Playing to the endgame in financial services
There are many deals and more consolidation ahead
Ultimately, the model may be airlines or aerospace
Size will count, but success will require more than empire building
MADELEINE JAMES, LENNY T. MENDONCA, JEFFREY PETERS AND GREGORY WILSON
Reproduced with permission from The McKinsey Quarterly, 1997 Number 4. Graphics on the original article do not appear on this site
Every week brings news of another financial services acquisition in the United States. Such events act as a reminder, if one were needed, that this massive and diverse industry is undergoing unprecedented consolidation. Consider these facts:
- In 1980, the 25 biggest banks generated a third of the industry’s net income. Today, they generate more than half.
- In 1990, the top 25 mortgage originators did 26 percent of the business. Today, they do 45 percent.
- A decade ago, the top 10 credit card companies held 45 percent of all outstandings. Today, they hold 57 percent.
- The top 10 mutual fund companies currently control 47 percent of all assets.
- The top 15 home and auto insurers write roughly two-thirds of all policies.
And so it goes for every sector of the financial services industry.
Sweeping though the consolidation has been, this is only the beginning. In fact, enough excess capital remains in banking alone to fund up to $1 trillion in future deals. If a company’s stock (or acquisition currency) is highly valued, it is often cheaper for it to acquire another company to gain access to valuable customers, a choice distribution network, and market-tested skills, rather than build these things from scratch. So the deals will keep coming.
There are three key points to bear in mind as the financial services industry consolidates. First, the national endgame is closer than it may seem. Second, the constant need for revenue growth, productivity improvements, and cost efficiencies is the force that is driving consolidation and transforming industry economics. Finally, any serious player must adopt an explicit growth strategy that incorporates expertise in both mergers and acquisitions and options-based valuation.
THE ENDGAME APPROACHES
The pace of consolidation is accelerating. The next five years will make the past five look tame, as players jockey for position while the new industry structure locks into place. The most effective way to stake out territory in the new landscape will be by means of M&A, which puts this issue squarely at the top of the strategic agenda. Senior management should ask tough questions about where their company is going in the next five years; and seek brutally honest answers:
- What is our view of the future? What role should we play in the new industry structure?
- Do we have the management talent, the market strength, and the world-class productivity to be a buyer in the consolidation game?
- If so, what kind of companies should we buy, and how should we go about valuing them?
- Do we need to sell part of our current business, and refocus?
- Perhaps most difficult of all: should we take advantage of generous valuations and sell our company to the highest bidder?
Five years from now, financial services will be virtually unrecognizable (Exhibit 1). Although there will still be thousands of small community banks, the industry, like airlines and aerospace before it, will be dominated by a handful of national and global giants that will dwarf even the biggest players we know today.1 They will have achieved their might by buying complementary or weaker players and transferring superior management skills to create value. As in airlines and aerospace, these behemoths will be tightly run; highly productive, innovative, and skilled at M&A; and intensely competitive with one another.
In banking, for example, the removal of the remaining geographic barriers to acquisition in 1997 has set the stage for a truly national marketplace. To see what this might mean, consider California, Florida, and North Carolina, where internal barriers were dismantled a long time ago. In these states, the top three banks already control more than 50 percent of all deposits. In the developed world as a whole, that share is 58 percent. By contrast, the top three US banks command only 13 percent of the national market.
Such a low share suggests that there is plenty of room for the best banks to expand nationally into less consolidated markets. The mergers between NationsBank and Barnett, and First Bank System and US Bancorp, point the way. In theory, current antitrust and nationwide deposit-gathering rules would allow the top 50 US banks to be amalgamated into just six mega-banks commanding roughly 60 percent of industry assets and 66 percent of revenues.2 The next 50 banks could be merged into a seventh bank of similar size (Exhibit 2).
Most of these mega-banks would be twice as big as today’s largest bank, Chase Manhattan. Given the state of deregulation and the variety of banking licences and corporate structures available, these six or seven mega-banks could evolve over time into full-line financial service providers; the US equivalent of universal banks.
As companies hunt for new products and channels in a consolidating environment, M&A activity will increasingly cut across artificially defined industry lines. Financial service firms of all types are discovering the need to provide investment management services to cater for the savings and retirement funding needs of baby boomers, for instance. Traditional banks have had to cross conventional industry borders to secure new revenue streams to meet these needs. The recent round of bank acquisitions of retail brokerage firms, such as Fleet Financial’s acquisition of Quick & Reilly, were driven by the need to gain new fee income by cross-selling products.
The same trend is also apparent in the wholesale arena. The acquisitions by NationsBank of Montgomery Securities and by Canadian Imperial Bank of Commerce (CIBC) of Oppenheimer epitomize revenue-driven acquisitions across separate but related industry lines.
Travelers Group is a prime example of an institution built on cross-industry deals (Exhibit 3). Its recent acquisition of Salomon Brothers continues the trend, and is also likely to spark similar deals by national competitors.
From the acquisition of Shearson in 1993 to that of BankAmerica’s consumer finance division in 1997, Travelers’ deals have garnered additional revenue of $16 billion (representing a compound annual growth rate of 43 percent) and created value to the tune of $31 billion (61 percent CAGR). The company shows great discipline in buying low (during down cycles or when companies are in trouble), spinning off unwanted businesses (such as Transport Holdings), and selling high (as with American Capital Management). It has proved it can cross-sell effectively across perhaps the largest distribution system in the industry, comprising Salomon Smith Barney Holdings, Commercial Credit, Primerica Financial Services, Travelers Life & Annuity, and Travelers P&C, among others. Over time, the model it embodies will become more and more powerful — and more and more common.
While size begets complexity and often impedes agility, the cost–benefit balance is tipping in favor of large institutions. As many financial products rapidly turn into commodity products, for instance, only the biggest players will be able to support the colossal advertising and promotion efforts — anywhere from $100 million to $300 million a year — that will be needed to build and support a truly national financial brand. So too with technology; on average, the top 10 banks today each lavish better than $1 billion on technology every year.
Size appears to be just as important in M&A. Our analysis of shareholder value creation during the past five years shows that big bank acquirers — those doing deals at least 50 percent of their own asset size — beat smaller acquirers by almost 30 percent. They also beat the bank composite by about 15 percent (Exhibit 4). Life insurance tells a similar story. The top five consolidators accounted for roughly half of all deals completed in the past three years. They all exceeded the industry’s average shareholder return, and the top two, SunAmerica and Aegon, posted nearly six times this average (Exhibit 5).
THE ROLE OF RATIONAL ECONOMICS
Unlike past merger booms, this consolidation wave is less about empire building than about raising revenue, cutting costs, and locking in continuous productivity gains to boost shareholder value.
Proof can be seen in the banking industry’s cost curves (Exhibit 6). The lower a bank’s efficiency ratio, the more revenue it keeps relative to its cost base, and hence the more efficient it is. Players on the wrong side of the cost curve — the high-cost banks on the right-hand side of the exhibit — account for much of the current overcapacity. Many of them can be expected to exit the industry, voluntarily or involuntarily. Long-term winners will strive continuously for greater efficiency, and will help take out costs via acquisition for those that cannot capture efficiency gains on their own.
In an environment of deregulation and consolidation, managements that have demonstrated their efficiency will be more natural owners of these assets than players that have yet to get their costs under control. They understand that there is still ample scope for further cost savings to be captured as the endgame draws nearer. Management vision and productivity are thus the key success factors that will influence how — and how quickly — cost curves shift over time. They will also determine where individual companies are positioned on these curves.
A sample of recent large deals shows that buyers are also superior to their targets in terms of efficiency ratio; skilled consolidators boast an advantage of almost 6 points on average (Exhibit 7). History reveals that high-cost players seldom succeed in tackling their cost problem on their own, no matter how severe it is. Even in transactions where the efficiency gap is smaller, such as First Union’s purchase of Signet and Wachovia’s of Central Fidelity, there are still substantial cost savings to be made.
M&A is an attractive proposition from the earnings perspective, too. In recent large transactions, synergies from cost savings and revenue enhancements ranged from 45 to 100 percent of a seller’s net income for in-market mergers. The figures for contiguous market mergers were 30 to 65 percent, and for out-of-market mergers 40 to 50 percent. When cost savings and revenue enhancements are put together, it’s clear that the equation of ‘one plus one equals three’ is often within reach for skilled buyers.
A natural result of consolidation and improved cost efficiency is higher competitive intensity and tighter pricing. The inefficient players at the far right of the cost curve in Exhibit 6 have to keep their prices high to turn a profit. As long as regulation protects them from competition, they provide a price umbrella for the rest of the industry. In the early days of deregulation, this price umbrella allows players with lower costs and higher productivity to earn huge profits. Soon, however, price competition takes over, and as margins get squeezed, the economics of inefficient players are destroyed, opening the door to further consolidation by productivity leaders.
Pricing is likely to follow the example set in other deregulating and consolidating industries, such as airlines and long-distance telecom. Prices typically fall by roughly 20 percent in the first five years after deregulation, and by another 20 percent in the next five years.3 As a result, high-cost, high-price players are either acquired and restructured or driven out.
While it can be difficult to discern real pricing trends in financial services because of cross-subsidies and shifts in the yield curve and in the mix of fees and spread income, we are already seeing the results of the price squeeze. In retail products, for example, average spreads on 30-year mortgages have plunged from 250 to 129 basis points during the past ten years when compared to 10-year Treasuries — a fall of almost 50 percent. Over the past four years, spread income on credit cards has declined by 10 percent and fees (or dollars per account) have plummeted by 60 percent in response to consolidation.
Wholesale products tell much the same story. In mutual fund custody, for example, real pricing (fee income) has fallen by 11 percent during the past decade. Master trust and international custody have each declined by 8 percent, while basic custody has slumped by almost 19 percent.
Our analysis suggests that a bank’s independence may be in jeopardy if its efficiency ratio is currently above 55 to 60 percent — unless that ratio is the temporary result of digesting an acquisition with higher costs. Those in the 50 to 55 percent range need to take immediate steps to improve their efficiency in order to keep pace with the expected downward shift in the cost curve.
Ample evidence attests that this downward shift will continue. One of the industry’s cost leaders, US Bancorp (formerly First Bank System), has announced a five-year efficiency improvement goal of 35 percent. If achieved, this will undoubtedly set a new industry standard. Banks will need to secure annual productivity improvements of roughly 5 percent over the next decade just to keep up with the pack. The best will set targets of more than double this figure.
Consolidation is also being fueled by the treasure trove of excess capital available to fund acquisitions and be diverted to more profitable businesses. In banking, for example, at least $46 billion was theoretically available at the end of 1996 (Exhibit 8). This translates into roughly $90 billion in market capitalization at the 1996 median market-to-book ratio of 2.0. Such a sum could support up to $1 trillion in future acquisitions if we assume the current leverage ratio of about 12.5:1, which is actually below the median of the past 15 years.
WHY M&A SKILLS ARE CRUCIAL
Because the consolidated endgame is driven by huge differences in productivity, many deals that appear at first sight to be overvalued or uneconomic will, we believe, ultimately prove to be value creating. This is not to say that some acquirers won’t pay too much or be unable to realize the value latent in their targets; indeed, the recent history of M&A reveals that many deals fail to return their cost of capital. But highly skilled, productive players (those on the far left-hand side of the industry cost curve) and players with unique brands, distribution systems, and management talent will succeed in M&A.
Companies like these can afford to pay more for acquisition targets, since their skills and market position allow them to identify and capture unique synergies and thus create more value. As a result, they will wind up buying the best assets when they come on the market, increasing their lead over other players (Exhibit 9).
Controlling your own destiny
Who will win as consolidation transforms the financial services landscape? At present, many passive players are failing to stand out from the crowd, neither building the necessary skills nor achieving the critical mass they require to control their own destiny.
For would-be winners with national and global aspirations, market capitalization is the metric to watch. It is the best indicator we have of how well managers are performing; indeed, recognizing this, many companies have now linked senior management compensation to shareholder value creation. As regulation falls away and competition intensifies, management talent and insight will become scarce commodities.
Exhibit 10 shows how players can plot their position along two axes: performance (market-to-book ratio, our proxy for market acceptance of management capabilities) and size (book equity). Your position on the map helps determine your ability to control your own market destiny, whether nationally or globally. Few players are safe in a dynamic, rapidly consolidating environment, however. Even long-term winners need a strategy to improve performance continually.
AFTER BANKING, INSURANCE
Until recently, the structure of the financial services industry was the product more of regulation than of economics. Banking, insurance, and brokerage were governed at both state and federal levels by an arcane hodgepodge of protectionist rules that let uneconomic players thrive. In spite of underlying business economics, profound changes in consumer preferences, and the transformation of global capital markets, no real restructuring could take place. But today, regulation is finally succumbing to these powerful market forces, and restructuring is under way.
In banking, current market competition and safety and soundness protections render anti-growth relics like the 1933 Glass-Steagall Act and the 1956 Bank Holding Company Act completely irrelevant. A variety of more market-oriented corporate structures and financial services licences (including retail bank charters such as a federal savings bank or an industrial loan company) permit sound customer strategies to be implemented without unnecessary worries about product, affiliation, or acquisition limitations. Consequently, the industry is undergoing vigorous restructuring, as recent acquisitions of retail bank charters by such companies as Merrill Lynch, the Travelers Group, and State Farm attest.
A similar trend is coming in life insurance. Industry cost curves reveal that the opportunity to capture economic surplus is far greater than in banking, partly because of the deterioration in expense ratios over the past five years (exhibit). If banking is a valid analogy, life insurers should expect their industry cost curve to shift downward as consolidators (among them players from related industries) continue to execute their acquisition strategies. As much as half the industry’s revenue may be up for grabs by more efficient players, whether they are traditional life companies or new entrants such as commercial banks.
The map identifies four categories of player:
National and global winners. Those companies positioned in the top right corner of the strategic control map will be able to decide their own destinies, partly because of the acquisitions they have already successfully completed. They have shown the marketplace they are the right size and possess the right mix of skills.
Savvy but small. Highly valued companies in the top left corner of the map may have the skills to determine their own future. Nevertheless, they are ripe for picking by larger consolidators bent on buying skills rather than building their own. Some of these savvy but small players are starting to acquire others to gain scale and thus secure more control over their own destiny.
Big but undifferentiated. The companies in the lower right corner of the map may be large enough to withstand most challenges to their near-term destiny, but they have been judged by the marketplace as lacking in skills. Their failure to expand revenue or manage costs efficiently makes them vulnerable as other players jostle for position.
At risk. Finally, the companies in the lower left corner of the map tend to be passive players, lacking in vision, critical mass, and skills. They are the prey of consolidators seeking new growth opportunities. Without a credible consolidation or growth strategy, many will be endangered in the long term.
Companies should ask themselves three basic questions about the strategic control map:
• Where are we today in relation to our current and future competitors?
• Where should we be five and 10 years from now as the market consolidates?
• How do we get there from here?
Building market position
M&A has become an increasingly important way to build market position at the expense of competitors, as the following case illustrates. In one region of the United States, there are three high-performing banks. Two of them are active acquirers. They employ slightly different consolidation strategies (extending geographic reach, moving into new businesses, building in-market presence), but both have a proven record in post-merger management.
A look at the performance of these three banks over a five-year period demonstrates that a successful consolidation strategy makes a major contribution to shareholder value creation. Banks A and B are the two acquiring banks; bank C is their non-acquiring neighbor. At the outset, C enjoys the highest market value, even though A and B have already launched their acquisition strategies.
Five years later, the tables have been turned. Having completed several large acquisitions, banks A and B have created more value for their shareholders than bank C, which has performed badly in comparison not only with its neighboring acquirers but also with the overall bank composite (Exhibit 11). In short, bank C has stalled.
Recently, bank C launched its own acquisition strategy to catch up. Unfortunately, it has been deprived of prime acquisition candidates by the continuing efforts of banks A and B to drive consolidation. Indeed, choice targets are rapidly disappearing in many industry segments. As for bank C, it must either rethink its strategy or seek out a merger partner of similar size if it is to secure a sustainable market position.
Ensuring a virtuous acquisition cycle
Executing acquisitions well can lead to a virtuous cycle that creates even higher shareholder value in the future (Exhibit 12). Getting your consolidation strategy right at the outset and then leveraging superior execution skills are two steps to set the virtuous cycle in motion. But successful M&A involves more than just waiting for that next deal to come along.
Most skilled acquirers have a dedicated M&A business unit that adopts a leveraged buyout mentality to create value through deals;4 stays in the deal flow constantly; turns regulation to its advantage; secures the best information and advisers; and draws on the skills, contacts, and knowledge of the whole organization. These acquirers also view post-merger integration as an essential skill that must be constantly honed.
When Travelers purchases a troubled company, for example, it vastly improves both management and cost structures. Its sense of urgency and strategic purpose is almost palpable. Its ability to meet ambitious cost and revenue goals is in part the result of high employee ownership (its goal is 20 percent after five years) and of the fact that a large proportion of compensation for senior management takes the form of restricted stock that cannot be sold for three years.
Needless to say, the fundamental skill in doing deals is valuation. We believe that to value a target solely on the basis of discounted cash flow (DCF) is wrong, given the uncertainty of a dynamic market. In our view, options valuation represents the best way to capture the full value of financial engineering measures such as lowering the cost of capital, reducing unnecessary regulatory costs, gaining tax and accounting advantages, and restructuring assets through securitization. It is also the best way to evaluate unique synergies in distribution and product lines.
Using this more sophisticated valuation technique reveals that there is no single “true” value for a company. The value — and hence what an acquirer can rationally afford to pay — depends on who the buyer is and what unique synergies it can capture.
An acquirer can create value in three basic ways. Most obvious of these, and fully reflected in the price of most deals today, are universal synergies: the kinds of profit improvement that drove the bank roll-up deals of the 1980s. Examples include taking out excess costs, raising the yield on investments, or improving pricing. Any acquirer with access to state-of-the-art practices will in principle be able to achieve these gains, although managers with deep experience in post-merger integration can usually capture them more quickly and efficiently than novices.
Also essential, but less often reflected in current deal pricing, are endemic synergies: gains that require real changes in the way things are done. The additional revenue that can be earned by selling the products of an acquired company is the best example. How much value is created will depend on the channels and products that the buyer and seller own, and how dominant they are in each. The better the fit, the more value an acquirer can create, and the more it can afford to pay for the acquisition. Often, however, this fit can be properly appreciated only by management teams that truly understand what consumers want and which channels best meet their needs. The options available and the value that can be created vary widely from one acquirer to another.
The deciding factor in most deals today, however, is the value that can be created by capturing truly unique synergiesthat are distinctive to a particular buyer. Examples include revenue plays from special skills or assets (such as distribution channels or databases); leveraging a company’s existing business base to create new business opportunities; and perhaps even changing the industry structure to seize a competitive advantage. Many recent acquisitions of asset management companies fall into this category.5 For players with broad distribution networks, asset management can complement other customer services such as financial planning. Indeed, not being in this business could prove costly, especially if competitors have already established dominant positions.
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Given the skills of leading players, the underlying economics of the financial services industry, and the withering away of regulation around the world, we believe there is enough pent-up economic energy and capital to drive consolidation both within segments and across traditional industry borders at an accelerating rate for the foreseeable future. The trend is just beginning to gain momentum, and the industry, shareholders, and consumers will all benefit. Those aspiring long-term winners that first understand and then act to influence this process will have a head start in the race to the consolidated endgame.
Ultimately, most winners will be vigorous and profitable consolidators. Identifying and capturing consolidation opportunities leads to a virtuous acquisition cycle and thence to still higher shareholder value. The key ingredients are management vision, market position, and skills, all of which will be determining factors as we reach the highly consolidated, fiercely competitive endgame early in the next century.
The publicly owned or stock insurers have responded by purchasing other insurers with their appreciating stock, in an effort to spread more revenue over their cost base. In addition, they have issued stock options as incentives to agents and employees to improve growth and cut costs.
Mutual insurance companies are a different story. Owned by their policyholders and with limited access to capital, they are unable to grow through acquisition. They also have a hard time hiring and retaining talented employees without the benefit of stock incentives.
The traditional way for mutual companies to realize the advantages of public ownership — to ‘demutualize’ or convert from policyholder ownership to stock ownership — is complex, time consuming, and expensive. Unwilling to suffer the pain, many mutuals have lobbied state regulators to permit new holding company structures that will allow some public stock issuance. Demutualization in any form is likely to accelerate the trend toward consolidation in the insurance industry as more companies become available for takeover
Notes
Copyright © 1997 McKinsey & Company. All rights reserved.