Three Gentlemen in Arizona

Bank Director asked a small gathering of acquisition-minded bankers attending its recent

M&A conference to talk about the market dynamics that are affecting their banks’ acquisitions. A whole host of issues came into play, including market valuations, growth strategies, product expansion, and the ability to deploy technology in today’s highly competitive environment. Those bankers who participated in our forum were Daniel H. Chapman, director of national expansion, Northern Trust Corp., Chicago; Charles E. Gagnier, executive vice president, Amcore Financial, Inc., Rockford, Ill.; and Terry Spencer, executive vice president and treasurer, First American Corp., Nashville, Tenn.

Bank Director: We’ve certainly experienced a maelstrom of bank mergers and acquisitions during the last couple of years due a robust market for bank stocks plus favorable industry conditions. To begin, why don’t you each give us a brief background on your bank and what markets you cover?

Dan Chapman: I work for Northern Trust Corp., the lead bank of which is the Northern Trust Company of Chicago. [Before now,] Northern Trust was not very active in expansion and acquisitions. Over the past couple of years we’ve done about three transactions. Historically, Northern Trust has episodically responded to inquiries from expansion or acquisition candidates.

About a year-and-a-half ago, however, management decided to more strategically approach this issue. It’s a very simple equation. Northern Trust is principally a private banking and personal trust and investment management company. At the present time our locations in Florida, Texas, Arizona, California, and Illinois cover about 20% of the wealth demographics in the United States, and we’d like to double that. Doing so takes a strategically oriented approach, hopefully, on an acquisition basis, but if not that way, by de novo operations.

Charles Gagnier: We stand in direct contrast to this because we’re one of the small players around this table. We’ll approach $4 billion in total assets sometime soon. The last couple of years we’ve been active with our first entry into the Wisconsin marketplace. We’ve acquired two relatively small holding companies there, and at the end of March, we’ll add a third. That will give us about $750 million in assets in Wisconsin, with about 22 locations.

Additionally we’ve moved into Iowa with the acquisition of what is billed as the largest independent investment management group in that state with assets exceeding $1.5 billion.

Our own strategic geographical region is somewhat smaller, I’m sure, than some of my colleagues here. We’re looking in the 200-mile radius right now around the Rockford [Ill.] area. That gets us far enough for our appetite and for our wallet. We generally look to acquire leaders in the marketplaceu00e2u20ac”institutions that are ranked either first or second.

Terry Spencer: We’re about an $11 billion holding company headquartered in Nashville. We’ve done five bank transactions, primarily in what we call our target market geographic area: Tennessee and the surrounding trade areas. I think the largest of [the transactions] was about $700 million in total assets. We have focused primarily on in-market consolidationsu00e2u20ac”banks with an overlapping presence with our own. This allows us to achieve some cost reduction opportunities and further increase our depth in a particular marketplace. Like Chuck [Gagnier], we like to be number one, two, or three in a marketplace.

In December we did our first big market-extension transaction: our announced acquisition of Deposit Guaranty Corp. Deposit Guaranty is a $7 billion holding company headquartered in Jackson, Miss. with a very strong share in Mississippi. It also has a presence in Louisiana, Arkansas, and some overlapping presence in Memphis, as well.

Organizationally, a couple of years ago we formed a unit we called First American Enterprises. This unit focuses on the nonbanking activities of the company. We acquired a couple of investment securities companies there.

We’ve been aggressively trying to expand the nonbanking aspect of our business, focusing primarily on two areas that we identified as having significant potential for us and something we know a little bit aboutu00e2u20ac”what we call “related competency.” The investment distribution business and security sales are good examples.

We acquired INVEST Financial, a company that is a third-party marketer. They are, in essence, the wholesaler of investment products, annuities, mutual funds, and the like, for more than 400 banks around the country. They do about $3 billion worth of product sales a year.

At about the same time, we acquired a 49% interest in The SSI Group, Inc., which is a health care claims processor. I mentioned “related competencies.” We really don’t want to stray too far afield, so we want to make sure we know something about [the businesses] we are buying. The health care claims process is not unlike a credit card payment process, and the business was very much like the credit card business was some years agou00e2u20ac”very paper intensive, very inefficient. We bankers have been trying for years to move paper out, automate the payment mechanism, and increase profits in that regard. So it’s an area in which we thought there might be a significant amount of opportunity.

BD: You’re all talking about growth through acquisitions. What advantage does size bring to an institution and do you believe a bank can grow too large?

Chapman: In my opinion, the maximum size hasn’t been reached yet. It does give us certain advantages. We are prone to look at acquisitions that can bring, either immediately, or through future distribution, significant fee-based business such as fiduciary activities, estate settlement, or investment management. With brokerage, for example, we’re very aggressive in our willingness to grow that business, but frankly, we do most of that growth internally.

There are certain exceptions to that. Our corporate institutional business works in huge pools of assets, and there have been some examples in our organization where acquisitions of companies have brought related competencies to our table. For example, Northern Trust was not strong in indexed funds management. So we recently made an acquisition to bring that expertise in-house. I think that will continue. Also, we were not strong in the area of record keeping for large retirement funds. We acquired a company to bring that inside, because it made a good complement to what we were doing on the corporate institutional side of our business.

Gagnier: I don’t think there is any real evidence that a bank can get too large. There are too many success stories are out there already. I will say that we try to feed on that, however. When you’re part of a smaller family of organizations you try to demonstrate that you are an alternative to that “bigness.” Of course, the bigger you get, it seems, the more resources you can bring to the table, that’s for sure. But I think there are institutions that wind up poorly managing their operation if they become too centralized.

Amcore is headed down the path of the supercommunity bank concept. After an acquisition, we still keep our boards. We do some consolidation when we think the marketplace is ready for it and where the communities are ripe for it, but we like to keep the management in place. We like to keep the decision making at the local level, empowering those people to make the kinds of decisions that affect their customers. So to that extent, we see ourselves as an alternative to the big operations.

With respect to the kind of operations we do get into, let me tell you a little bit of a horror story. Once, we got into the collection agency business. Now, I believe the types of industries a banking organization should get into are those where they can use the channels of distribution and the delivery system that they already have. We thought there was a fit in terms of the collection business, but not so. We recently sold that company after being at it for a few years and not making any real money. We just chalked it up as part of our R&D program and decided to dispose of it. I think great care has to be taken with respect to those kinds of new ventures.

BD: Terry, how smoothly has First American integrated its acquired businesses?

Spencer: Where we really have found it is in securities distribution. We have been, over the last couple of years, not only growing the nonbank side of our business in terms of fee generation, but also in terms of the mix of our revenues between the intermediation business and the fee business. We all lust for the kind of distribution that they have at Northern Trust, but we’ve gotten ourselves up to the point where fees now represent about 40% of our revenues, and that’s pretty good.

We’ve done that through a couple of means. Number one is investing in acquisitions of the nonbank businesses as we’ve talked about, but also [by growing] internally. For example, four or five years ago, we only had about 50 licensed sales people in our entire organization that could sell annuities or securities. There are about 500 now, so what INVEST has brought to the table is the expertise and the scale in terms of sourcing product that we would not have been able to do on our own. So they’ve not only assisted the transformation in terms of the nonbank side of the business but also within the banking business in terms of diversifying our revenue sources.

BD: We often hear that one of the contributing factors causing some institutions to sell is the need to support the infrastructure to keep up with technology. Have you experienced this first hand?

Spencer: I would say very, very definitely, that’s a factor. If I were asked what the broad themes were in the consolidation of the industry today, I would point to three driving forces. Obviously, valuation would be the first one. The second one I would term relevance or obsolescence. And the third one is very realu00e2u20ac”technology.

In technology, it’s not just the year 2000 issue that we are facing, but the ability to capture and apply information to make meaningful decisions that can impact both the customer and the bottom line of the company.

That was really a driving force in our acquisition of Deposit Guaranty. I think Bud Robinson, the CEO, said it best when he stated: “They have what we wanted.” So our investment in customer information technology and the other management systems really paid off in that regard.

But [regarding year 2000], you do see an awful lot of companies, both medium size and the little guys, looking around saying, “Gee, I’ve got this thing staring me in the face, and that’s an awful big bullet. Wouldn’t it be better for me to make it somebody else’s problem?” So yes, absolutely, it’s a very real factor today.

Gagnier: I’m running into it, too, in terms of the calls we make or some of the unsolicited calls we get, when people are concerned about the year 2000 issues. But beyond year 2000, it runs the myriad of DP issues. I think community banks, in many respects, can last forever if they want to. If it’s a family-owned community bank out there they can compete with the Amcores and the Northerns and the First Americans. I would bet that my colleagues here would agree. But at the same time, it gets to be a very tiresome kind of existence, I think, as they try to address all those technological issues. We believe we have fairly sophisticated customer information systems. We do a lot of targeted marketing. We have built customer profitability models, product profitability models, etc. We translate those into meaningful expressions as they relate to our customer base, so that all of our employees, especially those who have direct customer contact, understand who’s really profitable and who’s not. Smaller institutions don’t have that capability, and it will be a long time before they ever get it.

BD: I’ll come back to something I skipped over when we were talking about size. The other interesting market dynamic right now, certainly in the past six months, has been price.

Gagnier: Thought you’d never get to it!

BD: Regarding some of the 4x book prices that have hit the news, do you think we have a rational market out there?

Chapman: We would all say it’s irrational and that the prices are way too high, I would expect, because we are all sitting on the [acquiring] side of the table, at least at this point.

We have an interesting dilemma in our business because when Northern Trust makes an acquisition, we tend to add 25%-40% to the cost because we have to make significant new investments in product delivery and personnel and things like that. So if we are at the table in a highly competitive arena with other potential acquiring institutions and the conventional discounted cash flow analysis is done for establishing an acquisition purchase price, while the others are typically showing cost reductions, we are typically showing cost increases. It really makes a big difference in what we do.

We’re additionally impeded because, as most people who follow our stock know, we are in a stock buyback period. So it takes a relatively large transaction sizeu00e2u20ac”more than we are really comfortable with in most of the markets where we are now lookingu00e2u20ac”for us to get a pooling transaction. This means that there’s going to be more shareholder dilution associated with our acquisitions unless there can be significant cost reductions achieved.

BD: How have you managed that dilemma?

Chapman: We manage it by sliding from the conventional analysis over into what we refer to when we get beyond the parameters of pricing discipline and say it’s “strategic.” That’s generally the way that we look at overpaying, if you want to put it that way. Overpaying, based on what our models show us, is reasonable. In our case, it’s pretty easy to rationalize that because there are very obvious strategic markets that we need to be in. When we find an attractive target it’s generally just as easy for them to figure that out as it is for us. So we then begin to look at pricing in a more strategic way, and that falls back on this analysis: How much does it cost you not to be there? This is opposed to the conventional analysis: looking at the combination of revenues and the deduction of expenses. So, going back to your question, I think most all the prices that we are seeing fall in the “strategic” region.

Spencer: I have experienced this now since our Deposit Guaranty transaction. If you really look at the data, the only reason that prices are where they are and the “optics,” I’ll call them, or transaction multiples, are where they are, is because the stock market is where the stock market is. You can make a very strong case that prices have probably held steady, maybe even have declined, somewhat, if you look at prices on a relative P/E basis. In other words, if you look at it exchange for exchange, cash flow to cash flow, if you look at in terms of what you are giving up, ultimately, and what you are getting, ultimately, relative P/Es and, indeed, relative pricing has stayed pretty stable. So when you see 4x book and 25x earnings, you are seeing the impact of the higher valuations in the stock market. That’s what I would characterize as the “two $500,000 cats for the $1,000,000 dog” story. Because in essence, the people aren’t getting cash. The overwhelming majority of transactions that are driving this kind of pricing are stock swaps. They are pooling transactions. So if you look at a deal as, piece of paper for piece of paper, and then peel away the onion and look at what’s underneath, what, actually, are you conveying to their shareholders? Prices actually have been quite steady. It’s exchange ratios that are meaningful, as opposed to dollars.

BD: O.K. So is that an easy sell to shareholders?

Spencer: No it’s not! That’s the other part of this story. When we announced the Deposit Guaranty plan of action, we knew, obviously, what the pricing optics were and that there would be some sticker shock. But we believed strongly in the transaction and what it did for our store.

We have said for some time that we want to be among the most highly valued, high-performing companies in the country. We have a peer group of 16 companies and banks that we call “Sweet 16.” As we were running the analysis on Deposit Guaranty it became clear to us that it increased our profitabilityu00e2u20ac”it was significantly accretive to earnings. It strengthened the company’s balance sheet in terms of liquidity and geographic diversification. But it got hammered in the marketplace immediately after the deal was announced: sticker shock.

So we had to go back to the investors. We spent several days in New York talking to the analysts and our large shareholders to really get them [to look beyond the] optics. We said, “Let’s take out the sticker shock, and let’s actually look at what you are getting for what you are giving up, and you will see that it’s a very favorable trade.”

So you’re right, it was tough sell because you can’t do it in soundbites. You have to really tell the story and be very comprehensive.

BD: Chuck, how has this market pricing hit you from Amcore’s perspective? You’re generally in the market for smaller institutions.

Gagnier: We think that 3x-4x multiples are clearly on the high side of the value for a franchise. When we’re negotiating, I spend a lot of time talking to a target about the fact that, while we’re attempting to acquire their organization, in the final analysis, when we are using stock as our currency, they are, in fact, acquiring us. We spend a lot of time talking about our growth potential and the fact that we are undervalued in the marketu00e2u20ac”we try to be persuasive in that regard. And I believe we have been. In one of our last three deals, we ranked third in terms of the price offered and in another one we ranked a close second. So I think that says there is something else out there, truly, besides price.

We come to conferences like this and we hear a lot of teasing and a lot of kidding about 3x, 4x, 5x book. But the reality is that when these people go home, they’ve got some idea of what their institution is worth. As a seller, they really don’t want us or anybody else overpaying because the real question is, what’s that going to do to the next deal we bring to the table? You’re sitting there as a shareholder and if you see excessively dilutive deal, or something that runs adverse to your interest as a shareholder, then you’re not going to be a happy camper.

BD: In terms of making the negotiations run more smoothly, have you found more emphasis on the part of sellers to address the so-called “social issues” such as compensation, retirement plans, charitable foundations, and the like?

Gagnier: We’ve never had a deal where the executive compensation or those kinds of issues stood in the way of anything we wanted to get done. We’ve found them all to be manageable. Maybe we just haven’t come upon a difficult situation. As I said, we like to keep management in place. It’s not as much of an issue for us because we don’t want the shell of the organizationu00e2u20ac”we want the whole enchilada.

Now it doesn’t always work out that way. Some individuals already have exit contracts negotiated. Some of them have other retirement plans. It depends on their age, their own station in life, and their own individual needs or desires, at least as it relates to the CEOs of those corporations.

Chapman: I would enhance that by saying that when we are in an acquisition discussion, it’s national in scopeu00e2u20ac”it could be anywhere from Seattle to Miami, from the Northeast to the Southwest. So especially when we are entering a new market, it has all the reverse attributes of an in-market acquisition. So the very first thing we cover is management retention and management contracts. Because if we don’t have that, we don’t have a need for the institution. Especially when you consider that the institutions are relatively small that we are talking to. So we get that on the table up front.

I would say that the “warm fuzzy” element of our negotiation probably goes beyond some others, because we tend to have more success in acquiring an attractive target that’s been approached by others. Because typically, in many cases, what that target has seen in the past is a race for revenues and all of the consolidation that [is typical of an] in-market acquisition Then we come to the table saying, “Oh, by the way, we need you, and we’re probably going to add 25%-40% cost to this, which means everybody you

want to keep is going to stay, and we want the whole board to be involved because they helped build this business.” So they get very interested.

Spencer: I think the social issues certainly have to be dealt with up front in any transaction. Oftentimes they are the most difficult part of any transaction. Obviously the management and CEO of the acquired company are going to be concerned about their employees and the communities that they serve.

We are beginning to see the foundations popping up. We are establishing a foundation in Jackson, Miss. for that very reason. We certainly want to emphasize our commitment to a community. We are not going to go in, acquire the company, and pillage the community.

I think everybody here would agree that we can only be as successful as the communities we serve at the end of the day. So it’s something we spend a lot of time reinforcing and focusing on. It’s a meaningful part of any transaction.

BD: One more question. I’ll turn the tables on you a little bit because you have been speaking as acquirors. I’ll ask you now if it’s possible for institutions in this business today to remain independent?

Spencer: The best defense is a happy shareholder. So long as management is performingu00e2u20ac”adding value and performing at a level in excess of that which an acquiror could come in and dou00e2u20ac”then that’s what management is there for, to continue to add value at that rate. Now, we are all aware of what happens if you don’t perform at such a level. But that’s what we get paid to do, to add shareholder value. If we can no longer do that in a manner that is consistent with shareholders’ expectations, then there are certainly other alternatives for the board to pursue.

Chapman: I would agree. And also, just to achieve the goal that Terry is talking about is getting harder and way more expensive than it’s ever been. In our case, we are a niche player, which so far has caused us to have absolutely superlative performanceu00e2u20ac”the best defense that we can have. But I fear for those who can’t put the hundreds of millions of dollars that are required for companies like ours to put in, just in technology advancement alone. It’s not near as easy to enhance shareholder value today as it has been. Fewer and fewer banks can. Therefore, there’s going to continue to be more and more consolidation. But to answer the question: Sure, you can stay independent.

Gagnier: I think the very things that make you successful as an independent, thriving institution are the kinds of things that make you attractive as a target. I think Terry put it very nicely. At the end of the day, what have we done for our shareholders? If we serve them well, they are going to treat us well.

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