Do Mergers Work?

As chairman and chief executive of North Fork Bancorp., John Kanas has made his mark by taking “stake-out” positions in underperforming local competitors’ stocks and then prodding them to sell outu00e2u20ac”often to him. Since 1993, the Melville, New York-based bank holding company has nearly tripled its size to $9.9 billion by acquiring six thrifts in the New York area.

But it’s what Kanas actually does with an acquiree that distinguishes North Fork from other, less-successful, acquirers. With a keen eye for leveraging location and customers into higher profits, North Fork cuts noninterest expenses by as much as 55% in the first year and replaces certificates of deposit with no-interest checking accounts to cut funding costs. It also introduces a menu of fee-based bank products and an aggressive new sales culture to boost revenues.

“We spend a lot of time during the [changeover] explaining to people what our culture is like and inviting them to join us,” Kanas explains. “But to be blunt, we only keep the people who we think will work at the pace we’re accustomed to working at, and we don’t keep the rest.”

That senior management at most North Fork acquirees lose their jobs has made Kanas a feared man in Long Island banking circles. Indeed, one thrift recently rejected a buyout offer from him that was priced substantially higher than a rival suitor’s. But shareholders love Kanas, and with good reason. Over the past five years, his well-honed M&A strategy has helped produce overall returns of nearly 600%, among the best in the industry.

“John has a tremendously keen sense of what can be taken out of an acquired institution on the cost side without hurting its operations,” says Irv Cherashore, a North Fork director and co-owner of Winchester Group, a New York money management firm. “He’s very disciplined in terms of what he’s willing to pay, and he’s always focused on bringing out the most in shareholder value from an acquisition.”

There are other John Kanases out thereu00e2u20ac”bankers who have reaped hefty returns for shareholders by capitalizing on the decade’s consolidation fever with well-articulated strategies.

The erstwhile Norwest Corp., which took on the Wells Fargo & Co. name after merging with the San Francisco company last fall, has used a disciplined, formulaic approach to acquisition to generate gains above peer averages. So, too, have mid-sized players like Fargo, N.D.-based Community First Bankshares and smaller companies, including Texas Regional Bancshares in McAllen, Texas and San Rafael, Calif.-based Westamerica Bancorp.

But despite all the excitement generated by this decade’s deal-making frenzy, at least four recent studies have found that the majority of recent bank mergers and acquisitions have been busts for shareholders. Those studies have shown that, in general, returns for acquirers have fallen far short of their non-acquiring peers, suggesting that many of the key assumptions behind the industry’s M&A boom are more ego- and asset-inflating fantasies than value enhancers.

“I’m not sure that boards or managements have been completely honest with themselvesu00e2u20ac”or their shareholdersu00e2u20ac”about how successful they’ve really been with the deals they’ve done so far,” says Kenneth Smith, a Toronto-based partner with management consultant Mitchell Madison Group, who headed up one of the studies.

Some dispute the validity of measuring performance against peers, and others say more time is needed to register the full impact of mergers on bank income statements. But there’s no denying that such findings raise one overridingly crucial question for directors in an industry that many observers believe is only halfway down the consolidation road: Do mergers work for shareholders?

Catching the wave

Since 1990, the number of banks in the country has been slashed by one-third, to less than 10,000, according to the Federal Deposit Insurance Corp. In the first three quarters of 1998, 261 bank mergers or acquisitions and 76 thrift deals were announced, according to SNL Securities. Total deal value, powered by the megamergers announced in the spring, was $272 billionu00e2u20ac”smashing the 1997 full-year total of $96 billion. Few expect the trend to slow much. The third quarter saw a combined total of 112 bank and thrift deals announced, maintaining the pace.

The arguments in favor of continued consolidation make intuitive sense. Stunning technology improvements, deregulation, and globalization all seem to support the notion that scale can create efficiencies. From data processing operations to call centers, the ability to serve more customers usually translates into lower per-customer costs. And diversification, in terms of both business lines and geography, offers the potential to lower risk.

More to the point, historically high valuations have placed banks under pressure to boost revenues. Wall Street views the industry as a growth market, yet the reality is that revenues are growing at only about 6% annually. “Lack of revenue momentum is a killer for the industry,” notes James McCormick, president of First Manhattan Consulting Group. “We have been priced as an industry that’s going to continue to generate very high [earnings-per-share] growth, but that won’t happen if revenues don’t grow faster.”

These dynamics have created pools of both buyers and sellers. Some bankers today look at their stock prices and realize that their operations can’t support such valuations. Others conclude that they simply can’t compete. So why not sell now, while the getting is good?

“If you’re trying to compete with a bank that’s several times your size, the software expenditures you need to make to have the product development, database marketing, and market-segmentation capabilities the big guys have means you have to spend several times the amount they’re spending, per-customer, to compete,” Smith explains. “That’s not sustainable.”

Buyers, on the other hand, believe that they can gain efficiencies by doing deals. In-market deals offer the potential to eliminate both competition and costly redundancies; furthermore, it’s much easier to rationalize ramping up new products if you have, say, 1 million customers, as opposed to 200,000. And though few have been able to get a handle on the cross-selling game, most are confident that, with time, they will better understand customer needs and more effectively sell burgeoning product menus.

In anticipation of that day, many banks remain committed to aggressively beefing up their customer portfolios. And doing it via acquisition is seen as more cost-effective than going out and drumming up new business yourself. In the meantime, an acquisitionu00e2u20ac”when structured as a pooling transactionu00e2u20ac”has the effect of increasing short-term earnings, even if it doesn’t really improve overall value.

Reaching for returns

Someday, more bank acquirers might register bigger returns as a result of the acquisitions that have occurred in recent years. But the truth so far is that while shareholders of selling institutions have reaped big one-time windfalls from the consolidation boom, active acquirersu00e2u20ac”those who seem to have the most to gain from a dealu00e2u20ac”have thus far failed to produce shareholder returns that measure up to their peers, even as their balance sheets have grown.

“There are no clear-cut findings that suggest bank mergers uniformly lead to efficiency gains,” Federal Reserve Board Chairman Alan Greenspan stated in testimony before Congress this summer. He noted that only four of nine mergers studied by the Fed resulted in improved performance and said that often returns are “muted by large-company inefficiencies,” while customers of merged institutions sometimes “face bureaucratic inflexibility.”

In Mitchell Madison’s research, Smith compared total returnsu00e2u20ac”dividends plus stock-price appreciationu00e2u20ac”generated by mid-sized and large acquirers with those produced by a group of peers. For each deal, the clock began running three months before the merger was announced, to adjust for the impact of rumors, to two years after the transaction closed. The criteria was straightforward: If returns exceeded those reported by peers, the deal was a success; if not, it was a failure. The results? Fully two-thirds of all bank mergers valued at $1 billion-plus between 1990 and 1995 produced shareholder returns below the peer average.

A spring study by SNL produced similar results. Examining banks that, in the five years ended in March, acquired the most assets as a percentage of their size in three size categoriesu00e2u20ac”over $20 billion in assets, $5 billion-$20 billion, and under $5 billionu00e2u20ac”it found that of the top 10 in each group (30 in total), only eight had produced returns greater than the 249.37% registered in an all-bank index. Significantly, such big-name acquirers as NationsBank Corp., First Union Corp., and KeyCorp achieved lower-than-average results, while mid-sized and small banks fared somewhat better.

These results fall in line with yet another, broader study by Mercer Management Consulting, which found that 57% of mergers valued at $500 million or more, across all industries, fail to produce returns equal to those of peer companies. “There’s a certain sense of inevitability to bank consolidationu00e2u20ac”especially the in-market deals. I mean, do we really need so many banks?” says Mercer Vice Chairman James Quella. “But from the shareholders’ perspective so far, it has not been true that ‘bigger is better.’”

Not everyone agrees. Sherry Jarrell, an assistant professor of finance and economics at Wake Forest University’s Babcock Graduate School of Management, says looking at peer performance is too simplistic; that there are simply too many variables that can affect a bank’s performance. “What if a merger saves a bank from horrendous failure?” she asks.

Jarrell has looked at 130 mergers, including about a dozen bank deals, that occurred early in the decade. She benchmarked her study, using five firms of similar size and strategy for both the buyer and selleru00e2u20ac”and even created fictitious scenariosu00e2u20ac”to project what would have happened to the companies’ performance had they not done a deal. “If you look at a five- or six-year period following a merger, you find that most create significant economic value.”

Looking out for shareholders

Despite such protestations, a consensus appears to be emerging that, for many banks, mergers aren’t all they’re cracked up to be. The question is, what explains the failure of so many mergers and acquisitions to produce better shareholder returns? And what, if anything, can a board do to ensure that a merger by its bank will generate results where it counts most: on the bottom line?

As any director who’s been through the process can attest, mergers can be murky business, at best, and the answers to those questions often don’t come as easy as they probably should.

While board members have a fiduciary responsibility to ask smart questions of management during a merger, the truth is that many outside directors are busy with their own businesses and are, perhaps, not knowledgeable enough about the finer points of the deal to raise good questions.

And feeling allegiance to bank management or the communityu00e2u20ac”or a concern about holding onto your own board seatu00e2u20ac”is only human nature for directors. CEOs of larger banks, for instance, typically garner higher pay packages than those of smaller institutions, while many selling managements receive big severance packages at the expense of shareholders.

“There’s a human element to being a director,” acknowledges Cherashore, who sits on the boards of several other companies and was a director of North Side Savings Bank before it was acquired by North Fork in 1996. “But I don’t represent the president of the bank. I’m elected by the shareholders, and that’s where my allegiance has to lie.”

Despite that, only one person interviewed for this story could recall a time when directors shot down a bank merger deal proposed by management. “You see it happen a lot in other industries, like manufacturing. But most bank [acquisitions] are considered done deals by the time they get to the board,” Quella says. “Directors need to remember that their first and foremost responsibility is to the shareholdersu00e2u20ac”not to keeping management happy, not to maintaining continuity. At the end of the day, it’s about shareholder value.”

But it can be difficult to strike the right balance between watchdog and advocate, because most boards rely on management to generate the numbers to justify the deal. “We’re not in a position ourselves to refute the savings that an acquisition can generate, or the timetable,” says one director, who requested anonymity. “The best we can do is apply our own business expertise and question those numbers hard.”

Even if management is presenting realistic numbers, M&A is a risky game, simply because it’s about gambling on the future. “You’re working on assumptionsu00e2u20ac”what the rate structures and environment will be likeu00e2u20ac”and some of those are bound to change on you,” Cherashore notes.

Digging below the surface

Still, the responsibility for deciding on the prudence of a merger falls on the board. And that means asking plenty of probing questions to make sure you understand the potential impact of a deal.

While every merger is different, experts say that most of those that fail to produce good returns do so because of poor executionu00e2u20ac”at least on the surface. And no wonder. The cost savings wrought by the typical acquisition require branch closures, layoffs, and the integration of complicated, often conflicting, back-room technologies.

Board members canu00e2u20ac”and shouldu00e2u20ac”keep tabs on such integration issues, but the best place for directors to assert themselves is before a deal is consummated, when decisions over the concurrent issues of pricing and strategic vision are being formulated. This is the stage where boards, with their veto power, wield the greatest power and, thus, have their best opportunity to set the tone for the deal and lay out a blueprint for how that vision will be achieved.

What is the deal rationale? Does the pricing make sense? Is there a strategy for actually achieving the synergies management wants to achieve? And how will you know if success is forthcomingu00e2u20ac”are there interim milestones for management to strive toward?

Scrutinize the details of a proposed merger closely, playing the role of devil’s advocate, and use your business sense and intuition to assess the deal logic. Is the intention to build market share? That might make sense for an in-market transaction, if it’s followed up with cost cuts and a pricing strategy. But market share by itself should never be an objective.

“There are a lot of things that become statements of purpose for a deal that sound nice but have nothing to do with value creation,” Quella says. Directors “should ask, ‘Where’s the source of value for the shareholder? And is the management team knowledgeable enough to achieve that value?’ Those are the things that matter to owners.”

Start with pricing, which remains the most important area for defining expectations. Overpay, and not only are you in for years of playing catch-up to justify the price, it can also push once-rational managements to do irrational things.

“When you see mergers that fail to produce good results, it’s usually that the buyer overpaid relative to what it achieved in the integration,” says Les Biller, president and a director of Wells Fargo & Co. “You have to be realistic about your expectations when you’re negotiating a dealu00e2u20ac”not overstate what you think you can accomplishu00e2u20ac”and have the discipline to walk away because the pricing is so dear that you can’t generate good returns for shareholders.”

In the 1980s, it wasn’t unusual for banks to “surprise” investors by achieving unexpected efficiencies from a deal. But those market imperfections have largely evaporated. Today, most of the anticipated cost savings from a deal are priced into the front end. Competition and an ever-smarter market pushed average multiples during the first three quarters of 1998 to 284% of book value, and 22.7 times earningsu00e2u20ac”up sharply from the 192% of book and P/E of 16.6 registered in 1996, according to SNL.

A failure to achieve back-office synergies and other cost-cutting efficiencies can make the deal a bust early on. But even if those savings are attained, most deals now must be justified in terms of added revenues that can be generated over time. “Acquisitions today don’t work based on cost savings,” Kanas points out. “We have to assure ourselves that we can improve revenues with the new customers we acquire.”

Realistic goals

McCormick and others agree that the single biggest indicator of a merger’s success is whether explicit objectives that make good business and financial sense are articulated prior to the deal. A good board will elicit a solid, doable vision of where the deal will take the bank on the revenue side and how the profit goals will be achievedu00e2u20ac”along with some pre-established markers to indicate progress. That gives investors confidence and the organization a direction to pursue.

Without a good plan, a deal can quickly unravel. Many mergers, for instance, are sold with the idea that one-plus-one can equal three, by cross-selling each partner’s products and services to the other institution’s customers. But after years of hard work trying to play the cross-sell to their advantage, banks have little to show for those efforts.

Norwest has worked on cross-selling for years, but still registers only about five relationships-per-customer in its highest penetration areas, well off its goal of eight. “In general, cross-selling hasn’t worked out very well so far,” McCormick says.

Biller, who has helped engineer dozens of deals in recent years, disputes that, but agrees that acquirers run into the most trouble by failing to accurately acknowledge the “customer disruption” that often follows branch closures and name changes. Indeed, customer runoff was a major factor behind Wells Fargo’s poor performance following its hostile 1996 acquisition of First Interstate Bancorp.

It may sound odd, but a First Manhattan study found that, between 1993 and 1997, core deposits held by the biggest acquirers (and their acquirees) actually shrunk by an average of 2.5%, while non-acquirers saw a modest gain of about 1.5%.

Why? In their quest for short-term profits, many acquirers increase spreads by lowering deposit rates. While that might work for a few years, the effect is often to drive customers away, lowering a bank’s long-term revenue potentialu00e2u20ac”and thus the value of the franchise.

There are exceptions to this rule. North Fork seeks, by design, to lower funding costs by shifting high-interest rate savings account holders to demand deposits. “We understand the deposit base is going to shrink because we’re not as aggressive with interest rates,” Kanas says. “But we also know we’re going to generate other, more-profitable business into those locations.”

But North Fork’s strategy is admittedly unique. Most managements and boards don’t enter a merger assuming they’ll lose a lot of customers, industry observers say. So if customer runoff comes unexpectedly, even the most conservative managements may begin to take extraordinary risks that may only compound the problems.

“If you do a deal and you’re stretching the envelope, under additional scrutiny, and [investors] are saying, ‘You’d better prove to me this works, because I’m really skeptical,’ then your management goes into budgeting sessions [with an eye toward] more aggressively seeking sources of short-term income,” McCormick explains. “And that can make things worse in the long run.”

Among the best ways to avoid such problemsu00e2u20ac”and the other critical area boards should focus onu00e2u20ac”is setting forth clearly who will be in charge of the post-merger bank. Surprisingly, many boards and managements ignore this crucial element. “They say, ‘We’ll just be a bigger bank and figure it out,’” McCormick says. He calls this hot-tub management: “We’ll all get into the hot tub together and figure something out.”

Maintaining the vision

Failing to define early on what the corporate culture will look like, experts say, is an almost-guaranteed recipe for failure. “Often, you put those two cultures together and discover you don’t have an appropriate decision-making process for the choices you have to make,” Smith says. “The two groups think in such completely different ways, they don’t even talk the same language. And that can lead to some insurmountable problems.”

Better to have one organization emerge as the dominant oneu00e2u20ac”something the best acquirers already know. Wells Fargo teams each acquired branch with a so-called “buddy bank” that’s already in the system and can transmit what CEO Richard Kovacevich calls “the hundred little things we do each day” to new employees. And North Fork uses a take-no-prisoners approach, where managements that don’t buy into the new program are let go. “We never do mergers; we acquire,” Kanas says simply.

With that cultural imperative and its well-defined approach to generating value, you’d think it would be a no-brainer serving on North Fork’s board. But with so many mergers failing to live up to expectations, Cherashore says it’s anything but.

Stepping out from a day-long board meeting one November morning, he talks about the pressure he and other directors apply on Kanas to ensure that each merger North Fork embarks on produces long-term value for investors. “You’ve got to say, ‘Listen, fellows, what can go wrong?’ and be willing to dig into the dark side of every deal,” Cherashore advises.

“Ask as many questions as you can, to make sure what you’re embarking on makes sense, because ultimately you’re going to have to turn around to shareholders and say, ‘We recommended it; we voted on it’,” he adds. “You can’t get away from that.”