Value Creation - Mergers and Acquisitions in the Banking Industry - Thesis Example

Value Creation - Mergers and Acquisitions in the Banking Industry INTRODUCTION This paper reviews much of the scientific literature on the market for corporate control of banks and other financial institutions through mergers and acquisitions (M&A). The evidence indicates that corporate takeovers generate positive gains, that target firm shareholders benefit, and that bidding firm shareholders do not lose. Much attention has been devoted to the issue of the motivations behind managerial pursuit of an acquisition policy and the resulting impact on firm value. For banking, in particular, the issue is of crucial importance. Bank mergers and acquisitions (M&A’s) come in waves, and today they are once again at the top of many corporate strategic agendas. The dominance of the US and Europe in the current global financial services landscape means that most European and American banks enter new markets outside their region through transatlantic M&As. These developments are not lost on bank CEOs, who must keep a watchful eye on competitors’ strategies and assess what these acquisition moves mean to their own bank’s position. With their massive increases in market capitalization due to mergers, leading banks are in a strong position to invest heavily in new products or services and to make even larger acquisitions. This would pose a significant competitive threat that would require other banks to respond. Indeed, all acquisitions will result value enhancing unless there exists some element of market inefficiency, i.e., imperfect competition in either the product and/or labor market and/or agency conflicts. Most large mergers and acquisitions fall short of achieving the desired synergies. In January 1999, The Economist reported that study after study of past merger waves has shown that two of every three deals have not worked. And at least 50% of major mergers since 1990 have eroded shareholder returns. Reasons for failed mergers are diverse and complex, but most can be attributed to losing something: critical people, customers, market confidence. Uncontrolled costs, hidden losses, unrealized benefits, avoiding decisions, cultural barriers, and power struggles can also undermine the most promising unions. Despite the high failure rate, M&As that succeed can pay large dividends. The most successful acquiring firms have clearly established and well-understood acquisition processes, both for ensuring good strategic decisions before the acquisition decision is made and for integrating the acquired firm once the deal is complete. This has created an interest amongst other banking firms to make a research on the M&As and the reasons behind their success or failure. But this is not that easy in many cases the acquisition has a complex effect on the Bank’s value. Hence there is a need to determine methods to find whether the acquisition has resulted in value addition or not. The objective of the study is to use event study methodology and accounting performance techniques to determine whether value was created as a result of mergers and acquisitions that created ‘mega banks’. In order to analyze this problem, this study will examine stock data and charts for the five mergers of JP Morgan and Chase Manhattan Corp. (JP Morgan Chase); JP Morgan Chase and Bank One; and Bank of America and Fleet Boston; Wells Fargo & Co. and Pacific Northwest Bancorp; and Citicorp and Travelers Group Inc. The event study methodology will utilize stock market abnormal price returns of both the acquiring and target companies from 2 years prior to the merger through to 2½ years after the merger (including the announcement date), to determine if shareholders experienced an abnormal change in stock value, as well as examine the Sharpe Ratio for the merged banks. The accounting performance technique will utilize operating and absolute cash flow returns as well as returns on equity for both pre- and post-merger periods. A Case Study of Five Mergers & Acquisitions in Banking Industry Citicorp Merger with Travelers Inc.: The merger of the two companies was announced on April 6, 1998. The companies described the deal as a merger, valuing it at $140 billion, but the mechanism is essentially a stock swap, with Travelers paying $70 billion for Citi's shares. As per literature the event date is taken as April 6, 1998 and event study analysis is performed with event window from April 6, 1996 to Oct 6, 2000.Much of Wall Street liked the deal, and Citicorp's stock shot up $35.625 to close at $178.50, while Travelers raised $11.3125 to close at $73. Travelers will issue 2.5 shares for each Citicorp share, and current stockholders of each company will own about half of the new enterprise. The markets average return was .18% and that of Citigroup was 24.93% on the event date. The ASPR for the event date was 24.75%. This clearly indicates the shareholders approval of the merger and corresponding rise in value of the company. The average market return for the window was .016% and that of Citigroup was .25% which is really good on long time perspective of merger. The CASPR stood at .234%. The Standard deviation of the daily return for the year was found to be .032% and corresponding sharpe ratio was 7.31. Note: Market return on event date = [(closing value-opening value of Nyse)/opening value]*100 (all values for event date) = [(6165.329-6154.332)/6154.332]*100 = .18% Company return on event date =[(closing value-opening value of Citicorp)/opening value]*100 (all values for event date) = [35.625/(178.5-35.625)]*100 =24.93% ASPR = 24.93-.18=24.75 Market return for window = [(closing value-opening value of Nyse)/( number of days *opening value)]*100 (all values for available window values) = [(6937.635-5999.332)/(932*5999.332]*100 [data available only after 3/19/98] = .016% Company return on event date =[(closing value-opening value of Citicorp)/opening value]*100 (all values for event window) = [35.625/(178.5-35.625)]*100 =.25 CASPR = .25-.016=.234 Sharpe Ratio =(mean return for the period- mean market return for the Period)/σ =.234/.032=7.31 From accounting perspective with $698 billion of assets, the merged enterprise would be the largest financial-services company in the world, slightly larger than Bank of Tokyo-Mitsubishi. The new company, to be called Citigroup, would also be by far the most valuable in the business, with a market capitalization of about $135 billion. The deal would give Travelers the ability to market mutual funds and insurance to Citicorp's retail customers while giving the bank access to an expanded client base of investors and insurance buyers. The whole deal resulted in the formation of the world's biggest financial-services company and offering banking, insurance and investment operations in 100 countries. This resulted in the raise of prestige and good will which is of great importance in banking sector. Formation of JP MORGAN CHASE: It is formed on September13, 2000 from the merger of Chase Manhattan Bank and J. P. Morgan & Co. From event analysis point of view, the event date is taken as September 13, 2000 and event window from September 13, 1998 to March 13, 2003. The share price fell down on the event date clearly depicting shareholders disinterest in the merger. Though the market on the whole was fall, the mergers of this magnitude generally create good returns. The company share return reduced by .61% compared to market’s fall of -.74. The ASPR stood at .13. The market return was negative for the event window at .004 and that of JP Morgan was also negative at .017 The CASPR stood at -0.013% which is very low for a merger of this magnitude. The standard deviation was found to be .03623 and Sharpe ratio was very low at -.35 indicating the failure of the merger among the shareholders. The Chase-JP Morgan deal created an investment-management giant with $720 billion in assets under management, the companies said. Fifty-two per cent of those assets are invested in stocks, 25 per cent in bonds and 23 per cent in cash or other asset classes. Slightly more than a third of the assets come from overseas. JP Morgan Chase is considered as one of the leading global financial services firm with assets of over $1.4 trillion. They have operations in more than 50 countries with 170,000 employees. They are considered as the leaders in financial services for consumers, investment banking, small business, asset management, private equity, commercial banking, and financial transaction processing. They are also a component of the Dow Jones Industrial Average. Wells Fargo & Co and Pacific Northwest Bancorp Merger: The event date was May 19th, 2003 and the market return on that day was .95% gain whereas the Wells Fargo & Co share returns fall down at 1.71%. The ASPR was found to be 2.66% negative. This implies the negative attitude of shareholders about the merger as per the event methodology technique. The event window is from May 19th ,2001 to November 19th ,2005 and corresponding market and share returns are .0042 and .016. The CASPR is found to be .0118. This implies the positive attitude of the shareholders towards acquisition in course of time. But on the other hand the accounting techniques show positive results about the merger. Pacific Northwest Bancorp is a Seattle-based bank holding company, and its primary operating subsidiary is Pacific Northwest Bank. With nearly $3.1 billion in assets – approximately $2.7 billion in Washington and $385 million in Oregon – PNWB and its subsidiaries focus primarily on commercial banking. The company has more than 800 employees and 58 banking locations, including 53 along I-5 in western Washington and throughout central Washington, and five in Portland, Ore But on the other hand the accounting techniques show positive results about the merger. Pacific Northwest Bancorp is a Seattle-based bank holding company, and its primary operating subsidiary is Pacific Northwest Bank. With nearly $3.1 billion in assets – approximately $2.7 billion in Washington and $385 million in Oregon – PNWB and its subsidiaries focus primarily on commercial banking. The company has more than 800 employees and 58 banking locations, including 53 along I-5 in western Washington and throughout central Washington, and five in Portland, Ore. Under the terms of the agreement, approved by the boards of both companies, PNWB shareholders will receive $35 in Wells Fargo common stock for each PNWB share. The exchange ratio will be determined by dividing $35 by the average of the closing prices of a share of Wells Fargo common stock on the New York Stock Exchange for the 20 consecutive trading days ending on the day immediately before the meeting of PNWB shareholders called to vote on the proposed merger. Based on the average closing price of Wells Fargo common stock for the 20 trading days prior to the special meeting ($50.2490), Pacific shareholders will receive 0.6965 of a share of Wells Fargo common stock in exchange for each share of Pacific common stock upon completion of the merger. Bank of America merger with Fleet Boston On October 27, 2003, Bank of America announced a definitive agreement to merge with Fleet Boston. The event window for event date October 27, 2003 was chosen as October 27, 2001 and April 27, 2006. For event date market return was .025% and share return was .98% and corresponding ASPR was .955%. This clearly indicates the shareholders support for the acquisition. The corresponding market and share returns for the event are .01 and .07. The CASPR is found to be .06. This implies non inclined attitude of shareholders. Bank of America’s merger with FleetBoston Financial creates the first banking institution with a truly national scope, serving approximately 33 million consumers in the United States, with leading or strong market shares throughout the Northeast, Southeast, Midwest, Southwest and West Coast. The company also provides a full suite of products and services for 2.5 million business clients in the United States and around the world. Ultimately, the merger delivers the combined capabilities of two powerful organizations for the benefit of customers, shareholders and communities. Customers will benefit from the broadest retail franchise in the nation and a shared commitment to service and process excellence. They also will gain access to a wider range of consumer and business products and services under the same company’s roof. JP MORGAN CHASE acquisition of bank one: The event date is Jan 14, 2004 and event window is from Jan 14, 2002 to Jul 14, 2006. The market and company return for the day are calculated to be.14and .358. The ASPR was at a healthy .21. for event corresponding values were .016 and .010. The CASPR was at weak -.006 which reflects shareholders rejection of the deal. The JP Morgan Chase - Bank One merger was looked upon favorably by many industry analysts who felt that the deal would strengthen JP Morgan's weak retail business and extend the bank's presence geographically across the US. However, some analysts thought otherwise. JP Morgan Chase had only recently come into existence as the product of a merger between JP Morgan & Company Incorporated and Chase Manhattan Corporation and the integration of the two had not yet been completed. Acquiring a new retail bank at this point would complicate the situation and increase the risk for the newly merged entity, in their opinion. Valuing a merger: The ultimate value potential of a post-merger organization is determined largely during the merger's creation, through a set of managerial actions—implicit and explicit, conscious and unconscious—we call post-merger organization design. The actual value created is determined by the execution of that design. During the past decade, post-merger organization design has moved from the periphery of M&A concern to center stage. Leading M&A practitioners now fully appreciate the complexity of forging two organizations and their distinct cultures into a single successor company that can outperform competitors over the long term. Furthermore, these organizations more readily appreciate how critical a discipline of traditionally "soft" factors has become in the "hard" short-term make-or-break of successful transactions. Finally, technology that can accurately measure some of these soft factors is now readily available. Companies can therefore measure many aspects of the organization before the deal to assess the merger's potential and then, once the deal is complete, measure its progress. In this issue the event study methodology and accounting techniques come for support of technological research of a merger. We investigate the performance of 5 mergers in the US banking sector employing event studies and accounting studies jointly. We find that event studies and accounting studies may not be used as substitutes in the analysis of merger performance as suggested in the previous literatures. Further in our case study we find that there is a lot of difference between the theoretical value reported by event study methodology and accounting techniques. This clearly implies that one method cannot be used as a substitute for another. EVENT STUDY METHODOLOGY: An Event study uses transactions data from financial markets to predict the financial gains and losses associated with newly disseminated information. For example, the announcement of a merger between two firms can be analyzed to make predictions about the potential merger-related changes to the supply and the price of the product(s) subject to the merger. Investors in financial markets bet their dollars on whether a merger will raise or lower prices. A merger that raises market prices will benefit both the merging parties and their rivals and thus raise the prices for all their shares. Conversely, the financial community may expect the efficiencies from the merger to be sufficiently large to drive down prices. In this case, the share values of the merging firms’ rivals fall as the probability of the merger goes up. Thus, evidence from financial markets can be used to predict market price effects when significant merger-related events have taken place. The majority of previous M&A studies have measured the short-term stock price reaction to merger announcements applying event study methodology. Results are consistent with regard to the value effect on the shareholders of the target firm and on the shareholders of the combined firm. The shareholders of the bidding firm either lose or slightly benefit from the mergers whereas those of the target firm receive large abnormal returns for selling their shares. In most cases, the combined abnormal return is significantly positive. But the analysis of the M& A should be performed based on the long term implication of the merger on the shareholders. This necessitates the determination of the period of study which should be long enough after the merger to study its impact on the market. Further the impact should not be continuation of the pre merger market change. Hence it is necessary to include the pre merger period also in analysis so as to avoid any misinterpretation. In our case study we have taken a pre merger period of 2 years and post merger period of 2 ½ years. There exist only a few event methodology studies that compare the financial performance of merging firms before and after the transaction. While some studies find an increase in the performance of the companies involved in mergers others find a decrease. The contradiction in the acceptance of the merger by the shareholders can be attributed to a number of reasons, such as the recent losses of the acquired bank and the difference in managing style of the two involved organization. This was the case with JP Morgan Chase in a different way. It recent failure to cop up with a merger of Chase in 2000 was clearly reflected in the merger of Bank One in 2004. Further as the event study is dependent on individual shareholders and his perspective of the financial institution acquired may vary which results in contradictions with the event study. Event studies have become pervasive; there has not been a concomitant refinement in their technique. The specification of an event study in terms of a system of abnormal returns and, in particular, emphasizes the possible limitations of using a methodology when misspecification may be present. But event study generally predicts the shareholder’s present and future mentality on the acquisition. Further the support of the shareholders for the merger immediately after merger announcement results in high returns which help in paying higher dividends. This results in greater support of the shareholders on combined firm in the future. This high support was evident with Citicorp which resulted in paying higher dividends by it. ACCOUNTING TECHNIQUES: The accounting technique gives a measure of the assets, revenue and liability of the two involved banks prior to acquisition and the same of the combined firm after the acquisition. Furthermore, accounting studies employ control firms in order to control for economy. The accounting techniques help in accessing the firm’s liability and assets for the future. It gives the total assets available for future investments. It gives a good account of the total returns of the merged organisation in terms of equity and thereby helps in accessing the value created by the merger. It gives the real account of the company’s fortunes in terms of physical without any consideration for the market. The company’s future in terms of the revenue available for new investments is accessed only through accounting techniques. But in modern public organisation the shareholder’s support greatly the company’s future in long term. Hence the accounting technique alone cannot predict the value created by the merger. The partial contradictory results of event studies and accounting studies raise an important question which has remained unanswered until now: Can we freely choose between both approaches when analyzing the performance of corporate bank mergers? So far, despite the contradictory results, the two approaches measuring the economic gains of mergers have been employed as substitutes. In most of previous literatures (Healy, Palepu and Ruback (1992)) they find a great relation between the two methods. They find a significant positive relationship between the measures of the two and hence they advocate the use of both as substitutes. Both the studies predict the future of the organisation in different terms, former in terms of shareholders support and the latter in terms of company’s assets and liabilities. In contrast in our case studies we have developed an industrial economic model which implies that both approaches have to be used as complements. The model is based on the following belief that either of the two completely does not predict the value created by the merger. Both the methods analyse one part completely and fails to account for the other. The merger confers strong negative externalities on the firms outside the merger -in the following called outsider- but in the same industry. In this case, the financial performance of the merging firms –the insiders- may be worse than in the initial situation, but still better than that of outsiders in the merger of competitors. Therefore, companies have an incentive to preempt their competitors merging with a rival. If markets are efficient, the stock price of merging firms will rise regardless of whether the transaction is profitable or not because the risk of the firm is becoming an outsider is eliminated. This explains why mergers may reduce profits and raise share prices. CONCLUSION: The literary review of the value creation through mergers and acquisitions has implied a great deal on modern trends in financial institution management in the last decade. Further the case studies clearly reveal the fact that all major mergers do not always pay rich dividends. The main reason for this shortcoming of such mergers is attributed to a number of reasons. Hence there is a great need for the financial organization to analyze the value that would be created through the acquisition and mergers. This gap to a certain extent is filled by event study methodology and accounting techniques. But there were also discussions on selecting the correct method for analyzing the value created through mergers and acquisitions. In our study, we have clearly emphasized the variation in the value found by the two methods through the five case studies on bank mergers to create mega banks. The real asset and revenue of the organization is not considered in event study whereas the shareholders perspective is left out in accounting techniques. Both the approaches make a sense in a way or another. Neither the share holder nor the real assets and revenue can be neglected in determining the value created through merger. This emphasizes the need to use both the techniques in conjunction so as to arrive at a proper value created through acquisitions and mergers. The choice of enriching the analysis with the proposed colligation of the two method will turn out to be useful and fruitful, because it has made it possible on one hand to capture the shareholders perspective of the market reaction while the previous works were not able to capture, and on the other hand to better appreciate the characteristics of the accounting technique to valuate the assets; with belief that the methodological choices made in the present literature could of some help and applicable for future researches studying the M&As, relating to any sector and to any international market. References Andrade, Gregor& Mitchell, Mark & Stafford, Erik. (Spring 2001). New Evidences and Perspectives on Mergers. Journal of Economic Perspective. Volume 15. Asquith P. (1983.).Merger Bids, Uncertainty, and Stockholder Returns. Journal of Financial Economics, 11, pp.51-83. Betzer, Andre´& Metzger, Daniel (September 18, 2006) Event Studies and Accounting Studies in Merger Analysis – Are they really Substitutes? 3/9/08 from http://ssrn.com/abstract=940085 Focarelli D., Panetta F., Salleo C.(November 2002).Why Do Banks Merge?. Journal of Money, Credit and Banking. Vol. 34, N.4, pp. 1047-1066. Gygax.A, Sawyer .K.R(February 19, 2001). How Eventful are Event Studies? Melbourne:University of Melbourne Jensen, Michael.C & Ruback, Richard S. April 1983. The Market For Corporate Control: The Scientific Evidence. Journal of Financial Economics 11 (1983) 5-50. 3/9/08 from http://papers.ssrn.com/ABSTRACT_ID=244158 Martin, Mitchell(1998) Citicorp and Travelers Plan to Merge in Record $70 Billion Deal : A New No. 1:Financial Giants Unite. International Herald Tribune 3/9/08 from http://www.iht.com/articles/1998/04/07/citi.t.php?page=1 Palmucci, Fabrizio and Caruso, Annalisa. Measuring Value Creation in Bank Mergers and Acquisitions.January 17, 2008. Available at SSRN: http://ssrn.com/abstract=676522 Shill,Walter E.& Mackenzie David W. How to Build Value into a Merger. Outlook Journal. March 9,2008 from http://www.accenture.com/Global/Research_and_Insights/Outlook/By_Issue/Y2005/HowMerger.htm Read More