As many banks' M&A interest remains frozen by the interest rate environment and recent industry tumult, credit unions' appetite for deals with banks is unthawing.

Harborstone CU's planned acquisition of Seattle-based First Sound Bank marks the fifth such deal this year, lagging 2022's record of 16 such M&A announcements. However, that activity has picked up recently with three announcements in the span of two months. Credit union acquisitions by banks make up 9% of all US bank deal activity so far in the year.

The latest deal, which was motivated by an attractive price tag for the seller and geographic expansion for the buyer, used a unique equity provision to overcome current mark-to-market hurdles.

Price tag

First Sound Bank was set to be acquired by BM Technologies Inc. in an all-cash deal for about $7.22 per share, but that transaction fell apart in December 2022 after facing regulatory hurdles. Banks began calling and expressing interest in a new deal shortly after the termination was announced, although the spring industry tumult that led to three regional bank failures also dried up bank M&A discussions completely, President and CEO Marty Steele said in an interview.

"Everybody got spooked," Steele said. "The state of the market right now for bank M&A is terrible. I think the only reason that I had interest is because of scarcity value."

There are currently 14 banks with less than $10 billion in assets headquartered in the Seattle-Tacoma-Bellevue, Wash., metropolitan statistical area, according to S&P Global Market Intelligence data. Nine of those have less than $1 billion in assets.

Harborstone CU was not spooked, and when it made an unsolicited offer, it was too good to pass up, Steele said.

First Sound Bank shareholders will receive about $6.90 to $7.10 per share in cash. The $22.4 million deal values First Sound Bank at 150.96% of tangible common equity, above the median of 135.19% for US bank deals so far this year, according to Market Intelligence data.

Credit unions must pay cash when acquiring banks because they do not have stock. An all-cash deal was attractive to First Sound Bank because it "removes the risk from the shareholders of having to get stock," Steele said.

Many factors go into the price a credit union can pay to acquire a bank. Sometimes, credit unions' tax-exempt status allows them to pay a higher price than another bank could. But an issue of "double taxation" also plays into the higher prices because if a bank is structured as a C-corporation, the deal will be taxed twice — once at the corporate level and again at the shareholder level.

Traditional bank M&A deals are typically structured as a sale of stock, avoiding the double taxation. The double taxation issue is "always a factor" in credit union deals, Steele said.

In an interview with Market Intelligence, Harborstone CU President and CEO Geoff Bullock said the price was based entirely on First Sound Bank's projected forward earnings.

The price is "comparable to building a branch in Seattle, but imagine you're building a branch that already has $175 million of deposits in it and a really robust loan portfolio," Bullock said. "It's a home run."

Equity provision

The ultimate price that First Sound Bank shareholders will receive depends on the bank's equity value at closing.

Though First Sound Bank managed its investments and loans "very well," the inclusion of the provision was motivated primarily by the interest rate environment, said Charley McQueen, president and CEO of McQueen Financial Advisors, which was financial adviser to Harborstone CU on the transaction.

"When we're looking at a lot of transactions today, we've come across people who've made some really, really bad decisions in investments, and made some really bad decisions on portfolio and [have] huge amounts of 30-year mortgages at 2.75%, 3%. So it's nice when we come across a bank like this that made good decisions and makes this process much easier," McQueen said.

However, given widespread industry concerns over unrealized losses on securities portfolios, "everyone in the transaction felt that this would be a fair way to make sure that both sides came out of the combination in a very good spot to continue to succeed and grow," McQueen added.

McQueen said many more transactions will have similar provisions moving forward. Financial institutions have increasingly been using this less common provision to overcome mark-to-market hurdles.

Steele described the provision, which the two CEOs decided to include together, as a "win-win."

"It was an incentive for me to build some capital between now and closing" through earnings or raising capital, Steele said. "If I can do that, the credit union gets more capital at closing and my shareholders get more."

Bullock also described the provision as beneficial to both institutions.

"We don't want it to be a situation where [First Sound Bank] can have huge success through the end of the year, and they're not rewarded for it," he said. "We know that they are a really well-run bank. ... We do want to give space for them to overperform and incentivize finishing strong."

Strategic rationale

Deepening Harborstone CU's presence in Seattle, where it sees "overwhelming opportunity," was the main strategic driver of the transaction, Bullock said.

First Sound Bank's expertise in various lending segments, particularly small business administration (SBA) lending, was also attractive.

"It's incredibly competitive to find talented small business lenders, especially SBA experts, and that is such a unique niche," Bullock said. "So to have one of the best small business lending teams in our entire market join up with us, it feels like a really big win."

For First Sound Bank, which is structured like a private bank in that it has one branch in a high-rise building and caters to small businesses and high net worth individuals, Harborstone CU's commitment to the bank's existing market and lending verticals was attractive.

"They have a desire to expand into my market, which is Seattle metropolitan area. And they have a desire to get more heavily involved in commercial and private banking, which is what I do. And so instead of me getting kind of merged into their business model, they want to expand into my business model," Steele said.

Second time around

Only one other credit union-bank deal has been announced in the Evergreen State since 2015 — Sound CU's acquisition of Bank of Washington in 2019. Steele was also the president and CEO of Bank of Washington, making the Harborstone CU deal his second time selling a bank to a credit union.

Harborstone CU hopes to strike more bank deals in the future.

"It's just another way to grow and to be competitive in a very competitive market," Bullock said.