Close Analysis of Merger Target Can Pay Off

For many boards and senior managers today, no issue is more important or difficult than determining how best to evaluate merger and acquisition choices.

Once management decides to go beyond internally generated growth and to look for a partner, a number of complex issues arise.

Most fundamentally, which bank should you buy or combine with? What is the focus of your acquisition strategy: the desire for greater scale, geographic expansion, or more product diversity? Should you pursue an in-market or out-of-market deal?

How should you value a potential target? What values can be created in a combined bank? What steps must be taken (both cost reduction and revenue related) to generate that value?

Keeping an Eye on Your Rivals

What is the competition doing? What other banks will vie for the best acquisition targets, and how will they value those banks?

Given that most mergers fail to meet expectations, why will the acquisition you are considering be successful?

Although critically important, decisions to agree to a combination and to begin doing due diligence are often based on board-level relationships and a sense that the deal "feels right."

While gut feelings should not be ignored, banks have the opportunity to gain detailed insight into the likely success of a possible combination well before due diligence begins and, in fact, before even approaching a "target" bank.

Picking the Right Approach

Up-front merger analysis allows a bank to determine its acquisition approach based on the value it hopes to achieve from a combination and the likelihood of achieving that value.

In fact, many of the most successful acquirers have developed multibusiness data bases that give them an edge on competitors in evaluating a target, as well as helping them devise a detailed game plan and obtain the "value added" of an acquisition as soon as possible.

Acquirers no longer wait for due diligence to begin their analysis; rather, they develop a detailed understanding of a target as soon as possible.

A great deal of public information on a target is readily available, and additional information can be obtained with a little digging.

The raw material for this analysis includes publicly available Federal Deposit Insurance Corp. and call report data; in-house and industry data bases offering key operating statistics on various businesses, and narrowly focused internal interviews and competitor analysis.

Begin with the Branch System

Although the biggest cost savings potential exists in the back office, banks typically begin their analysis in the branch system. Branch information is readily available, and many of the opportunities for improving the bottom line in the near term involve revenue and cost actions in that area.

The thrust of branch analysis is to understand the strengths and weaknesses of the target's system.

In some cases, the two systems overlap, allowing branch closures; in others, the combined bank may be able to lead in certain key markets. The analysis may show that noncore branches can be sold.

In addition, quantifying the impact of a best-practices approach across the branch system can result in significant revenue improvement and cost reduction targets.

A Four-Step Analysis

Detailed analysis, which has a substantial payback, consists of four phases.

* Analyze the net savings from branch closures. In this early analytical phase, in-house or proprietary models are used to determine where overlap occurs.

Initially, distance between branches is often considered to be the key variable; for example, the average city dweller will travel less distance than a country resident.

However, a more meaningful analysis looks at branches on a street-by-street basis and is customized based on local preferences (someone in Los Angeles may be more willing to travel than a New Yorker).

Models can be developed early in the process to include the impact of traffic density, parking availability, branch configuraiton, etc., in determining branch success.

Of course, cost savings can and must be considered in light of likely account retention before closure decisions are made; Community Reinvestment Act analysis must also be completed.

Beyond expense reduction, performing a pro forma combination of the "ideal" post-acquisition branch structure presents management with a clear picture of branch "network scale" opportunities.

Network scale refers to the fact that, in part due to enhanced market penetration, customer convenience, and branch share within selected geographic areas, the combined bank has the opportunity to increase its strength significantly in deposit and new-business size.

To give a simple example, a strong 20% combined share of branches in a particular location can translate into a 30% share of deposits in that location. Conversely, this analysis can also point to areas of oversaturation.

* Determine how much you can reduce support costs. Indirect costs constitute almost 40% of branch banking expenses. These costs include regional management, product management, marketing and advertising, and the key cost area, the branch back office.

By determining what drives those costs in your own bank (number of branches, number and type of transactions, and so forth) as well as the mix between fixed and variable costs, banks can develop a preliminary model of what the indirect cost structure of the combined bank would look like and, within a fairly narrow range, quantify the potential for cost savings.

Additionally, access to external information on best-practices performance will increase the quality of the analysis.

Clearly, assumptions need to be refined as the acquisition process unfolds. However, among the benefits of this preliminary analysis is a sharp focus on areas to examine if due diligence occurs.

* Quantify the range of possible revenue increases. Public information is available concerning branch-based deposits, fees, and consumer loans.

Some of the leading acquirers have developed approaches to compare "acquirer" and "target" banks, based on deposit, fee, and loan generation performance and, thereby, to determine which branch system is the best performer in these key areas.

Successful acquisitions are not static processes. If a merger is to work, the best skills of each player need to rub off on the other.

For example, if the laggard bank in fee generation (whether acquirer or target) can institute the successful practices of the other, a real dollar benefit results.

This part of the analysis quantifies, within a relatively narrow range, the potential cost of instituting best practices in the branches. Banks base this range of opportunity on actual current performance and not on a theory or wish list.

This can only be attained through detailed implementation planning. Obviously, crunching the numbers is only the first step.

* Evaluate cash raising opportunities by exiting marginal geographies. Even after the combination, a number of locations are unattractive for the merged bank long term, because of size or performance.

Often, these are candidates for sale to another bank that has critical mass in an area or wants to build market share in a location. (Alternatively, an acquirer can decide to invest to build its presence in a location.)

Assessing the extent of the "exit/fix" situation early in the process provides added insight both into the degree of "hands on" management required and the extent to which the branch system can be "milked" to pay for the acquisition.

Look at All Major Businesses

While understanding branch-based opportunities is important, the branch system itself is only the starting point of the analysis required; depending on the bank, substantially more revenue can be generated from other business and support areas.

Up-front analysis should also include a detailed assessment of other key consumer areas (for example, lending, mortgages, trust, and other products of importance), as well as wholesale (corporate lending, key noncredit products, treasury capabilities, etc.) and major support functions, in particular, the back-office and central overhead areas.

This process leads to: pro forma profit-and-loss statements for these businesses on both a stand-alone and merged basis; an assessment of the target bank's strategy and tactics; a preliminary perspective on how to increase the bottom line for each business after the combination; and a framework for the due diligence process.

Although much branch data are public, information concerning most of the businesses listed above is difficult to obtain. Banks use a number of sources in developing these profiles, often beginning with a model based on their own business-by-business economics.

Internal and external experts in the various businesses are also excellent sources to evaluate growth/scale opportunities and, often, to learn about specific banks. Top banks also develop likely scenarios and brainstorm to test hypotheses.

Ending Up with Solid Numbers

This process has elements of art as well as sceince. The end products of such a process, however, are numbers good enough to lead to some initial conclusions, to assist in screening and prioritizing, and to strengthen the foundation for decision-making by complementing "gut feel."

Up-front analysis allows an acquirer to focus quickly on key areas; in the case of a merger of equals, it may lead to one of the partners being a bit more equal than the other.

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