In the bank acquisition business, nothing fails like success. Acquirers are the putative winners. They get the notice, the press kudos, even the plaudits of many analysts. But their shareholders do much less well.
In fact, fresh evidence compiled by Mitchell Madison Group indicates that, from an acquiring shareholder's perspective, the majority of 1990- 1995 bank mergers were at best a wash and at worst a keen disappointment, an apparent triumph of managerial adrenaline over managerial intelligence. But this need not be the case in the future.
Mitchell Madison measures how well large mergers (over $1 billion) perform for shareholders by comparing the total returns (dividends plus stock price appreciation) received by the acquiring bank's owners with those received by the shareholders of a group of large regional and superregional peer institutions from three months before the merger announcement (to adjust for the impact of rumors) to two years after the transaction closes.
If shareholder returns exceed those recorded by peers, the merger is a success; if they fall short, the merger is not. This is the ultimate test of a merger: All things considered, would the shareholders have been better or worse off if they had simply purchased an industry mutual fund?
Based on the Mitchell Madison criterion, only a third of all billion- dollar deals from 1990 through 1995 were winners. This means, of course, that in two-thirds of the deals, total shareholder returns lagged those of peer banks. Significantly, the failure rate in bank mergers is higher than that in U.S. business as a whole. During the same period, the proportion of all U.S. mergers that failed came to just about a half.
Bank mergers can be divided into three types: in-market combinations; new-market entries (whether the acquiree is in an adjacent or distant market); and specialty-business acquisitions (where the target is a nonbank in a related financial business-for example, mortgage servicing). Somewhat ironically, a bank's best hope of achieving merger success in the 1990-1995 period was to acquire a nonbank. Specialty-business acquisitions were on average moderately beneficial to shareholders.
Not so with bank-to-bank pairings, especially the new-market-entry variety. The data reveal that when a bank entered a new market via merger during this period, it achieved, on average, a shareholder return only 91% as large as that recorded by its peers. When it picked up an in-market or cross-town entity, a more propitious type of combination, it just about broke even, raising the question of why go through the turmoil of what has typically been a wrenching consolidation experience.
The lack of conspicuous success in bank mergers is in some senses predicted by the theory of efficient markets. This theory, beloved of academics, holds that, given access to the facts, the market will make a correct assessment of the future contribution of the bank acquirer to its acquiree, and this assessment will be fully reflected in the price premium that is demanded. If it accepts this premium, the acquirer will have paid a price equal to the current stand-alone, risk-adjusted value of its target, together with its foreseeable contribution to the increase in the target's future value. Under such circumstances, the deal alone should not create any net value for the acquirer's shareholders.
That being the case, value creation in mergers would seem to depend on market imperfections. Either the acquirer knows something about potential value that the market doesn't, or more likely, the acquirer is better able to fulfill the deal's potential than the average bidder.
Improving the value of any business entity self-evidently requires an increase in its return per unit of risk. Return improvement depends, in turn, on cutting costs and/or raising revenues. Thus, it can be argued that to create shareholder value in mergers, an acquirer must do a better job than the market anticipates in some combination of cost reduction, revenue enhancement, and/or risk management.
Is it possible to surprise the market by stellar cost reduction? Some years ago, having little experience with the phenomenon, investors may indeed have been surprised by the extent of feasible expense reduction in cross-town bank mergers.
So it is conceivable that acquisition premiums may not have fully reflected the potential earnings fillip, enabling acquirers to create value. This certainly was the case in the Wells Fargo-Crocker deal in the mid-'80s, and the market's sense of surprise may have persisted for some years thereafter, affecting other deals as well. But by the early '90s, the market probably had formed a realistic estimate of potential productivity gain in bank mergers-a number ranging from 15% to 50% of the acquiree's expense base, depending on the degree of market overlap. Very likely, it is now possible to surprise the market only with better and faster execution or with new types of cost savings.
New approaches to cost savings include aggressive sourcing of purchased goods (direct and indirect), which can shave purchasing bills by 10% to 15%, and original avenues for outsourcing, which promise perhaps an even bigger payoff. Since the market does not expect acquirers to outsource so- called proprietary functions-for example, item processing-those resolved to strip away everything that is profitably outsourceable could well catch investors off balance and thereby generate substantial value.
It may be somewhat more difficult to surprise the market in the area of revenue enhancements. There is always talk about merger-spawned abilities to add products, to cross-sell the acquiree's customers products to which they previously had only limited exposure, and even to raise prices for new services and new service combinations.
In practice these benefits seldom materialize. In fact, in many mergers, revenue diminution is more likely than revenue enhancement. This is because problems of systems integration often retard product development while indiscriminate product homogenization as well as ill-advised branch cutbacks tend to boost customer attrition.
Yet sustainable revenue gains can be won if the acquirer is able to expose the acquiree's customer base to a generous dose of well-executed segmented marketing. But this won't be possible unless current approaches are materially refurbished. Success in data base marketing, which has thus far eluded most banks, rests on the adoption of what we call the continuous learning cycle-a multistage process that embraces improved data collection, better customer valuation measures, more sophisticated statistical techniques, and organizational changes that facilitate constructive line- staff interactions and move the bank from a silo or product orientation to a true customer focus.
Another avenue for creating value in mergers is through superior risk management. The major risk is of course credit-related. Credit risk can be reduced (and since most banks aren't getting paid enough for this risk, such a reduction is required) by better loan underwriting and increased portfolio diversification.
It is often possible to greatly improve diversification, without sacrificing returns, through loan sales and purchases. In other cases, returns may fall (say, when credit derivatives are employed), but risk will often decline more than proportionally, raising the institution's return- risk ratio and thus its value to shareholders.
If the market is measuring bank performance primarily in terms of current accounting earnings, which say little about the threats to future earnings, it may underestimate the impact of intelligent diversification policies that, by reducing the volatility of those future earnings, impart strength to stock values. As a result, acquirers with superior risk management skills can add value to their targets while achieving greater diversification in the combined entity.
To summarize: Value in mergers depends on raising a potential acquiree's return-risk ratio by more than the market thinks likely. Acquirers best able to do this will be those that can exploit sourcing and creative outsourcing opportunities, can master the intricacies of data base marketing, and can get a better handle than most on troublesome portfolio risks, especially credit.