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Chapter 19 - Acquisitions and Mergers in Financial- Services Management CHAPTER 19 ACQUISITIONS AND MERGERS IN FINANCIAL- SERVICES MANAGEMENT Goal of This Chapter: The purpose of this chapter is to understand why the financial services industry undertakes so many mergers each year and to determine what legal, regulatory, and economic factors should be considered when the management of a financial services provider wants to pursue a merger Key Topics in This Chapter • • • • • • Merger 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 Outcomes Chapter Outline I II III IV V VI VII Introduction Mergers on the Rise The Motives behind the Rapid Growth of Financial-Service Mergers A Profit Potential B Risk Reduction C Rescue of Failing Institutions a The Credit Crisis: Impact on Mergers D Tax and Market-Positioning Motives E The Cost Savings or Efficiency Motive F Mergers as a Device for Reducing Competition G Mergers as a Device for Maximizing Management’s Welfare (An Agency Problem) H Other Merger Motives I Merger Motives That Executives and Employees Identify Selecting a Suitable Merger Partner A Merger Premium B Exchange Ratios C Dilution of Ownership D Dilution of Earnings The Merger and Acquisition Route to Growth Methods of Consummating Merger Transactions A Pooling of Interests B Purchase Accounting C Purchase-of-Assets Method D Purchase-of-Stock Method Regulatory Rules for Bank Mergers in the United States 19-1 Chapter 19 - Acquisitions and Mergers in Financial- Services Management VIII IX X XI A Bank Merger Act of 1960 B Competitive Effects of Mergers C The Public Benefits Test D Justice Department Guidelines E Herfindahl - Hirschman Index F The Merger Decision-Making Process by U.S Federal Regulators Merger Rules in Europe and Asia Making a Success of a Merger Research Findings on the Impact of Financial-Service Mergers A The Financial and Economic Impact of Acquisitions and Mergers B Public Benefits from Mergers and Acquisitions Summary of the Chapter Concept Checks 19-1 Exactly what is a merger? Mergers simply mean the financial transactions that result in acquisition of one or more firms by another institution Here, the 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 institution To affect a proposed merger, the board of directors must ratify the same This can be possibly done when shareholders of all the parties involved approve the merger transaction once it is negotiated among the management of the parties to the merger Once the shareholders of each firm involved give approval to the merger, approval must then be sought from the Department of Justice and the principal federal regulatory agency of each firm in the merger 19-2 Why are there so many mergers each year in the financial-services industries? Many mergers and acquisitions have happened in the entire financial-service sector in recent years Many of these mergers have occurred because of lower legal barriers that previously prohibited or restricted expansion With several acts like Riegle-Neal Interstate Banking Act of 1994 and Gramm-Leach-Bliley (GLB) Act of 1999 being passed, mergers in financial services received a legislative boost This convergence and consolidation trend has brought banks into common ownership with security and commodity broker–dealer firms, finance companies, insurance agencies and underwriters, credit card companies, thrift institutions, and numerous other nonbank service providers 19-3 What factors seem to motivate most mergers? Among the most powerful merger motivations are the belief among the stockholders of the firms for greater profit potential if a merger is consummated or their expectation of a possible reduction of cash flow risk or earnings risk However, from a management’s perspective, there is 19-2 Chapter 19 - Acquisitions and Mergers in Financial- Services Management an expectation to gain higher salaries and employee benefits, greater job security, or greater prestige from managing a larger firm The other various anticipations of merger partners involve the possible rescue of failing institutions, the gaining of a tax advantage where profits of one merger partner may be offset by the losses of another merger partner, and the search for market-positioning benefits in new markets or in superior locations in existing markets Another motivation is the pursuit of lower cost and greater efficiency so that the merged institution achieves a greater margin of revenues over operating expense as well as maximizing the welfare of management 19-4 What factors should a financial firm consider when choosing a good merger partner? The following items are the principal factors usually reviewed by the acquiring organization: The firm’s history, ownership, and management The condition of its balance sheet The firm’s track record of growth and operating performance The condition of its income statement and cash flow The condition and prospects of the local economy served by the targeted institution The competitive structure of the market in which the firm operates The comparative management styles of the merging organizations The principal customers the targeted institution serves Current personnel and employee benefits 10 Compatibility of accounting and management information systems among the merging companies 11 Condition of the targeted institution’s physical assets 12 Ownership and earnings dilution before and after the proposed merger It is absolutely essential to thoroughly evaluate the proposed corporate merger before it occurs 19-5 What factors must the regulatory authorities consider when deciding whether to approve or deny a merger? The federal supervisory agencies prefer to approve mergers that will enhance the financial strength of the institutions involved as they encourage the need for improving management skills and strengthening equity capital Under the terms of the Bank Merger Act, each federal agency must give top priority to the competitive effects of a proposed merger This means estimating the probable effects of a merger on the pricing and availability of financial services in the local community and on the degree of concentration of deposits or assets in the largest financial institutions in the local market Mergers that would significantly damage competition cannot be approved unless there are mitigating instigating circumstances (e.g., one of the firms involved is failing) Public convenience must also be weighed by the regulatory agencies to determine if the merger would improve the supply of needed services that are perhaps currently not being conveniently and efficiently provided to the public 19-3 Chapter 19 - Acquisitions and Mergers in Financial- Services Management Along with these, the other factors that must be weighed to approve a merger include the financial history and condition of the merging institutions, the adequacy of their capital, their earnings prospects, strength of management, and the convenience and needs of the community to be served 19-6 When is a market too concentrated to allow a merger to proceed? What could happen if a merger were approved in an excessively concentrated market area? The Justice Department guidelines require calculation of the Herfindahl-Hirschman Index (HHI) as a summary measure of market concentration HHI reflects the proportion of assets, deposits, or sales accounted for by each firm serving a given market HHI may vary from 10,000 (i.e., 1002)—a monopoly position, where the leading firm is the market’s sole supplier—to near zero for unconcentrated markets As per the Department of Justice guidelines established in 1997, the Federal Reserve merger policy states that the market area is too concentrated to allow a merger, if the postmerger HHI increases 200 or more points to a level of 1,800 or more or if the postmerger market share rises to 35 percent or more If the Justice Department decides that the resultant merger will make the banking market too concentrated they are likely to challenge the merger in federal court However, merger combinations exceeding these standards often require mitigating factors (such as greater likelihood of future market entry) in order to gain Federal Reserve approval 19-7 What steps that management can take appear to contribute to the success of a merger? Why you think many mergers produce disappointing results? There are several steps management can take to improve their chances of success of a merger • • • • • • They can know themselves by thoroughly evaluating their own financial condition, track record of performance, strengths and weaknesses of the markets it already serves, and strategic objectives They can also create a management-shareholder team before any merger to a detailed analysis of the potential mergers and new market areas Establish a realistic price for the target firm based on a careful assessment of its projected future earnings discounted by a capital cost rate that fully reflects the risks of the target market and target firm Once a merger is agreed upon, create a combined management team with capable managers from both acquiring and acquired firms that will direct, control, and continually assess the quality of progress toward the consolidation of the two organizations into a single effective unit that satisfies all federal and state rules They should also establish lines of communication between senior management, branch and line management, and staff that promotes rapid two-way communication of operating problems and ideas for improved technology and procedures Create communications channels for both employees and customers to promote (a) understanding of why the merger was pursued and (b) what the consequences are likely to be 19-4 Chapter 19 - Acquisitions and Mergers in Financial- Services Management • for both anxious customers and employees who may fear interruption of service, loss of jobs, higher service fees, the disappearance of familiar faces, and other changes Finally they should set up customer advisory panels to comment on the merged institution’s community image, availability of services and helpfulness to customers Mergers sometimes produce disappointing results because of ill-prepared management, a mismatch of corporate cultures, excess prices paid by the acquirer, inattention to customers’ feelings and concerns and a general lack of fit between the two firms 19-8 What does recent research evidence tell us about the impact of most mergers in the financial sector? A recent study, which looked at the earnings impact of approximately 600 national bank mergers, found no significant differences in profitability between merging and comparably sized nonmerging banks serving the same local markets However, CEOs at a substantial majority of the nearly 600 U.S bank mergers believed their capital base improved and they were now a more efficient banking organization However, as a study by Rose found that there is no guarantee of success in a merger This study of 572 banks which purchased nearly 650 other banks found a symmetric distribution of earnings outcomes for these mergers—nearly half displaying negative earnings results Finally, a recent study published by the Federal Reserve Board finds that mergers and acquisition in the financial sector often produce operating cost savings (economies of scale) However, these are generally for small firms and there is no evidence of cost reductions among large financial firms or of any improvements in the management quality 19-9 Does it appear that most mergers serve the public interest? Most studies that have looked at this issue find few real public benefits In fact, about one-third banks changed their pricing policies The most common change was a price increase following a merger, particularly in checking account service fees, loan rates, deposit interest rates, and safedeposit box fees On the positive side, there is no convincing evidence that the public has suffered a decline in service quality or availability following most bank mergers Moreover, mergers may significantly lower the bank failure rate Crossing state lines seems to be somewhat effective in helping to stabilize asset and equity returns, reducing the chances of insolvency and resulting in lower operating costs However, some smaller businesses may suffer a bit if their principal bank is acquired and they don’t yet have a relationship with the new owners Mergers and acquisitions tend to stimulate market entry of new competitors This situation can have multiple outcomes as some customers quickly look around for new service providers or can also lead to cost cutting including firing some employees who then start up new financial firms to challenge their former employers Hence, mergers and acquisitions usually generate a mixture of winners and losers 19-5 Chapter 19 - Acquisitions and Mergers in Financial- Services Management Problems and Projects 19-1 Evaluate the impact of the following proposed mergers upon the postmerger earnings per share of the combined organization: a An acquiring bank reports that the current price of its stock is $25 per share and the bank earns $6 per share for its stockholders; the acquired bank’s stock is selling for $18 per share and that bank is earning $5 per share The acquiring institution has issued 200,000 shares of common stock, whereas the acquired institution has 50,000 shares of stock outstanding Stock will be exchanged in this merger transaction exactly at its current market price Most recently, the acquiring bank turned in net earnings of $1,200,000 and the acquired banking firm reported net earnings of $250,000 Following this merger, combined earnings of $1,600,000 are expected b Suppose everything is the same as described in part a; however, the acquired bank’s shares sell for $36.00 per share rather than $18.00 How does this affect the postmerger EPS? a Assuming the acquiring bank as Bank A and the bank being acquired as Bank B, we can find the individual banks’ P-E ratios as follows: A’s P-E ratio = $25 per share = 4.17 $6 per share B’s P-E ratio = $18 per share = 3.6 $5 per share To find the postmerger earnings per share, we first find the total shares of Bank A issued to the stockholders of Bank B to complete the merger If the shareholders of Bank B agree to sell out at B’s current stock price of $18 per share: They will receive 18 25 of a share of stock in Bank A for each share of B’s stock Thus, a total ( ) of 36,000 shares of Bank A 50,000 Bank Bshares× 18 25 will be issued to the stockholders of Bank B to complete the merger The combined organization will then have 236,000 shares outstanding Based on the projected earnings after the merger, stockholders’ earnings per share will be: Earnings per share = Combined earnings $1,600,000 = = $ 6.78 Shares of stock outstanding 236,000shares 19-6 Chapter 19 - Acquisitions and Mergers in Financial- Services Management b If the shareholders of Bank B agree to sell out at B’s current stock price of $36 per share: They will receive 36 25 of a share of stock in Bank A for each share of B’s stock Thus, a total of approximately 72,000 shares of Bank A 50,000 Bank Bshares× 36 25 will be issued to the stockholders of Bank B to complete the merger The combined organization will then have 272,000 shares outstanding ( Earnings per share = ) Combined earnings $1,600,000 = = $5.88 Shares of stock outstanding 272,000shares 19-2 Under the following scenarios, calculate the merger premium and the exchange ratio: a The acquired financial firm’s stock is selling in the market today at $14 per share, while the acquiring institution's stock is trading at $20 per share The acquiring firm’s stockholders have agreed to extend to shareholders of the target firm a bonus of $5 per share The acquired firm has 30,000 shares of common stock outstanding, and the acquiring institution has 50,000 common equity shares Combined earnings after the merger are expected to remain at their premerger level of $1,625,000 (where the acquiring firm earned $1,000,000 and the acquired institution $625,000) What is the postmerger EPS? b The acquiring financial-service provider reports that its common stock is selling in today’s market at $30 per share In contrast, the acquired institution’s equity shares are trading at $20 per share To make the merger succeed, the acquired firm’s shareholders will be given a bonus of $2.00 per share The acquiring institution has 120,000 shares of common stock issued and outstanding, while the acquired firm has issued 40,000 equity shares The acquiring firm reported premerger annual earnings of $850,000, and the acquired institution earned $150,000 After the merger, earnings are expected to decline to $900,000 Is there any evidence of dilution of ownership or earnings in either merger transaction? a A merger premium will be paid amounting to: Merger premium (in percent) = Acquired firm's current stock price per share + Additional amount paid by the acquirer for each share of the acquired firm's stock × 100 Acquired firm's current stock price $14 + $5 = ữì100 =135.714 percent $14 With an additional $5 per-share bonus the acquired institution's stock will be valued at $19, slightly lower than the acquiring institution's stock for a $19 ÷ $20 or at a 0.95:1 exchange ratio 19-7 Chapter 19 - Acquisitions and Mergers in Financial- Services Management Hence, the earnings per share from the merger will be: Earnings per share = Combined earnings $1,625,000 = = $20.70 Shares of stock outstanding 78,500shares Before the merger, the acquiring institution had an EPS of $20 ($1,000,000 ÷ 50,000 shares), whereas a postmerger EPS of $20.70 is reported This suggests there will not be any earnings dilution for the shareholders of the acquiring institution b If the acquiring bank's stock is currently selling for $30 per share and the acquired institution's shares are trading at $20 per share and also, the acquired firm's shareholders are offered a $2 per-share bonus to merge, the merger premium will be: $20 + $2 Merger premium (in percent) = ữì100 =110 percent $20 With an additional $2 per-share bonus the acquired institution's stock will be valued at $22, lower than the acquiring institution's stock for a $22 ÷ $30 or at a 0.73:1 exchange ratio Post-merger earnings per share = Combined earnings $900,000 = = $6.03 Shares of stock outstanding 149,333shares Before the merger, the acquiring institution reported an EPS of $7.08 ($850,000 ÷ 120,000), whereas the postmerger EPS is $6.03 Hence, the acquiring institution's shareholders will experience some earnings dilution as well as some decline in their ownership share because of a considerable reduction in the earnings per share of the acquiring company 19.3 The Goldford metropolitan area is presently served by five depository institutions with total deposits as follows: Goldford National Bank Goldford County Merchants Bank Commerce National Bank of Goldford Rocky Mountain Trust Company Security National Bank and Trust Current Deposits $750 million 500 million 325 million 250 million 175 million Calculate the Herfindahl-Hirschman Index (HHI) for the Goldford metropolitan area Suppose that Rocky Mountain Trust Company and Security National Bank propose to merge What would happen to the HHI in the metropolitan area? Would the U.S Department of Justice be likely to approve this proposed merger? Would your conclusion change if the Goldford County Merchants Bank and the Rocky Mountain Trust Company planned to merge? The Herfindahl-Hirschman Index for the Goldford Metropolitan Area is calculated as follows: 19-8 Chapter 19 - Acquisitions and Mergers in Financial- Services Management Bank Goldford National Bank Goldford County Merchants Bank Commerce National Bank of Goldford Rocky Mountain Trust Company Security National Bank and Trust Total Current Deposits $ 750 million 500 million 325 million 250 million 175 million $2,000 million Current Deposit Market Share 37.50% 25.00% 16.25% 12.50% 8.75% 100.0% Current Deposit Market Share Squared 1,406.25 625.00 264.06 156.25 76.56 2,528.13 The Goldford market has an HHI above 1,800 and is, therefore, highly concentrated It would be difficult for any bank mergers to take place inside the Goldford Metropolitan area because of its highly concentrated status and because no matter which two of the five banks wish to merge with each other, the resulting change in HHI would be relatively large If Rocky Mountain Trust Co and Security National Bank merge, their combined market share is 21.25 percent and the HHI climbs to 2,746.875, a change of 218.75 points which may not be acceptable to the regulatory authorities Even, if Goldford County Merchants Bank and Rocky Mountain Trust Company plan to merge, the combined market share of these two banks is 37.5 percent and the HHI rises to 3,153.125, a change of 625 points which will, in all probabilities, be challenged by the regulatory authorities 19-4 Gregory Savings Association has just received an offer to merge from Courthouse County Bank Gregory’s stock is currently selling for $60 per share The shareholders of Courthouse County agree to pay Gregory’s stockholders a bonus of $5 per share What is the merger premium in this case? If Courthouse County's shares are now trading for $85 per share, what is the exchange ratio between the equity shares of these two institutions? Suppose that Gregory has 20,000 shares and Courthouse County has 30,000 shares outstanding How many shares in the merged firm will Gregory’s shareholders wind up with after the merger? How many total shares will the merged company have outstanding? The merger premium must be: $60 + $5 Merger premium (in percent) = ữì100 =108.33percent $60 The exchange ratio between the respective banks' shares is: ($60 + $5) ÷ $85 = 0.7647 to If Gregory Savings has 20,000 shares outstanding and Courthouse County has 30,000 shares, Gregory’s shareholders will receive 0.7647 × 20,000 = 15,294 shares from Courthouse County The merged firm will have 45,294 shares of stock outstanding 19-9 Chapter 19 - Acquisitions and Mergers in Financial- Services Management 19-5 The city of Dryden is served by three banks, which recently reported deposits of $250 million, $200 million, and $45 million, respectively Calculate the Herfindahl index for the Dryden market area If the second and third largest banks merge, what would the postmerger Herfindahl index be? Under the Department of Justice guidelines discussed in the chapter, would the Justice Department be likely to challenge this merger? The banking market in Dryden has the following structure: Bank Bank Bank Totals Deposits $250 million 200 million 45 million $495 million Market Share 50.51% 40.40% 9.09% 100.0% Squared Market Share 2,550.76 1,632.49 82.64 4,265.89 Thus, the Herfindahl-Hirschman Index is 4,265.89 in the Dryden market area This is a highly concentrated market to begin with If the second and third largest banks merge, the post-merger Herfindahl-Hirschman Index climbs to 5,000.51 because the combined share of banks B and C jumps to over 49 percent Clearly, the Herfindahl Index rises by more than 700 points and far exceeds 1,800 in total This merger would be challenged by the Department of Justice in the absence of mitigating factors 19-6 In which of the situations described in the accompanying table stockholders of both acquiring and acquired firms experience a gain in earnings per share as a result of a merger? A B C D P-E Ratio of Acquiring Firm 12 P-E Ratio of Acquir ed Firm 12 Premerger Earnings of Acquiring Firm $750,000 $470,000 $890,000 $1,615,000 Premerger Earnings of Acquired Firm $425,000 $490,000 $650,000 $422,000 Combined Earning s after the Merger $1,200,000 $850,000 $1,540,000 $2,035,000 The rule is that the stockholders of both acquiring and acquired institution will experience a gain in earnings per share of stock if an institution with a higher P/E ratio acquired an institution with a lower P/E ratio and combined earnings not fall after the merger Only cases A and C meet these criteria and the shareholders in these two cases should experience an earnings-per-share gain 19-7 Please list the steps you believe should contribute positively to success in a merger transaction in the financial-services sector What management decisions and goals should be pursued? On average, what proportion of mergers among financial firms would you expect would be likely to achieve the goals of management and/or the owners and what proportion would likely fall short of the mergers’ objectives? Why? 19-10 Chapter 19 - Acquisitions and Mergers in Financial- Services Management The steps an institution can take that will contribute positively to the success in a merger include the following: A B C D E F G The institution must first evaluate its own financial condition, understand its own strengths and weaknesses and its own goals Mergers can then magnify strengths and minimize weaknesses The institution should form a team to perform a detailed analysis of all potential new markets and acquisitions The institution must establish a realistic price for the acquisition After the merger, a combined management team should be formed to continually work towards and assess the progress towards the consolidation of the two firms A communication system needs to be formed between senior management and other managers so everyone feels involved in the merger Communication channels need to be formed so customers and employees understand why the merger took place and what the consequences of the merger are likely to be Customer advisory panels need to be formed to evaluate and comment on the bank’s image in the community, marketing effectiveness and general helpfulness to customers Management decisions and actions which could cause problems for the merger include mergers where there is a poor understanding of each other’s culture, where an excessive price is paid for the merger, where customers feelings and concerns are ignored, where there is poor management, and where the new firm cannot move forward in a cohesive manner According a research by Rose, it appears that roughly half of all mergers achieve the goal of an increase in earnings (or profitability) The other half of mergers sees a decrease in earnings for the new firm Among the institutions that experience gains, lower operating costs, greater employee productivity, and faster growth appeared to have influenced the greater earnings 19-11 ... Mergers in Financial- Services Management Bank Goldford National Bank Goldford County Merchants Bank Commerce National Bank of Goldford Rocky Mountain Trust Company Security National Bank and Trust... have 45,294 shares of stock outstanding 19-9 Chapter 19 - Acquisitions and Mergers in Financial- Services Management 19-5 The city of Dryden is served by three banks, which recently reported deposits... goals of management and/ or the owners and what proportion would likely fall short of the mergers’ objectives? Why? 19-10 Chapter 19 - Acquisitions and Mergers in Financial- Services Management
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