The Impact of Legislation on Acquisitions of Nonbank Industries

Bank Director asked Owen Ryan, industry specialist leader, financial services, Deloitte & Touche, to comment on bank reform legislation and its impact on nonbank industry mergers and acquisitions.

Bank Director: Financial modernization has been widely publicized as a major impedance for banks reaching into nonbank areas such as insurance and securities. Many believe legislation was just a formality and the Citicorp/ Travelers deal proved that banks can do whatever they want or need. Do you agree that legislation was needed for banks to move into this arena? How is the actual legislation impacting banks?

Owen Ryan: I think the legislation was needed. My understanding is the Citicorp/ Travelers deal required the law to change before the transaction could be finalized. The law allows financial service companies, whether they be banks, insurers, or broker/dealers, to look for opportunities to expand into non-traditional territories. This strategy is a defensive play in a sense because the “one silo” companies have a much narrower product offering.

For example, over the last decade, many bank customers moved their money into asset managment. The banks were unable to compete with potential returns from asset managers, so they were losing a share of the wallets of their clientele. The same can be said today of insurance companies looking to establish or buy banks. They need to be able to offer their customers short-term investment options, like a CD, without tying up

customer money in long-duration insurance products that may not be appropriate for

the individual.

Financial services companies that fully understand the specific product needs of their customers over their lifelines and deliver tailored solutions will be the winners. MetLife and Merrill Lynch are examples of companies that are proactively offering their clients new products or solutions.

Is there a current scramble to grab all of the right targets?

Yes, there is a scramble, and from my perspective, more convergence will likely take place over the next 24 to 36 months. Many companies struggled with what they could and could not do after Gramm-Leach-Bliley passed, because of the privacy issue. Until the privacy rules were worked out, there was some hesitancy in buying a company in a converging market because companies didn’t know what they would be allowed to do with the information aquired. For the first six months after Gramm-Leach-Bliley, for example, our clients were concerned about what could and couldn’t be shared. Why would a bank buy an insurance company if it couldn’t use some of that data to figure out what products its customers might want? Also, how should an acquirer set up the infrastructure to make sure it didn’t violate the rules and complied with privacy issues? One impediment is that the infrastructure is expensive to put in place, particularly with regard to technology investments. Today, companies are more comfortable in knowing how to operate within the privacy rules, although their monitoring of compliance has not yet been tested and some companies appear more vigilant in their efforts than others.

The next issue is how to make cross selling work. It makes almost no cross selling sense to do these transactions if you cannot effectively cross-sell and thereby capture the value in a convergence deal. Of course, herein lies the challenge. Think of it from the bank officer’s perspective with regard to a long-standing, trusted, and profitable customer relationship. Would I really want to turn that relationship over to someone who is in the insurance or asset management part of the operation; that is, someone who may not treat my customer with the same level of care and respect? So the trust issue is a potentially significant barrier from the cross-selling perspective. Do I want to turn my good customer over to someone in the organization whose product I don’t understand? Do I want to move the money out of my operation and into to another? There is a real hesitancy in supporting other areas of the organization. Will we retrain our insurance agents, brokers, and loan officers to sell these other products? There is so much to know about the nuance of each product that it is probably not feasible to do so and it’s difficult to succeed. Finally, how do we incite these employees to cross-sell? Clearly, there is a need to align compensation with overall corporate goals.

Are we waiting for the consumer to become familiar with banks as experts in all financial matters? Do you think that the issues of trust, return on money, and efficiency seem to be falling away from the younger generations?

I absolutely believe that. Some companies have made the mistake of looking at their market as a mass market and have been slow in figuring out mass customization. There are several questions: How do we distribute our products? Do we have agents, brokers, or bank officers sell the products? What happens if we just sell or distribute through the mail or online? Suddenly, we are cannibalizing our employees’ compensation. But if we don’t do it, someone else will. There is hesitancy in offering multiple avenues for customers to buy products, but without stereotyping, we see that a 20-year-old wants to buy a product in a different way than a 60-year-old—which is why banks should offer a variety of ways to access their product in the marketplace. The companies offering only one way to do it because they don’t want to upset their brokers, agents, or bank officers are eventually going to lose a big part of the market.

Can you give an example of a successful bank acquisition of an insurance company? What made this particular match a success?

I can’t name a U.S. bank that has really made it work so far. Many point to Citigroup and say it is doing a great job; time will tell. It appears to have many of the right things in place, but is still struggling to make cross-selling happen to the extent it wants it to happen.

It’s too early to make a judgment call?

Yes, but to date some of the European companies have had more success. Examples include ABN AMRO, ING Groep, and Credit Agricole, a French bank and one of the largest sellers of insurance in its market. In the United States, even banks that have acquired insurance agencies or brokers for distribution have had mixed records so far.

Some have made it work on a smaller scale, but I don’t know of any that have pulled it off on a large scale, including the Fleet acquisition of Summit. Summit was building its insurance agency network when Fleet acquired it. But it appears that Fleet will abandon this strategy.

Looking at a potential acquisition from the board of directors and management standpoint, how is due diligence different when you are buying a nonbank institution than when you are buying a bank?

Overall, the objectives of due diligence are the same regardless of whether the transaction is a consolidation or convergence play. You need to clearly understand what you are getting yourself into. The challenge with a convergence transaction is that typically the buyer does not fully understand the business of the seller—it is not his expertise. The key to a successful convergence transaction, therefore, is to acquire the right management—a quality team that knows what it is doing.

Other important issues to understand when performing due diligence are track record, brands, previous success, outlook for the market, cultural fit, and the cross-selling synergy that can be realistically gained out of the transaction.

What are the valuation differences between banks and nonbank institutions?

Historically, insurance companies have had lower valuations than banks. The insurance industry hasn’t delivered competitive returns because it’s overcapitalized, and insurance executives are competing on price much more than they should, thereby treating their products like commodities. Valuations of banks have improved because of their success in controlling costs, raising revenues through new fees, and using capital effectively. Leveraging technology to take out costs and drive up returns will help change the insurance industry. The mutual structure of many insurance companies has insulated them from shareholder pressure so they were not forced to deliver the kind of returns they need to be competitive. Many mutual executives argue that they didn’t need to deliver profits because there were no shareholders, just policyholders. I don’t necessarily agree with that. I think you should always make your operation as profitable as possible, whether it is for your policyholders or your shareholders. One of the things we still see from current valuations is that it’s easier for banks to afford insurance companies than vice versa because of the currency value, that is, their cheaper relative share price.

Given the fact that it is a relatively soft market in the insurance industry right now and given the potential upside for cross selling, is this a good time to make that type of investment?

I think so. The market—the insurance industry in particular—should consolidate and take out some players. Banks did that in the 1980s. The insurance industry hasn’t gone through that yet, so it may be time for the banks to help that happen. So I believe now is a good time for banks to go after the insurance industry. Valuations are attractive enough whereby they can afford to do it. There is a feeling—and I’ve spent time talking with many insurance company executives—that they are waiting for something to happen and to see who will go first. It will be interesting to see if the American General transaction stimulates some activity. Convergence will make sense over the long term as customers want more convenience and one-stop financial services. They want a company that gives them the opportunity to have all the desired services available. The question you have to ask yourself is: Do you want to be a leader, fast follower, or laggard?

What are some of the softer issues related to the differences in culture, such as management, succession, and compensation? Do you have any advice on what the board of a bank might expect when it is looking at one of those other industries?

That’s a great question because one of the changes we see in the M&A environment is acquirers showing more concern about culture. Statistics show that a clash of cultures causes many deals to fail. But what’s more convincing is to talk to the people who have lived through it. They don’t talk about strategic mistakes, they talk about the new team not being able to work together. The notion of two CEOs shaking hands and both feeling that it’s going to work is just not the right way to look at it. In a number of our deals, we do what we call a “culture print” in which we actually assess the culture during the due diligence phase to make sure that the companies can be melded into one. You can make all the numbers look right, but if you can’t get the two teams to come together then you will not have a successful transaction.

What do you look for in that process?

We look at how management treats the employees. What are the benefits? What is the training program? How do employees behave towards one another? What is the work environment like? Is it a place that focuses on rewarding employees? Are employees just a commodity, or are they viewed as an asset? If we have two organizations—one views its employees as a commodity and the other views them as an asset, then that deal is probably not going to work.

Do companies really admit that they view their employees as a commodity? Most companies say their employees are number one. How do you get to the heart of that?

That is why we use the due diligence process. We dedicate some of our team resources during the diligence process to understanding a company’s culture. Interestingly enough, employees are usually very forthright about their employers.

Is management succession a dilemma when a bank is buying an insurer? Would you keep the same two management teams in place?

Typically, there will be one CEO in the combined organization, as co-CEOs generally do not work. However, there may be a job for each of the two executives running their respective predecessor companies. For example, if John Hancock and Fleet were to do a transaction, management could be structured whereby the Fleet CEO runs the banking operations and the John Hancock CEO runs the insurance operations. Regardless of structure, friction is likely to be less of an issue if egos are managed. The reality is that both executives and management teams need to recognize that they need each other. There aren’t too many situations where bank executives go over and run the insurance operations or vice versa. Over the last 10 years, I’ve seen bank executives try to run insurance companies and insurance executives try to run banks, usually with less than optimal results.

Are there other pressing issues for companies looking to expand?

The best deals are those not found in an auction environment. The best deals are those management has carefully studied and decided to go after. Unfortunately, many deals are done by companies deciding to put themselves up for sale in a situation where there are more than a handful of bidders and each prospective buyer gets only a few days to perform due diligence. The next thing you know, you have put in a bid and you win—it’s the winner’s curse. Suddenly, you are about to own this company and realize that you don’t know as much about it as you would like.

The better deals are those where the board of directors sits down with management and works out an M&A strategy that ties to the overall corporate strategy. Management develops and then cultivates, a list of targets. During the cultivation period, the dialogue with the targets should focus on making sure a deal would be a good strategic fit, on how things would operate, and the roles of critical team members. This is what drives a successful M&A transaction. So if you want to be a successful acquirer, always remember you need to be proactive and create your own opportunities.

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