Description

First Horizon Corp is an $8 billion market cap, run-of-the mill merger arb situation with the shares trading at a >40% discount to the offer price…

Ok…it’s not run-of-the-mill, it’s an arb situation on a super-regional bank in the middle of a regional bank crisis where the acquiror has pushed the timeline past the terms of the merger agreement and there’s no regulatory clarity.

Still, I think the situation is interesting with a favorable risk-reward skew.  Under current market conditions, I think there’s ~53% upside to a deal getting completed and ~12% downside if a deal breaks.  However, I think there’s a decent chance this regional banking panic will subside at some point in the coming weeks and the break price will actually be above where the shares are currently trading.

Given macro prognosticating and banking crises seem to be the VIC community’s topics du jour, I will keep this brief as I’m sure many others on this site are much more knowledgeable of the situation than I am.

Business Overview

• First Horizon is a 159 year-old bank, headquartered in Memphis, TN, with $79 billion of assets and 414 branches across 12 states
• Loan book is split 78% / 22% Commercial vs. Consumer.  Within Commercial, the split is 71% C&I, 29% CRE.  Consumer portfolio is 94% mortgages, 6% credit card & other
• The loan book skews heavily towards Tennessee, Florida, Texas, North Carolina, Georgia (i.e. all regions with significant population tailwinds) and Louisiana
• 82% loan-to-deposit ratio
• Deposit mix is 33% savings, 4% time deposits, 27% other interest-bearing and 36% demand deposit accounts
• FHN has very strong deposit market shares in Tennessee (Memphis, Chattanooga, Knoxville and to a lesser extent Nashville) and Louisiana (Lafayette).  Smaller market shares in Florida and the Carolinas
• 10.2% common equity tier 1 ratio, 13.3% total capital ratio
• The company has generated a 17.0% return on average tangible equity over the past three years

Background / Timeline of Events

• On February 28, 2022, TD Bank Group announced they would acquire First Horizon for $25.00/share ($13.4 billion) in cash, plus a ticking fee equal to $0.054/share per month starting nine months after deal signing and up to closing.  FHN dividends of $0.15/quarter would continue to be paid out until closing
  • As part of the transaction, FHN issued $494 million of Series G perpetual preferred stock to TD Bank Group
    • First Horizon management are using ~$150m of the proceeds for employee incentives and retention
  • TD as part of the transaction is donating $40 million to the First Horizon Foundation, serving local communities
• Pro Forma for the transaction, TD Bank would become the sixth largest bank in the U.S.
• Termination fee of $436 million payable by First Horizon upon termination of the merger agreement under certain circumstances

• On February 10, 2023, TD and FHN announced that they have mutually agreed to extend the outside date of their proposed transaction from February 27 to May 27, 2023, in accordance with the terms of the merger agreement
  • From the press release issued: “TD and First Horizon are fully committed to the merger and continue to make significant progress in planning for the closing and the integration of the companies. Shareholders of First Horizon have voted overwhelmingly to approve the transaction, and progress is being made on a Community Benefits Plan in support of local communities across the TD and First Horizon footprints in the U.S.”

• FHN filed its 10-K on March 1, 2023, where they noted:
  • On February 9, 2023, FHN and TD agreed to extend the outside date to May 27, 2023. Subsequent to the extension, TD recently informed FHN that TD does not expect that the necessary regulatory approvals will be received in time to complete the Pending TD Merger by May 27, 2023, and that TD cannot provide a new projected closing date at this time. TD has initiated discussions with FHN regarding a potential further extension of the outside date. 

Neither TD nor FHN have commented to the market the reason for the delay, which is what is likely weighing on the spread.  Analysts have speculated it could be related to AML or TLAC issues, or that the OCC can’t approve the CBP until new CRA (Community Reinvestment Act) rules are put in place.

Will the deal close?  Will it get recut?

For a number of reasons cited below, I think the deal overall will likely still close.  But given that it will last past the May 27th expiration of the merger agreement, I think it’s fairly likely that the deal will be “recut” in some way.  Given no fundamental change on FHN’s part, combined with TD’s public enthusiasm for the deal, I think any recut will not match the recent decline in the regional bank index.  In my simplistic analysis below, I’m assuming a removal of the ticking fee and a 10% hit to the original cash consideration.

Reasons why it still seems likely a deal will be completed:

• For TD, look at the map below.  FHN is a perfectly complementary footprint and this whole crisis hasn’t changed the strategic rationale at all
  • TD’s footprint is primarily in the Northeast, Mid-Atlantic, Metro D.C. and the Carolinas
  • Look at the stock charts at KRC and VNO (proxies for San Fran and NYC commercial real estate, respectively).  I would think the Southeast is where you want to be if you’re slowly building out a U.S. national bank franchise
  • For FHN, the CEO is slated to become Vice Chair of TD Bank U.S., which has to have a nice ring to it for a banking exec sitting in Memphis watching a regional bank crisis unfold

• TD on their March 3rd earnings call: 
  • We've opened discussions with First Horizon about a potential additional extension. I cannot speculate on when we will receive approval. I can tell you that we are fully committed to the transaction. We have a robust community benefits plan in place with broad community support across our combined footprint and our teams have made progress on integration plans. This is a great transaction that offers scale and new capabilities to our U.S. franchise
  • TD noted at a March 7th conference noted they’re still “very committed” to the transaction and are “working really hard to get the deal closing as soon as possible”
• Analysts at merger arb funds note a number of other anecdotes that suggest TD and FHN are committed (e.g. continued integration efforts between FHN and TD, TD execs at FHN offsites, etc.)
• While this administration might not love the idea of bigger banks buying smaller banks, allowing this deal to go through seems like a no-brainer given the current banking backdrop

Below, I attempt to sketch out a base case “risk-reward” based on where I think the PF deal price is today.  Obviously things are quite fluid in the U.S. regional banking space, banks are inherently fragile, etc., so take with a grain of salt.  

Isn’t there a run on the deposits at all regional banks?

• FHN’s management claim it’s business as usual
• FHN’s uninsured deposits are roughly in line with national and super-regional bank peers at 48% of total
• Mapping against some of the more problematic regional banks, there doesn’t look to be much depositor flight going on at FHN:

But if you mark-to-market their treasuries/MBS holdings…?

FHN does not have a huge held-to-maturity securities portfolio.  As of December 31, 2022, the balance sheet had $1.371 billion of securities held to maturity, where the fair value was $1.209 billion.  Knocking this difference off of their equity would translate into a 9.9% CET1 Ratio and a 13.1% total capital ratio.

I’d also note that the 10-year has gone from yielding 3.88% at the start of the year—and ~4.0% before the SIVB bank run— to 3.40% today.  Yet for some reason I haven’t heard any bank analysts starting to talk about the massive tailwind for banks from AFS AOCI gains…

Hedging Considerations / Risk Management

I was originally going to post this as a way of taking advantage of the market panic, with the idea that it wouldn’t take all that much for U.S. regulators (and perhaps Warren Buffett) to instill some confidence in the U.S. banking sector.  After all, most banking panics don’t occur when banks are 1) generally well-capitalized (as they are in the U.S.), 2) loan-to-deposit ratios are sitting at lows, 3) loan books are generally in good shape with low credit losses.

However, the potential for European bank contagion- where banks are more thinly capitalized, the regulators are even less competent and their sovereign collateral is potentially even more “toxic”- isn’t a helpful development.

I think this trade still works if one decides to hedge or partially hedge a basket of super-regional bank peers.

Otherwise I think it’s prudent to manage risk here through position-sizing.

If interested, I’d point people to the event driven desk at Raymond James, who have done a lot of good work on this situation.

Appendix

Key Risks:

• Incompetence of U.S. regulators
• Continued bank runs

Catalyst

• Clarity on timing of a potential deal-closing