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Digging Deeper in Due Diligence

Why do so many banking acquisitions fail to deliver promised efficiencies and returns? One big reason might be the inability of acquirers to uncover lingering organic revenue-growth slowdowns that lead many banks to sell in the first place.

That’s the key finding of a new study from First Manhattan Consulting Group (FMCG). “If you’re going to acquire, odds are that potential targets that are willing to sell are having revenue-momentum problems,” says Jim McCormick, the New York firm’s president. Even so, many investment banks-and by extension, bank boards-employ industry-average revenue-growth expectations to justify deals. Unless the buyer is among the small handful of banks capable of reversing revenue-growth slides, the deal likely won’t meet expectations-even if cost-cutting goals are met.

“All you need is a 3%u20134% revenue shortfall versus the more-optimistic assumption, and it will eat up all of the efficiency gains that were assumed and cause problems,” McCormick says.

The findings seem to suggest that boards of acquiring banks are either being hoodwinked by scale-hungry managements and/or investment bankers to sign off on deals that aren’t all they’re billed to be, or that they’re complicit in what amounts to a draining of shareholder money. Then again, it could simply be that even after decades of evolution, many bankers and boards still don’t fully grasp what separates the industry’s haves from the have-nots.

FMCG’s study focused on retail deposit franchises, which typically account for more than half of a bank’s income. Researchers “scrubbed” publicly available pre-purchase data of recent acquirees to eliminate deposits from escrows, large corporations, acquisitions, and the like, and come up with organic growth figures. The analysis showed that the sellers in 18 of the 20 biggest acquisitions since 2002 had experienced lower-than-average same-store revenue growth in the years preceding the deal.

Not surprisingly, poorer-than-average returns follow: Researchers found that a group of banks focused on organic growth outperformed its acquiring peers 57% to 38% in total shareholder return during 1998u20132004.

It seems inexplicable that acquiring boards aren’t using-or demanding-solid revenue-growth figures before signing off on a deal. What explains it? Sellers with revenue troubles naturally try to “dress up” their banks in the run-up to a sale – opening de novo branches, boosting free-checking accounts to raise short-term deposits and boosting spreads. More often than not, such efforts lead to greater customer attrition rates that must be addressed later.

You’d think investment bankers, aware of such practices, would dig deeper. Instead, McCormick says, they typically offer up “simplistic assumptions” justifying a deal on industry-average revenue and earnings growth. “They hope they don’t get called on it. … (But) there is no such thing as ‘industry average.’”

Directors are part of the problem, too. McCormick says he’s spent a lot of time in boardrooms, “and you don’t see many directors putting up their hands and saying, ‘Tell me about the revenue assumptions we’re using.’”

Steve Nelson, a principal with Hovde Financial, a Chicago investment bank, disputes the notion that investment bankers aren’t thorough enough in their due diligence. “Any investment bank worth its salt will include five years of organic-growth numbers in its executive memorandum,” he says.

Nelson also notes that FMCG’s study focused on larger banks. Community banks often sell for management succession or liquidity reasons, not revenue troubles, and it’s easier to divine true organic growth with a smaller institution. “With the bigger banks, it’s more difficult to get a handle on those numbers.”

McCormick speculates that simple nau00efveté might be at the root of the problem. He notes that 25 years ago, most banks were assumed to have the same returns on equity. Countless studies have since shown the metric varies widely among banks, and now it’s a key performance gauge.

FMCG has devoted a lot of effort recently to examining “same-store deposit growth,” arguing that other industries, such as retailing, focus on such measures of existing operations with good success. The firm’s research shows that there are wide disparities in per-share revenue growth, with the top 20% of banks boasting annual growth of 12% or more, while the bottom 20% get 1% or less.

Acquiring boards should expand their diligence to include examinations of street-corner net deposit growth over time, McCormick says. They also should break down non-acquisition-related revenue growth by business lines-and versus local competitors-to better understand what they’re buying and create rational expectations for future performance. He also suggests using “mystery shoppers” to get a handle on how well a potential target’s employees execute on management’s plan.

“You need to understand, as well as you can, what you’re buying,” McCormick says. Few would argue with that.

Rising Use of ERM

An overwhelming majority of companies have started to use enterprise risk management as a strategic business tool to more effectively manage a variety of risks that can impact the firm’s capital and earnings-but most firms say they still have a long way to go, according to a report released by The Conference Board.

The report, based on The Conference Board/Mercer Oliver Wyman survey of 271 risk management executives, found that more than 90% of executives say they are building or want to build enterprise risk management processes into their organizations but only 11% report they have completed their implementation.

Enterprise risk management (ERM) is a framework, instituted by a firm’s board of directors and management, applied strategically and across the enterprise, designed to identify potential events that may impact the firm, manage risks within defined parameters, and provide reasonable assurance regarding the achievement of the firm’s business objectives.

Companies continue to face increasing pressures to implement ERM processes. Both industry and government regulatory bodies, as well as investors, are increasingly examining these policies and processes. Boards of directors in a rising number of industries are now required to review and report on the effectiveness of ERM frameworks in their companies.

“Most companies are in the process of adopting enterprise risk management to contribute to the value of the organization, to meet rising corporate governance challenges and regulatory actions particularly in the U.S, and to meet the challenges arising from external and internal risks,” says Ellen Hexter, senior research fellow and program director for The Conference Board and coauthor of the report. “Enterprise risk management is clearly gaining ground.”

The survey results indicate that more than two-thirds of both boards of directors and senior management staff consider risk management to be an increasingly important responsibility. At the financial/operational levels, especially among chief financial officers, there is an even higher awareness of the importance of ERM. Behind this trend: pressures to reduce the unexpected volatility of earnings and a need to implement internal mandates demanded by the Sarbanes-Oxley Act and other similar regulatory frameworks globally.

The study finds that companies fully embracing ERM are better able to improve management practices, such as strategic planning, and have a greater ability to understand and weigh risk/reward equations in their decisions.

State High Court Rules on Lending Fee Limitations

In a ruling that has significant impact for banks, mortgage lenders, and trustees of securitized mortgage loans, the Illinois state Supreme Court unanimously rejected a state law that severely restricted the fees that lenders can charge and imposed crippling penalties on companies that exceeded the restriction.

The court held that the 30-year old Illinois Interest Act’s limitations provision, which prohibits lenders from charging more than 3% of the principal in points and fees when the interest is in excess of 8%, was preempted by federal law. The court’s ruling in the case (U.S. Bank National Association et. al. v. Michael Clark et al.) reversed an appellate court decision that held that Illinois lawmakers had opted out of the preemption clause of the federal Depository Institutions Deregulation and Monetary Control Act (“DIDMCA”).

“This is an important decision for the financial services industry, and the mortgage lending sector in particular,” said Dianne E. Rist, a litigation partner at Chapman & Cutler who coordinated defense of the case before the Illinois Supreme Court.

“Banks, other lenders, and trustees of securitized portfolios were faced with a serious question of which law they were obligated to follow in Illinois,” she continued. “This ruling provides much-needed clarity for the mortgage lending industry on how it should operate in Illinois. The decision also extends to national banks that have sizable lending operations in the state, as well as institutions that operate as trustees for securitized mortgage pools, which provide capital to the lending industry.”

In the banks’ brief to the court, the financial institutions argued that: “Congress passed DIDMCA to achieve uniformity in the home lending industry. Courts across the country have recognized that uniformity is critical to promote the stability and viability of financial institutions, …” and if the court upheld the appellate decision, it would “create utter chaos in Illinois’ home lending market.”

The case is a consolidated action of a number of lawsuits involving financial services companies, including assignees and trustees of securitized mortgage portfolios. After originally triumphing in the trial court, the banks were dealt a reversal in a March 2004 appellate court decision. Since then, banks have defended a number of class actions and other lawsuits alleging that lenders were violating the Illinois Interest Act’s limitation on fees for residential mortgage loans.

Correction: In the Third Quarter 2005 issue, Bank Director inaccurately identified Todd Leone with Clark Consulting. His correct title is managing director for the compensation group of Clark Consulting. We regret the error.

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