Blurring the Lines—Strategies for Making Nonbank Acquisitions

This roundtable session focuses on creating franchise value through making nonbank acquisitions, internal growth, and de novo growth. The participants were Stephen M. Klein, attorney, Graham & Dunn; Jean-Luc Servat, managing director, Fox-Pitt, Kelton; Gregory J. Lyons, partner, Goodwin Procter; Kathleen Smythe, managing director, Keefe, Bruyette & Woods (Smythe was with Putnam Lovell Securities at the time of the roundtable); John M. Wepler, senior vice president, Marsh Berry; and Jerri Moss, associate publisher, Bank Director, moderator.

Are you familiar with franchises that have successfully chosen a path of generating internal growth rather than growth by acquisition?

KLEIN: There’s a predominant bank in the Northwest market called CityBank, which has shown returns on assets of more than 3.00. Aside from 15 or 20 years ago when it did one small deal, CityBank has avoided doing them. CityBank made the decision not to acquire because it’s been highly profitable and management feels it can do a better job of expanding its market in specialty areas than to buy someone else and try to change who they are. So far, it’s worked.

LYONS: It seems that internal growth works best, such as with Fifth Third Bancorp, where there is already brand recognition and expertise in a particular area and when the real issues are either customer access or product development. In certain respects, the idea of “build it and they will come” only works if they already know you. The classic example is a 529-college savings plan, where you have the 401(k) platform and want to build up a new product and revenue stream from existing expertise. It helps both your access and reputation.

WEPLER: In terms of de novo or internal growth on the corporate side, I don’t know a bank that has established a successful insurance operation, primarily because of the amount of capital required to attract high-quality insurance producers. There is a tremendous amount of execution risk associated with establishing and bringing a corporate insurance operation up to scale in a rapid manner. Our research at Marsh Berry shows that, on average, there is a breakeven period of 4.5 years before a de novo can show positive GAAP earnings. In addition, the people worth hiring typically own a high-quality insurance operation that could only be secured through acquisition.

On the retail personal lines side, HSBC and People’s Bank in Bridgeport, Conn., have done very well. People’s Bank started with an acquisition of RC Knox, which was a foundation agency. It quickly recognized a need to complement the internal infrastructure at RC Knox to aggressively go after the bank’s large retail customer base. In HSBC’s case, the personal lines insurance platform was built internally without acquisitions. It’s important to understand that if you go out and buy a high-quality foundation agency, such an agency typically has a commercial lines focus and most often only writes retail personal lines business to accommodate its commercial customers. Such agencies, despite their quality, do not have the infrastructure or the experience to engage in mass marketing or to manage phone traffic, which is what you need in order to go after the bank’s retail customers. Peak performing banks often acquire a foundation agency to secure the talent on the corporate side and build de novo, with the assistance of their new acquired partner, a full palette of personal lines retail offerings.

SERVAT: There are plenty of examples of organizations that have done well through de novo or internal growth, but there are two things you must have: a geographic market and a product that lends itself to growth. Steve mentioned the Washington market, and Columbia Bank is a good example of an institution that expanded systematically just by picking up lending teams and filling into new markets. It has grown from about a half a billion dollars to around three times that size, primarily through opening up facilities, and it did an incredible number per year. A number of banks have been able to do that in the California marketplace, on both a small and larger scale, because the growth is there. Silicon Valley Bancshares is a good example of growth, as it’s been able to roll out its franchise on a national basis and keep it going in all markets. Why? Once again, it was riding a wave that just happened to have high growth.

So internal and de novo growth are fine opportunities if your underlying market offers that growth. During the 1990s, many of the smaller and mid-size players capitalized on the fact that the larger players were focused on big M&A transactions which created dislocated consumers. I think that trend is probably reversed today. With every large bank talking about customer service and retention, the opportunity to pursue these kinds of strategies is severely reduced in all markets.

LYONS: But if you do have the underlying growth, you can spend more on advertising or spend time pricing products more effectively rather than spending the money on an acquisition and then running into the problems of integrating it afterwards.

SERVAT: Yes, but this is a bit of a mirage because in some parts of the country, it’s available, and in others, it’s not. Realistically, as an ongoing strategy, an institution must offer an absolutely superior product, like a Citigroup or a Wells Fargo. For most banks, internal growth will be really difficult to use as an ongoing expansion strategy, because they are back down to an underlying secular rate of growth of maybe 7% or 8%, if at all.

LYONS: Larger organizations can even use their expertise for internal growth and to provide private labeling to other institutions.

KLEIN: To achieve success with internal growth, a bank must be very good at what it does. I’ll use CityBank again as an example. It understands real estate, lending, and how to evaluate the risk.

The biggest change I’ve seen, in regard to expansion, is community banks and mid-size banks now branching into each other’s backyards. That creates a different competitive landscape, because they’ve always had their hometowns and their ability to dominate on the service aspect. However, they are now competing against like-type institutions, and not just the big institutions that compete on price and product. Everyone thinks of M&A, but I believe branching is an equally powerful force changing the way people do business and has created something of a revolution in the industry.

SERVAT: Banks must be careful, because we’ve seen plenty of instances where they’ve attempted that strategy and the branches fizzled out.

KLEIN: It creates a different type of competition.

SMYTHE: It does, but when banks do branch acquisitions, they often forget that they have only half the equation, which is the deposit side. They need the other half, the asset side, to make the acquisition work. Invariably they underestimate the time that it really takes to leverage those deposits and to grow earnings assets. It’s not six months. It’s a year and a half at the least.

SERVAT: That’s a good point. The common wisdom is that branch acquisitions are terrific because banks don’t have the premium, and that they are easy. We’ve all experienced the downside. I can remember when Bank of America did some divestitures in California, for example. A number of banks bought Bank of America branches and then each one of these banks did a public offering and raised some capital, only to find themselves confronted with hostile shareholders later on because they could never deploy the funds fast enough. Those funds turned into landmines and it was very painful.

LYONS: On the other hand, Citizens Financial Group’s acquisition of 345 Mellon Bank branches seems to have done very well. They had the brand name and made the marketing work.

SERVAT: If you get a large enough organization that’s true. But for smaller independents, what initially looks like a very cheap way of bulking up and an almost no-lose proposition, can end up turning in to a no-win proposition.

SMYTHE: Banks should be careful and know what they are actually buying in a branch acquisition because all branches are not created equal. In a branch package, sellers may include a couple of “dogs.”

WEPLER: Steve spoke earlier about the revolution taking place in community banks with higher and higher levels of competition. The real struggle is how to differentiate yourself and maximize the level of retention you can achieve with your customers. There is a revolution that is taking place: Banks are tying to get on the other side of the customer. They are trying to solve the problems of their commercial and high-net-worth customer base, help them consolidate their vendors and act as a consulting resource as opposed to just providing products and services. Success can only be achieved by gravitating toward becoming the ultimate trusted adviser. Banks can evolve by providing a level of service that’s comprehensive and touches the customer on a monthly, as opposed to a biannual basis. They can filter through the organization and meet with many different individuals on many different financial services topics and really become a virtual board member to those customers as opposed to just a service provider.

BANK DIRECTOR: How successful is it to attempt to start a new nonbank business from scratch as opposed to acquiring a business, such as insurance or subprime lending, for example?

KLEIN: It’s suicide.

LYONS: That’s generally right, and it is why we see many alliances between banks and nonbank entities. Advisor Central is an example of where banks and other financial institutions have gotten together with the idea of building a better mousetrap and gaining market share more quickly than if they tried to do it on their own. As you say, doing it yourself is almost impossible, but doing it with others can actually work better.

KLEIN: Even with the passage of Gramm-Leach-Bliley, banks have not taken advantage of the ability to start these businesses.

LYONS: Even Citigroup is getting rid of Travelers now.

KLEIN: Right. There is a different mentality among these various types of companies, and integrating and paying people on a different basis can become a challenge. If you put the five best players on a basketball team you may think you have a winning team, but if the chemistry is not there, they’ll implode. That’s the risk of doing this. You could really bet your bank if it’s not done right.

SMYTHE: Another effect of Enron will be that specialty finance companies will be examined with a fine-toothed comb. I feel that financial institutions will be much more reluctant to take a look at subprime sectors in particular until everything is sorted out.

SERVAT: I might be a little less negative on this, just to take the counterpoint. I believe it goes back to some of the points made earlier. One of the things is whether the activity is complementary. Look at SBA lending, for instance. Some banks have developed very solid and effective SBA shops, but it gets back to the competence of the people and M&A integration. A bank can have a terrific target and good pricing, but a management that’s incompetent at the integration will blow it. There are many things that can go wrong. There are some people who are good at this, and there are some who are terrible at it.

It can happen successfully, just as people can grow de novo if they find the right teams of people. For instance, you could build a successful asset management practice as long as you are patient, but the danger is more than simply the internal competence of the people. Specialty finance, even on a standalone basis, is toxic. No one really wants to stay in it for more than the two years of upticks, and then they’ll probably want to short it on the downside and continue to make money. That’s not an option for a bank’s management.

KLEIN: The obstacle is risk assessment. As an example, BB&T has gained competence in the insurance area—it understands how to buy those companies and become a line of business. The problem is how to assess businesses that you’re not familiar with. How do you know, other than by reputation, that these people are going to be successful?

SERVAT: It boils down to the process and the skill level. Look at Greater Bay Bancorp. It’s done a remarkable job of taking in diverse businesses and basically leaving them managed by the same people. So far, the controls in place have worked and Greater Bay is controlling it with a rather light hand, without knowing anything about the businesses itself, but trying to work it from the distance. They have focused on their process as opposed to the underlying businesses.

SMYTHE: Most successful institutions already have some underlying kernel of knowledge, such as Boston Private Bank’s management team, which came from Boston Safe. It’s a natural extension of their expertise, rather than a foray into a completely different business.

LYONS: Looking at it in the inverse way, that’s why the Fidelities of the world actually created banks as an extension for their overall market. They are doing the investment advisory work and have a name in that business, and for them, the bank itself is a specialty niche or specialty product to help round out their business. Frankly, that’s the classic example these days of a de novo in which there is no competitive risk, because the bank is not supposed to compete by itself.

WEPLER: The choice to either go de novo or to grow by acquisition has much to do with product line. When you get further down the commodities continuum, the expertise of any one individual isn’t as important in the production side as it is on the management side. On the non-commodity commercial side, while management is always important, production expertise is critical, and you need to have a host of high-quality production individuals who go out and get the business.

KLEIN: We’ve had experience with companies like Puget Sound National Bank, Ranier Bank, and West One Bank in Portland. Frankly, the most successful banks have grown through a variety of these strategies. They’ve grown through branching, through selective acquisition, and through new products and services. It’s a blend that works. If you look at the successful growth institutions, the Wells Fargos of the world, for instance, they’ve made acquisitions in a line of business, and you can’t be a successful acquirer and just do it sporadically. You really have to be on top of it. You have to understand due diligence. You have to understand integration. The more you do it, the better you get at it.

BANK DIRECTOR: If you’re sitting on the board, what considerations should you have if the bank plans to go outside its traditional line of business?

SMYTHE: I would weigh the risk versus return. In other words, if I were on a board, I would need to know very clearly why a strategy that is a radical departure from our current lines of business is better than staying the course. I would then attach a factor to risk adjust the potential reward. It really is a strategic decision.

LYONS: I think part of it is to evaluate whether you really have at least a kernel of expertise in the business or whether it’s something you need an alliance or need to acquire resources for. It seems that the basic difference is if you don’t have the expertise or the name recognition, then you acquire it. If you do have it, and it is a question of access or new product development, you go internal. You go de novo if you need some kind of a specialty institution to fill out your set. The board should really do the analysis and figure out which one of those, if any, fits. It also should remember that you can’t stretch out too far into a new area.

SMYTHE: One other possibility is a “dip-the-toe-in-the-water” strategy. Can you take a stake in a company, and see how it works, and then acquire the rest? That’s what some of our clients have done.

KLEIN: What I’ve seen work best is to maintain ongoing customer relationships. If I’m on the board of directors, some form of due diligence or familiarity with the customers is critical, because the risk can be substantial.

WEPLER: I think the decision has a great deal to do with the extent that nonbanking service is part of your bank’s overall strategy. If it’s a significant part of your overall strategy to change the culture of the bank and to become more customer-focused, then look at whether or not you have the luxury of waiting to build capabilities yourself or need to pursue an acquisition strategy. And if acquisition is the best route, then look within your footprint and determine whether or not there’s a large, competent, capable provider with enough market mass. You’ll need to acquire expertise, sophisticated leadership, and the technical proficiency that will allow you to come in on a turnkey basis and minimize execution risk, as opposed to buying a number of small entities and trying to integrate them. If such an entity is not available, then building internally specific product lines or an entire operation could be the only alternatives.

LYONS: A classic example is Mellon Bank. It always had a strong investment management business but it has really transformed itself into an investment management firm within two or three years. Although we really haven’t talked about outsourcing or getting rid of noncore businesses, that’s another way to minimize your exposure.

KLEIN: Jean-Luc referred to Umpqua Bank, which has what it calls “stores” instead of branches. What we’re really talking about is the ability to sell products and services and the development of the sales culture. That’s what the big banks have done so well.

SERVAT: For directors, one of the first things should be almost instinctual: How comfortable are you with the business? Do you get excited? Does it have be explained? If it takes three board meetings to explain, it’s not the right decision. It’s almost a gut-level decision. People are an equally critical factor. And time—how much time do you have? Will you feel secure that both the earnings of the organization and the people are going to carry you through? Do you have three years or do you have a much shorter time frame? If it’s less than three years, you’re going to have a problem, because it’s not enough time to move in, grab the wheel, and drive that organization. So I would look at the business, the target, the people, and the timing as the things the board should consider and feel good about on an instinctual level, without hours of explanation needed.

BANK DIRECTOR: How do you work through different comfort levels between inside and outside members of the board?

KLEIN: What’s interesting is that the board really has one key decision to make: whether to retain the CEO. These other things really are, as Kathy said, gut-level decisions.

SERVAT: Yes, and it’s the same thing with due diligence. If your stomach is churning, it’s probably not a good deal!

KLEIN: But as a board member, you really are relying on management.

SERVAT: You are, but unless you step back and follow your own instinctual response, you will inevitably follow whatever management says. Management has more information, but they do not necessarily have the perspective. They are so immersed in the transaction itself, that they lose the perspective.

KLEIN: Well then, you may have the wrong management team.

LYONS: No, it’s sort of cliché, but I think the classic view of the board is that the directors have to step back and ask, “Is this really the right thing for the institution to do?” They have the ability to look at it from a higher level, because they are not in the day-to-day grind. In fact, I think they do a disservice to the institution if all they do is say, “We’ll listen to the management, and if they’re OK with it, we’re OK with it.”

KLEIN: Ultimately, though, it is management that will make it happen, and you need a disciplined management team.

SERVAT: Right. I agree you must have confidence in management, but I think when you have a management ready to embark on such a different strategic course, the board has to be comfortable with that direction. That takes more than perusing a three-ring binder with 400 pages that you received two days before the meeting. To me, the best decisions have been made by people who somehow have the ability to listen to their instincts, and then leave to management what they do best—the execution.

SMYTHE: I think the board members need to be like Missourians and say, “Show me. We take our fiduciary duty to shareholders to heart, and while we trust management, we need to be convinced.”

WEPLER: While there are a whole host of issues directors should look at, I believe there are four important areas the board should examine in making a nonbank acquisition: 1) Does it assist the bank in getting closer to the customer? 2) Is it accretive to earnings? 3) Is the bank minimizing execution risk through structure and retention tools to retain employees and, therefore, earnings at targeted levels? 4) Is the bank acquiring the necessary skills to make the acquisition successful?

Also, in terms of nonbank acquisitions, the level of involvement by the chairman and CEO of the acquiring entity is key to the success. The chairman and CEO must be very engaged and regularly stand up in front of their people and say, “This is the future of our business and I expect you to play a meaningful role in helping us become closer to our customer base. If you don’t, we’ll find someone who will.” That kind of leadership is not only advisable, it’s required for any nonbank acquisition’s success.

LYONS: But with some acquisitions, like securities brokerage, if you lay into them too much, you’re going to find all your guys heading out the door. In this melding of corporate cultures, you have to know when to pull them in and when to let them stand on their own. It’s a fine line.

WEPLER: The greatest crime in a nonbank acquisition is when a bank with a bureaucratic structure stomps out the entrepreneurial life of the acquired organization. One way to maintain entrepreneurial spirit, even with disparate cultures, is by having a quantifiable, measurable, and well-communicated compensation plan that doesn’t eliminate the greed factor so prevalent in many of these successful independently-owned companies. Establishing a cross-selling program is one thing, yet providing immediate, W-2 return in some form for desirable performance is not only advisable, but a prerequisite to success.

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