| Strategists
or Lemmings?
By Thomas K. Brown
Bank M&A activity is driven
by both rational and irrational factors. Smart deal-makers
learn how to tell the difference.
Consolidation in the banking industry
is a force that won't be denied. One has only to look
at the torrent of mega-deals announced so far this year:
Citicorp/Travelers Group; NationsBank Corp./BankAmerica
Corp.; Banc One Corp. and First Chicago/NBD Corp.; and
Norwest Corp./ Wells Fargo & Co.
This phenomenon has both a rational
and an irrational side. Rational forces pushing consolidation
include the gradual deregulation of the industry that
has occurred since the mid-1970s. No longer protected
by artificial geographic barriers, banks now have to compete
in an open market where only the strongest survive. The
current low level of interest rates coupled with an unprecedented
bull market in bank stocks has also enabled acquirers
to justify prices and premiums that would be deemed excessive
in a higher rate environment.
But irrational forces also play a role.
Chief among them is "group think," or the tendency
of managers to follow like lemmings whenever a peer company
announces another blockbuster transaction. Much of what
passes for strategy in the industry is simply a game of,
"Can you top this?" Underlying this group think
are some flawed theories, most notably the idea that bigger
is better and that consumers want to satisfy all their
financial services needs through a single provider. Mountains
of empirical evidence exist to refute both theories, which
suggests that some recent deals are proceeding under false
assumptions.
The challenge for senior managers is
to parse through their own thinking and separate out sensible
motivations from the irrational ones. They need to make
sure they're doing deals for the right reasons. The distinction
is important. Study after study has shown that most acquisitions
fail to create value for the acquirer's shareholders.
After examining deals that occurred in this decade, Mitchell
Madison Group principal Kenneth Smith concluded, "The
majority of the 1990-95 bank mergers were at best a wash
and at worst a keen disappointment, an apparent triumph
of managerial adrenaline over management intelligence."
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Whatever the player motivation, this
deal-making is likely to continue into the foreseeable
future. Consider the activity so far this year. While
the aggregate value of transactions is unprecedented --
over $250 billion --the number of deals on an annualized
basis is pretty much in line with each of the last five
years. This suggests consolidation is occurring as part
of a steady, long-term trend, which one can date back
to the lifting of interstate barriers in 1985.
I believe, in fact, that this trend
could span another two decades. Despite what seems like
-- and has been -- incredible consolidation since 1985,
the U.S. still has more than twice as many banks per capita
as the average of other industrialized nations. The process
of consolidation has a long way yet to go.
Darwinian
Banking
By far the most important factor driving
consolidation, albeit often forgotten, is the gradual
deregulation of the banking industry that has been occurring
since the mid-1970s. The heavy federal and state regulation
of previous decades had created an inefficient, closed-loop
banking system.
Innovations such as the development
of the commercial paper market and increased competition
from less regulated players like mutual funds finally
opened the doors to product and geographic deregulation.
The loosening of geographic restrictions produced national
bank ownership and branching.
Heavy regulation had acted as a shield
to protect many inefficient and poorly managed organizations.
Now, in a deregulated environment, those companies became
prey to stronger ones, a process securities analyst Dick
Fredericks has termed "Darwinian Banking." Some
of the transactions announced this year, such as Star
Banc Corp.'s takeover of Firstar Corp., can be viewed
as the strong taking over the weak.
Many acquirees are also influenced
to sell by the high absolute levels of their stock prices,
price/earnings ratios, and price/book multiples. Bank
stocks have enjoyed a once-in-a-lifetime sector bull market
within the context of an unprecedented bull market for
U.S. equities in general. Some sellers are heavily influenced
by the belief that "it just doesn't get any better
than this." Ironically, this belief first took hold
five years ago, yet bank stocks have continued trading
higher ever since.
Critical to this process has been the
historic decline in interest rates over the last 18 years,
and the last three years in particular, lowering the risk-free
rate of return and the cost of capital for acquisitions.
With lower hurdle rates of return for acquirers come high
purchase prices.
The range of p/e multiples has also
widened among individual banks. Historically, the range
among banking companies was incredibly narrow. Only a
few earned valuations outside the pack as investors perceived
little differences in growth rates. That has now changed
dramatically. Back in 1984, a five-multiple gap existed
between the highest bank p/e and the lowest; that gap
has since expanded to 15 multiple points.
Such a wide range of multiples gives
those at the high end, such as Star Banc and Fifth Third
Bancorp, a tremendous currency advantage. They can offer
a large enough premium to the target to encourage a sale
while not diluting their own earnings. Star Banc, for
example, acquired Firstar -- a bank of essentially the
same asset size --by offering a 40% premium to Firstar's
current market price. Despite the large premium, Star
Banc was essentially swapping its currency for 21.4 times
Firstar's 1999 earnings stream. Assuming only modest improvements
in Firstar's underperforming franchise, this will produce
accretion to Star Banc's earnings and improved shareholder
value for both companies.
Acquisitions can also return value if
they are used to obtain or improve a specific skill set
or product capability. Banc One acquired First USA not
just for its credit card business, but also for its expertise
in information-based marketing. Numerous banks have bought
investment banks over the past year largely to obtain
equity underwriting skills. Globalization carries that
process a step further. Acquisitions that enhance the
global capacities of buyers can also build significant
shareholder value, which is clearly the motivation behind
the Citicorp/Travelers merger. There is no question that
the Information Age is leading to "the death of distance,"
with the result that bank customers have more need for
international banking services.
Finally, management succession can drive
consolidation in a logical way. With the financial services
business in the midst of revolutionary change, the management
skills required are quite different from those used in
the past. Some banks are motivated to sell when they reach
a succession inflection point and recognize their own
deficiencies in this area.
Such are the reasonable motives for
participating in deals. There are also a number of irrational
factors at work that influence decisions to buy or sell.
Many of these involve theories that are often accepted
as fact but fail to stand up to a rigorous analysis.
Chief among these is the notion that
increasing size is essential for achieving economies of
scale. NationsBank president Ken Lewis, who will run the
nation's largest retail banking franchise following the
merger of NationsBank and BankAmerica, said last year,
"I cannot overemphasize the importance of sheer size
and scale in today's environment." Meanwhile, UBS
banking analyst Tom Hanley wrote a report asserting that
while asset size "does not guarantee success, it
nevertheless brings scale advantages and the ability to
leverage the enormous technology investment requirements
that will be necessary in order to compete longer term."
These are bright and experienced individuals.
But they are simply dead wrong! In no industrialized nation
can you find any strong positive correlation between bank
asset size and profitability/growth rates. The evidence,
in fact, points in the other direction, as explained in
an article on bank size and technology published last
year in the Journal of Retail
Banking Services. "Our study shows that although
there are some significant differences between large,
medium and small banks in their use of Information Services
and Information Technology, creative thinking and careful
planning are the key ingredients to success, regardless
of bank size," wrote authors Uma Gupta and William
Collins.
While economies of scale do exist in
banking, I believe that the diseconomies of management
scale more than offset the economies of processing scale.
As organizations expand their geographic range and product
complexity, they inevitably become more difficult to manage.
Their ability to adapt to market conditions also becomes
impaired.
Managers who believe in the virtues
of bigness like to flog the "convergence" theme,
the idea that consumers want to satisfy all their financial
services needs through a single provider. Citicorp cited
this as a rationale for its announced merger with Travelers,
commenting in an internal publication, "The principal
reason for the merger is to create a company that can
provide the broad financial services and products that
are increasingly needed by customers all over the world."
Unfortunately, increasing product breadth as a strategy
to generate high profitability and faster growth flies
in the face of experience, both within and outside the
financial services industry.
Superficially, the concept of convergence
seems to make sense. Some customers may indeed desire
one-stop shopping. But the actions of most consumers suggest
otherwise. Nigel Morris, president of Capital One Financial
Corp., recently noted that the average consumer patronized
eight financial services providers in 1996, up from four
in 1993. Far from consolidating their range of financial
relationships, consumers are actually expanding them!
They apparently don't believe any one financial institution
offers the best deal across a broad product line.
It is often stated as a truism that
increased diversification is positive for shareholders.
The flip side of this idea is that concentration, whether
by industry or geography, is bad for banks. Like much
conventional wisdom, this prejudice doesn't hold up to
close examination. If you look, for example, at the commercial
real estate lending crisis of the late '80s and early
'90s, you'll find that Wells Fargo had the highest exposure
to that market of any top 50 bank. But few suffered a
lower level of losses as a percentage of exposure than
Wells. It wasn't the absolute level of exposure that caused
loan problems as much as it was the poor credit decisions
made by lenders.
Intel CEO Andy Grove has a wise comment
on the illusory virtues of diversification. "I'd
rather," Grove said, "have all my eggs in one
basket and spend time worrying about whether that's the
right basket than try to put one egg in every basket."
That comment could be applied to banking as well as computer chips.
Napoleonic
Complex
In analyzing bank mergers, one should
never overlook the purely subjective motivations that
often affect the judgment of senior managers. The pressure
of group think, ego flexing, and a fixation on survival
all play a role in deals.
Group think in this context starts with
the belief that the consolidated banking industry will
take on a barbell shape, with some very large companies
at one end and some small ones at the other, but few in
the middle. Group think instructs executives that being
trapped in the middle is to perish. Consequently, the
pressure is on to grow through acquisition, regardless
of price and integration risk. Obviously, this message
hasn't percolated through to Fifth Third and other successful
banks in the mid-size category. They have demonstrated
convincingly that it is possible to manage a bank successfully
and provide stellar returns without growing assets faster
than your peers.
On the other hand, there's no ignoring
the fact that acquisitions can be exhilarating and personally
satisfying to the CEO. He gets to run a larger company,
after all, which beats the tedium of managing a rapidly
changing business day-to-day.
Here's a modest proposal for suppressing
this ego/ boredom factor: CEOs should be held to 10-year
term limits. Such an innovation might go far toward eliminating
the Napoleonic complex in banking. Is it just a coincidence
that the CEOs of the most voracious acquirers have been
in their positions for over 10 years? The longer most
mortals function as CEO, it seems, the more interested
they become in the trappings of power and the pursuit
of acquisitions.
Also in need of suppression is the
idea that survival equals success and that the way to
survive is to do more acquisitions. CEOs and board members
sometimes forget that their primary responsibility is
to make decisions that will enhance long-term shareholder
value rather than benefit employees and themselves. Would
most shareholders rather own the bank that's going to
be the biggest in 10 years or the one that will provide
the highest return? The late Roberto Goizueta of Coca-Cola
certainly never forgot his primary mission. "A publicly
traded company," Goizueta said, "exists for
one purpose and one purpose only: to increase shareholder
value. If it does that, all other good things will follow."
Many bank CEOs trying to survive today's
frenzied M&A scene could profit from Goizueta's advice.
Mr. Brown
is managing director with Tiger Management, a New York-based
hedge fund.
Copyright © 2003 by Banking
Strategies, published by BAI.
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