The Fine Line Between Justifying M&A Deals and Ruining Them

Warning to bank executives: a little self-restraint can go a long way in preserving the value of bank M&A.

Yes, to justify deals buyers often tout the excess expenses they can wring out of sellers, especially when their operations overlap. KeyCorp and New York Community Bancorp are among those that have pledged ambitious cost cuts as part of recent deals.

Yet banks must be mindful not to chop too much, or they could risk alienating clients, upsetting employees and damaging the value of the financial institutions they are buying.

"There's a science to identifying cost savings, and then there's an art to executing it," said Emmett Daly, a principal in investment banking at Sandler O'Neill. "If you aren't good at both, you can see the value of the deal completely evaporate. That's why there are a fair number of critics out there that say acquisitions don't create value."

When M&A activity is frothy, buyers often overpromise to justify the deal, Daly said. The current M&A cycle still appears to be in its infancy, he said, adding that most banks still seem to be conservative and disciplined with cost-cutting projections in the current environment.

Banks generally focus on the fat they can take out of acquisitions, rather than on potential revenue gains, because cost cuts are easier for analysts, investors and others to track, industry observers said.

"We tend to like acquisitions that are in-market and driven by cost savings with one side clearly in control," said Mike Mayo, an analyst at CLSA. "Revenue synergies should just be icing on the cake."

Generally, a buyer should be able to cut 25%-30% of a seller's noninterest expenses in an in-market transaction, industry experts said. For a deal that expands the buyer's geographic reach, those numbers usually drop down to 15%-20%.

Cleveland-based KeyCorp has forecast that it should be able to cut $400 million, or roughly 40%, of First Niagara Financial Group's noninterest expenses after it completes its purchase of the Buffalo, N.Y., bank. Separately, New York Community is aiming to cut $150 million by halving Astoria Financial's costs; both operate in the New York City area.

Those targets will likely be challenging to hit, but they are achievable, industry observers predicted.

A seller's efficiency ratio, which looks at noninterest expenses as a percentage of revenue, is a good indicator of how much room there is to cut, said C.K. Lee, a managing director of investment banking at Commerce Street Capital.

A higher efficiency ratio suggests more opportunities to lower a seller's cost structure, perhaps by eliminating jobs or closing branches where there are overlaps, he said.

Astoria, for instance, had a 74% efficiency ratio at Sept. 30, compared with a much stronger 46% at New York Community. The $49 billion-asset New York Community is planning to close branches after it buys the $15.1 billion-asset Astoria, though it has not said how many.

"The last time we did a transaction where the seller's efficiency ratio was [very high], we had meaningful upside," Joseph Ficalora, New York Community's president and chief executive, said in a recent interview. "The opportunity to recognize cost savings isn't alien to us. This fits our business model and it is sizable."

KeyCorp declined to comment for this story.

The $95.4 billion-asset company's executive said during a recent investor conference hosted by the BancAnalysts Association of Boston that 40% of its cost savings would come from systems and third-party contracts, 15% from branch closings and the rest from reduced back-office functions, office space and Federal Deposit Insurance Corp. assessments.

Projected expense-cutting is "based on extensive due diligence," Don Kimble, Key's chief financial officer, said during that presentation.

During a deal's due diligence, a potential acquirer and its advisers typically conduct a "top-down" assessment of a seller's expenses, Daly said. A suitor can often cut up to a fifth of a target's costs by simply combining the companies, but additional savings typically require that there be overlapping branches and business lines.

As negotiations continue, a buyer's due diligence shifts to a "bottom-up" approach and the crafting of a more precise plan about where costs can be trimmed, Daly said. At this stage, individual business line managers are assessed.

A large amount of expense-cutting is tied to vendor relationships, said John Stockamp, a senior manager in West Monroe Partners' banks and credit union practice. As a result, it is important to review contracts and look for ways to renegotiate terms or terminate agreements in a cost-effective manner, Stockamp said.

Executives also need to worry about cutting too much. For instance, a buyer could risk losing clients if it closes too many branches or cuts too much staff, said Allen Tischler, a senior vice president in the financial institutions group at Moody's Investors Service.

"Just focusing on the cost side isn't the entire picture," Tischler said. "You need to do it in a way that you're retaining what you're buying."

Executives should consider how they will communicate layoffs, Lee said. Morale and productivity could suffer if the remaining employees feel as though laid-off workers were treated unfairly, he added. At the same time, top performers could be motivated to seek employment elsewhere.

Rival banks will often look for opportunities to capitalize on missteps.

Malvern Bancorp in Paoli, Pa., held job fairs after BB&T agreed to buy National Penn Bancshares in Allentown, Pa.

There are "several smaller banks in western New York that are drooling over the potential dislocation from the KeyCorp-First Niagara deal," said Ted Kovaleff, president of Informed Sources Service Group, which owns stock in First Niagara. Those banks "are expecting to make hay while the sun shines."

New York Community's executives said their planned branch closings are unlikely to harm service because there are plenty of instances where New York Community and Astoria have branches on the same block.

"We can provide the same services easily from one location instead of two," Ficalora said.

Still, the Astoria deal — which also included a dividend cut and a balance-sheet restructuring — has been greeted coolly by the markets. Ficalora insists he is not discouraged.

"[New York Community's] stock is down, but the opportunity is also that it is down," he said. "That creates an opportunity for people to invest in this deal."