The credit-quality kicker in the Banc of California-Pacific Mercantile deal

Bank mergers are no slam dunk.

A new regulatory filing tied to the pending merger between two West Coast community banks is a reminder that, after an announcement, sellers often have to work quickly to get their houses in order or risk derailing the deal.

When Pacific Mercantile in Costa Mesa, California, agreed to be sold to Banc of California in Santa Ana in late March, it pledged to shore up credit quality before the deal’s expected completion in the third quarter. The company has been able to meet that condition of the $235 million transaction.

The $1.6 billion-asset Pacific Mercantile is required to shore up credit quality by increasing the total amount of shareholders’ equity and the loan-loss allowance above Dec. 31 levels, according to the filing. The company raised that total by nearly 5% in the first quarter to $184.4 million, as an increase in shareholders’ equity offset a slight decline in the allowance. Recoveries of charged off loans also factor into the equation.

The requirement should help the $8 billion-asset Banc of California manage any issues it inherits from Pacific Mercantile. About 13% of Pacific Mercantile’s its loans are in high-risk categories such as entertainment, food services and transportation, according to a recent investor presentation. Classified assets at Pacific Mercantile fell by 30% in the first quarter from the end of 2020 to $63 million.

The stipulation tied to Pacific Mercantile’s shareholders’ equity and its allowance was the product of talks between the companies that began late last year.

Denis Kalscheur, Pacific Mercantile’s chairman, held informal talks with Jared Wolff, Banc of California’s CEO, and the leader of an unnamed bank, in December and January, though no terms were discussed, according to the recent regulatory filing.

Banc of California and Pacific Mercantile agreed to a nondisclosure agreement on Jan. 30 that allowed them to exchange information privately. Two days later, Banc of California sent an all-stock proposal that valued Pacific Mercantile at roughly $200 million, or a 46% premium to its stock price at the time.

The filing noted that James Deutsch, a Pacific Mercantile director, and Kirk Wycoff, who is on Banc of California’s board, abstained from discussions and votes because of their affiliation with Patriot Financial Partners, which owns shares in both companies.

The companies went back and forth on some key matters in early February, including the number of board seats each would get and the nuts and bolts of the allowance requirements. But they were close enough to an agreement on Feb. 4 that they set up a 45-day exclusivity period.

Pacific Mercantile informed the other interested bank that it “was moving in a different strategic direction and would reach out [if it] decided to continue exploring a potential transaction,” the filing said.

Banc of California submitted the initial draft of the merger agreement on Feb. 23. The filing said that the final negotiations, which took place in late February and early March, centered on “certain due diligence matters, including … certain [Pacific Mercantile] credit matters.”

Banc of California’s board approved the merger on March 19. Pacific Mercantile’s board signed off on the deal on March 22. The deal value, boosted by an 18% increase in Banc of California’s share price since its initial offer, priced Pacific Mercantile at 146% of its tangible book value.

Banc of California expects the transaction to be 12.9% accretive to its 2022 earnings per share. It should take about two years for the company to earn back any dilution to its tangible book value.

Banc of California plans to cut about 35% of Pacific Mercantile’s annual noninterest expenses while incurring $18.1 million in merger-related expenses. Two Pacific Mercantile directors will join Banc of California’s board.

“Pacific Mercantile is a strong strategic fit for Banc of California,” Wolff said in a press release announcing the deal. “Their size, business focus, and deposit profile perfectly align with our existing operations, and will accelerate our growth and operating scale in key markets.”

The filing noted that six investment funds collectively own nearly 52% of Pacific Mercantile, including Patriot, with an 11.3% stake, and Fourthstone, which has 10.6% of the company’s outstanding shares.

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