Was a Canadian LaSalle deal possible?

Mandarins mangle merger math

In the weeks that have passed since the federal budget came down, public commentators have joined the ever-growing group that is opposed to the removal of the deductibility of interest paid for foreign acquisitions.

Just yesterday, Andy Willis put his new forum and format to great use, with this analysis:

American banks, as you may have noticed, are changing hands at a fair clip. Today saw Bank of America table a $21-billion (U.S.) offer for LaSalle Bank, the No. 2 player in the Midwest. This was a branch network Bank of Montreal would love to own.

Earlier this year, the action was in the south, where Spain’s Banco Bilbao Vizcaya Argentaria SA agreed to pay $10-billion for Compass Bancshares, which has branches in both Alabama and Texas. This bank would be a neat fit with Royal Bank’s U.S. retail operations, which are crying out for greater scale

Going forward, any domestic bank trying to finance one of these big U.S. acquisition must do so with an eye towards the tax implications on foreign borrowing contained in Finance Minister Jim Flaherty’s March budget. That’s the measure that shocked big business by stipulating that Canadian companies borrowing money to finance foreign deals will no longer be able to deduct the interest costs against their Canadian income.

The locals have crunched the numbers, and figure that Bank of America and the Spanish bank enjoyed a cost of capital that’s up to 15-per-cent lower than a Canadian bank’s. In finance terms, that means running a 100 metre dash against a sprinter with a 15 metre head start. Canadian banks aren’t going to win many of these races – they’re not going to buy quality assets such as LaSalle and Compass. If they do win, they face far larger challenges in making deals pay off for shareholders.

Now, I think LaSalle went to a U.S. buyer as the purchase price of US$21 billion is too much for a Canadian bank to swallow. The market caps for BMO and CIBC are about US$31.7 billion and US$29.5 billion respectively. I’m all for a big deal, but those numbers are a tad impractical.

Nevertheless, for a simple analysis, imagine that BMO had acquired LaSalle for US$21 billion, and financed just 25% of the purchase price with debt (US$5.25B). Had they issued a flurry of paper at, say, LIBOR (a so-so rate) to do it, the annual interest cost would have been about US$285 million. At a 34.9% tax rate, the implied deduction would have been US$99.5 million. Now, LaSalle did about US$1.034 billion in earnings last year (B of A paid 20.3x 2006 earnings), so the Canadian bank’s ability to write off that US$99.5 million in interest makes all the difference in the world, given the quantum of the deduction as compared to the incremental pre-synergy earnings.

And since BMO is trading at 14.2x 2006 eps, doing a LaSalle deal at 20x is likely awfully dilutive even with massive synergies. But the tax piece must make it impossible.

I’m all for the Department of Finance closing the Hungarian shell game that has allowed Canadian firms to drop their actual tax rates by meaningful amounts, but the rules must certainly be able to be drafted to allow a Canadian bank, for example, to acquire a U.S. one without having their hands tied behind their backs. But wouldn’t it be easier to just send a stern memo to the Canadian accounting firms and tell them to cease and desist? They’re the ones structuring these vehicles, after all.

See our earlier pieces “You’ve got to be kidding“, “Globe reads blogs part 2“, “FP reads blogs and competition part 2” and the “Friday interview with Martin Langlois“.

MRM