The Future of Large Bank Transactions

Bank Director asked Sanjiv Sobti, senior managing director of Bear Stearns & Co. to share his insights on large bank merger and acquisition activity in the U.S.

Bank Director: Could you give us an overview of the factors influencing the slowdown in larger bank transactions this year?

Sanjiv Sobti: A major factor influencing the recent slowdown is that a number of companies are still busy assimilating recently closed large transactions. Notable among this group are FleetBoston, Fifth Third, and U.S. Bancorp. At this time they would only engage in another bank acquisition of a fill-in nature.

A second factor is that other historically active acquirers are on the sidelines with an internal focus. Notable among these banks is Bank One and BankAmerica. That being said, these companies may pursue opportunistic, fill-in business line acquisitions.

In addition to these factors are concerns about asset quality, fueled in part by rising concerns about the economy. Merger activity tends to slow as banks have greater comfort with their own asset quality and underwriting than that of potential merger counterparties. The First Union/Wachovia merger announcement, proof that sentiment can shift dramatically and quickly, surprised the market given that First Union was viewed as internally focused and both companies have experienced meaningful deterioration in asset quality.

The slowdown really boils down to the fact that there are few large banks that are both acquisition-ready and have a relatively strong currency to enter into acquisitions that are financially attractive to them.

Will this slowdown continue?

We have to put this in perspective. At the large-cap level the industry has already experienced significant consolidation in the last five and 10 years. Therefore, it is logical that large bank merger activity will not continue at the pace witnessed from 1996 to 1998.

The dynamics are different for middle and smaller-sized banks. There remain a considerable number of these banks which will likely feel continued pressure to engage in transactions to stay strategically relevant. The interest rate easing cycle has bought some time for the lower-tier performers among these companies; however, ultimately they have to affiliate out.

Can you give a sense of the larger picture for bank consolidation?

The whole bank consolidation process has been playing out in stages. We went through a period, the two-year merger boom from mid-1996 to mid-1998, during which transactions were entered into on terms biased in favor of sellers. During this period, companies felt that in order to solidify their opportunity to remain independent they had to establish their place in the pecking order of size. It was a period in which one transaction became a catalyst for the next transaction. Banks jockeyed for their desired size ranking in order to preserve independence as a strategic option. This was happening against

the backdrop of a stock market that was receptive to banks and

hospitable to deals.

Then, in 1999 and 2000 we went through a period during which the early returns from some of the major mergers were turning out to be quite negative. At the same time, we were also entering into an interest-rate-tightening cycle. The stock market cooled dramatically towards transactions, and even conservatively priced transactions were greeted with skepticism. Potential acquirers went into a reactive mode to sale overtures from companies that were at risk of missing earnings expectations, due in part to a less conducive yield curve. The beginning of asset quality deterioration was also becoming apparent. Companies with quality franchises that found themselves in this predicament—missing earning expectations—chose to ride out the storm with a partner rather than risk the type of massive stock price decline that had greeted the slew of earnings disappointments seen in the first half of 1999. Transactions during this period were announced at terms less attractive to sellers, and more attractive to acquirers, than transactions entered into from mid-1996 to 1998.

We are currently in a period in which the margin compression risk has been mitigated by monetary policy easing. This has eased the pressure on one class of potential sellers. However, for others this has been replaced by the pressure on earnings from asset quality deterioration and tepid revenue growth in a dramatically slower economic environment. Banks that are further behind the curve in addressing long-term strategic challenges and/or are nervous about their asset quality may become motivated sellers in this environment. Asset quality problems can be addressed more discreetly in the context of mergers through a “non-operating” special provision rather than by taking regular provisions through operating earnings. From that standpoint, we continue to be in a period in which consolidation will be driven more by the existence of motivated sellers rather than aggressive buyers.

Though these factors may play a role in slowing down transactions, strategically speaking, is it still good reason for a large bank to acquire another large bank?

Absolutely. The synergies on the cost side are significant, and there are revenue synergies to be realized, too. The question is: How will the value of the synergistic benefits be shared between the shareholders of the selling and acquiring companies, respectively? As I mentioned, in the 1996 to 1998 timeframe, the selling shareholders realized the vast majority of the value of these benefits. Since then, acquiring companies have been successful in preserving a greater portion of these benefits for their shareholders. In certain circumstances, I expect increased pragmatism by potential sellers in accepting modest or negligible premiums to facilitate transactions.

It’s still a buyers’ market, but a very cautious buyers’ market. Is there more of an impetus today to expand business lines horizontally by acquiring an investment bank or an insurance company rather than buying another bank?

Bank acquirers are looking to transactions to generate earnings growth through cost savings and revenue synergies and/or to gain critical mass necessary to establish their brand. However, many acquirers recognize that they have not solved the issue of capturing a greater share of the customer wallet or the issue of accelerating lackluster long-term growth trends. In fact, some people feel that acquiring banks that lack revenue vibrancy may further damage long-term growth prospects.

So in buying more of the same, it doesn’t necessarily increase your overall value if those assets don’t bring something greater to the mix. Could it even dilute your value and hinder growth?

Increasingly, banks are becoming more internally focused as they attempt to configure their organizations to achieve higher growth. While size can be a facilitator in aligning these strategies, it can also be an impediment. Size allows companies to make larger investments in products, technology, and delivery channels. But, size can be an impediment if the bureaucracy that results from increased size translates into a lack of unified culture and customer focus.

Do you think that the size of some institutions protects them from downturns in the economy or shields them from credit losses?

Good point. Size frequently facilitates geographical diversification. As risks are spread over a larger geographic area, exposure to localized economic problems is mitigated. The desire to reduce localized exposures has been prevalent throughout the consolidation process after the early 1990s recession.

Would the same hold true for banks purchasing diversified lines

of business?

Banks have made acquisitions of securities companies and asset management companies to offer a more complete product array and increase customer penetration. While this type of activity will likely continue, it will not be as extensive on the insurance side since most companies don’t have delivery channel management processes to harness the potential synergies. Since Citigroup is the only U.S. bank/insurance model, there is little pressure on bank managements to pursue insurance deals. Banks are currently confronted with more urgent challenges.

So far, we’ve seen selected, highly focused companies realizing the benefits of superior execution. Some of these are smaller companies, such as Southwest Bank in Texas and Commerce Bancorp in New Jersey. Larger banks like Charter One, Comerica, Fifth Third, Firstar/U.S. Bancorp and M&T have also realized the benefits of focusing on their core competencies.

Changing focus for a moment, can you address the impact that the elimination of pooling-of-interest accounting will have on banking transactions this year?

It’s certainly going to change the environment. Conventional wisdom was that the demise of pooling will dramatically reduce merger activity in the banking industry. We’ve seen some early indicators that the market can readjust to cash earnings fairly rapidly. The adjustment to cash earnings, in conjunction with the ability to create more flexible transaction structures using purchase accounting, may actually provide a boon for merger activity.

Can you explain some of the implications of purchase accounting?

An acquirer can immediately sell significant operations of a target, which would have voided a pooling transaction. The ability to divest operations allows buyers to optimize value by retaining the businesses from which the most synergies can be garnered.

Further, the elimination of pooling may well result in increasing contested M&A activity. In a pooling environment, transactions

are often announced with a lock-up option, precluding an interloper from using pooling-of-interests accounting. This not only discourages interlopers from disrupting announced transactions, it also discourages companies from making outright hostile bids. It is extremely difficult to consummate a hostile pooling transaction.

In a pooling environment, P/E is more important than size. In a purchase accounting environment, on a comparative basis, size will be more important, due to the ability to manage capital structure. Thus, the larger the absolute size of an acquirer, the more in absolute dollar terms a capital structure can be leveraged, giving a significant advantage to the largest companies

Will size become more of a driving factor in terms of making acquisitions?

It certainly will become an issue once the largest banks again start to focus externally.

Any advice for directors considering mergers this year?

In order to achieve longer-term success, companies need to formulate and execute on well-defined vision, whether investing in the business or consummating strategic partnerships. Successful acquirers have a keen focus on the nuts and bolts of execution. They quickly move toward integrating operating platforms. They also implement a unified culture as quickly as human nature will allow cultural changes to take place.

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