Acquisitions and Mergers in Financial Services Management: Trends and Motives

1. Chapter Nineteen Acquisitions and Mergers in Financial- Services Management

2. Key Topics • Merger Trends in the United States and Abroad • Motives for Merger • Selecting a Suitable Merger Partner • U.S. and European Merger Rules • Making a Merger Successful • Research on Merger Motives and Outcomes

3. Introduction • A globe wave of mergers involving banks, securities firms, insurance companies, and other financial-service providers has been under way • Reflects the great forces of consolidation and convergence that are dramatically reshaping the financial-services industry • This trend is driven by • Intense competition • Deregulation • The search for the optimal size financial-services organization

4. Mergers on the Rise • Many of the mergers sweeping through the banking industry reflect lower legal barriers that previously prohibited or restricted expansion • For example, in the U.S., the Riegle-Neal Interstate Banking Act of 1994 and the Gramm-Leach-Bliley (GLB) Act of 1999 • The GLB law opened wide the arena for bank–nonbank financial-service combinations • Permits banks, insurance companies, and security firms to acquire each other • Critics of the GLB law argue that while GLB may result in reducing U.S. financial firms’ risk exposure, it does not appear to hold great promise for major improvements in operating efficiency

5. Mergers on the Rise (continued) • Competition among European financial firms is becoming more intense, leading to continuing mergers and acquisitions • Financial-service mergers in Europe have slowed from time to time due to a slowing economy and European governments attempts to protect their home banks from acquisition by outsiders • Asia and Japan also have experienced a growing number of mergers • Due to an effort to shore up credit quality problems, fend off the ravages of deflation and sluggish economies, and compete with powerful U.S. and European banks

6. TABLE 19–1 Recent Leading International Financial-Service Mergers and Acquisitions

7. TABLE 19–2 Some of the Largest Financial-Service Mergers and Acquisitions in American History

8. The Motives Behind the Rapid Growth of Financial-Service Mergers • Mergers usually occur because • The stockholders involved expect to increase their wealth or reduce their risk exposure • Management expects to gain higher salaries and employee benefits, greater job security, or greater prestige from managing a larger firm • Both stockholders and management may reap benefits from a merger

9. The Motives Behind the Rapid Growth of Financial-Service Mergers (continued) • Profit Potential • Some argue that the recent increase in financial-service mergers reflects the expectation of stockholders that profit potential will increase once a merger is completed • If the acquiring organization has more skillful management than the firm it acquires, revenues and earnings may rise • Especially true of interstate or international mergers where many new markets are entered • If the acquiring firm’s management is better trained than the management of the acquired institution, the efficiency of the merged organization may increase • May result in more control over operating expenses

10. The Motives Behind the Rapid Growth of Financial-Service Mergers (continued) • Risk Reduction • Many merger partners anticipate reduced cash flow risk and reduced earnings risk • The lower risk may arise because • Mergers increase the overall size and prestige of an organization • Open up new markets with different economic characteristics from markets already served • Make possible the offering of new services whose cash flows are different in timing from cash flows generated by existing services • Mergers can result in a more stable financial firm, able to withstand fluctuations in economic conditions

11. The Motives Behind the Rapid Growth of Financial-Service Mergers (continued) • Rescue of Failing Institutions • The failure of a company is often a motive for merger • Many bank mergers have been encouraged by the FDIC as a way to conserve federal deposit insurance reserves and avoid an interruption of customer service when a depository institution is about to fail • The great credit crunch of 2007–2009 resulted in numerous financial firms either failing or in real trouble for which mergers and acquisitions were often the only option

12. The Motives Behind the Rapid Growth of Financial-Service Mergers (continued) • Rescue of Failing Institutions

13. The Motives Behind the Rapid Growth of Financial-Service Mergers (continued) • Tax and Market-Positioning Motive • Many mergers arise from expected tax benefits • Especially where the acquired firm has earnings losses that can be used to offset taxable profits of the acquirer • There may also be market-positioning benefits • A merger will permit the acquiring institution to acquire a base in a completely new market • Examples of U.S. market-positioning acquisitions: • Bank of America Corp. acquiring FleetBoston Financial Corp. • Wachovia Corp. acquiring Golden West • Capital One Corp. acquiring North Fork Bancorp and Hibernia Corp.

14. The Motives Behind the Rapid Growth of Financial-Service Mergers (continued) • The Cost Savings or Efficiency Motive • Large-scale staff reductions and savings from eliminating duplicate facilities have followed in the wake of some of the largest mergers in the financial-services sector • Research has shown that sometimes the single most important merger motivation was the desire to reduce operating costs followed by a plan to diversify into new markets • Many mergers are of the market extension type • Means that the merging institutions do not overlap much or at all in terms of geographic area served

15. The Motives Behind the Rapid Growth of Financial-Service Mergers (continued) • Mergers as a Device for Reducing Competition • When two competitors are allowed to merge, the public is served by fewer rivals for their business • Service quality may diminish and prices and profits may rise • More aggressive prosecution of the antitrust laws may need to be considered

16. The Motives Behind the Rapid Growth of Financial-Service Mergers (continued) • Mergers as a Device for Maximizing Management’s Welfare (An Agency Problem) • Management may view a prospective acquisition as a way to increase salaries and employee benefits, lower the risk of being fired, and enhance managers’ reputation in the labor market from working for a bigger firm • If managers reap these benefits at the expense of company stockholders, an agency problem emerges

17. The Motives Behind the Rapid Growth of Financial-Service Mergers (continued) • Other Merger Motives • Increased growth capacity • Enables a lending institution to expand its loan limit to better accommodate large and growing corporate customers • This is particularly important in markets where the lender’s principal business customers may be growing more rapidly than the lending institution itself • Give smaller institutions access to capable new management and costly new electronic technology

18. Selecting a Suitable Merger Partner • How can management and the owners of a financial firm decide if a proposed merger is good for the organization? • Measure both the costs and benefits of a proposed merger (not easy to do) • A merger is beneficial to the stockholders in the long run if it increases the stock price per share • The price of a financial firm’s stock depends upon • The expected stream of future dividends flowing to the stockholders • The discount factor applied to the future stock dividend stream, based on the rate of return required by investments of comparable risk

19. Selecting a Suitable Merger Partner (continued) • In order to maximize stockholder value, the proposed merger should • Improve Operating Efficiency (reduce operating cost per unit of output) • Consolidate operations and eliminate duplication • Geographic Diversification • Product Line Diversification • Find an acquisition target whose earnings or cash flow are negatively correlated (or have a low positive correlation) with the acquiring organization’s cash flows

20. Selecting a Suitable Merger Partner (continued) • A major consideration in any proposed merger is its probable impact on the earnings per share (EPS) of the surviving firm • Stockholders of both acquiring and acquired institutions will experience a gain in earnings per share of stock if both of the following occur • A company with a higher price-to-earnings (P-E) ratio acquires a company with a lower P-E ratio • Combined earnings do not fall after the merger • In this instance, EPS will rise even if the acquired institution’s stockholders are paid a reasonable premium for their shares

21. Selecting a Suitable Merger Partner (continued) • As long as the acquiring institution’s P-E ratio is larger than the acquired firm’s P-E ratio, there is room for paying the acquired company’s shareholders a merger premium • High-premium deals often yield disappointing results for the stockholders of the acquiring firm

22. Selecting a Suitable Merger Partner (continued) • Exchange Ratio • The number of shares of stock offered by an acquiring bank for each share of stock of the acquired bank • Dilution of Ownership • Spreading the firm’s ownership over more stockholders so that the average shareholder’s proportion of firm ownership declines • Results from offering the acquired firm’s stockholders an excessive number of new shares relative to the value of their old shares • Dilution of Earnings • Spreading a fixed amount of earnings over more shares of stock so that the EPS of the combined firm declines • Will occur if the P-E of the firm to be acquired is greater than the P-E of the acquiring firm

23. The Merger and Acquisition Route to Growth • The acquired firm (usually the smaller of the two) gives up its charter and adopts a new name (usually the name of the acquiring organization) • The assets and liabilities of the acquired firm are added to those of the acquiring institution • A merger normally occurs after managements of the acquiring and acquired organizations have struck a deal • Proposed transaction must then be ratified by the board of directors of each organization and possibly by a vote of each firm’s common stockholders.

24. The Merger and Acquisition Route to Growth (continued) • If the stockholders approve (usually by at least a two-thirds majority), the unit of government that issued the original charter of incorporation must be notified, along with any regulatory agencies that have supervisory authority over the institutions involved • In the U.S., the federal banking agencies have 30 days to comment on the merger of two federally supervised banks • There is a 30-day period for public comments as well • Public notice that a merger application has been filed must appear in a newspaper of general circulation serving the communities where the main offices of the banks involved are located • The U.S. Justice Department can bring suit if it believes competition would be significantly reduced after the proposed merger

25. The Merger and Acquisition Route to Growth (continued) • The principal characteristics of the targeted institution that are examined by the potential acquirer fall into six broad categories • The firm’s history, ownership, and management • The condition of its balance sheet • The firm’s track record of growth and operating performance • The condition of its income statement and cash flow • The condition and prospects of the local economy served by the targeted institution • The competitive structure of the market in which the firm operates (as indicated by any barriers to entry, market shares, and degree of market concentration)

26. The Merger and Acquisition Route to Growth (continued) • In addition, potential acquirers will look at these factors as well • The comparative management styles of the merging organizations • The principal customers the targeted institution serves • Current personnel and employee benefits • Compatibility of accounting and management information systems among the merging companies • Condition of the targeted institution’s physical assets • Ownership and earnings dilution before and after the proposed merger

27. Methods of Consummating Merger Transactions • Mergers usually take place employing one of two methods • Pooling of interests • Purchase accounting • For mergers begun before July 1, 2001, the Financial Accounting Standards Board (FASB) permitted use of the pooling of interests • Merger partners merely sum the volume of their assets, liabilities, and equity in the amounts recorded just before their merger takes place

28. Methods of Consummating Merger Transactions (continued) • In contrast, under purchase accounting the firm to be acquired is valued at its purchase price and that price is added to the total assets of the acquirer • The acquirer records the acquisition at the price paid but must value the acquired firm at market value plus goodwill (if the acquisition price and market value are different) • No goodwill is figured in when using the pooling of interests approach • After 2001, the pooling of interest method for merger accounting was eliminated for U.S. financial firms

29. Methods of Consummating Merger Transactions (continued) • Another way to view the merger process is to determine exactly what the acquirer is buying in the transaction • Assets or shares of stock • Purchase-of-assets method • The acquiring institution buys all or a portion of the assets of the acquired institution, using either cash or its own stock • The acquired institution usually distributes the cash or stock to its shareholders in the form of a liquidating dividend and the acquired organization is then dissolved

30. Methods of Consummating Merger Transactions (continued) • Purchase-of-stock method • The acquiring firm assumes all of the acquired firm’s assets and liabilities and the acquired firm ceases to exist • While cash may be used to settle either type of merger transaction, in the case of commercial banks, regulations require that all but the smallest mergers and acquisitions be paid for by issuing additional stock of the acquirer • A stock transaction has the advantage of not being subject to taxation until the stock is sold, while cash payments are usually subject to immediate taxation

31. Methods of Consummating Merger Transactions (continued) • The most frequent kind of merger among depository institutions involves wholesale banks merging with smaller retail banks • Lets money center banks gain access to relatively low-cost, less interest-sensitive consumer accounts and channel those deposited funds into profitable corporate loans

32. Regulatory Rules for Bank Mergers in the United States • Two sets of rules generally govern the mergers of banks and other financial firms: • Decisions by courts of law • Statutes enacted by legislators, reinforced by regulations • For example, the Sherman Antitrust Act of 1890 and the Clayton Act of 1914 forbid mergers that would result in monopolies or significantly lessen competition in any industry • Whenever any such merger is proposed, it must be challenged in court by the U.S. Department of Justice

33. Regulatory Rules for Bank Mergers in the United States (continued) • The Bank Merger Act of 1960 • Requires each merging bank to request approval from its principal federal regulatory agency before a merger can take place • National Banks – Comptroller of the Currency • State Member Banks – Federal Reserve • State Insured Banks – FDIC • Each federal agency must give top priority to the competitive effects of a proposed merger • Mergers with anti-competitive effects may be approved if it can be shown that there are significant public benefits • For example, providing convenient services or rescuing a failing bank

34. Regulatory Rules for Bank Mergers in the United States (continued) • The degree of concentration in a market is measured by the proportion of assets or deposits controlled by the largest institutions serving that market • The Justice Department guidelines require calculation of the Herfindahl-Hirschman Index (HHI) as a summary measure of market concentration • It is the sum of the squared market share for all banks in a specific market area • where Ai represents the percentage of market-area deposits, assets, or sales controlled by the ith financial firm in the market, and there are k financial firms in total serving the market

35. Regulatory Rules for Bank Mergers in the United States (continued) • Under the latest Department of Justice (DOJ) Guidelines • If a market has a postmerger HHI below 1,000 points, then the market is unconcentrated; no further DOJ review • A market is considered moderately concentrated if its postmerger HHI is 1,000 to 1,800 points and as a result of the proposed merger the change in the HHI is less than 100 points; usually no further DOJ review (unless the change in the HHI > 100 points)

36. Regulatory Rules for Bank Mergers in the United States (continued) • Under the latest Department of Justice (DOJ) Guidelines • A market is considered highly concentrated if the postmerger HHI lies above 1,800 points and the postmerger change in the HHI exceeds 50 points; usually no further DOJ review (unless the change in the HHI > 50 points) • If the change in the HHI > 100 points in a highly concentrated market, significant competitive issues will be raised and a suit to block the proposed merger may be filed by the DOJ

37. The Merger Rules in Europe and Asia • The European Commission – an executive body of the European Community currently based in Brussels –has emerged as a key mediator of mergers involving European businesses • Because the European Commission cannot break apart a merger after that combination has occurred, the Brussels commission has been somewhat more aggressive in denying some companies permission to merge • The doctrine of collective dominance suggests that if a significant European market would become so concentrated as a result of a proposed merger that only about four firms would come to dominate that market, then the European Commission may vote to block any further market concentration

38. The Merger Rules in Europe and Asia (continued) • In Asia, merger rules are in a state of flux as leading nations seek to modernize their merger review process and develop more definitive guidelines for merging firms • In assessing a proposed mergers, Asian authorities emphasize • Market share • Availability of alternative sources of supply for the consumer • Whether foreign firms are involved that will significantly impact domestic institutions in a dangerous way • Mergers that appear to rescue losing domestic companies, protect jobs, and bring new technologies and managerial talent into the host country often receive favorable rulings

39. Making a Success of a Merger • Many mergers simply do not work • A variety of factors often get in the way • Poor management • Mismatch of corporate cultures and styles • Excessive prices paid by the acquirer for the acquired firm • Failure to take into account the customers’ feelings and concerns • Lack of strategic “fit” between the combining companies

40. Making a Success of a Merger (continued) • Helpful steps that improve the chances for a desirable merger outcome • Acquirer must start by evaluating its own financial condition • Must have detailed analysis of possible new markets • Must establish a realistic price for target firm • After merger, combined team must direct progress towards consolidation • Must establish communication between senior management and all employees • Must create communication channels for customers and employees to understand why merger took place • Should create customer advisory panels to evaluate and comment on merged bank’s image and products

41. Research Findings on the Impact of Financial-Service Mergers • The Financial and Economic Impact of Acquisitions and Mergers • Merger-active financial companies tend to grow faster than nonmerging firms • Generally, acquiring financial firms, on average, are not more profitable than the firms they buy • This suggests that management of the acquiring firm hopes to buy into success • Acquired companies are often significantly less profitable than the firms they compete with • Acquirers pay sizable premiums for target firms • Thus, stockholders of acquired companies often gain a financial advantage, while acquirers often wind up with mixed results

42. Research Findings on the Impact of Financial-Service Mergers (continued) • Public Benefits from Mergers and Acquisitions • Research has found few real benefits from the public’s perspective • On the positive side, there is no convincing evidence that the public has suffered from a decline in service quality or in service availability • There is also some evidence that bank failure rates decline in the wake of merger activity • Mergers and acquisitions usually have multiple outcomes and generate a mixture of winners and losers

43. Quick Quiz • What factors should a financial firm consider when choosing a good merger partner? • What factors must the regulatory authorities consider when deciding whether to approve or deny a merger? • When is a market too concentrated to allow a merger to proceed? • Does it appear that most mergers serve the public interest?