By Jeff Babcock and Jim Cameron February 2017
STRATMOR’s early discussions with the shareholders of First Priority Financial began in the Fall of 2015. To accomplish their growth aspirations, Mike and Dave Soldati initially asked about their prospects for acquiring a small mortgage bank as an alternative to recruiting more LOs. Much to our surprise, the conversation reversed course to a discussion of First Priority’s marketability and value as a potential seller.
After a somewhat dismal 2014, origination market conditions throughout 2015 had improved nicely to the point that midsize Independent mortgage bankers were enjoying their best year since the remarkable 2012 boom market. Consequently, there were relatively few M&A transactions consummated that could serve as good comparables to help prospective sellers, such as the Soldatis, calibrate their respective opportunity.
Fast forward to mid-2016 when Caliber Home Loans completed their acquisition of First Priority. This deal, along with several other transactions in the STRATMOR pipeline, now enable us to confidently provide tangible guidelines as to those characteristics that contribute positively to enterprise value versus those that materially detract from a lender’s value and marketability. We have, through the process of representing selective sellers in recent transactions, acquired first-hand knowledge of those characteristics which are most critical in determining premium values.
STRATMOR’s recent experience absolutely confirms that there are still many more motivated, well- capitalized buyers for retail origination platforms than there are such entities available for sale. It continues to be a true “sellers’ market” for mid-size Independents. The challenge for prospective sellers is not just attracting a buyer, aligning with the right buyer to optimize the sale execution of their company.
Accomplishing this is not a passive activity. Quite the contrary, we believe that selling shareholders can (and should) proactively position their organization to strategically fit with the most motivated buyers — and thereby realize the level of economic value which reasonably satisfies their financial expectations.
In our recent representation of two high-performing sellers, we learned first-hand that highly competitive bids from multiple bidders will be realized where the seller scores high on the following quantitative and qualitative criteria.
Sustained Profitability. Management’s ability to achieve consistent Net Income margins is one of the most compelling value elements. By consistent, we mean profitability which is not simply linked to origination market conditions with wide variances between good years and bad years.
The best performance benchmark is the MBA and STRATMOR Peer Group Roundtable (“PGR”) program for the middle-market Independent mortgage bankers in the Retail production channel. In this context, Net Income margin is defined as the channel profitability including all allocated expenses.
Margin consistency says all kinds of good things about management, including pricing discipline, expense control, etc.
Product Mix. For obvious reasons, today’s buyers are focused on (sometimes even obsessed with) a seller’s purchase business share — but not just for the last six months. A consistently above-average purchase share demonstrates management’s commitment to building and maintaining referral sources over several years. There is a sense that where this is the case, a lender’s sales force will not revert to refinance volume when there is a mini interest rate rally. A strong purchase business culture eliminates some of volatility in the inherently cyclical mortgage business.
The next most impactful element of product mix is a prospective seller’s government lending share (inclusive of FHA, VA and USDA loans). It is generally assumed that government originations generate higher revenues and margins than agency conventional loans. The PGR average government share for midsize Independents has been 40 percent for 2014/2015.
Another consideration is the share of jumbo originations. In contrast with government products, jumbo loans generate significantly lower revenues and are a drag on earnings. The PGR jumbo average for mid-size Independents is four percent. Obviously, therefore, a significantly above average jumbo share is generally a negative.
Model Match and Cultural Compatibility. These two concepts are thrown about loosely in M&A discussions, but they are both absolutely critical to the success of an acquisition. Model match refers to the fundamental style of doing business — branch network composition, originator compensation structure, product focus, mortgage banking disciplines, etc.
Corporate culture is all about the effectiveness by which a lender deploys and manages its human capital. An assessment of culture typically includes corporate values, leadership style, strategic direction, management effectiveness, communications, accountability, etc. While no two organizational cultures will be exactly alike, they must be compatible. The history of mortgage banking M&A is littered with examples of failed transactions which resulted from culture clashes, many of which were probably avoidable if the parties made cultural considerations a higher priority.
Compliant Originator Compensation Plans. This topic has assumed greater significance with the advent of Dodd-Frank and is often among the first questions from a prospective buyer. Within this context, compliant means uniform commission structures based entirely on volume with as few variations as possible. Any commission arrangement that is tied to revenue levels is a doubtful plan. Incentive compensation will also be reviewed in terms of possible exposure to Fair Lending violations. Bank buyers are particularly sensitive to these issues given the strategic importance of “reputation” and “trust” across virtually all Bank operations.
Buyers also expressly prefer that a prospective seller has completed its transition of originators to a non-exempt status such that they are eligible for minimum wage and overtime compensation.
More generally, changes to lender compensation plans — especially changes to sales compensation — should be enacted prior to an acquisition so that the seller’s staff does not perceive that such changes were implemented as part of the sale or initiated by the buyer. Where the buyer must initiate compensation changes, it introduces uncertainties that are likely to detract from value.
Sales Force Quality. In every mortgage company sale, the primary asset being acquired is the origination capacity, quality and loyalty of the lender’s field sales force. Sales force quality is typically measured in terms of productivity, tenure/ turnover, age and concentration. A detailed analysis of a lender’s production performance provides an analytical assessment of sales management effectiveness (recruitment, training, motivation, retention).
At STRATMOR, we accomplish this assessment by segmenting a client lender’s sales force into quintiles based on performance and then compare the metrics against the industry population using our Originator Census® benchmarking survey tool.
Since the top 40 percent of originators typically account for about 80 percent of total production, it is insightful to focus on these performers. For example, in a recent sell-side engagement, the client’s top two originator deciles closed an average of 7 loans per month, had tenure of 5.6 years, were 46 years old and experienced virtually no turnover.
All this client’s turnover occurred in to the bottom 40 percent of loan officers. And, since Originator Census® data differentiates between voluntary and involuntary terminations, we can glean a sense of how proactive a lender is in clearing out low producers. Originator Census® data also allows us to consider the ethnic and gender composition of a given lender’s sales force. From a buyer’s perspective, all of these originator segmentations and benchmarking comparisons with other lenders provides an objective picture of the seller’s ability to achieve a production forecast.
Management Effectiveness and Tenure. Although subjective in nature, there appears to be a correlation between management effectiveness/tenure and financial performance ranking among PGR participants. For example, management effectiveness should be assessed in terms of leadership, strategic planning, employee satisfaction, accountability and communications. Does the subject company bring a history of adapting to change, innovation, creative utilization of technology, dependable management reporting and cost controls? Mortgage banking is a people business where 80 percent of expenses are related to compensation. Management’s ability to leverage its human capital is therefore an indispensable skill.
Production Momentum. Management’s track record in improving market share is the best measure of production momentum. Whenever feasible, STRATMOR encourages clients to seek out local or regional market share reports. A prospective seller that can demonstrate a consistent ability to gain market share, irrespective of the industry cycle, is more valuable than lenders whose volume tracks with the industry trends.
Company Reputation. Management’s ability to earn respect and appreciation from counterparties, regulators, borrowers and even competitors provides great comfort to a prospective buyer. Investor Report Cards are one source of objective reputation assessment. Systematic measurement of borrower satisfaction, e.g., STRATMOR’s MortgageSAT Borrower Satisfaction program, and management’s use of such insightful information are another indicator of a management team that listens and responds to the market.
Go-Forward Management Roles. Inasmuch as a key element of an acquisition’s economics comes from eliminating redundant overhead and support functions, the enthusiastic commitment to such actions by key seller executives, who are most responsible for holding together the seller’s production organization, is a critical deal point.
In our role of transaction advisor in dozens of mortgage company sales in recent years, we have observed certain seller characteristics which are often perceived as unfavorable. These practices tend to deter buyers, thereby reducing a seller’s marketability, and detract from a given seller’s enterprise value.
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