observations about the

integration process

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Due Diligence

• Ensure due diligence is comprehensive and covers:• financial, operational, and compliance issues

• Conduct due diligence with other team members such as finance, accounting, lending, human resources, legal and outside consultants

• Develop plans to integrate internal audit functions• Ensure weaknesses identified in due diligence are

considered in finalizing the deal• Suggest opportunities for additional synergies for cost

savings

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Due Diligence

• Due diligence considerations• Accounting • Allowance for Loan Loss adequacy• Management inquiries

• Legal issues• Commitments / Contingencies

• Deferred compensation and benefit plans• Contracts (core system, credit/debit cards, other 3rd parties)• Valuation – real estate, buildings

• Goals• Financial• Non-financial

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Due Diligence

• Other Considerations• Internal Control Environment “tone at the top”• Expectations and evaluation process for employees• Compliance issues and violations• Security issues• Past fraud issues • IT vulnerabilities• What is the expected outcome (name, board seats, etc.)

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Post-Merger Integration

• IA should be part of the integration team• Play advisory role to functions carrying out the integration• Identify gaps in the integration plan• Monitor progress and project plan documentation –

timelines are being met• Monitor activities necessary to achieve expected

synergies• Highlight potential gaps in the internal control structure• Data conversion process

• Quality control and validation

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Merger Approval and Close

• IA participation in this phase may be limited• Focus on legal documents and regulatory approval

• Keep apprised of progress• During this phase, IA can continue to monitor the

merging CU’s performance• Any deterioration or activity increasing risk

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Merger Strategy

• IA’s role normally very limited• Stay appropriately informed about merger strategy

and current activity• Evaluate the process used in assessing and

managing risk• Advise on systems and processes that could reduce

acquisition risk

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Mergers – What Can go Wrong

• Undiscovered Contracts/Transactions• Unrealistic Expectations (board seats)• Retention of Sr. Execs• Compensation levels• Benefits disparity• Asset quality

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How Can IA’s Role be Expanded

• Stated intention of IA to participate in mergers/other projects• Does management know you want to participate?

• Active participation with the audit/supervisory committee• If strong committee, IA’s value in merger process can be

communicated to management• Share cases of IA positive effect on the merger process

• Impact on financial implications, losses avoided• Change cultural perception

• Is the IA function perceived as value added?• Does it encourage IA input as advisor and consultant?

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How Can IA’s Role be Expanded

• Professional proficiency and experience• Is management convinced that IA has necessary skills

• Annual audit plan• does the audit/supervisory committee support plan flexibility• Allocation of resources for special projects• Ability to timely address requests for assistance and input

• Research and gain good understanding of target CU• Know financial performance and risks

• Always maintaining objectivity• Be sensitive to making management decisions

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Insight. Oversight. Foresight. SM

Questions?

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Thank you

William G. Astrab, CPAShareholder Cell: 540.903.3481Email: [email protected]

Services

• Audit• Mergers &

consolidations• IT assurance

• Vulnerability assessments

• Penetration testing• Member business

loan reviews

• Commercial loan consulting

• Internal audit co-sourcing

• Loan loss & delinquency control systems

• CUSO consulting• Regulatory compliance

mergers & the role of internal audit 19 - session 5... · • develop plans to integrate...

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