Mergers of equals are rarely popular with investors, and last year's union of the old KeyCorp and Society Corp. has been a dud thus far. But the bank is slowly winning favor on Wall Street.

For a while it looked as though Victor Riley and Robert Gillespie had created a colossal mistake on the lake. It was October 1993 and Riley, the hands-on, retail-oriented chief executive officer at KeyCorp, had announced a merger with Society Corp., run by Gillespie--a polished corporate lender with a penchant for planning. The deal would create a $60-billion-asset bank with operations in 13 states and headquarters in Cleveland. Sadly for them, Wall Street greeted the news with a raucous round of raspberries. Even Banc One Corp. Chairman John B. McCoy complained that the deal was bad for banking. "I guess I thought we weren't going to get rave notices--but I didn't think we'd get trashed either," Riley says today.

One problem was that this was a merger of equals--and also a market extension since there was little overlap between the banks. Wall Street is highly suspicious of this kind of deal, preferring in-market consolidations where cuts in redundant staff, back office facilities and branches yield bonanza-sized cost savings. But as Riley points out, "This (merger) had a very limited amount of that ingredient." The projected savings totaled only $100 million--hardly enough to make a numbers-crunching analyst reach for his or her calculator. Instead, the active ingredient was "revenue enhancement." Putting Key and Society together, Riley and Gillespie reasoned, would produce revenue opportunities that neither could achieve on its own. Skeptical of such promises, the Street preferred to wait and see.

Another concern was the significant difference in cultures between the two merger partners. Based in Albany, NY, Key was a consumer and small business bank with a sprawling branch network. Society, on the other hand, was more of a corporate bank. And since this was a merger of equals, it was unclear whose culture would win out, or whether the people from Key and Society could ever work together. "History shows that when you put white and black together...you get mud," says Thomas Brown, a regional bank analyst with Donaldson, Lufkin & Jenrette. "I was not a fan, nor am I a fan now, of this merger."

A year later, the new KeyCorp--the merged institution adopted the KeyCorp name, while headquartering itself in Society's office tower overlooking Lake Erie--is beginning to change some minds on Wall Street.

The bank reported strong double-digit earnings growth through the first three quarters of this year, and says it should achieve its $100-million cost reduction goal in the first quarter of 1995. More promising yet, some of the revenue synergies that Riley and Gillespie foresaw are beginning to emerge. The bank now enjoys an impressive number of buy recommendations--23 in all--from analysts. Says an upbeat Riley, "We're seeing some early wins that tells me we probably underestimated what this cross-fertilization can achieve." The duo's long-term goal is to build a financial services company that can compete with the country's best nonbanks.

There are still critics, to be sure. Key wants to build fees to 50% of total revenue within five years--versus only 25% now--and analysts worry that such an aggressive objective might cause it to overpay for nonbank acquisitions. And there are unsettling rumors that Riley and Gillespie have feuded at times, which could distract the bank if it got out of hand.

It's worth studying this deal because no matter how much Wall Street might dislike mergers of equals, this will not be the last one in banking. Most in-market transactions impose surrender terms on the institution being acquired. One reason why they tend to be so successful is that an acquiring bank typically forces its management style, systems and procedures on the other institution. It's effective but often times brutal. With industry earnings still at record levels, there is reluctance by some banks to accept such drastic terms, and an incentive to maintain more control over their destiny. If Riley and Gillespie can make their merger work, it may embolden others to follow suit.

Ask Gillespie why he wanted to merge with Key and he'll matter-of-factly say the banks were a perfect fit. Key was scattered across eight northern states from Maine to Alaska. Society, on the other hand, was pinned down in Ohio, Indiana and Michigan, and had a small thrift outpost in Florida. Key focused its attention on consumers and small business, and had only a few corporate loans. Society was a big corporate bank with specialties like institutional trust, asset-based financing, leasing, health care and commercial real estate. At the risk of oversimplification, Society had the products and old Key the customers. From Gillespie's perspective, "(Society) was all dressed up with no place to go."

Where's the Beef?

Ask Riley the same question and you end up getting a story that explains a lot about banking today. In 1991, Riley led his senior management team through a process of self-analysis. The objective was to create a five-year plan that would allow Key to continue its double-digit earnings growth. The group concluded--much to Riley's alarm--that this might not be possible. Federal Reserve cuts in interest rates had boosted Key's net interest margin, and the bank had steadily reduced its overhead, but neither trend would last forever. "To us it became obvious that we needed revenue enhancement," Riley explains. "We put the plan together, but to me it had holes."

It also was common for Riley and Gillespie to get together on occasion, "to say hello and have dinner," as Riley puts it. They had discussed possible joint ventures but never a merger--until that difficult planning session heightened Riley's apprehension about the future. At one point Riley discussed his concerns with Gillespie and found that he was worried about Society's future. "They had come to the conclusion that to expand would cost a hell of a lot of money," Riley says. "From there our talks changed. 'What would happen if we put the banks together?'"

What happened was a merger that might solve each other's biggest problem if done skillfully. But the banks' contrast in cultures was a concern since "we didn't want to put together two companies that didn't fit," says Gillespie. And he agrees there are differences. "That's perceived in some quarters to be a negative--but that's why we did the deal," he says. There are also similarities between the two banks. Both have strong credit cultures, and both had grown through acquisition in recent years. Senior executive vice president Henry Meyer III argues that concerns about the banks' incompatibility are misplaced. "There's one unprintable word--bullshit!" he says.

The management structure of the new organization preserves a delicate balance between Society and old Key. The 63-year-old Riley became chairman and CEO of the new bank. Gillespie, 50, stepped down to become president and chief operating officer--but is slated to replace Riley as CEO at yearend 1995. (Riley will stay on three or four more years as a nonexecutive chairman.) The new board of directors is comprised equally of former Society and old Key members.

Riley and Gillespie also appointed two senior executive vice presidents and chief banking officers, one from each bank. Meyer--who oversees affiliates in Alaska, Oregon and Washington and is CEO of Society National Bank, KeyCorp's largest unit--spent 22 years with Society prior to the merger, ending up as a vice chairman. His counterpart is Gary Allen, who's responsible for Key's banking affiliates in the other nine states, and previously was CEO of $14-billion-asset Key Bank of New York.

But this same one-from-column-A, one-from-column-B approach is a big reason why many analysts dislike mergers of equals. "There's no reason for these guys to share that job," says NatWest Securities analyst John Heffern, who maintains a buy recommendation on KeyCorp's stock and is generally supportive of the merger. One explanation may be that Meyer and Allen are both talented and experienced bankers, and by working together would further the process of cross-fertilization. Another may be that it provides an open competition to replace Gillespie as president when he replaces Riley. But analysts generally fear that trying to maintain a delicate political balance in a merger of equals may lead to poor staffing decisions. Worse, it may be a sign of the indecisiveness that has plagued such deals in the past.

Certainly there have been some terrible mergers of equals in recent years. One notable example is the C&S/Sovran combination in the late 1980s, which stumbled over asset quality problems and was later acquired by NCNB Corp. But there also was the successful marriage of Chemical Banking Corp. and Manufacturers Hanover Corp. in 1991, which did offer big savings since it was an in-market deal, yet still required that the banks combine their organizations with a degree of balance. The latter is a challenge that Chemical seems to have met successfully.

The real problem here is that the KeyCorp merger emphasizes revenues--which are not predictable--over cost reductions, which usually are. "Analysts like cost savings because they're 'charitable,'" Gillespie says. In-market deals can exert powerful leverage on earnings, but they don't necessarily grow external sources of revenue unless the partners happen to have similar businesses which can be combined to capture economies of scale. "We would rather see a bank find a new product or a new sales channel that creates superior growth in (earnings per share) and dividends," wrote Heffern in an Alex. Brown & Sons research report shortly before he left the firm for NatWest. "In our opinion, such a manner of growth is far superior to cost-cutting alone and will receive a higher valuation from investors."

Heffern's comments notwithstanding, the market still favors in-market mergers, in part because they are cost-driven and provide more immediate benefits to shareholders. But there's a related line of thinking which holds that American banks need to consolidate in order to remain strong and competitive, and thus in-market deals serve an important public function as well. This was pretty much John McCoy's point when he panned the merger last year, although some people suspect he wanted Key for himself. ("John is a very competitive person," says Riley, who denies that he ever held merger talks with McCoy.) Looked at this way, the merger did nothing to further the cause of consolidation, and not only did Riley and Gillespie cheat their shareholders, they were unpatriotic to boot.

It's understandable that analysts would prefer a deal whose benefits are more easily quantified. But cost-cutting alone wasn't going to get Riley or Gillespie where either man wanted to go. "I think we have to take some excesses out," says Riley about the wisdom of in-market consolidations. "But if we're going to compete, we have to become a financial services company." And the companies that Riley wants to tangle with are tough nonbank competitors like Merrill Lynch & Co. "We have to increase our lines of business, we have to get more product out there. We have to do more relationship banking."

Riley and Gillespie are actually waging a high-stakes contest over perceptions. To execute its long-term strategy, Key must be able to make acquisitions, especially in nonbank areas like asset management. But to do that, it must have a strong stock price, since equity is the median of exchange. And to do that, Riley and Gillespie must convince analysts and investors that their merger can succeed. This wooing of Wall Street is as much a part of running a public company as quarterly earnings statements, but takes on added significance when your story is not backed up with lots of munchable numbers for the data junkies.

How the Numbers Add Up

That said, KeyCorp's earnings through the first nine months of 1994 are suggestive of a company that is heading in the right direction. Net income was $660 million, compared to $588 million in 1993. The bank's performance ratios through the midyear point ranked near the top of its industry peers, a group that includes such high-flyers as Banc One, Norwest Corp. and Wachovia Corp. Through the first three quarters, return on assets was 1.43%, return on equity was a stellar 19.65% and the efficiency ratio was 58.8%. Key also has a strong balance sheet: Tier 1 risk-adjusted capital was 8.72%; and the ratio of non-performing loans to total loans was only 0.64%.

Through mid-October, Key's stock was trading at around $29, representing only a modest premium over its book price. Wall Street bulls generally like the bank because it significantly outperforms the average for its superregional peer group, and yet its stock has a price/earnings ratio slightly under the average for the group. "KeyCorp is our favorite among the regional banks, providing at least 11% annual (earnings per share) gains over the next two years," wrote S.G. Warburg & Co. analyst Francis X. Suozzo in an August research report.

A significant factor in KeyCorp's performance to date has been its steady delivery of promised cuts in overhead. Most of the projected reduction will come through the consolidation of corporate and support staff in Cleveland, and by reducing its total number of data processing facilities. About half these total savings will be realized by yearend, with the balance occurring by March 31, 1995. At first blush, shaving a mere $100 million from Key's 1993 noninterest expense of nearly $2.4 billion does not seem that significant. But NatWest's Heffern says even those cost cuts translate into a $60-million after-tax gain, and will account for about 3% of Key's earnings this year. "I wouldn't dismiss it," he cautions.

Still, the purpose of this deal was to grow, and Key has notched some early wins here as well. The bank says it has identified $30 million in new revenues that are directly attributable to the merger. The most successful example of revenue enhancement to date has been a nationwide effort to aggressively expand Key's small business lending activities--which has contributed $17 million in annualized revenue. Through mid-August, the bank had generated $387 million in new loan volume--besting its original $200-million target with ease and prompting Riley to growl that "I thought (the goal) was modest, but everyone else thought it was a stretch." A lot of the gains are occurring in Society's territory, where the bank had not been as aggressive as the old KeyCorp. One advantage has simply been the ability to learn from Key, explains senior vice president Sandy Maltby, who oversees the program. "We just bought ourselves years at the old Society," she says. Affiliates in the old Key network, on the other hand, benefit from having a broader array of fee-based products to sell.

Providing a Resource

Maltby also points out that of the 10 best states for small business, KeyCorp is in five of them. "To me that says, 'Gosh, what an opportunity!"' The effort is being augmented by a Cleveland-based national resource center that provides customers with all their account information over the telephone, but also acts as a conduit to managers within the bank who can provide them with basic advice on running a business. The center has been averaging 3,000 calls a month.

The bank has been exploiting revenue synergies on the corporate side as well. James Fishell, an executive vice president who manages Key's specialty finance group, says the bank is aggressively marketing its lease and health care finance capabilities in old Key's territory. Fishell expects Key's $1.4-billion leasing portfolio to grow "well into the double digits" this year, while health care lending has a similar growth trajectory. The bank also is pushing residential real estate development--an area where old Key was more active than Society. In Ohio, Fishell expects to grow development loans from only $20 million at the beginning of the year to $85 million by yearend 1995. And Fishell's operation has bagged media deals in Washington and Maine totalling $62.5 million. Overall corporate loan growth through the first six months of this year was 13.8%, and the bank figures that an additional $11 million in annualized revenues from corporate lending can be attributed to the merger. In the asset management area--one of Society's strengths--Key also was selected by the Alaska Permanent Fund to manage $150 million over the next 24 months, business that Society probably would not have gotten on its own.

The resource center concept is also being applied on the corporate side, where it aids in the cross-fertilization process. Through a facility located in Seattle, Key provides its banking affiliates in the West and Pacific Northwest with expertise in specialized lending, foreign exchange trading and various employee benefit products--none of which were available from old Key. To encourage local Key bankers to use the center, they and not the center "own" the customer and get to keep any additional revenue.

KeyCorp's long-term strategy is to build a customer-driven financial services company that earns as much money from fees as it does from loans. Key wants to significantly expand its activities in asset management, which becomes even more important since the bank may sell its mortgage servicing company. And it is aggressively experimenting with various forms of branchless banking, including its Virtual Nationwide Call Network, a system of four regional telephone call-in centers that handles account information and markets various specialized products like private banking and brokerage.

Gillespie believes that merger-related revenue will be a significant factor in KeyCorp's bottom line by 1996. It had better be, he adds, because that's also the point when net interest margins may be under the most pressure from continued increases in interest rates by the Federal Reserve. "People worry that banks can't grow their earnings at double digits, and that's why we trade at only nine times earnings," he says. The key (if you'll forgive the pun) will be developing specialized business lines--activities like lease finance, corporate trust and money management--which can provide double-digit growth.

In August, Key brought more than 60 analysts in for a day's worth of presentations by bank executives. It was well worth the effort because the result was a slew of buy recommendations. But investors have been slow to climb aboard, and the stock still trades about 10% below the old KeyCorp's pre-merger level--hardly an endorsement of the new institution's prospects. It could be a function of the fact that bank stocks in general have been bouncing around, as investors fret about the effect that rising interest rates will have on industry earnings. Or it might be that the market is not yet convinced that the new KeyCorp isn't a mistake on the lake. "I think one thing the market is saying is that the integration process is going to be a lot tougher than people believe," says Bear, Stearns & Co. analyst Lawrence R. Vitale, who rates the stock a hold. It's as if investors have decided, "'We're going to watch and wait," Vitale adds.

Key will continue to acquire other banks. In June it acquired the Bank of Boston Corp.'s units in Maine and Vermont, which total $1.8 billion in assets, and also First Citizens Bancorp of Indiana. Earlier it had acquired an Indiana thrift and some $500 million in deposits from the Resolution Trust Corp. in New York, Oregon and Washington. These are primarily fill-in deals (except for Vermont, where Key did not have a franchise), and as such are barely a blip on the market's radar screen. But some analysts do worry that in its eagerness to expand, Key might overpay on a larger deal and take on significant dilution of its earnings per share. "I'm a little ill-at-ease about whether they will hold the line on pricing discipline," says Heffern.

Targeting Asset Management

One possible reason for this concern is that Key must expand its asset management operation since most of the recent growth has come from lending. Today it has only $32 billion under management, with only $5 billion in mutual fund assets. And that probably presages a big acquisition or two.

The fear that KeyCorp might overpay to acquire a large money manager apparently emanates from Society's past--and specifically two acquisitions that Gillespie engineered a few years ago. In 1990 he took over Toledo, OH-based Trust-Corp, then two years later outbid local rival National City Corp. to pick up Ameritrust, also of Cleveland. Both TrustCorp and Ameritrust were troubled institutions, and while they credit Gillespie with skillfully integrating them into Society, some analysts still believe that he overpaid for what in reality were damaged goods.

There also have been widespread rumors--some analysts have even cited them in their research reports--that Riley and Gillespie have butted heads in KeyCorp's aerie on the lake. While these rumblings are difficult to substantiate, one report says that Gillespie was more willing to stretch on acquisition prices than Riley, whose own deals at the old KeyCorp entailed only modest dilution that was easily worked off. Rodgin Cohen, a banking attorney with the New York firm of Sullivan & Cromwell and Riley's advisor on the Society deal, questions whether such accounts are true. Cohen also was Key's attorney on the recent Maine and Vermont deals, and has handled a number of other matters for the bank. "I haven't seen it," he says of reported tension between the two men. "I may not see it directly, but I haven't seen it indirectly."

There's no disputing that Riley and Gillespie are very different people. "Anyone who spends time with Victor and Bob knows they are not cut from the same cloth," says Meyer. Riley is a hands-on manager who has spent 21 years as the old KeyCorp's CEO and is unaccustomed to sharing power. Back then he never appointed a president or vice chairman, preferring to have senior managers report to him directly. Riley also seemed to have a difficult time living with a number two; in 1992 he hired two experienced bankers for the purpose of creating a succession race, but both had left the bank by the time it merged with Society. True to his temperament--but at odds with the normal role of a CEO--Riley runs the bank while Gillespie develops KeyCorp's long-term strategy. But it is a much larger bank and therefore more difficult for Riley to control. "Victor doesn't know everything in this company today," says Meyer. "That's hard on him because he did know everything in the old company."

Gillespie, by contrast, is a delegator, a person whom Meyer says "relies more on the group around him than Victor did." Riley also credits Gillespie with having a better view of the horizon--or at least the necessary disposition to spend time gazing upon it. "Bob and I are somewhat different," Riley explains. "Bob is a planner." Riley says he has asked Gillespie to develop a long-term strategy for the bank. "What it allows me to do is manage, get involved," Riley continues. "Then he can take his plan and roll it out."

Alliance of Self-interest?

Both men have ample reason to make this deal work, which should insure their cooperation regardless of style or philosophical differences. Riley wants to go out on top, leaving behind a bank in sound financial condition with excellent prospects for the future. And Gillespie, he gets the gift of a lifetime--a much bigger bank to run after Riley retires. "(Gillespie) ought to be content to sit back and let Victor do his thing for a few years," one analyst says.

Since Key is a public company, the ultimate test of this merger is whether it has been good for shareholders. Since KeyCorp's stock trades for less today than it did before the merger, one is moved to say it has not. But that is a very short-term perspective. And Riley and Gillespie are trying to build a bank for the ages, which is a long-term endeavor. Implicit in criticism of the deal is the assumption that other options were available to both companies. They could have continued on their own, but might have fallen behind in the consolidation race. They could have sold out, but there were only a small number of buyers who could pay the price that either bank's huge capitalization and a premium for control would have required. Riley and Gillespie must execute, they must deliver their promised revenue enhancements, or shareholders would have been better off without the merger. But they are making progress, and this could turn out to be the real deal.

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