Professional Documents
Culture Documents
Madeleine James
Lenny T. Mendonca
Jeƒfrey Peters
Gregory Wilson
PLAYING TO
THE ENDGAME
IN FINANCIAL
SERVICES
170 THE McKINSEY QUARTERLY 1997 NUMBER 4
VERY WEEK BRINGS NEWS of another financial services acquisition in
E 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.
Mimi James is a consultant in McKinsey’s New York oƒfice, Lenny Mendonca is a director in the
San Francisco oƒfice, Jeƒf Peters is a principal in the Boston oƒfice, and Greg Wilson is a principal
in the Washington, DC oƒfice. Copyright © 1997 McKinsey & Company. All rights reserved.
• 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 oƒten 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
eƒficiencies 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.
Few
Although there will still be players (future
universal banks,
thousands of small commu- nonbanks)
Number of players
Hundreds
nity banks, the industry, like
airlines and aerospace before Product/service
niche players
it, will be dominated by a
handful of national and glo-
Thousands
Micro-market
niche players
bal giants that will dwarf (community banks,
credit unions)
even the biggest players we
know today.* They will have Defender Reserving the
Industry shaper
achieved their might by buy- right to play
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.† The next 50 banks could be merged into a seventh bank of similar
size (Exhibit 2).
Exhibit 2
could evolve over time into
Six mega-banks: A plausible endgame?
full-line financial service pro-
$ billion
Assets
Market
capital
viders – the US equivalent of
Bank A
622.9 79.2 universal banks.
Bank B
563.1 94.7
Bank C
571.5 As companies hunt for new
96.1
Bank D
542.2 products and channels in a
95.7
Bank E
490.3 47.7
consolidating environment,
Bank F
381.0 82.0
M&A activity will increas-
(Next 50 308.0 53.3
banks) ingly cut across artificially
Source: FDIC; Y-9 bank holding company reports; McKinsey analysis defined industry lines. Fin-
ancial 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.
While size begets complexity and oƒten 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 eƒforts –
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. Exhibit 4
Proof can be seen in the banking industry’s cost curves (Exhibit 6). The lower
a bank’s eƒficiency ratio, the more revenue it keeps relative to its cost base, and
hence the more eƒficient 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
Exhibit 5
20
10 year CAGR:
Revenue = 8.2%
In an environment of deregulation
Costs = 7.1% and consolidation, managements that
0 have demonstrated their eƒficiency
0 Revenue 100
* Based on the top 100 BHCs. In 1986, the top 100 BHCs’ assets were
will be more natural owners of these
$1.9 trillion or 67% of the industry total; In 1996, they were $3.5 trillion
or 76% of the industry total
assets than players that have yet to
Source: FDIC Y-9 report; McKinsey analysis 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 shiƒt 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 eƒficiency 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 eƒficiency 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.
Acquirer/target
hancements are put together,
Fleet/Shawmut
11
it’s clear that the equation of
Washington Mutual/Great Western
11
“one plus one equals three” National City/Integra
8
is oƒten within reach for Chemical/Chase
7
skilled buyers. First Bank System/US Bancorp
6
NationsBank/Boatmens
5
A natural result of consoli- Wells Fargo/First Interstate
4
dation and improved cost NationsBank/Barnett
3
eƒficiency is higher compet- First Union/Signet
2
itive intensity and tighter Wachovia/Central Fidelity 1
Pricing is likely to follow the example set in other deregulating and consoli-
dating industries, such as airlines and long-distance telecom. Prices typically
fall by roughly 20 percent in the first five years aƒter deregulation, and
by another 20 percent in the next five years.* As a result, high-cost, high-price
players are either acquired and restructured or driven out.
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.
≠ Robert Crandall and Jerry Ellig, Economic Deregulation and Customer Choice: Lessons for the
electric industry, Center for Market Processes, 1997.
Ample evidence attests that this downward shiƒt will continue. One of
the industry’s cost leaders, US Bancorp (formerly First Bank System),
has announced a five-year eƒficiency 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.
7.78 7.94
Median 1980–96: 6.16 7.53 7.38
6.95
6.30 6.20 6.35
5.99 6.16 5.97
5.71 5.61 5.41 5.62 5.66 5.51
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
Source: Compustat; McKinsey analysis
and players with unique brands, distribution systems, and management talent
will succeed in M&A.
Companies like these can aƒford 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).
Exhibit 9
Control
have now linked senior management 6 your own
destiny
compensation to shareholder value
5
creation. As regulation falls away and
competition intensifies, management
$4 b lli
4
0
$3 0 b
bi llio n
lli n
on
i
3
commodities.
i
$1
o
0
bi
Big but
lli
2 At risk
on
undifferentiated
Exhibit 10 shows how players can plot
1
their position along two axes: perfor- 0 5 10 15 20 25
Book equity ($ billion)
mance (market-to-book ratio, our
Expense ratio
50
changes in consumer preferences, and the 40
transformation of global capital markets,
30
no real restructuring could take place.
20 1995
But today, regulation is finally succumbing
to these powerful market forces, and 10 Trend
1990
restructuring is under way. 0
Life/annuities premium 100
A similar trend is coming in life insurance. The traditional way for mutual companies
Industry cost curves reveal that the to realize the advantages of public
opportunity to capture economic surplus is ownership – to “demutualize,” or convert
far greater than in banking, partly because from policyholder ownership to stock
of the deterioration in expense ratios over ownership – is complex, time consuming,
the past five years (exhibit). If banking is a and expensive. Unwilling to suffer the pain,
valid analogy, life insurers should expect many mutuals have lobbied state regulators
their industry cost curve to shift downward to permit new holding company structures
as consolidators (among them players from that will allow some public stock issuance.
related industries) continue to execute their Demutualization in any form is likely to
acquisition strategies. As much as half the accelerate the trend toward consolidation
industry’s revenue may be up for grabs by in the insurance industry as more companies
more efficient players, whether they are become available for takeover.
traditional life companies or new entrants
such as commercial banks.
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 leƒt 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 undiƒferentiated. 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 eƒficiently makes them
vulnerable as other players jostle for position.
At risk. Finally, the companies in the lower leƒt 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 diƒferent consolidation strategies
(extending geographic reach, moving into new businesses, building in-market
presence), but both have a proven record in post-merger management.
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.
Exhibit 11
Original
2.3
market value
1.6
(December 1990)
2.9
Additional
2.1
value creation 2.1
≤ $6.3 billion
value implied
Total after
15.1 by bank
five years 11.3 composite but
not realized
10.0
Recently, bank C launched its own acquisition strategy to catch up. Unfor-
tunately, it has been deprived of prime acquisition candidates by the
continuing eƒforts 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.
Exhibit 12
Greater
scale Improved
productivity
Improved
management
Better
skills
More
customers Higher
Broader
revenue
scope
Higher
Expanded
operating
distribution efficiency;
Acquisitions lower costs
Improved
margins
Higher
Enhanced
brand equity
market share
Improved
stock valuation
Most skilled acquirers have a dedicated M&A business unit that adopts a
leveraged buyout mentality to create value through deals;* 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.
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 eƒficiently than novices.
Also essential, but less oƒten 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 aƒford to pay for the acquisition. Oƒten, 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 synergies that are distinctive to a par-
ticular buyer. Examples include revenue plays from special skills or assets
(such as distribution channels or databases); leveraging a company’s exist-
ing 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.*
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.
Given the skills of leading players, the underlying economics of the finan-
cial 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
≠ See Olive M. Darragh, Victor G. Dodig, and Ronald P. O’Hanley, “Will success spoil investment
management?” The McKinsey Quarterly, 1997 Number 2, pp. 56–68.
borders at an accelerating rate for the foreseeable future. The trend is just
beginning to gain momentum, and the industry, shareholders, and con-
sumers will all benefit. Those aspiring long-term winners that first under-
stand and then act to influence this process will have a head start in the
race to the consolidated endgame.