It seems we are entering a new epoch in banking, where demographic changes in America's population are forcing institutions to strengthen their investment management skills. This tectonic shift in the geology of banking was the driving force behind Mellon Bank Corp.'s December 1993 acquisition of mutual fund giant Dreyfus Corp. for $1.8 billion. The feeling then was that Mellon CEO Frank Cahouet had bet his career on the Dreyfus deal. True, if there really is a new epoch, then acquiring Dreyfus - coupled with Mellon's earlier purchase of The Boston Co. - makes sense conceptually. But a year or so later, one has to wonder about the wisdom of Cahouet's wager.
Mellon financed the deal by issuing a ton of new stock to Dreyfus shareholders, which had the effect of diluting its post-merger earnings per share by 15%. Is dilution ever justified? NatWest Securities Corp. analyst John Heffren says yes - when it meaningfully enhances a bank's growth rate. But it's entirely possible that Mellon's old shareholders will never make out on this deal. Dreyfus contributes about 15% of Mellon's earnings, but accounts for about 30% of its outstanding shares. Heffren says the deal ended up being a "massive wealth transfer" from Mellon's old shareholders to those at Dreyfus. To work off that much dilution, Heffren figures that Cahouet will have to double Dreyfus' earnings - which is asking a lot. It's possible that Mellon will eventually buy back some of its stock, which would help. But since the transaction was structured as a pooling of interests, the bank is prohibited from making any significant repurchases for two years after the deal closed, which would be the summer of 1996.
If Frank Cahouet can't make this deal accretive to earnings per share within, say, three years of running Mellon and Dreyfus as a combined organization - which would be the summer of 1997 - he probably deserves to be fired. That may seem like a harsh statement, since he is a respected CEO and deserves credit for having turned the bank around in the late 1980s. But asking Mellon's old shareholders to take a 15% haircut to ensure the institution's long-term viability is, to my way of thinking, unfair. Cahouet argues that he is building Mellon for the future, repositioning it for the new era. But if Mellon's future was so uncertain that taking on massive dilution was justified, then it would have been better to sell the bank at a premium to someone else. Where is it written that Mellon - or any public company - has an inalienable right to remain independent? Of course, the 62-year-old Cahouet is close enough to retirement age that he'll never be held to account if the Dreyfus acquisition fails to pay off.
I wouldn't be surprised to see more deals where banks cite the urgency of the times as justification for overpaying, which in essence is what Cahouet did. But there should be a strict "means test" for all mergers: No end can ever justify any means that punishes existing shareholders. The survivors won't be those CEOs with a flair for high-concept strategy or the dramatic deal - it will be those who consistently reward their owners quarter after quarter, and the hell with how they do it.
