The Federal Reserve's aggressive tightening of monetary policy is altering previously struck bank M&A deals and giving pause to some would-be buyers.

Rapidly rising interest rates have provided some benefits to banks, such as boosting net interest margins, but not all effects are positive. When rates rise, the value of many bonds banks own can drop. This is leading to massive unrealized losses in banks' available-for-sale securities portfolios, which have taken a chunk out of accumulated other comprehensive income, or AOCI, and driven down tangible book values. At the same time, the rate environment is altering merger math as rate marks drive up buyers' tangible book value dilution and earnback periods.

The combination of those two dynamics is proving to be a headwind for M&A.

Unrealized losses

One specific issue buyers are running into during deal discussions is determining a seller's true tangible book value given the rise of unrealized losses in banks' available-for-sale securities portfolios, Matt Resch, managing director and co-head of M&A and capital markets with PNC Financial Institutions Advisory Group, said in an interview.

The deterioration of securities portfolios is a widespread issue, with only 53 U.S. banks posting a year-over-year improvement in AOCI in the second quarter.

Moreover, the U.S. banking industry recorded total AOCI losses of $423.58 billion during the first six months of the year.

Those losses have in turn weighed on banks' tangible book values, with a large majority of U.S. banks posting both quarter-over-quarter and year-over-year declines in adjusted tangible book value in the second quarter.

"We have a number of transactions that we're working on, and that's one of the hot-button issues: How can we get our arms wrapped around what is real tangible book value?" Resch said.

Distorting deal math

The rapidly changing interest rate environment is making it harder to strike deals and also altering deals that were announced prior to the Fed's aggressive rate moves.

For deals announced in late 2021 and early this year, marks on loan portfolios are dramatically different than originally modeled, which is driving up tangible book value dilution and earnback periods, Resch said.

One such example is Home BancShares Inc.'s acquisition of Happy Bancshares Inc., which was announced in September 2021 and closed in April. A prolonged closing period coupled with rapidly rising rates impacted what was once a triple-accretive deal by making it dilutive to tangible book value by 43 cents with an earnback period of 18 months.

The impact of the rate environment on deal math makes M&A less appealing to Home BancShares, its chief executive said on a July 21 earnings call.

"You go to mark that loan book [with] these rates now and that's really going to be pretty disastrous," Chairman, President and CEO Johnny Allison said. "I don't know if M&A can be done."

Communicating with the Street

For banks that do strike deals in the current environment, detailing the impact of rising rates to investors can be a hassle.

"It's an annoyance because it's one more thing to explain," William Burgess, a managing director and co-head of financial services investment banking at Piper Sandler, said in an interview. "You have to explain why the numbers look a little bit different than you would have expected a year or two ago in a normalized rate environment."

Serial acquirer Seacoast Banking Corporation of Florida did just that during a call to discuss its announced acquisition of Professional Holding Corp. The Stuart, Fla.-based company estimated tangible book value dilution of 6.4%, or 4.4% excluding dilution driven by rate marks, and an earnback period of 2.3 years, or two years excluding the impact of rate marks.

Chairman, President and CEO Chuck Shaffer cautioned on the Aug. 8 call that the 2% increase in tangible book value dilution and slight increase in the earnback period is "simply accounting and all of it will be earned back over a short period of time through income and into capital with zero execution risk."

But the explanation for why tangible book value dilution and the earnback period were higher does not change the numbers.

"The cost of [tangible book] dilution in this rate environment is the cost," Compass Point analyst Laurie Hunsicker wrote in an Aug. 9 note where she discussed the transaction. "An added disclosure doesn't change that [tangible book] dilution pain."

On top of the impact of unrealized losses in securities portfolios and rate marks on merger math, the current uncertain environment is also compelling buyers to be extra communicative about things like the target's interest-rate sensitivity and credit exposure, OceanFirst Financial Corp. Chairman and CEO Christopher Maher said in an interview.

The Red Bank, N.J.-based company has struck four deals since 2018, including its currently pending acquisition of Partners Bancorp.

"You start to layer these things on and it's too much noise and too many things to explain," Maher said. "If you have to spend a lot of time explaining why a transaction makes sense, then you're going to lose a lot of people on that just right off the bat."

Some banks blaze ahead

Despite the rising rate environment's impact on deals and the headache of having to explain that impact, some buyers are forging ahead with their M&A strategies. As such, some investment bankers are trying to ease some of the uncertainty.

"We're starting to do loan marks as we're preparing to announce a transaction to get a sense for what the impact could be," Piper Sandler's Burgess said.

In bank M&A, loans are marked to market upon close. Estimating where loan marks could fall prior to announcement is "very unusual" and a practice Burgess has "almost never" done, but now it is "becoming more the norm because you saw what a big difference the rate environment has had on valuations of loans and securities," he said.

Rising rates are not putting a damper on Community Bank System Inc.'s M&A appetite, President and CEO Mark Tryniski said on a July 25 earnings call.

"Rates go up, rates go down," Tryniski said. "The loan marks, the credit marks, the core deposit intangible marks, none of that really makes a difference." Instead, Community Bank System prefers to value a seller based on cash flow, he said.

Provident Financial Services Inc. President and CEO Anthony Labozzetta agreed that though the rate environment and impact to AOCI makes the M&A environment "a lot more noisy … if you had two good banks before, you're going to have two good banks now or [after] the deal," the executive said on the company's July 29 earnings call.

"These things should not get in a way of a good transaction if it's strategic in nature," Labozzetta added. "[But] it might change some of the optics and how the world sees things."