The Perfect Blend: Mastering the Art of Merger

It is still the largest branch acquisition in the history of the U.S. banking industry, and the margin for error in its integration was thinner than the space between hope and prayer. In late 1999, Sovereign Bancorp Inc. purchased 279 branches with $11.8 billion in deposits and $7.9 billion in loans from the new FleetBoston Financial Corp., which had been forced by the U.S. Justice Department to divest enough of its New England franchise to make a pretty fair-sized bank.

But Sovereign faced several challenges, beginning with the composition of the branches themselves. Some came from BankBoston Corp., others from Fleet Financial Corp.u00e2u20ac”the two banks had merged earlier in the year to form FleetBostonu00e2u20ac”and they would have to be combined into a coherent business unit. Bankers from Fleet and BankBoston had been bitter rivals for years, but now lions and lambs would be expected to lie down together. Worse yet, the deal put Sovereign’s balance sheet in a vice, and skeptics were saying that Sovereignu00e2u20ac”a thrift headquartered in Wyomissing, Pennsylvaniau00e2u20ac”had gotten in over its head. “There was a lot of snickering,” recalls chief technology officer John McCarthy, who had come over in the deal from BankBoston where he had spent 32 years. “‘Who is this Pennsylvania thrift and what makes it think it can do this?’”

There was little room for error when it came time to convert the branches to Sovereign’s processing system. Working under tremendous pressure to meet a nearly impossible set of deadlines, the thrift’s integration team took this disparate collection of branches, business lines, and staff and skillfully combined them with Sovereign’s operations in Pennsylvania and New Jersey. A decisive factor was the strong leadership and hard-headed pragmatism of people like McCarthy and John Hamil, chief executive officer of Sovereign’s New England operation, who saw to it that the integration was completed successfully. The acquisition has since paid off handsomely for Sovereign and few people are snickering nowu00e2u20ac”particularly on Wall Street, where Sovereign’s star has been rising of late.

Integrating a bank can be a lot like cleaning fish after the CEO has had all the fun catching them. The work is messy and opportunities for glory are limited. Combining the operations and staff of two large organizations can be mind-numbing in its detail, with tens of thousands of decisions that have to be made, and exhaustive in its physical demands, because there is usually a sense of urgency to get the process done quickly.

There should also be a sense of caution because integration snafus can have a devastating effect on the acquirer. Just ask Paul Hazen, former chief executive officer at Wells Fargo & Co., who acquired First Interstate Bancorp in 1995 after a protracted takeover battle, then stumbled badly as he tried to integrate the two large banks. When Wells Fargo’s integration woes finally drove down the price of its stock, Hazen was forced to sell out to Norwest Corp. Institutional investors have become increasingly leery of large bank mergers in part because of horror stories such as this, and their skepticism puts even more pressure on the acquirer’s integration skills.

After nearly two decades of intense consolidation, experienced bankers should have no excuse for fumbling a post-merger integration. There have been enough bank acquisitions since the mid-1980su00e2u20ac”including a great many where the subsequent integration did not go smoothly, even if they didn’t blow up they way Wells Fargo’s didu00e2u20ac”that Bank Director set out to devise a list of dos and don’ts. One might call them the “Six Rules for Highly Effective Mergers,” and to ignore any one them could put your dealu00e2u20ac”and your institutionu00e2u20ac”at risk.

1st Rule: People make the difference.

OK, it sounds like motherhood and apple pie, but the most valuable things in a bank are not the financial assets on the balance sheet, or such physical attributes as a branch system or processing centers, but the people who work there. And yet after some transactions, the acquired employees are treated as if they were just another piece of property. When they are given respect and are ably led, they are capable of doing amazing thingsu00e2u20ac”and amazing things are sometimes required during the integration process.

A perfect example of this was Sovereign’s acquisition of the FleetBoston branches in New England, which was a complicated transaction from the very beginning. What Sovereign actually received was not a discrete branch system, but rather separate pieces that had to be assembled into a functioning business unit. Its branches in eastern Massachusettsu00e2u20ac”including Bostonu00e2u20ac”came from Fleet, while its branches in Connecticut, Rhode Island, and New Hampshire came from BankBoston. In addition to all the necessary branch personnel, Sovereign also received approximately 2,000 people from both banks to service nearly $8 billion in consumer, small-business, and middle-market loans. Throw in about 500 automated teller machines, and you had the basic architecture of a fair-sized regional bank. “I often refer to it as a multiple organ transplant,” quips Hamil, a veteran New England banker who had been president of Fleet’s Massachusetts bank prior to the divestiture.

As if that wasn’t challenging enough, there were some unusual financial aspects to the deal as well. Half of the $1.4 billion purchase price was financed with junk bonds, because Sovereign’s stock was trading so low that issuing that much new equity would have seriously diluted the interests of its existing shareholders. But with coupon rates of more than 10%, that junk debt threatened to be a significant drag on Sovereign’s cash flow. The $1.4 billion acquisition premium also exceeded the thrift’s tangible equity, which under regulatory accounting rules, took its tangible capital account down to zero. The Office of Thrift Supervision, which oversees Sovereign, does not impose a minimum tangible equity standard on thrifts, but if Sovereign had been a commercial banku00e2u20ac”whereby it would have been required to have higher levels of tangible equityu00e2u20ac”it might not have been able to do the deal.

Investors reacted with predictable alarm to Sovereign’s vanishing capital and soaring debt, and its stock quickly nosedived. The company was under extreme pressure to consolidate the acquisition and start earning money from it as soon as possible. “The concern of the Street was that at the end of the day, we wouldn’t be able to keep the customers or add new customers and would end up overpaying for what we bought,” says Hamil.

Rather than convert the acquired branches to Sovereign’s systems all at onceu00e2u20ac”the company does not do its own processing but outsources that function to Fiserv Inc.u00e2u20ac”the conversions were staggered over several months. The first batch of branches was connected to the Sovereign mother ship in March 2000, with subsequent conversions following in June and August. This helped minimize service disruptions, as did another decision that the bank made early on.

McCarthy says that instead of trying to enhance the various banking systems of the acquired branches, Sovereign chose to go for speed and simplicity instead. “We very quickly made the decision to go with what we had.” McCarthy credits the bankers who came over from Fleet and BankBoston for not using the conversion as a “bully pulpit” to argue for systems improvements. “It was ‘How do we make this work?’ rather than ‘How do we make this like we had?’” says McCarthy. “The people were excellent. They really took the hill.”

Hamil also points out that there was considerable merger experience in the newly expanded organization. “I think what really saved the day was that Sovereign had already been through some large acquisitions,” he says. “And the people who had come in through BankBoston and Fleet had been through some pretty big ones as well.” Hamil especially liked the way his New England colleagues rose to the challenge of integrating such a complex acquisition so soon after joining Sovereign. “Most people checked their ego at the door,” he says. “A lot of them didn’t know each other and, in some cases, had competed against each other.”

In the three years since Sovereign acquired the branches, the company has been rebuilding its tangible equity levelu00e2u20ac”which now stands at 3.29%u00e2u20ac”and has paid back $175 million of the junk bonds. The company also increased deposits by $700 million and loans by $1 billion over that time. And it has started a variety of new businesses that were not part of the acquisitionu00e2u20ac”adding, for example, approximately 100 people to build a cash management operation and also creating a trust and private banking division. Instead of losing customers, as many people predicted, it has been gaining them. John Kline, a bank analyst at Sandler O’Neill & Partners, credits the acquisition with hastening a transformation in Sovereign’s business mix and culture. “This is not a traditional thrift anymore,” he says. “It’s more like a commercial bank. I think it has been a good deal.”

One of the most important decisions that Sovereign made at the very beginning was to bring in strong leaders like Hamil, McCarthy, and Joseph P. Campanelli, president and chief operating officer of the company’s commercial and business banking division. Hamil and Campanelli had worked together at Fleet and, prior to that, at Boston-based Shawmut National Corp., which Fleet had acquired in 1996. All three executives knew the New England banking market very well, and Hamil is especially well known there. “If you walk down the street with John, you’re going to get stopped by a lot of people wanting to say hello,” laughs Kline.

Greg Fleming, co-head of the global financial institutions group at Merrill Lynch & Co., says that filling important leadership positions are among the very first decisions that must be made in any acquisition. “You need to figure out who’s going to be doing what from a management standpoint to a pretty fine level of detail.” Fleming suggests that the top 75 to 100 positions should be settled as quickly as possible. “That’s important,” he says. “All the top people need to know what they’re going to be asked to do. Systems are important, but people are a big piece of any deal.”

2nd Rule: Don’t overpay.

This may seem like strange advice when discussing post-merger integration, but the size of the premium that an acquiring bank pays for control often determines how soon it must complete the integration, and how aggressively it must cut costs in the combined organization. Most bank acquisitions over the past 20 years have been between institutions in the same geographic market. The rationale was fairly straightforward: cut costs while holding on to most of the revenue and watch the savings fall to the bottom line. So far so good, but bad things happen as soon as you overpay.

Historically, most banks have financed their mergers by issuing stock. But if they have to issue too much stock because they’ve paid a huge takeover premium in a sizeable transaction, it will dilute the interests of existing shareholders on a per share basis. The only way to avoid dilution is to accelerate the profitability of the newly merged bank, and this sometimes leads the acquirer to hurry the integration or to cut more deeply than it should.

This is exactly what happened when First Union Corp. of Charlotte acquired Philadelphia-based CoreStates Financial Corp. in September 1997. First Union paid an enormous premium to acquire CoreStatesu00e2u20ac”nearly six times its tangible book value. “I think that was the high-water mark for pricing [in bank acquisitions],” says Kline. The only trouble was, this was a market extension rather than an in-market merger, so there were few opportunities to save money by eliminating redundant resources and overlapping operations. “We enormously overpaid for the company,” agrees David Carroll, co-head of the merger integration team at Wachovia Corp., which merged with First Union in May 2001. “You can have the most skilled integration people in the world, but if you have a dilutive transaction, it will force you to stretch to do things.” And that is precisely what transpired with the CoreStates deal. An effort to revamp CoreStates’ retail banking operation resulted in significant customer defection when service deteriorated, and the acquisition was ultimately judged by Wall Street to have been disastrous for First Union.

When a buyer grossly overpays for an acquisition, there’s almost nothing it can do to salvage it during the integration process. “Right there, right off the mat, it’s probably not going to work,” says Fleming.

3rd Rule: Understand why you’re doing the deal.

This might seem too obvious to mention, but a successful integration is really just the skillful execution of a detailed plan. Sometimes one bank will buy another without thinking through precisely how it intends to extract value from the acquired franchise. This “ready-fire-aim” approach to acquisitions may not get you into as much trouble as grossly overpaying for a deal, but it can have negative consequences nonetheless. “You should have a clear idea of what you want to do with that acquisition when you get it,” says Mike McKeon, a managing director at the consulting firm Booz Allen Hamilton. “You should have some architecture on paper beforehand.”

One successful bank acquirer that has always had a detailed plan in mind for the financial institutions it acquires is North Fork Bancorp. in Melville, New York, a Long Island community about 35 miles outside of New York City. North Fork’s strategy has long been to acquire underperforming thrifts, eliminate their senior management, and offer their customers a far more robust product set. “We needed thrifts that were willing to have themselves transformed to a larger business model,” says John Kanas, North Fork’s chairman and chief executive officer.

After nearly 10 acquisitions since the mid-1990s, North Fork has a detailed blueprint for how it extracts value from its deals. The acquired institution’s management team is quickly eliminated, accounting for about half of the cost savings that North Fork achieves in its deals, which Kanas says averages about 55%. Branch personnel at the acquired institution are given a much more extensive product menu to sell, along with a generous incentive compensation plan.

Core depositsu00e2u20ac”particularly commercial checking accountsu00e2u20ac”are favored over higher cost certificates of deposit. In short, the thrifts are converted to higher earning commercial banks as quickly as possible. “The truth of the matter is,” says Kanas, “unless people are willing to do a deal on our terms, it’s not an opportunity for us.”

4th Rule: Let the deal determine how quickly you integrate.

The old viewu00e2u20ac”say, circa 1997u00e2u20ac”was that the acquired bank had to be integrated as quickly as possible to avoid diluting the interests of existing shareholders. A more recent view, which seems to have taken hold after Norwest’s highly successful acquisition of the old Wells Fargo in March 1998 (in which it took the Wells Fargo name), calls for a slower, more deliberate pace to minimize the kind of service disruptions that often chase away customers. The answer to whether a bank acquisition should be done quickly, or at a more measured pace … is yes. Or to be more precise, it depends on the size and complexity of the transaction itself.

Norwest’s takeover of Wells was structured as a merger of equals, with neither bank paying a premium. With fewer financial pressures, the integration team spent a considerable amount of time choosing between various systems at both banks to create the best technology platform possible. Ultimately, says Web Edwards, chief technology officer, the team chose the old Wells Fargo systems for wholesale and small-business banking, and Norwest systems for mortgage and consumer finance. The retail system ended up combining elements from both, although most of it came from Norwest. On the other hand, when Wells Fargo acquired Salt Lake City-based First Security Corp. in December 1999, it converted the much smaller bank directly to all of its systems in a few months. “That kind of merger has a much shorter timetable,” says Edwards.

The merger of Wachovia and First Union (the new bank took the Wachovia name) was also structured as a merger of equals, and this integration is likewise occurring at a more measured pace. As of last December, the integration was two-thirds complete, with the capital management and corporate and investment banking businesses having been converted to common systems. A bigger challenge by far is converting the deposit systems of both banks to a common platform. Carroll says the Florida retail bank was successful converted in late November, and there are three more retail conversions yet to come.

Perhaps the best perspective on integration pacing comes from James McCormick, president at First Manhattan Consulting Group, who advises banks “to proceed as quickly as your experience and competency allows. But going beyond that leads to significant downside risk. From a present value standpoint, the faster the better. Getting your cost savings six months sooner than you otherwise might isn’t immaterial. You can’t forget that. But if you’re playing around with customer attrition, it isn’t worth it.”

5th Rule: Keep lines of communication open to your employees.

Mergers are inherently threatening, particularly when they are of the in-market kind and thus can expected to yield significant layoffs. And any apprehension being felt by employees is likely to be transmitted directly to customers. The advice of M&A veterans like Wells Fargo’s Edwards is to designate one spokesperson for every significant issue and have that person act as the only channel for information. “That way everyone hears the same message,” he says.

“You’ve got to take care of employees, because employees take care of customers and customers take care of shareholders,” explains Greg Chestnut, a partner at the consulting firm Accenture. Chestnut says it’s especially important to keep employees focused on their own business activities so that the bank’s revenue production doesn’t level out or worse, even fall. “One of the biggest sins you see is people taking their eye off the ball from the top on down,” he says.

During the conversion of its New England branches, Sovereign’s integration team as well as senior executives in Wyomissing held a conference call each morning to prepare for the day’s events. Oftentimes they held a late afternoon debriefing session to review the day’s events. Hamil, McCarthy, and others also spent considerable time meeting with employees throughout New England. “We spent a lot of time talking,” says Hamil. “We spent a lot of time encouraging. We spent a lot of time talking about Sovereign and what its advantages were to people.”

6th Rule: Take care of your new customers.

At the end of the day, most acquisitions are made to gain new customers, so make sure you treat them like the assets they are. No one understands this better than Carroll, since First Union’s rough handling of the CoreStates acquisition resulted in a flood of customer defections. Carroll claims the actual loss rate was not as high as the 30% tally cited in some press reports at the time, but was significant all the same. “We very much went to school on that merger,” he says. Carroll says the systems conversions for Wachovia’s capital management and corporate and investment banking operations were completed without any disruptions in customer service. “Done; complete; no customer impact with them,” he says. And Wachovia is using The Gallup Organization to measure satisfaction among its retail customers.

Perhaps of all the changes that have occurred in the bank M&A market, the most prominent is the increased sensitivity that acquirers have to the importance of minimizing service disruptions. Because when things go wrong, says McCormick, “you take all the customers who were a little dissatisfied before and throw them right over the line.”

All this talk about integrating bank mergers may seem a little strange given that there were so few of them in 2002, at least compared to previous years. There had been just 192 deals through early December of last year, according to SNL Financial, compared to 261 in 2001 and 504 in 1998u00e2u20ac”the most active year on record for bank mergers. Yet this remains a highly fragmented industry, and acquisition activity is sure to resume once stock prices recover and the U.S. economy regains its footing. And when that happens, knowing how to clean the fish after the CEO has caught them may be the difference between eating well and going hungry. |BD|

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