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 shar
Trang 1CHAPTER 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 Introduction
II Mergers on the Rise
III 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
IV Selecting a Suitable Merger Partner
A Merger Premium
B Exchange Ratios
C Dilution of Ownership
D Dilution of Earnings
V The Merger and Acquisition Route to Growth
VI Methods of Consummating Merger Transactions
A Pooling of Interests
B Purchase Accounting
C Purchase-of-Assets Method
D Purchase-of-Stock Method
VII Regulatory Rules for Bank Mergers in the United States
Trang 2A 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
VIII Merger Rules in Europe and Asia
IX Making a Success of a Merger
X 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
XI 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
Trang 3an 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:
1 The firm’s history, ownership, and management
2 The condition of its balance sheet
3 The firm’s track record of growth and operating performance
4 The condition of its income statement and cash flow
5 The condition and prospects of the local economy served by the targeted institution
6 The competitive structure of the market in which the firm operates
7 The comparative management styles of the merging organizations
8 The principal customers the targeted institution serves
9 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
Trang 4Along 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 do 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 do 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
Trang 5for 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 safe-deposit 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 do 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
Trang 6Problems 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:
$25 per share A’s P-E ratio = 4.17
$6 per share =
$18 per share B’s P-E ratio = 3.6
$5per 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:
Combined earnings $1,600,000
Shares of stock outstanding 236,000shares
Trang 7b 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
Combined earnings $1,600,000
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
= ×100 =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
Trang 8Hence, the earnings per share from the merger will be:
Combined earnings $1,625,000
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) = ×100 =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
Combined earnings $900,000
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:
Current Deposits
Goldford National Bank $750 million
Goldford County Merchants Bank 500 million
Commerce National Bank of Goldford 325 million
Rocky Mountain Trust Company 250 million
Security National Bank and Trust 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:
Trang 9Current Deposits
Current Deposit Market Share
Current Deposit
Market Share Squared
Goldford National Bank $ 750 million 37.50% 1,406.25 Goldford County Merchants Bank 500 million 25.00% 625.00 Commerce National Bank of Goldford 325 million 16.25% 264.06 Rocky Mountain Trust Company 250 million 12.50% 156.25 Security National Bank and Trust 175 million 8.75% 76.56
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) = ×100 =108.33percent
$60
The exchange ratio between the respective banks' shares is:
($60 + $5) ÷ $85 = 0.7647 to 1.
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
Trang 1019-5 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:
Deposits
Market Share
Squared Market Share
Bank 1 $250 million 50.51% 2,550.76
Bank 2 200 million 40.40% 1,632.49
Bank 3 45 million 9.09% 82.64
Totals $495 million 100.0% 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 do stockholders of both acquiring and acquired firms experience a gain in earnings per share as a result of a merger?
P-E Ratio of
Acquiring
Firm
P-E Ratio of Acquir ed Firm
Premerger Earnings of Acquiring Firm
Premerger Earnings of Acquired Firm
Combined Earning
s after the Merger
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 do 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?