Chapter Nineteen Acquisitions and Mergers in Financial- Services ManagementKey TopicsMerger Trends in the United States and Abroad Motives for Merger Selecting a Suitable Merger Partner U.S. and European Merger Rules Making a Merger Successful Research on Merger Motives and OutcomesIntroductionA globe wave of mergers involving banks, securities firms, insurance companies, and other financial-service providers has been under way Reflects the great forces of consolidation and convergence that are dramatically reshaping the financial-services industryThis trend is driven byqIntense competitionqDeregulationqThe search for the optimal size financial-services organization Mergers on the RiseMany of the mergers sweeping through the banking industry reflect lower legal barriers that previously prohibited or restricted expansion For example, in the U.S., the Riegle-Neal Interstate Banking Act of 1994 and the Gramm-Leach-Bliley (GLB) Act of 1999 The GLB law opened wide the arena for banknonbank financial-service combinationsPermits banks, insurance companies, and security firms to acquire each otherCritics of the GLB law argue that while GLB may result in reducing U.S. financial firms risk exposure, it does not appear to hold great promise for major improvements in operating efficiency Mergers on the Rise (continued)Competition among European financial firms is becoming more intense, leading to continuing mergers and acquisitionsFinancial-service mergers in Europe have slowed from time to time due to a slowing economy and European governments attempts to protect their home banks from acquisition by outsiders Asia and Japan also have experienced a growing number of mergersDue to an effort to shore up credit quality problems, fend off the ravages of deflation and sluggish economies, and compete with powerful U.S. and European banksTABLE 191 Recent Leading International Financial-Service Mergers and AcquisitionsTABLE 192 Some of the Largest Financial-Service Mergers and Acquisitions in American HistoryThe Motives Behind the Rapid Growth of Financial-Service MergersMergers usually occur because1.The stockholders involved expect to increase their wealth or reduce their risk exposure2.Management expects to gain higher salaries and employee benefits, greater job security, or greater prestige from managing a larger firm3.Both stockholders and management may reap benefits from a mergerThe Motives Behind the Rapid Growth of Financial-Service Mergers (continued) Profit Potential Some argue that the recent increase in financial-service mergers reflects the expectation of stockholders that profit potential will increase once a merger is completedIf the acquiring organization has more skillful management than the firm it acquires, revenues and earnings may riseEspecially true of interstate or international mergers where many new markets are enteredIf the acquiring firms management is better trained than the management of the acquired institution, the efficiency of the merged organization may increaseMay result in more control over operating expensesThe Motives Behind the Rapid Growth of Financial-Service Mergers (continued) Risk Reduction Many merger partners anticipate reduced cash flow risk and reduced earnings riskThe lower risk may arise becauseMergers increase the overall size and prestige of an organizationOpen up new markets with different economic characteristics from markets already servedMake possible the offering of new services whose cash flows are different in timing from cash flows generated by existing servicesMergers can result in a more stable financial firm, able to withstand fluctuations in economic conditionsThe Motives Behind the Rapid Growth of Financial-Service Mergers (continued) Rescue of Failing Institutions The failure of a company is often a motive for mergerMany bank mergers have been encouraged by the FDIC as a way to conserve federal deposit insurance reserves and avoid an interruption of customer service when a depository institution is about to failThe great credit crunch of 20072009 resulted in numerous financial firms either failing or in real trouble for which mergers and acquisitions were often the only optionThe Motives Behind the Rapid Growth of Financial-Service Mergers (continued) Rescue of Failing Institutions The Motives Behind the Rapid Growth of Financial-Service Mergers (continued) Tax and Market-Positioning MotiveMany mergers arise from expected tax benefitsEspecially where the acquired firm has earnings losses that can be used to offset taxable profits of the acquirerThere may also be market-positioning benefitsA merger will permit the acquiring institution to acquire a base in a completely new marketExamples of U.S. market-positioning acquisitions:Bank of America Corp. acquiring FleetBoston Financial Corp.Wachovia Corp. acquiring Golden WestCapital One Corp. acquiring North Fork Bancorp and Hibernia Corp.The Motives Behind the Rapid Growth of Financial-Service Mergers (continued) The Cost Savings or Efficiency MotiveLarge-scale staff reductions and savings from eliminating duplicate facilities have followed in the wake of some of the largest mergers in the financial-services sectorResearch has shown that sometimes the single most important merger motivation was the desire to reduce operating costs followed by a plan to diversify into new marketsMany mergers are of the market extension typeMeans that the merging institutions do not overlap much or at all in terms of geographic area servedThe Motives Behind the Rapid Growth of Financial-Service Mergers (continued) Mergers as a Device for Reducing CompetitionWhen two competitors are allowed to merge, the public is served by fewer rivals for their businessService quality may diminish and prices and profits may riseMore aggressive prosecution of the antitrust laws may need to be consideredThe Motives Behind the Rapid Growth of Financial-Service Mergers (continued) Mergers as a Device for Maximizing Managements Welfare (An Agency Problem)Management may view a prospective acquisition as a way to increase salaries and employee benefits, lower the risk of being fired, and enhance managers reputation in the labor market from working for a bigger firmIf managers reap these benefits at the expense of company stockholders, an agency problem emergesThe Motives Behind the Rapid Growth of Financial-Service Mergers (continued) Other Merger MotivesIncreased growth capacityEnables a lending institution to expand its loan limit to better accommodate large and growing corporate customersThis is particularly important in markets where the lenders principal business customers may be growing more rapidly than the lending institution itselfGive smaller institutions access to capable new management and costly new electronic technologySelecting a Suitable Merger PartnerHow can management and the owners of a financial firm decide if a proposed merger is good for the organization?Measure both the costs and benefits of a proposed merger (not easy to do)A merger is beneficial to the stockholders in the long run if it increases the stock price per shareThe price of a financial firms stock depends upon1.The expected stream of future dividends flowing to the stockholders2.The discount factor applied to the future stock dividend stream, based on the rate of return required by investments of comparable riskSelecting a Suitable Merger Partner (continued)In order to maximize stockholder value, the proposed merger shouldImprove Operating Efficiency (reduce operating cost per unit of output)Consolidate operations and eliminate duplicationGeographic DiversificationProduct Line DiversificationFind an acquisition target whose earnings or cash flow are negatively correlated (or have a low positive correlation) with the acquiring organizations cash flowsSelecting a Suitable Merger Partner (continued)A major consideration in any proposed merger is its probable impact on the earnings per share (EPS) of the surviving firmStockholders of both acquiring and acquired institutions will experience a gain in earnings per share of stock if both of the following occurA company with a higher price-to-earnings (P-E) ratio acquires a company with a lower P-E ratioCombined earnings do not fall after the mergerIn this instance, EPS will rise even if the acquired institutions stockholders are paid a reasonable premium for their shares Selecting a Suitable Merger Partner (continued)As long as the acquiring institutions P-E ratio is larger than the acquired firms P-E ratio, there is room for paying the acquired companys shareholders a merger premiumHigh-premium deals often yield disappointing results for the stockholders of the acquiring firmSelecting a Suitable Merger Partner (continued)Exchange RatioThe number of shares of stock offered by an acquiring bank for each share of stock of the acquired bankDilution of OwnershipSpreading the firms ownership over more stockholders so that the average shareholders proportion of firm ownership declinesResults from offering the acquired firms stockholders an excessive number of new shares relative to the value of their old sharesDilution of EarningsSpreading a fixed amount of earnings over more shares of stock so that the EPS of the combined firm declinesWill occur if the P-E of the firm to be acquired is greater than the P-E of the acquiring firmThe Merger and Acquisition Route to GrowthThe acquired firm (usually the smaller of the two) gives up its charter and adopts a new name (usually the name of the acquiring organization)The assets and liabilities of the acquired firm are added to those of the acquiring institutionA merger normally occurs after managements of the acquiring and acquired organizations have struck a dealProposed transaction must then be ratified by the board of directors of each organization and possibly by a vote of each firms common stockholders. The Merger and Acquisition Route to Growth (continued)If the stockholders approve (usually by at least a two-thirds majority), the unit of government that issued the original charter of incorporation must be notified, along with any regulatory agencies that have supervisory authority over the institutions involvedIn the U.S., the federal banking agencies have 30 days to comment on the merger of two federally supervised banksThere is a 30-day period for public comments as wellPublic notice that a merger application has been filed must appear in a newspaper of general circulation serving the communities where the main offices of the banks involved are locatedThe U.S. Justice Department can bring suit if it believes competition would be significantly reduced after the proposed mergerThe Merger and Acquisition Route to Growth (continued)The principal characteristics of the targeted institution that are examined by the potential acquirer fall into six broad categories1.The firms history, ownership, and management2.The condition of its balance sheet3.The firms track record of growth and operating performance4.The condition of its income statement and cash flow5.The condition and prospects of the local economy served by the targeted institution6.The competitive structure of the market in which the firm operates (as indicated by any barriers to entry, market shares, and degree of market concentration)The Merger and Acquisition Route to Growth (continued)In addition, potential acquirers will look at these factors as well1.The comparative management styles of the merging organizations2.The principal customers the targeted institution serves3.Current personnel and employee benefits4.Compatibility of accounting and management information systems among the merging companies5.Condition of the targeted institutions physical assets6.Ownership and earnings dilution before and after the proposed mergerMethods of Consummating Merger TransactionsMergers usually take place employing one of two methods1.Pooling of interests2.Purchase accountingFor mergers begun before July 1, 2001, the Financial Accounting Standards Board (FASB) permitted use of the pooling of interestsMerger partners merely sum the volume of their assets, liabilities, and equity in the amounts recorded just before their merger takes placeMethods of Consummating Merger Transactions (continued)In contrast, under purchase accounting the firm to be acquired is valued at its purchase price and that price is added to the total assets of the acquirerThe acquirer records the acquisition at the price paid but must value the acquired firm at market value plus goodwill (if the acquisition price and market value are different)No goodwill is figured in when using the pooling of interests approachAfter 2001, the pooling of interest method for merger accounting was eliminated for U.S. financial firmsMethods of Consummating Merger Transactions (continued)Another way to view the merger process is to determine exactly what the acquirer is buying in the transactionAssets or shares of stockPurchase-of-assets methodThe acquiring institution buys all or a portion of the assets of the acquired institution, using either cash or its own stockThe acquired institution usually distributes the cash or stock to its shareholders in the form of a liquidating dividend and the acquired organization is then dissolvedMethods of Consummating Merger Transactions (continued)Purchase-of-stock methodThe acquiring firm assumes all of the acquired firms assets and liabilities and the acquired firm ceases to existWhile cash may be used to settle either type of merger transaction, in the case of commercial banks, regulations require that all but the smallest mergers and acquisitions be paid for by issuing additional stock of the acquirerA stock transaction has the advantage of not being subject to taxation until the stock is sold, while cash payments are usually subject to immediate taxationMethods of Consummating Merger Transactions (continued)The most frequent kind of merger among depository institutions involves wholesale banks merging with smaller retail banksLets money center banks gain access to relatively low-cost, less interest-sensitive consumer accounts and channel those deposited funds into profitable corporate loansRegulatory Rules for Bank Mergers in the United StatesTwo sets of rules generally govern the mergers of banks and other financial firms: 1.Decisions by courts of law2.Statutes enacted by legislators, reinforced by regulationsFor example, the Sherman Antitrust Act of 1890 and the Clayton Act of 1914 forbid mergers that would result in monopolies or significantly lessen competition in any industryWhenever any such merger is proposed, it must be challenged in court by the U.S. Department of JusticeRegulatory Rules for Bank Mergers in the United States (continued)The Bank Merger Act of 1960Requires each merging bank to request approval from its principal federal regulatory agency before a merger can take placeNational Banks Comptroller of the CurrencyState Member Banks Federal ReserveState Insured Banks FDICEach federal agency must give top priority to the competitive effects of a proposed mergerMergers with anti-competitive effects may be approved if it can be shown that there are significant public benefits For example, providing convenient services or rescuing a failing bankRegulatory Rules for Bank Mergers in the United States (continued)The degree of concentration in a market is measured by the proportion of assets or deposits controlled by the largest institutions serving that marketThe Justice Department guidelines require calculation of the Herfindahl-Hirschman Index (HHI) as a summary measure of market concentrationIt is the sum of the squared market share for all banks in a specific market areawhere Ai represents the percentage of market-area deposits, assets, or sales controlled by the ith financial firm in the market, and there are k financial firms in total serving the marketRegulatory Rules for Bank Mergers in the United States (continued)Under the latest Department of Justice (DOJ) GuidelinesIf a market has a postmerger HHI below 1,000 points, then the market is unconcentrated; no further DOJ reviewA market is considered moderately concentrated if its postmerger HHI is 1,000 to 1,800 points and as a result of the proposed merger the change in the HHI is less than 100 points; usually no further DOJ review (unless the change in the HHI 100 points)Regulatory Rules for Bank Mergers in the United States (continued)Under the latest Department of Justice (DOJ) GuidelinesA market is considered highly concentrated if the postmerger HHI lies above 1,800 points and the postmerger change in the HHI exceeds 50 points; usually no further DOJ review (unless the change in the HHI 50 points)If the change in the HHI 100 points in a highly concentrated market, significant competitive issues will be raised and a suit to block the proposed merger may be filed by the DOJThe Merger Rules in Europe and AsiaThe European Commission an executive body of the European Community currently based in Brussels has emerged as a key mediator of mergers involving European businessesBecause the European Commission cannot break apart a merger after that combination has occurred, the Brussels commission has been somewhat more aggressive in denying some companies permission to mergeThe doctrine of collective dominance suggests that if a significant European market would become so concentrated as a result of a proposed merger that only about four firms would come to dominate that market, then the European Commission may vote to block any further market concentrationThe Merger Rules in Europe and Asia (continued)In Asia, merger rules are in a state of flux as leading nations seek to modernize their merger review process and develop more definitive guidelines for merging firmsIn assessing a proposed mergers, Asian authorities emphasizeMarket shareAvailability of alternative sources of supply for the consumerWhether foreign firms are involved that will significantly impact domestic institutions in a dangerous wayMergers that appear to rescue losing domestic companies, protect jobs, and bring new technologies and managerial talent into the host country often receive favorable rulingsMaking a Success of a Merger Many mergers simply do not workA variety of factors often get in the wayPoor managementMismatch of corporate cultures and stylesExcessive prices paid by the acquirer for the acquired firmFailure to take into account the customers feelings and concernsLack of strategic “fit” between the combining companiesMaking a Success of a Merger (continued) Helpful steps that improve the chances for a desirable merger outcome1.Acquirer must start by evaluating its own financial condition2.Must have detailed analysis of possible new markets3.Must establish a realistic price for target firm4.After merger, combined team must direct progress towards consolidation5.Must establish communication between senior management and all employees6.Must create communication channels for customers and employees to understand why merger took place7.Should create customer advisory panels to evaluate and comment on merged banks image and productsResearch Findings on the Impact of Financial-Service MergersThe Financial and Economic Impact of Acquisitions and Mergers Merger-active financial companies tend to grow faster than nonmerging firmsGenerally, acquiring financial firms, on average, are not more profitable than the firms they buyThis suggests that management of the acquiring firm hopes to buy into successAcquired companies are often significantly less profitable than the firms they compete withAcquirers pay sizable premiums for target firmsThus, stockholders of acquired companies often gain a financial advantage, while acquirers often wind up with mixed resultsResearch Findings on the Impact of Financial-Service Mergers (continued)Public Benefits from Mergers and Acquisitions Research has found few real benefits from the publics perspectiveOn the positive side, there is no convincing evidence that the public has suffered from a decline in service quality or in service availability There is also some evidence that bank failure rates decline in the wake of merger activityMergers and acquisitions usually have multiple outcomes and generate a mixture of winners and losersQuick QuizWhat factors should a financial firm consider when choosing a good merger partner?What factors must the regulatory authorities consider when deciding whether to approve or deny a merger? When is a market too concentrated to allow a merger to proceed?Does it appear that most mergers serve the public interest?