Merging Interests

didn`t take long for Chase Manhattan Corp. to reap the benefits of its December acquisition of Hambrecht & Quist Group. Within three months of consummating the deal, Chase H&Q had already equaled its 1999 underwriting output by managing the public equity offerings worth $20 billion. The mergers and acquisition group saw its business jump, too; it advised on deals worth $64 billion in the quarter, more than triple last year`s effort. The purchase of Hambrecht & Quist has been so successful that Chase has since acquired three other investment banks: Sao Paolo, Brazil-based Banco Patrimonio de Investimento SA; London-based Robert Fleming Holdings; and Beacon Group of New York. To insiders, the success of the Hambrecht and Quist acquisition came down to one thing: personalities. We volunteered, says Christina Morgan, managing director and co-director of investment banking with Chase H&Q, referring to the investment bank`s decision to sell to Chase. She was head of Hambrecht and Quist`s investment banking activities prior to the deal. We chose Chase and Chase chose us. We all just like each other. The top people in each organization are compatible. That`s somewhat luck, somewhat chemistry. Surprisingly, the experiences of Morgan and her colleagues at Hambrecht and Quist are not unique. Investment bankers at a number of firms who sold to commercial banks in the past three years have said the same thing, which accounts for much of the success the acquiring banks have had in integrating their new entrepreneurial and high-risk subsidiaries. The relative ease with which banks have integrated their investment banking acquisitions is all the more surprising given that the latest deals come 67 years after the Glass-Steagall Act formally separated the two businesses. That separation, and the regulations that came with it, caused commercial banks to become institutionally-based bureaucracies that engendered slow-moving, fortress-like atmospheres. While federal deposit insurance ensured they held the lion`s share of the capital, they were limited in what they could do with it. Investment banking on the other hand, void of most government restrictions, took a much freer course and invested its limited capital in trading, equity underwriting, and mergers and acquisition advisory work. The structure was lean to compensate for higher funding costs (there are no insured deposits) and a premium was placed on the people that produced results. When the two groups first tried to get back together in the early 1990s, the results initially were disappointing. It was a scenario that followed previous failed attempts by banks to expand their product offerings outside deposits and prime-quality loans. Historically, these deals [to buy brokerages] have never made any money, says Katrina Blecher, an analyst who has covered regional banking for several Wall Street firms. Since 1997, however, the tide has begun to turn. In part, the pace of bank consolidation gave the industry more practice at handling acquisitions of investment banks. In 1996, banks were involved in acquisitions of four broker/dealers, with a total deal value just short of $1 billion. A year later, the number of deals jumped to 16, worth an aggregate of $6.2 billion. While the number of deals has generally declined since 1997 to 17 in 1998, 14 in 1999, and five through the end of May 2000 the size of individual transactions has grown. Chase`s $1.4 billion acquisition of Hambrecht & Quist replaced NationsBank Corp.`s $1.2 billion purchase of Montgomery Securities in 1997 as the largest-ever bank acquisition of a broker/dealer. That record has been broken twice already in 2000, first by Citigroup`s $2.2 billion purchase of Schroeders Plc`s investment banking operation in January, and then again in April when Chase paid $6.9 billion to acquire Fleming. The latter deal also included a sizable money management business. What`s instructional about these deals is that banks have had to let the acquisitions operate pretty much as before to get the most return on the increased capital they had invested in their investment banking arms. Most of the banks that have succeeded have taken a hands-off approach to managing their new subsidiaries, something that requires trust on both sides of the table. For example, KeyCorp and McDonald & Co. Investments, both of Cleveland, got together in 1998 in part because Bob Gillespie, KeyCorp`s chief executive, already knew William Summers, the former president and chief executive of McDonald, prior to announcing their deal. John C. McLean Jr., senior executive vice president of Wachovia Corp. and head of the bank`s corporate financial services division, says his team and the management of Interstate/Johnson Lane also were compatible on a personal level. Though Wachovia is based in Raleigh and Interstate/Johnson Lane was in Charlotte, managers of the two companies had similar views about how to treat customers and employees. And, says McLean, both groups were looking for what was best for the combined company. “One of the things that was not an issue with the group of people we were dealing with was the ego factor,” McLean says of the October 1998 deal. No one thought they had all of the answers, and the discussions were about what was best for the business. In fact, Interstate/Johnson Lane executives were the ones who suggested changing the name of the wholesale investment banking group to Wachovia Capital Markets, a name they felt would carry greater weight with wholesale customers. The retail brokerage which was the primary reason Wachovia wanted the firm was renamed Interstate Johnson/Lane Wachovia Securities. Good rapport also comes from an understanding between buyer and seller about what made the business successful in the first place. Chase understood what to expect when it acquired Hambrecht and Quist because it had spent a number of years developing its own in-house investment banking operation. Though the unit was limited in scope largely to debt underwriting and trading and syndicated loans, it was no slouch. It had generated nearly $1.9 billion in investment banking fees in 1999, a 25.6% jump from 1998, while the trading arm generated nearly $2.9 billion in revenues, compared with $1.9 billion the previous year. Equally valuable, the unit gave the bank an introduction to the business that proved important when it came time to buy an equity underwriter. Chase had additional insight into Hambrecht & Quist`s business as a result of its Chase Capital private equity investor unit. The unit had $15 billion in assets under management, including $8.7 billion in direct investments and $6.3 billion in leveraged loans and high-yield fund investments. Ultimately, both Chase Capital and Chase`s limited investment banking business both highlighted the need for the purchase of a company like Hambrecht & Quist. While the bank was strong in debt underwritings, it couldn`t satisfy all of its customers` needs because it was prohibited from underwriting equity offerings. And while the earnings from Chase Capital`s investment portfolio were strong, it was aggravating to have to send those companies to other Wall Street firms for initial public equity offerings. Morgan says Chase`s venture capital and capital markets units put the two companies on the same page. “As individuals, we were looking for the same things,” she says of the executives involved. They are very entrepreneurial. They started the syndication loan business from nothing. We both understand how to build things.Initially, the deal was thought too small by some analysts to give Chase a credible presence in the equity underwriting business. Consider, however, that an estimated 40% of the overall market capitalization is controlled by companies in high-technology fields Hambrecht & Quist`s primary markets and the deal takes on a different light altogether. Partnering with Chase enabled Hambrecht & Quist to offer a full range of products that its own limited capital base would not support. While it had the contacts to handle high-yield debt or syndicated loan transactions initiated by its customers, it didn`t have the capital to provide the service. Chase, on the other hand, had the capability but not the contacts. A synergistic match was formed. Now the combined institution can strongly compete for business with Silicon Valley companies. The ability to remain competitive was also one reason Piper Jaffray Cos. agreed to sell to U.S. Bancorp in December 1997. Andrew Duff, president of U.S. Bancorp Piper Jaffray, says consolidation had made it important to find a large partner. We thought that the landscape was changing, says Duff, who was director of fixed-income capital markets for Piper Jaffray prior to the sale. “We found that our clients would really like comprehensive solutions whereever possible. From the proposals [at the time] for changes in Glass-Steagall, we saw an opportunity to be the first” to provide those comprehensive services. Still, there was trepidation over pairing up with a stodgy commercial bank. “We did consider investment [bank buyers] because of the changes in Glass-Steagall and because activity was on the rise,” Duff says. “We felt there would be industry consolidation. And we were proactive in contacting [potential buyers]. But our focus quickly became partnering with a commercial bank. It seemed clear that the banks had a strategic interest in making acquisitions and offering our services to their clients.” Nonetheless, Duff and his crew did not immediately race across town to sign a deal with U.S. Bancorp. In fact, the two companies negotiated for nearly nine months before there was ink on the deal. During that period, they hashed out a number of issues, including who would manage what areas. In the end, Piper took over running the bond sales department and a couple hundred retail brokers, while the bank took over Piper`s asset management group. To ensure that there wouldn`t be a wholesale defection of its bankers, Piper Jaffray and the bank created a retention package, though Duff admits it was relatively modest. In doing so, he says the firm was sending a message to its employees that the combination offered its bankers more upside than remaining independent.”It was designed to say that we believe the merger was highly complementary to our business and was good for our clients,” Duff says. But, because of the transition and its difficulties, the company later felt compelled to provide an incentive to help them work through the difficulties. Looking back, he says the company lost virtually no one on the capital markets side, though some brokers did leave to join competitors. While it is hard to avoid such losses in any deal, that didn`t make it any easier. “In the war for talent, we don`t want to lose anybody,” Duff says. In the past, one of the biggest stumbling blocks for bank acquisitions of investment banks was compensation. The hierarchical structure of commercial banks meant that the highest-paid person in the organization usually sat in the chief executive`s chair. Conversely, the highest-paid person in an investment banking company sat virtually anywhere. In the mid-1980s, for example, Michael Milken`s $500 million in salary and bonus while working as a junk-bond dealer in Drexel Burnham Lambert`s Beverly Hills, California office dwarfed the compensation of Drexel`s CEO. To their credit, banks have seen the writing on the wall and have started to implement changes in their compensation structure, primarily to ensure they are not losing the war for human capital. Wachovia had begun changing the way it paid its corporate bankers well before agreeing to buy Interstate/Johnson Lane as a result of a review of the corporate banking group`s strategic role. That same review uncovered the need to acquire a broker/dealer. “That level of compensation [for investment bankers] was not foreign to us,” says McLean. “We didn`t feel we needed to go in and cut their pay level or increase ours. If we had not been working already to change our own compensation structure, it would have been more difficult.” Typically, pay levels at regional investment firms, while higher than at regional or, in some cases, even money-center banks, typically do not compare with the multimillion dollar pay packages the top producers on Wall Street receive. This makes it harder for commercial banks to break into the upper echelons of investment banking without significant effort. Blecher explains that, compared with commercial bankers, investment bankers are more likely to jump ship either to another firm or to an entirely different industry if they receive an immediate cash payout from an acquisition: “It`s difficult to keep your top producersu00e2u20ac”and to keep your top producers producing.””It`s critically important for banks to structure their incentive programs appropriately,” says Joe Duwan, a bank analyst with Keefe, Bruyette and Woods. “There is a pay-for-performance culture at investment banks” that bankers need to consider, he says. Another major sticking point involves technology. Getting both companies` data processing systems on the same page takes a lot of time and money, and it can delay new product offerings that both sides are counting on to generate new business. U.S. Bancorp, for example, launched its first joint product with Piper Jaffray this spring, more than 28 months after the acquisition was announced. Says Duff: “It`s very frustrating to have different back-office systems. Over time we are solving the issue. But it has not been easy.” When U.S. Bancorp Piper Jaffray did launch the product, it was met with resounding interest. The Prime Account offers clients access to their investment funds, online trading, and proprietary research and allows them to make deposits at any of the bank`s 1,000 branches and 3,000 automated teller machines. In less than a month, customers had deposited $100 million at those branches, with an average deposit size of more than $10,000. Even if the merged companies are able to offer joint products, there is concern at the investment bank level about interference from the bank`s management: Part of the reason banks have had a miserable time integrating acquisitions of companies outside the banking sector is their tendency to meddle. Observers point to the trouble Bank One Corp. has had with its First USA unit, for example. But Piper Jaffray`s Duff says interference was not an issue for his team because U.S. Bancorp recognized the strengths of the broker/dealer. The bank was looking for a platform to deliver investment products to its customers in its 17 midwestern and western markets. Likewise, the investment bank wanted to provide “comprehensive solutions” to its customers. “We recognized the cultural differences going in,” Duff says. “But we were also struck by it, in that we were very complementary. And when you have complementary services, you have a unique opportunity to achieve something new.” Chase H&Q`s Morgan agrees: “In bank mergers, the less you have in common, the better. We needed what they had. They needed what we had.” Indeed, where there were overlapping businesses, the deals were more rancorous. With NationBank`s 1997 purchase of Montgomery Securities, both buyer and seller had high-yield desks. The deal was further hurt by a clash of egos. Says one banker: “Hugh McColl and Tommy Weisel were unlikely [compatible] personalities.” Weisel left the firm in 1998 to launch merchant bank Thomas Weisel Partners. Things didn`t go any smoother in April 1998 when NationsBank merged with Bank America Corp. and acquired Robertson Stepens & Co. in the process. For one thing, the mega bank merger came just six months after BofA completed its purchase of Robertson Stephens. For another, NationsBank already owned Montgomery, which, like Hambrecht & Quist and Robertson Stephens, targeted clients in Silicon Valley. Things were unraveling for Robertson Stephens even before NationsBank entered the scene. When the firm initially agreed to sell to BankAmerica in June 1997 for $470 million, it planned to take advantage of the bank`s international presence to boost its own business. Those plans fell apart almost immediately because of internal disputes. A month-and-a-half after the Oct. 1 closing, the bank announced a change in policy regarding distribution of new stocks. No longer would potential executive clientsu00e2u20ac”and potential IPO candidatesu00e2u20ac”automatically receive shares in new equity offerings, a common practice among broker/dealers at the time. Instead, the bank implemented a new formula tied to each customer`s brokerage activity to determine who would get shares. By the time NationsBank announced it would sell Robertson Stephens to BankBoston Corp. in May 1998, the fallout had become more tangible. Bankers, including founder Sanford Robertson and Misha Petkevich, the firm`s investment banking head, had started to jump ship. Performance began to slip, and the number of initial public offerings the firm lead managed edged down to 15 in 1998, from 17 the year before. By March 1999, beleagered Robertson Stephens was slated to work for its fourth owner in 18 months when Fleet Financial Group bought BankBoston. By all accounts, though, the relative calm of the Fleet/Boston Financial Corp. merger has allowed Robertson Stephens to spread its wings again. In 1999, it took on 44 IPOs, nearly three times as many as 1998. By the first quarter of 2000, it had completed another 17 deals, as many as its total for 1997. Says KBW`s Duwan: “The consensus is that [Fleet`s acquisition of Robertson Stephens] has gone pretty well.” Duwan says Fleet has been successful with its other securities-related acquisition as well: its $1.6 billion purchase of discount brokerage Quick & Reilly Group. Despite initial skepticism about the purchase, the deal has performed well because the specialist operation, which focuses on technology issues, generates steady revenues regardless of the direction of the market. That, says Blecher, makes the deal “a home run.” In general, the odds have favored success for all banks that acquired investment-banking companies in the past three years. The acquirers have had a pretty good run as a result of the rise in stock prices. U.S. Bancorp, for example, saw a 45.6% growth rate in investment banking income in 1999u00e2u20ac”its first full year owning Piper Jaffrayu00e2u20ac”to $1.2 billion. Still, investment banking income is volatile. To protect against earnings blips, some banks try to limit the damage before it begins. Blecher praised Fleet for warning analysts every quarter not to expect strong earnings from Robertson Stephens and Quick & Reilly. “They tell the Street that this is great money, but the business is, nonetheless, volatile.” But this approach may not last forever. Blecher points out that shareholder expectations could ultimately undo the hands-off approach banks have applied to their securities and capital markets subsidiaries. “When you`re a bank shareholder, you`re used to consistency of earnings,” she says. “It`s good when [investment banking income] is strong, but the increase in volatility has hurt banks` pricing multiples.” Through it all, banks have had to deal with the customer base of the investment bank they acquired. For Cleveland-based KeyCorp, that has meant lower returns for its investment in McDonald, which has a lower concentration of clients in high technology companies than Chase H&Q and Piper Jaffray. That is not to say that the unit has not performed well for KeyCorp. In fact, capital markets income for the bank soared 47.8% during 1999, to $953 million, largely as a result of the acquisition. The companies that have benefited most are those that have focused in high technology and the Internet. According to the Industry Standard, there were an average of 26 Internet initial public offerings per month in the first quarter of 2000, more than triple the activity in the first quarter of 1999 and second only to the average of 27-IPOs-per month in the third quarter of 1999. Even more important, the average capital raised per month was $3.1 billion in the first quarter of 2000, nearly triple the $1.1 billion monthly average in the first quarter of 1999, and 40.7% higher than the previous high of $2.2 billion recorded in the second quarter of 1999. But things change more quickly in the capital markets than they do in conventional commercial banking. In June, average Internet initial public offering volume was off by nearly 50%u00e2u20ac”to 15 in April and 13 in May. Likewise, the capital being raised has fallen. In April, the funds raised just under $1.2 billion before falling to $846 million in May. This suggests that those banks with an Internet focus will see a decline in second quarter earnings. So while banks have enjoyed the fruits of their investment banking acquisitions for nearly two years, their resolve to let the subsidiaries operate as before is heading for a test as the markets waver. The bigger question is, says Blecher, “What is going to happen in a down market? Are the banks going to be able to stay out of running those businesses?” Only time will tell.