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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
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 Managements 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
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
19-2
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:
1. The firms history, ownership, and management
2. The condition of its balance sheet
3. The firms 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 institutions 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
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 markets sole supplierto 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
19-4
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 institutions
community image, availability of services and helpfulness to customers.
19-5
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:
As P-E ratio =
Bs P-E ratio =
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 Bs current stock price of $18 per share:
They will receive 18 25 of a share of stock in Bank A for each share of Bs 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
b.
If the shareholders of Bank B agree to sell out at Bs current stock price of $36 per share:
They will receive 36 25 of a share of stock in Bank A for each share of Bs 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
=
= $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 firms 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 firms 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
todays market at $30 per share. In contrast, the acquired institutions equity shares are trading
at $20 per share. To make the merger succeed, the acquired firms 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.
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
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
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.
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
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. Gregorys stock is currently selling for $60 per share. The shareholders of Courthouse
County agree to pay Gregorys 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 Gregorys shareholders wind up with after the merger? How many total shares
will the merged company have outstanding?
The merger premium must be:
$60 + $5
100 =108.33percent
$60
19-9
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 1
Bank 2
Bank 3
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 do 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
5
4
8
12
P-E Ratio of
Acquir
ed
Firm
3
6
7
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 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?
19-10
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 banks
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 others 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