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This article is sort of a version of myth busters — and this month I tackle the myth that mortgage companies in the current environment have “no value.” The concept of no value is typically meant to mean that a mortgage origination company is only worth what’s on the balance sheet. That turns out not to be true, based on the number of transactions that have been facilitated by the STRATMOR Group. The other misconception is that the only thing of value on the balance sheet is the servicing — and thus the goal of any lender should be to retain servicing, build up the MSR book (and thus the balance sheet) and then sell at the proper time. While servicing certainly can add value to a mortgage company, it certainly is not the only driver of value. In fact, there are plenty of buyers who prefer to acquire smaller companies that do not have servicing, so that really is not the most important driver. I talked with the STRATMOR team that focuses on M&A and learned some things about the actual valuation process that dispels this myth.
Specifically, there continues to be good deals for potential sellers right now. The reason is that there are a number of active buyers who have a good value proposition to select sellers, remain well capitalized and want to grow market share in a down market. Upfront premiums with solid earn outs are more the norm than the exception. In fact, Garth Graham at STRATMOR commented that the deals they were involved with in the fourth quarter 2022 (and the ones that already closed in January) all had upfront premiums based on buyer/seller alignment and meaningful financial synergies on a combined basis. None of these sellers had any retained servicing on the balance sheet.
Often, the premium being paid is driven by the ability for the buyer to add the seller’s production without having to add all the corporate expense. Meaning that the production being originated by the seller is “worth more” to the buyer than to the seller. This is often driven by the financial synergies. For example, the buyer rarely needs to retain the seller’s corporate administrative functions like HR, Accounting, Tech, Compliance, Risk and Secondary Marketing staff. That shows up on premium offers, meaning that the seller receives a lump sum payment at closing, plus an earnout based on the combined synergies. Plus, the seller gets to liquidate their balance sheet. So, the right deal can be a win-win.
In valuing a company, a potential buyer will look at the seller’s balance sheet, their past financial performance, plus a realistic estimate of the seller’s future performance under the new ownership (with and without potential synergies from the buyer). Then, it’s time to determine the deal structure (asset purchase or a stock deal), closing payment amount, and earnout rate/timeframe. The final price, while always negotiable, is often a combination of net worth as of a certain date and the discounted cash flows for the next three years forecast earnings. Valuations tend to be highly dependent on estimates and forward-looking assumptions, as opposed to historical numbers, since the residential mortgage industry is extraordinarily cyclical with a high degree of earnings volatility. The seller’s lending area, product mix and services, historical financial results, economics and industry outlook, and prospects for the future all certainly factor into the value. This is an overly simplified explanation of the process. A thorough examination of these factors and a review of alternative and comparable deal structures is one of the areas where the value of a competent advisor shows itself.
A few other highlights from my conversation with the STRATMOR team were that the seller’s ability to achieve consistent net income margins and sustained profitability is one of the most compelling value elements. Also, a prospective seller’s government lending share (inclusive of FHA, VA, and USDA loans) is important as it is generally assumed that government originations generate higher revenues and margins than agency conventional loans. But jumbo loans, as most are brokered out, can generate significantly lower revenues and are a drag on earnings. Therefore, a significantly above average jumbo share is generally a negative. Management’s ability to earn respect and appreciation from counterparties, regulators, borrowers and even competitors provide great comfort to a prospective buyer but are viewed as intangibles. Investor “Report Cards” are one source of objective reputation assessment, as is systematic measurement of borrower satisfaction. And lastly, in today’s environment, a mortgage M&A transaction must include buyers and sellers with aligned business models who share similar or same cultures and whose combined structure will include meaningful synergies.
Some of the factors that detract from value include minority ownership, multi-channel operations, a scattered branch network, a high cost/high expense business model, legal liabilities or investor claims and a lending footprint that is predominantly in a high-cost area.
The valuation analysis of a lender can be compared to that of appraising a house. The “Market Approach” is based on market multiples derived from publicly traded companies or actual sales of comparable companies or assets. The “Cost Approach” is based on the value of the underlying assets and liabilities of a business to estimate the equity value of the firm. (This approach, however, is not applicable to a mortgage production company without significant servicing assets). The “Income Approach” is based on the premise that the value of a business depends on its future earnings, discounted at a reasonable discount rate, that is commensurate with the time value of money and the inherent risk of the investment.
On an industry-wide scale, lenders generally rise and fall in value as a group. As one can see, determining the value of a residential lender or vendor is much more complex than taking last year’s earnings and multiplying it by three. Therefore, it is important to have an experienced and knowledgeable advisor, accounting and legal assistance, as well as a good dose of common sense involved in any deal. The industry forecast suggests that consolidation is not only needed, but inevitable. It’s not too late to evaluate all your options.
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