Strategic Opportunities in Bank Consolidation

This roundtable session focuses on both regulatory and strategic merger and acquisition issues as they affect community and mid-sized banks. The participants were John Duffy, president and co-chief executive officer, Keefe Bruyette & Woods; Mike McClintock, managing director, head of U.S. financial institutions, CIBC World Markets; Ben Plotkin, chairman and chief executive officer, Ryan, Beck & Co.; Christopher Quackenbush, principal, Sandler O'Neill & Partners; Robert Rinek, managing director, investment banking, U.S. Bancorp Piper jaffray; and Jerri Moss, associate publisher, Bank Director, moderator.

JERRI MOSS: What role has financial reform legislation played in M&A activity? How will reform legislation affect M&A in the future?

CHRISTOPHER QUACKENBUSH: I don’t think it’s had a tremendous impact. The legislation was playing follow the leader anyway. The industries were converging so they knew it was going to happen eventually. But “eventual” is the key word, because we don’t see insurance companies racing to buy banks or vice versa. We’ve seen different strategies. In the first model, the very large leaders in each industry have joined together—Citicorp and Travelers, Salomon Smith Barney. At the other end of the spectrum, MetLife recently bought a small bank and plans to homegrow the business. At this point it is still trying to figure out exactly how the bank fits in. The second, more prevalent model is when people put a toe in to see how it works, and then pursue consolidation down the road. It will be some time before there’s a tremendous amount of activity, although it was nice to see the Fed approve MetLife’s acquisition. And it didn’t seem to pose any unusual restraints on the operations of MetLife to become a bank holding company.

ROBERT RINEK: On this toehold strategy, Bank One did something interesting in its acquisition of Congress Life. Bank One bought the corporation, some licenses, and product filings and left the outstanding policies with the selling company. We might see more joint venture activity on the insurance side. We’ve been wrestling a bit with why there hasn’t been more activity between banks and insurance companies. One inhibitor is the lower return on equity for insurance companies. They don’t have the revenue growth and the bottom-line growth banks are looking for right now in terms of getting better valuations in the marketplace.

BEN PLOTKIN: There’s a great disparity between the largest financial institutions in this country and the community banks. We have gone to a barbell setup where a few very large financial institutions control most of the deposits and assets of banks worth less than $500 million. This difference is more pronounced as banks get into other businesses, particularly as it relates to management. There are greater demands on management at community banks that want to get involved in activities now permitted of financial institutions. Many community banks find that they’re just not equipped to deal with these new business lines. They must acquire that talent through acquisition or exit the business. So that’s been a big change, but I agree with Christopher, the legislation reflected reality; it didn’t cause it to happen.

JOHN DUFFY: I agree, and I think we all understand that Citicorp caused Gramm-Leach-Bliley. That deal was in our face and it changed the legislation, which is usually the way legislation happens in the United States, at least with respect to financial reform. The banks or someone else finds a way around it, then the legislation finally changes. So instead of a year into convergence, we’re probably five years into it. But we are still at a stage where more people are sticking their toe in the water to see how it feels rather than jumping in full scale.

The insurance industry is where the banking industry was 10 or 15 years ago in terms of consolidation and dealing with change. There are still a number of good-sized mutuals that will force change within their own industry as they go through the conversion process. Who are the winners? Which franchises would you like to own if you are at all attracted to that business? Some banks may eventually be attracted to the life business. I haven’t found any that are attracted to the P&C business. The underwriting arena is where banks in the lending business were 30 years ago in terms of trying to minimize the risk, generate more fee income, or take on less risk. As for convergence, there is one part of the financial services pie, the brokerage industry, which has largely consolidated itself. The banks have aggressively jumped in there. If you look at insurance, asset management, and brokerage, banks that have the market cap are more open to acquirers, unless things change dramatically.

PLOTKIN: Have they made it work?

MIKE McCLINTOCK: We view the legislation in a couple of ways. The insurance deals have primarily been acquisitions of agencies, although we had one client who bought an underwriter. Banks want the insurance product to fit into their system without the underwriting risk. I agree with John that until banks get comfortable with the underlying fundamentals in the insurance business, I don’t think there will be many deals. The insurance companies have lower ROEs and they need to increase efficiency.

Another important area of the legislation is merchant banking, which increasingly is playing a role in other parts of the investment banking practice. Clients expect us to make an equity investment and lend them money in order to get key investment banking business.

RINEK: Many banks have struggled with how to get into the life or annuity business. There are a number of situations where some of the life companies are going to banks and designing private label annuity programs for them to sell through their system. It’s very important for these insurance companies to gain client access. The banks have the clients and the relationships. The insurance companies are saying, “We don’t necessarily need our name on this product. We can put a product together on a private-label basis, with an A rating or better, and split the fees generated from that product.” This isn’t a scenario where these banks must own insurance companies. In many cases, they can work out joint ventures where they gain access to the product without spending much money.

QUACKENBUSH: But in time they must be able to offer the product. There will be people stepping up and finding ways to offer the product without taking risks they don’t understand. Some of the larger companies will want to own the product itself, to manage the creation and delivery of it. Today, a bank’s most valuable asset is still the customer, and it must find different ways to do business with that customer, both to increase the revenue stream and to lock in the relationship.

DUFFY: We’ve seen this same process happen with banks in the credit card business in the last 10 years. The competition grew fierce, and there were some banks with credit card businesses that could no longer manage them. They decided that there was more value in selling what they had and letting someone else take over. They may still get paid on an agent basis, but that’s not very profitable. If a bank is just distributing the product, the profit potential is fairly minimal and won’t have much impact on the bottom line.

PLOTKIN: Again, we need to differentiate between community banks and larger financial institutions. For community banks, their best asset is relationship management, and you have to compare that to the regional broker/dealers. The smaller broker/dealers are doing very well in this environment. They are enthusiastic about relationship management and they want assets from their customers, whether those assets are CDs, mutual funds, or annuities. Recently I was at a meeting with mutual broker/dealer CEOs, and they were quite optimistic about their ability to attract assets. If you go to a community bank meeting, you don’t hear that optimism. Thus money can be made collecting assets for community banks that, in turn, won’t have the expense of producing or developing products.

McCLINTOCK: Now everyone has an open architecture where customers can access their product distribution system. In the specialty finance area, we’ve gone to “category killers,” specialists who focus exclusively on one particular product, such as mortgages or credit cards. The banks that sell 15 products cannot possibly compete.

MOSS: Will e-finance have an impact?

QUACKENBUSH: Look at the electronic economy as a way to access and stay in touch with customers. You will probably not gain new customers right away, although that will happen in time. Banks are effectively locking in customers with services like bill payment, which is using e-finance to tie the bank to the customer.

RINEK: Many of the e-finance companies have shrunk significantly, and a number of them are having a difficult time raising money right now. If you look at the core competencies that each of these companies has, you see that they are very good, but as standalone entities, they are questionable ventures. Thus there is a big opportunity for banks to buy e-finance companies and integrate their distribution platforms and product ideas into their operations. They don’t have to create the technology, because it’s already there. We’ll see some M&A activity occurring in this sector over the next few years.

PLOTKIN: For most banks, e-finance is the relationship manager. In a local community, it’s another channel. More and more customers want the ability to access their accounts at midnight, process a trade, or pay their bills whenever they want. This is the way to empower customers and create some stickiness, because there are differences in the quality of technology from bank to bank. But I don’t necessarily agree that banks need to go out and buy e-finance companies. They can now replicate the technology at a very low cost, as it gets cheaper and as their service providers add bells and whistles. That’s a great new channel for banks.

RINEK: As technology redefines what people consider to be financial, there are a number of interesting products coming out, like stored-value cards and smart cards. Where do banks need to be in that area? Many large phone carriers like Verizon and AT&T are going to be players in this market and will take customers away from banks. The banks have to define their position in this area. Do they go out and create it themselves, or do they form joint ventures with some of the carriers? It will be interesting to see what happens, because the large phone companies are already well set up with stored-value cards and can aggressively go after this segment of the marketplace.

McCLINTOCK: I’m not a complete believer in stored-value cards, because customers are not adopting them. They will buy a phone card, but they have not bought a card that looks like a Visa that allows them to buy $100 in groceries or other products. I think the debit card is a huge growth vehicle for all banks. The debit card will grow faster than the stored-value card.

RINEK: The stored-value card should be marketed to the lower socioeconomic group, as opposed to higher-net-worth customers.

QUACKENBUSH: Like check-cashing customers?

RINEK: It should be targeted to people such as college students or those who need some type of discipline imposed on them in terms of budgeting their money. It doesn’t play to all banks, but it does play to certain institutions, like Wells Fargo, that have gone after that niche in the marketplace.

MOSS: To change the direction a little, can you comment on the recent hostile activity and the likelihood that it will continue?

QUACKENBUSH: We were involved on the offensive side of a hostile situation between North Fork and Dime Bancorp, representing North Fork, and then had to defend a hostile overture for Hudson River. In neither case did the hostile party get what it was after, and traditionally that’s been the result. While it’s not rare, it is less common that you actually win what you go after. I think that’s going to make people pause before they undertake a hostile maneuver.

DUFFY: So is it more fun to play defense than offense?

QUACKENBUSH: It’s more fun getting what your client wanted done, and in some ways, it works out fine in both cases. On the industrial side, we see the hostile suitor winning around 30% of the transactions, a third with someone else winning, and another third with things going back to life as usual. We’ll probably see a lower success rate in the banking area, but one or two cases where it’s successful.

Interestingly, the absence of pooling makes it much easier for people to finance hostile transactions and do part-cash, part-stock transactions. Also, we are continuing to see multiple separation, where some buyers have huge multiple advantage versus other potential buyers. If target company A decides to do a sweetheart deal with company B, then B should include a “whopping” 3% breakup fee in the contract to try and keep others away. If you’ve got a buyer in that market with a P/E that’s 2, 3, or 4 multiples higher, then it would be relatively easy for it to top an offer if it wanted to. That’s not going to happen routinely, but we’ll see the occasional deal that was mispriced and not structured properly. It’s a tough situation.

DUFFY: Even with involvement from the regulators, it’s still tough. From the defensive standpoint, you may put a company into play with a CEO who is guilty of mismanagement and deserves to be taken over and with shareholders who deserve to be rewarded for years of underperformance. You may get that company into play, but to be truly successful in a hostile transaction puts you in a distinct minority.

QUACKENBUSH: At the end of the day, you have to be the best buyer to win. Chances are you’re not going to make any friends. The poison pill is a great defense, and if a company doesn’t have a shareholder rights plan in place, then it’s highly recommended. I’ve fought poison pills, and they are tough. I’ve also used them as defense, and they are wonderful to have in your back pocket.

McCLINTOCK: Don’t forget that state laws are very protective of local companies. As a result of hostile activity—given that this is a people-driven business—many of your best assets will walk out the door, so you’ll end up losing customer relationships.

DUFFY: Remember, it’s a service business—we’re not talking widgets.

PLOTKIN: Right. But you also have the regulators. Generally, bank regulators like to keep charters, especially if they feel like managements are being taken advantage of. Also, the proactive shareholder phenomenon will continue. There is a group of individuals who have made a good livelihood out of stirring the pot with some naive numbers and board members, and typically they make money. They are also sending a message to the smaller banks, mainly the importance of having a strategic process and putting shareholder-oriented members on the board before somebody forces you to do so.

RINEK: The amount of publicity generated with the few hostile deals that took place in the market was a wake-up call for many banks. It also introduces the question: Who will be the perpetrators of hostile activities? Their image is going to change in the marketplace, and it will be interesting to see what the school of public opinion says about the people going forward, particularly when they want to go out and do friendly transactions. Will they be embraced by some of the acquirers as readily as they would have been before?

QUACKENBUSH: That’s an interesting point, because a few of the people who engaged in hostile activity probably had an aggressive reputation to begin with, whether deserved or not.

MOSS: Does a board of directors need to be wary when another bank takes a large stake?

PLOTKIN: That’s a wake-up call. If someone with a reputation as an acquirer takes a position in your bank, then, just like when any institution or individual takes a position, you call them and open the line of communication.

DUFFY: With shareholder activists, I’m assuming they want a takeout, but in some cases, I wonder what they see in the target to give them comfort at night to go home and sleep. I’m frequently puzzled by some of these acquisitions.

PLOTKIN: There’s an expectation gap.

DUFFY: I figure they buy some of these at market price and the takeout price is 30%, 40%, or 50% higher. Many of them have made a nice livelihood out of it, but I dare say there were some that were stuck in positions much longer than they thought. A few of them may have lost money, certainly from 1998 until this past summer.

QUACKENBUSH: As to the earlier question of whether you would be tarnished if you were a hostile acquirer, I don’t think that’s a great risk. It helps in some cases and it may cost you a deal here or there, but at the end of the day, again, because there are fewer buyers, the old saying holds true that the difference between hostile and friendly is just a couple of bucks.

RINEK: And the other side of that equation involves the John Kanases [CEO of North Fork Bancorp.] of the world as they become the champions of the institutional market. Institutional investors love people like that. They are driving shareholder value. So what if you are not a friend to many of the community banks? If you can go out there and get the top valuation for your business, then you are making your shareholders proud.

MOSS: Looking forward, what types of nonbank transactions are most likely to occur and why?

McCLINTOCK: To the extent that insurance companies become better performing, higher valued companies, they will be seen as acquirers for some community banks.

RINEK: When you look at the specialty finance area, the attractive companies right now are those that are driving high return on assets and on equity. They are not necessarily the commercial or consumer finance companies. They are the brokerage companies, the wealth management firms, and the money managers. And there are many of what we call “classic asset generators” in the commercial and consumer finance areas that want to sell, but no one wants to buy them. It’s really a conundrum, because you would think the banking institutions would want to go after these businesses, but they’ve looked at the risk return and concluded that it just isn’t attractive enough for them.

PLOTKIN: In many cases, banks have either put their toe in the water, or jumped in without understanding the business they were buying or without checking to see if their culture was in tune with acquiring a commission-based business. It’s problematic. In an effort to get more customers and to build walls around their current customers, they shouldn’t necessarily be trying to manage the money or use the balance sheet. They should focus on asset distribution in their local markets. It’s a much lower risk approach. It’s exactly the skill set that community banks need to work on to help develop customer relationships. Many broker/dealers are very good at that, and there are others that are not. It’s a similar situation with money managers. Some are very good at gathering assets and some are very good at managing assets. You want to be in the former and not the latter. As professionals, we should continue educating the banks because they don’t quite understand what they want at this point.

RINEK: If you look at the dollar amount of activity and the dollar value of acquisitions done in the nonbank financial area in the last three years, it’s gone from $34.8 billion in 1998 to $20.4 billion today. Take out the Associates deal that Citigroup did, which significantly skews the numbers, and there was only $6.3 billion of nonbank financial acquisition activity done in 2000. It has definitely gone down, which gives a fair degree of support to Christopher’s comment that it is an industry that has consolidated itself, and, in some cases, because of the difficulty in getting financing for many of these nonbank financials, companies have actually gone out of business.

McCLINTOCK: They haven’t survived because they lacked. What will happen is that many small, specialty-oriented finance companies will be created out of these sales.

RINEK: The other side of this is that some companies have survived the weeding-out process in these niches. Banks have looked at it and said, “We don’t necessarily need to duplicate what you are doing. Why don’t we joint venture? We don’t have to acquire you. We can leverage the infrastructure and the technology to go after that niche strategy.”

DUFFY: It’s similar to what happened in the credit card business. That’s one area where people are doing more in the asset management arena. It’s a fragmented industry. Prices are high, but that’s because of the larger deals, which are often driven by foreign companies or by companies that have extraordinary P/Es and can afford to pay big prices. People in the asset management industry have had a great 10-year run, and there are many smart guys in that business who realize the next 10 years may not be as rosy. Everyone has an 800 number, a website, or an open distribution channel, and it’s more challenging in terms of where to get new customers. We know that banks have the customers, and yet one of the reasons banks won’t look at the specialty finance arenas is because they are worried about the funding issue. We are a community of investors, not savers. Maybe that will change depending on what the stock market does in the next couple of years, but banks are asking how to become players in the asset management business. Most of them will continue losing customers.

McCLINTOCK: One of the issues we face is that asset managers make more money than their counterparts at the bank, and that’s a big hurdle.

QUACKENBUSH: They’ve got to get over that. As John said, the asset management business is so fragmented and there are a large number of assets sitting in various compartments. The challenge is getting over that cultural divide. Participants must be comfortable with the fact that someone who brings money to the bottom line should get paid and do well.

PLOTKIN: I don’t necessarily agree, because there are two ways to focus on the money management business. One is to focus on those who manage the dollars every day and the other is to focus on those who gather the assets and go to the best-of-breed manager out there—maybe through a wrap program—thus acting as a relationship manager with the customer. That’s an easier business to sustain, because it’s not dependent on a performance record.

QUACKENBUSH: Those people are still making lots of money.

PLOTKIN: But what we are talking about is nonbank activities that banks should get into. They really need an asset-gathering sales force, whether it’s through a mutual fund distribution arm or money management distribution arm, but they don’t necessarily need to manage the dollars on the back end.

RINEK: And that has become the entire means of existence for the retail broker. They are wealth gatherers. They’ve moved away from picking stocks; however employment by a banking organization could be an effective way to channel and keep that money with the bank, versus having it go elsewhere.

DUFFY: You’ve got community banks with customers who have a quarter of a million dollars. Most banks don’t have someone on the floor to talk to those customers intelligently about their options.

PLOTKIN: But many banks have bank brokerage operations, and third-party contractors focused on the short-term dollar. Sell that annuity and give me the highest price first, instead of gathering assets and getting the management annuity or fee over the next five years.

DUFFY: True, but I haven’t seen that many banks are satisfied with their efforts.

McCLINTOCK: It’s a tough sale. Look at the salesman that sells five products, such as term deposits, car loans, mortgages, investment management, and leasing. It’s not possible for one salesman to be an expert in all those products.

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