Nonbank Acquisitions: Exploring Ways to Boost the Bottom Line

Nonbank acquisitions continue to be attractive avenues for banks seeking to stand out among the competition. This roundtable session focuses on the ins and outs of nonbank acquisitions and business line expansion, the advantages of a strategic alliance versus an acquisition, and what directors should consider when contemplating a nonbank acquisition. Deborah Scally, editor of Bank Director, served as moderator.

Bank Director: What are you seeing in the market today for nonbank acquisitions and business-line expansion? Have you seen as many strategic acquisitions?

Jim Rockett: I find it very interesting that at a time when there was relatively little traditional M&A going on, there was quite a bit of nontraditional M&A occurring. In fact, our firm was involved in four of those transactions, and if it’s any indication, two were insurance agency transactions this year, one was specialty finance, and one was an investment adviser acquisition. So from what I’m seeing, insurance agencies are selling, in particular those with commercial lines because there are some specific opportunities to enhance traditional bank products through them. Plus, there is a great opportunity to augment the fee structure, because the larger you get, the better the return. Specialty finance is an area that could be toxic over the next few years. Banks don’t manage that very well. There are some advantages to investment adviser acquisitions for those banks that focus on high-net-worth individuals, so that may be an area that could create opportunities and synergies.

John Wepler: During 2002, we saw continued acquisition activity between banks and insurance brokers. Our firm focuses on helping banks buy insurance agencies. Over the past four years, there have been 276 acquisitions of insurance agencies by banks. During just the last year, there have been 69 transactions. To address the issue of whether these are strategic or not, we believe that it is first important to understand that back in 1997 or 1998, the M&A driver was primarily economic; banks were trying to diversify their margin spreads, as well as offer another product to sell.

Since that time, we’ve still seen banks look at insurance acquisitions as an economic model, yet there is a well-defined strategy that goes beyond the financials. Banks are quickly coming to realize that they are at war over customers, specifically in the commercial lines and the high-net-worth individual wealth market. We’ve seen many banks go out and look for the highest-quality insurance agency they can find and make that acquisition so that they can sit down with their commercial customers and not just sell insurance products, but really wrap their arms around that customer and provide a whole host of consulting services, such as human resource consulting, commercial lending, cash management, commercial insurance, VIP personal lines of insurance, and risk management loss control. This is all geared toward providing solutions as opposed to simply closing transactions with those customers, to enhance retention ratios and position themselves to call on that commercial business every week as opposed to once a year just to close the loan. So we’ve seen it become strategic, but deals are still scrutinized from an economic standpoint. They need to be accretive to earnings, and they need to present a very solid return on investment and internal rate of return.

Gary Penrose: Universally among all the banks that we deal with, we see a very strong interest in nonbanking transactions, both strategic and financial transactions, that really make sense and go to the bottom line.

Steve Nelson: Within our community bank clientele, there is a strong focus to find the right equilibrium between the various revenue streams a bank manages. In particular, they want to create or buy businesses that can provide predictable and growing fee income and reduce their historical reliance on spread income. Thus, management and boards are grappling with the best way to achieve that goal.

I agree with what Jim said about the toxicity of some specialty finance businesses—these are often tough businesses to get your arms around, especially given where we are at in the credit cycle, and one that a lot of folks are divesting. In contrast, with insurance agencies there are very logical expansion opportunities for community banks as small as $100 million in assets up to the superregional banks. On the small end of the continuum, one of the better community bank insurance agency acquisitions we have seen was Great River Financial’s acquisition of Cady Insurance in Burlington, Iowa, and on the large end, Community First and BB&T have voracious appetites for agencies.

One concern I would certainly point out to executive officers and boards is that a “strategic acquisition” can be a description for a deal that does not make financial sense. Whether it is an acquisition of an insurance agency, investment adviser, specialty finance company, bank, or thrift, the transaction needs to make financial sense. They need to be accretive to earnings in a reasonable period of time. Board members need to have management answer the question, “How does this deal impact our earnings per share?” If it’s accretive and it makes sense, then they can start talking about strategic implication and how it’s going to dovetail with our small-business clientele or their high-net-worth client base.

Penrose: In some cases we are seeing a “lead steer” mentality. Some have an interest in nonbanks because the bank next door, whomever it might be, is getting into that business, so they feel they need to be in that business as well. Yet in some of these cases, they don’t get the economics that they should out of the transactions. Smart buyers are buying smart. Their interest is the bottom line. But there’s also an increased interest because banks want to keep up with the lead steers.

Bill Mayer: Our clients have been looking at the initial developments from a couple of perspectives: Is it a transaction that makes financial sense and has relevance to the targeted customer base? Investment management acquisitions have been very hot over the last two to three years. Some banks have done more investment management deals than any kind of branch or traditional bank acquisitions. But the key is relevance, in terms of a given community bank’s strategic plans, and understanding what kind of nontraditional businesses they need to acquire in order to remain relevant to their customers and competitive vis-a-vis their larger bank competitors.

Rockett: One of the transaction types we haven’t heard much about recently are the mortgage operations, the cyclicality of which appears to me to be something that should create some real concern. These businesses are a big investment of time and management skills, and you can suddenly find yourself in a down cycle. There are also options like factoring companies, which may actually hold some attraction to banks that are looking to extend their existing client base with a different focus and different product. But right now I think there is a hesitancy by banks to get into businesses that they don’t understand and can’t manage well. They run the risk of finding themselves with egg on their face and having to explain that to their investors and shareholders.

Penrose: Jim, you are exactly right about mortgage banking—you’ve got to buy at the right time. If you had bought a mortgage banking company two years ago, it would have been one of the smartest investments you possibly could have made. If you buy a mortgage banking operation today, at its peak, who knows what’s going to happen to interest rates? Plus the refinance market is about finished, so you are looking at only the new home sales segment, which is simply not going to support mortgage banking in the way that it has, together with refinance, over the last two years.

Nelson: You can also look at countercyclical industries as ways to develop nondepository business lines, such as factoring companies and collection companies. This allows a bank to work both sides of the economic equation, but it gets back to a question of timing, the value proposition, and an understanding of the risks. When should a bank buy? When should it exit? How well does it understand this business? What is the upside and downside?

Wepler: I couldn’t agree more. Bill, you said earlier that the key word now is relevance. And in dealing with a lot of the bank CEOs we talk with and the boards we present to, they sit back in their chairs and say, “What is relevant to our future success?” The factoring and collection companies and mortgage businesses can provide enhanced returns and can be a good investment, but do they really get us closer to our customer? Focusing on the customer means taking the marketplace and converting it into a group of individuals who look to the bank as a solution provider. The real driver on a successful nonbank acquisition is getting away from the transactional side of the bank and focusing on the consultative side, to really go after high-net- worth individuals and corporate customers and provide them with solutions. We see that driving a longer-term agenda than a cyclical acquisition in the mortgage area or the collection area or the factoring area. It seems to me that the banks that focus on transactional acquisitions are the same banks that, when the market changes, seem to divest those acquisitions. Whereas banks that are really focused on the customer and are trying to enhance their customer relationships are providing solutions and becoming more consultative as opposed to transactional. Those banks seem to stick with their acquisitions through good and bad times, because it enhances those relationships and their control of their business.

Mayer: The lead-steer mentality that was referred to earlier is really a serious risk to a number of banks that approach the issue of strategic acquisitions from the standpoint of “What does it take for us to be competitive with banks in our area?” What they mean is, “What does it take to make us look just like our competitors?” as opposed to “What does it take to differentiate us and play to our strengths?” So I think the question of “Will this make me more competitive or not?” needs to be translated and discussed a bit more finely.

Nelson: It ultimately goes back to the strategic vision for the company and its ability to execute it. If there is a well-developed strategic plan that differentiates the bank from its competitors, is consistent with the bank’s core competencies, and is executed well, it’s a pretty good bet that attractive shareholder returns will follow. Among our community bank client base, we see a strong desire to enter or expand on a wealth management strategy. Wintrust Financial in Chicago is a prime example of a community bank articulating a unique strategic vision to the marketplace. In particular, it has done an excellent job of acquiring nonbank businesses with its Wayne Hummer and Lake Forest Capital Management deals. If you are a bank or thrift that is publicly traded and you’ve got a story in the marketplace that says “We’re a growth company with a strong wealth management division” or “We’re a business bank that captures full-customer relationships” or “We’re a retail bank that cross-sells a supermarket of financial products to consumers,” and then you do an acquisition that is consistent with this strategy and makes financial sense, the market will reward that decision.

Penrose: With nonbank acquisitions, it is important to structure them correctly. Unlike a bank that you go in and buy for cash or stock or some combination of both, in these nonbank transactions, whether they are mortgage banks, insurance agencies, or asset managers, first you need to structure them so that you’ve got the right people involved. Human capital is so critical in these businesses, far more important than in commercial banking. And you want to structure it so that you don’t pay everything upfront. You want to give employees incentives to stay and to augment their business and also to provide partial ownership or a long-term contract. Banks that don’t structure the transaction correctly are the ones that get burned.

Rockett: My experience is that bankers who have been involved in typical bank M&A are not as observant of that issue as they need to be and don’t have their arms around how to retain key people and reward them properly. The rewards in these types of businesses are considerably different than the compensation structure within the traditional bank. The consequence is that there are likely to be producers making a lot more money than even the CEO of the bank. In traditional banks that creates some real problems. I hope banks have learned their lesson from the disastrous experiment they had in investment banking. When they contemplate that disaster and the related waste of capital and consider their current opportunities, they should realize that they must find a way to keep key people on board. The bank has to give those people the proper compensation and incentives and make sure that they are locked in at the time the deal closes and have a proper earnout structure so that at the end of the day, the bank has realized the true value for what it purchased.

Mayer: It’s almost impossible to overstate how difficult it is to structure a deal to achieve all those objectives. Typically when a bank is looking at a nonbank acquisition from the seller’s perspective, the seller is looking to maintain as much autonomy as possible, particularly if there’s an earnout involved. A seller recognizes that, to some extent, the value of the business that’s being sold depends on maintaining a level of autonomy and independence from the bank. The seller recognizes, by the same token, that there are important cultural differences revolving around compensation, sales approach, and a whole host of other things that are very different from the traditional bank context. So you have a number of pressures being brought to bear from the seller’s side. From the buyer’s standpoint, the thinking is, “We bought it, we own it, we should control it.” How do you make the point to your board of directors that you don’t quite have complete control? It’s a very difficult dynamic.

Wepler: The end of pooling has opened up Pandora’s box on insurance agency acquisitions because to succeed, banks have to buy the highest-quality insurance broker in that market territory. Before purchase accounting was the only way to structure a deal, a lot of guaranteed pooling transactions were closed devoid of an earnout component. Such deals greatly reduced the greed factor that used to be prevalent in high-performing entrepreneurial businesses. Now, under purchase accounting, the bank is able to structure the transaction so that it provides an ongoing incentive for people to stay involved, to keep growing the business, and to manage the earnings, thus rewarding them for maintaining some autonomy while working within the bank’s structure to provide the type of return that the bank needs. Especially now, when valuations are in the 8+ times EBITDA range for high-performing foundation insurance agency acquisitions, the bank needs to manage the acquisition so that it provides the type of earnings that are required to make it accretive.

Also, under the new purchase accounting rules, you can be creative with booking identifiable and tangible assets and spreading that out over time, so that the bank doesn’t have to take a hit up-front. The result is that banks can be aggressive in pricing, they can buy best-of-breed insurance agencies, and they can pay a premium to get the right partners on board, yet they can still structure it so that the deal is accretive to earnings. This, in turn, provides an ongoing incentive for people to stay on board through the transition, manage the earnings, put up the type of results required, and become acclimated to the bank’s culture and committed to the new business going forward.

Mayer: At the risk of being a glass-half-empty type of fellow, while on one hand purchase accounting has created a world-class discipline for buyers, on the other hand, it’s never been more important to do due diligence; it’s never been more important to structure earnouts that are meaningful to avoid the risk of goodwill impairment. And valuation has never been more critical, particularly when you are representing a publicly held bank that’s venturing into this area.

Wepler: While I would agree with you, Bill, the counterbalance to that is that if you buy quality and hold selling principals accountable, the chances are that goodwill impairment will become a nonissue. If you look at the peak-performing banks that have made acquisitions of agencies, they’ve taken a commissioned growth rate of 11.3% and enhanced it to roughly 22.5%. As a result of keeping people’s heads in the game and giving them some autonomy to run the business, they have leveraged that revenue growth and have taken pro forma profitability or EBITDA from around 21.5% up to almost 30%. So pushing that accountability down through the organization with an earnout structure helps provide the incentive not only to recuperate and enhance the return, but also to manage the risks associated with goodwill impairment.

Nelson: When you look at the deals and their structures, the ones that we’ve seen working the best are the ones where the buyer conveys some cash to the seller, maybe 25% of the deal consideration, and if the buyer is a publicly traded company, maybe 50% in stock and 25% in an earnout. If the buyer is private, the earnout is much higher. Handled in this manner, the owners of the selling company are closely tied to the overall organization yet they are still able to get a little cash off the table. In these types of deals, everybody should be interested in creating a win-win dynamic. And as in most things, that comes through discussions, negotiation, and having an understanding of the seller’s motivation.

Rockett: You mentioned the win-win dynamic and the idea of the universal buy-in. Those concepts probably exist at the executive management level of a bank. But when you get down into the bank structure, the culture is so different that being able to assimilate these businesses, manage them properly, and appropriately reward the producers becomes very difficult. Unless these concerns are confronted at the beginning within the boardrooms and with executive management, it will be almost impossible to force the culture down into the banking organization. Because this cultural tension exists, there is always going to be the potential for the deal not to be as successful or as remunerative as the bank would hope.

Penrose: You’ve got to let those nonbank businesses run almost by themselves, which means that what’s critically important is the people you bring in. The most successful deals are those where there has been a long-term relationship among the executive officers of the companies. They know each other. They let their respective staffs run their businesses. Plus, they are able to augment their respective customer bases, so it’s a win-win situation. The deals that don’t work are those where there is not a strong relationship among the executives of the respective companies, and at the negotiating tables, it’s all about “me” rather than “we.”

Rockett: The other danger, though, is that a bank buys an agency or an investment adviser of a certain size, then expects to grow the business dramatically rather than live within the confines of what the target had been doing historically, because banks want to grow, grow, grow. And this growth can exceed the comfort zone of the current management group within that target company. Then all of the sudden you’ve got, in my view, some real challenges on your hands to maintain the value of that target.

Wepler: It comes down to the commitment of the CEO of the bank and that individual’s ability to communicate with the troops about the point of the acquisition. We’ve seen banks that have 800,000 depositors, and the branch manager is flooding the insurance agency with homeowners and automobile owners for quotes that include business the insurance agency really doesn’t want to write because it’s the type of client profile that’s loss-intensive and labor-intensive. This really doesn’t fit the mold of what the bank is trying to accomplish. In banks that have been successful in these ventures, senior management has made it clear that this is about taking your most important customers and trying to get closer to them. If you are going to go after retail customers with retail insurance products, you need to build that in over time.

Nelson: It also gets back to knowing what you are buying, and knowing the people. I think it’s a lot easier in smaller markets.

Bank Director: How important is it ahead of time to take a “barometer reading” from the customer base?

Nelson: In most cases, it’s probably more anecdotal than it is a formal solicitation of their customer base. Over time, loan officers will hear that small business customers have been requesting “X” or that a good customer went to a competitor because they offered “ABC,” and this serves as the rationale for developing or acquiring a particular nonbank business.

Penrose: The marketing study and market evaluation in these transactions tend to get flushed out in the negotiations rather than serve as an objective measurement. You’ve got an acquirer attempting to convince the seller on the merits of the transaction, explaining all the benefits that would be brought to bear on the target company, which typically would be subject to some kind of earnout. Often, you’ve got recitation of anecdotal opportunities for cross selling that are presented by the buyer when the buyer is trying to push the transaction; alternatively, the seller will cite cross-selling opportunities when the seller is pushing the transaction in terms of the synergies between the customer bases and the like.

Rockett: Cross selling is one of the things that banks have done poorly, particularly in these types of acquisitions. However, we represented ABD in its acquisition by Greater Bay Bancorp and my understanding after the fact is that ABD has brought a lot more than a revenue stream to Greater Bay. It has been able to transfer its customer base and has given Greater Bay very good cross-selling opportunities. So that may turn out to be an excellent strategic acquisition as well as a good, focused opportunity to enter the insurance brokerage arena.

Penrose: You can’t determine upfront what the response is going to be from the customer. What’s critically important in these businesses is the relationship between the producer and the customer. It doesn’t have to be the CEO or the top two or three people in the company, but it has to be all the producers. They have to buy into the concept. They have to buy into the culture. They have to buy into the new structure. That’s what you are buying. You are buying that relationship, and you want to make sure you keep those producers happy. And if you structure the transaction correctly, if there’s a cultural philosophical fit, you are more likely to have success with the customer.

Wepler: Because the insurance business went through 13 years of soft market prior to the current hard market, those agencies that have survived, by and large, have been sales organizations that are focused on problem solving and serving their clients. Banks often look at insurance acquisitions not only as a way to enhance revenue and diversify margin risk but also to give their evolving culture a jump-start, to be more driven to building a wall around the customer and smothering that customer with a lot of solutions as opposed to just transactions. I would say in the most successful bank/agency deals, the agencies are bringing in as many bank customers as the banks are referring insurance customers.

Bank Director: When does it makes sense to consider a strategic alliance instead of an acquisition, and what are the risks on both sides of that question?

Mayer: As we’ve noted, knowing the people involved and building a deal based upon a preexisting, long-term relationship is a critical ingredient for success. That especially holds true in the strategic alliance and joint venture arena. There’s a constant push-pull in these strategic alliances, where both sides are examining whether they need to spend more, versus managing the risks more carefully. Questions regarding how much to invest and what are the realistic benchmarks for performance–all those issues will be handled much more sensitively and successfully if an existing relationship is in place.

Rockett: Banks tend to like a situation that they can control completely. Strategic alliances never give them that kind of comfort, therefore, culturally it can be difficult for bankers to go into strategic alliances. That said, both in terms of the management of capital and in terms of the ability to give free rein to the other institution, there’s a lot of positives with strategic alliances. Bankers may approach them more open-mindedly as time goes on and they see that they can achieve at least a significant number of their objectives while not getting immersed in the managerial and cultural requirements of owning the business.

Nelson: I agree. Not everybody is going to be a Wells Fargo and own a wide array of financial products themselves. There are going to be certain business lines that they own, and there are going to be certain business lines that they need to offer to their client base as a solution-oriented adviser. Some of those may come from an acquisition of a nondepository entity or through a strategic alliance. Even if they do think that there’s a potential for an acquisition, an alliance is a nice way to dip a toe in the water to see whether a more permanent partnership might work down the road.

Penrose: Strategic alliances are a much softer approach to the business. With a strategic alliance, both parties generally feel more comfortable going into the transaction up-front, notwithstanding the fact that the banker doesn’t have control—they usually like to have that. But if you run it for a year or two, everybody buys into it—the producers, the two organizations. If it’s successful, then you go forward with a transaction where you do have a controlling interest. So it’s a good way of testing the water, absolutely.

Wepler: In terms of bank/insurance joint ventures, we have only seen a limited number that have been successful. That’s primarily the case because banks do joint ventures when they are not really committed to the business. Theoretically, alliances can work as well as an acquisition, but if a bank considers a joint venture because it is not terribly committed to the insurance business, that’s tough. The relationship managers of the bank have enough products to sell, so that if you don’t have someone who is totally on board, who has the commitment of senior management, then the referrals aren’t going to happen. In theory it can work very well. In practice, we’ve only seen a handful that have worked.

Rockett: That’s true of commercial lines, but when you look at things like life insurance and annuities, there’s been a lot more joint venturing that has been pretty successful.

Penrose: Good community banks focus on the relationship. If they do that, then it’s an easy cross sell in terms of insurance, asset management, or whatever it might be.

Wepler: It just seems that in all the joint ventures we look at, about 80% of the time is spent crafting a dissolution agreement for when the alliance inevitably fails! I find joint ventures contrary to the whole vision of an alliance—you go into the process understanding that it may be difficult, therefore you need to be able to unravel the transaction. One thing about an acquisition is that you are in the deal together and you’ve got to make it work; there’s no unraveling it. In an acquisition, people really reach down to their bootstraps and figure out how to make it work.

Mayer: One of the issues that a lawyer faces is to decide which negotiating sessions are going to include clients and which should not. I think you are well served in terms of preserving deal karma and the cultural affinities between the two parties by leaving [dissolution] discussions as much as possible to the lawyers, with the business points being explained individually.

Rockett: I would agree with you on that, Bill. The exit strategy is a critically important process, but it certainly is a distraction if you get the principals arguing about those points up-front. However, the reality is that joint ventures, at some point, are going to end. They may end because there’s an acquisition of the bank. They may end because the string has simply run out, and when that happens, the fight over the relationship with the customer and who controls the products that were delivered by the joint venture can be significant. If you don’t have that properly buttoned up, you end up with litigation and a lot of bitterness.

Wepler: Who owns the customers is the biggest question. If a bank enters a joint venture with an insurance agency and that insurance agency is bought by another bank, whose customer relationship is it? That is the riddle that we haven’t been able to solve, and a lot of people have been challenged by that.

Bank Director: What is your best advice for directors considering a nonbank acquisition?

Rockett: I think the most important question for directors to ask is “Do you understand the business and can you manage it?” If the board doesn’t ask that question and get a satisfactory answer, then it will learn later on that it’s made the wrong decision.

Penrose: From my perspective, it’s understanding human capital. Do you have the right people involved? Do you have the right producers involved? Philosophically, culturally, is there a fit? If you have the right people, the right producers, generally speaking, you can get to the financial issues.

Mayer: It’s also really important going into a negotiation to have a clear sense of how much control you need and how much autonomy makes sense, and then to agree on how important it is for one party to operate independently—usually the selling nonbank entity—and how much control is really necessary from the standpoint of the acquirer. I think if you can reach an agreement, at least in concept, on what’s necessary on both sides of that spectrum, then there’s a high probability of a successful negotiation going forward.

Wepler: My advice to directors is that if you are making a nonbank acquisition in an area that’s not core to the bank, first you need to understand the market and understand the business. It’s going to present a whole unique set of challenges and a whole new set of opportunities, and many banks don’t fully appreciate the nuances of the insurance industry. Number two, you’ve got to buy best-of-breed quality that has the strongest human capital and a proven track record of financial performance. Finally, after the deal closes, there needs to be a well-defined playing field and operating rules for that playing field. There needs to be incentive compensation to drive the business. There needs to be regularly reinforced CEO commitments. There needs to be a willingness to acquire in and out of the footprint in order to have a strong, viable business long term, outside of the cross-selling initiative. You also need to set realistic cross-selling expectations and have a performance-tracking measurement system to keep everybody excited and to track performance relative to the goals set in the beginning.

Nelson: In addition, have an understanding of the seller’s business–you need to understand why it is selling. Is management going to stick around? Do you trust them? Do you believe in what they have to say? Is it a well-run organization? Have you done your due diligence? From an integration standpoint, do your people really understand the cultural issues and differences? Obviously, it’s important to communicate. Whenever there’s a deal, we like to talk about the three Cs–being credible, being consistent, and communicating with the relevant constituencies of a company (e.g., shareholders, customers, and employees). You must maintain the entrepreneurial spirit of the target entity. From the buyer’s standpoint, you should ask, “Why are we doing this?” Or “Why shouldn’t we do this?” And from the financial standpoint, “How does this deal impact our earnings per share?” That’s a very basic question that every board member should ask with regard to the short and long-term prospects of the business.

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