Over the past two decades banking executives have spent billions of stockholder dollars trying to create value by acquiring other institutions.
Though some of these attempts, such as the Chase-Chemical merger, have been remarkably successful, many others have been disappointing. A few, such as the First Union-Money Store and Conseco-Green Tree acquisitions, have been disasters.
In the short term, almost all the economic value created in mergers and acquisitions flows directly to the shareholders of the acquired institution and to the investment bankers who engineered the merger. In stock mergers, target stockholders enjoy an average short-term gain of about 24%, while acquiring stockholders gain only about 5%. With cash purchases, the disparity is even greater: Target stockholders earn a 32% premium while acquirer stockholders gain only 1%.
Obviously, equities markets believe that it is far better to be acquired than to acquire. But why? And why do so many bank executives seek to acquire in the face of such obvious market bias?
From an investment analysts point of view, the market value of a business has two components: the capital that investors have paid in, and the added value the business uses that capital to create. The second, market value added or MVA, measures the actual amount of shareholder wealth created.
Over time it correlates strongly with economic value added, or EVA (a registered trademark of our firm) the actual profit accrued by shareholders after a business deducts its cost of capital from the net after-tax operating profit.
Market value can also be separated into current operations value, the no-growth value of the firm, and future growth value, the future EVA improvements the market anticipates. This future-growth-value component creates a tremendous challenge for mergers and acquisitions because the market has already factored future performance improvements into its current valuations. These expectations of improvement support the price at which the stock is currently trading.
In almost all mergers or acquisitions, acquiring banks must offer price premiums significantly above current market prices to ensure control of targets. The recent deals under which Citigroup Inc. is to buy Associates First and Chase is to buy J.P. Morgan involve significant control premiums. Citigroup is to pay a 50% premium ($10 billion) over the pre-deal market price for Associates First, and Chase a premium of 20% (approximately $5 billion) for J.P. Morgan.
To recoup these huge outlays, merged organizations must deliver performance improvements significantly higher than those already assumed in their pre-acquisition market valuations just to stay even with those valuations. In some cases, the profit growth rates required to justify the acquisition may be twice as high as predicted pre-deal growth rates for the target companies. The pre-deal earnings growth rates predicted for Associates First and J.P. Morgan were 8% and 7%, respectively; the post-deal rates for both were 14%.
Acquiring institutions, however, have deployed so much additional capital that incremental capital charges will generally offset strong improvements in operating results. Many institutions cannot meet their elevated post-merger growth projections, and markets penalize their stocks harshly and disproportionately.
These effects can be so damaging that acquiring organizations are forced to unload the acquisitions at great loss. Conseco, for example, has announced that it will divest Green Tree Financial, while First Union is closing Money Store. At midday Thursday, Conseco stock was trading at $7.0625, 85% below its price when the merger deal was announced, and First Union was trading at $24.75, 59% below the price when that deal was revealed.
To understand why acquisitions have been so popular in the banking industry, consider the ways that banks reward the senior executives who make strategic acquisition decisions.
Banking executives, like executives in most fields, are generally eager to increase the size of the organizations they manage. Their natural bias toward growth makes it difficult for them to address dispassionately the critical questions about an acquisition. It becomes even more difficult if their incentive plans do not tie their compensation tightly to shareholder value creation, as measured by EVA.
Executives compensated on increases in revenues and/or profits, earnings per share, or rates of return will look favorably on acquisitions that improve these measures. Most acquisitions will increase revenues, gross profits, head counts, and budgets, and may also improve ratios like earnings per share or return on equity.
The fatal irony is that acquisitions can produce apparent improvements in such measures while actually destroying shareholder value. Even increases in market value are not adequate measures of managerial performance, since increases in stock prices do not necessarily yield real increases in MVA. If, for example, a firm returns $70 million to shareholders on $100 million of additional investments, its apparent market value could increase by $70 million. But real MVA would actually decline, by $30 million.
The only way to ensure that executives base their decisions on the long-term interests of their owner-shareholders is to implement incentive plans that compensate managers in exactly the same manner as shareholders in proportion to real increases in MVA. In practice, the most effective way is to base all incentive compensation on EVA improvements, since markets reward real growth in EVA with real and often disproportionate increases in MVA.
The specific details of such incentive plans can vary, but they must incorporate two attributes: Compensation bearing a straight-line relationship to real growth in EVA.
Incentives designed to ensure that cumulative pay is aligned with cumulative performance.
The easiest way to implement these is by establishing deferred bonus reserving mechanisms, where most of the bonus associated with exceptional performance in one year is reserved and can only be earned when performance improvements are sustained over time.
To be truly effective, these new incentive structures must be implemented throughout the organization, at each organizational level. Whether they are back-office clerks or executive vice presidents, bank employees will not act like owners until they are measured and paid like owners.
Mr. Shih, Mr. Kapitan, and Mr. Huebsch are members of the financial institutions practice at Stern Stewart & Co. The New York consulting firm specializes in aligning management and shareholder interests.
