Pub. 5 2015-2016 Issue 3

O V E R A C E N T U R Y : B U I L D I N G B E T T E R B A N K S - H E L P I N G C O L O R A D A N S R E A L I Z E D R E A M S November • December 2015 17 In the pre-recession world, the due diligence process of reviewing a target’s loans and loan classification system was a critical part of an acquisition. Historically, this allowed the acquirer to impose its asset quality discipline on the target and make adjustments to the final purchase price for improperly classified loans. The recession disproved the validity of this historical method. Classification systems based on historical performance are no longer reliable because history is no longer a predictor of future economic events or their magnitude. The loan review process is still an important exercise in evaluating the present condition of a bank's assets, but it cannot be used to estimate future performance under diverse economic conditions. Under the new economic environment, monetary policy and regulatory response, extrapolating loan review/loan classification analysis to the future will provide misleading answers. The only proper way to gauge the pro forma performance of an acquired portfolio involves a detailed evaluation of loan vintage. Identically classified loans of different vintages will have different risk criteria. Every banker knows that collateralized loans made during depressed real estate prices have very good loan-to-asset values, while identically classified loans made during real estate booms have questionable loan-to-asset values. Yet under existing loan review processes, two ostensibly identical performing loans with the same loan-to-asset value on the books are treated the same, irrespective of their vintag- es. The false comfort from a detailed loan review process will not only skew the purchase price in the wrong direction, but it will also create potential performance issues under changing economic conditions. The post-recession era has been dominated by an "unnat- ural" rate environment, due to a monetary policy designed to deal with the global recession. This rate environment has had a substantial impact on bank portfolio yields. Interest rates artifi- cially controlled by monetary policy have created periods of low yielding loans across different loan categories. Different rates of loan growth during these time periods have in turn created different loan yieldmixes in bank portfolios. These varying rates of growth, coupled with different maturities established during these periods, have substantially affected loan portfolio yields. Audited financial statements, loan reviews and other out- dated analytics cannot quantify and segregate these parcels of loans with unique maturities and yields, which are driven by loan growth rates during different periods. The only tool for quantifying this critical information is a vintage or origination analysis of a target's portfolio. Relying on average return on assets or even marginal return on assets is a formula for mis- information. Two banks with identical average return on assets could have radically different actual pro forma performance. These areas reflect a few of the more common and serious flaws in present-day M&A analytics. While the short-term im- pact of these analytical deficiencies might seem negligible, and perhaps even offset by the perceived success of a transaction, many acquirers and their shareholders will pay the price in the intermediate and long term.  Kamal Mustafa, the former head of global M&A at Citibank, is the chairman and CEO of Invictus Consulting Group.