Every acquisition starts with high hopes, and the purchase of Mellon by Bank of New York is no exception. The senior managements of the two banks are upbeat, and for now look at ease with each other in private as well as in public, even to the extent of completing sentences for each other, and pretending (despite the 63:37 ownership ratio and the 10:8 management ratio in favour of Bank of New York) that the deal is a merger rather than a takeover. American shareholders have joined the love-in with such enthusiasm that they literally applauded on Monday last week when the two banks first unveiled the plan to fold Mellon into Bank of New York. Bob Kelly, currently president, chairman and chief executive officer of Mellon, says they were endorsing the deal on strategic grounds, as matching their own assessment of the securities services industry as scale-driven, technology-intensive and increasingly global in nature.
But, as befits a former CFO, Kelly says the financial logic was an even more powerful incentive to clap hands. He describes the IRR to shareholders down to 2011 of 19 per cent as “truly extraordinary – probably double the cost of capital” even without the proposed revenue synergies that will accrue as the transaction is implemented. On unchanged revenues, the cost savings alone are projected to increase pre-tax earnings by 18 per cent to $4.5 billion. Restructuring costs will dilute EPS for Bank of New York shareholders, but their Mellon equivalents gain straight away, and all shareholders will benefit from increased cash earnings as soon as the transaction closes. “The shareholders saw not only the strategic value associated with it, but also the financials, which are very, very compelling,” explains Gerald Hassell, president of the Bank of New York. “When you put both companies together, and you look at the initial cost savings we laid out, the transaction is accretive for both sets of shareholders almost immediately, on a cash basis. On the growth prospects we believe we can realise, it gets increasingly accretive.”
That growth depends on the realisation of the revenue synergies. These are listed as putting Mellon fund management clients on to the Bank of New York securities services platform, and vice-versa; selling Bank of New York’s global reach to Mellon custody and wealth management clients, and Mellon risk management services to Bank of New York clients; distributing Mellon asset and wealth management services through the Pershing distribution platform owned by Bank of New York; and diverting Bank of New York credit clients into the cash management and stock transfer services of Mellon. None of these gains have yet found their way into the financials of the deal, but Hassell and Kelly believe they will eventually find their way into the share price.
That potential upside in the stock is why both Kelly and Hassell expect both sets of shareholders to stay with the merged entity. “This is huge for both sets of shareholders, which is so unusual,” says Kelly. “It is so unusual to see a merger where both stocks go up on the news.” Bank of New York rose 12 per cent on the first day and Mellon 6 per cent, and both stocks seem to have settled since into a slightly higher trading range. “Ultimately, the shareholders have not given us full value,” continues Kelly. “We have probably got about a quarter of the value that should accrue to shareholders, but they will want to know more about how the merger will actually come together, and they are going to want to see ultimately that we are going to start to integrate these companies well without affecting customers. And when they start to see that, we will get recognition in our share price, rapidly.”
Hassell and Kelly accept that striking the deal is easier than implementing it. The integration plan sets a 30 month timetable from the anticipated closing on 1 July 2007. “Together, we are much stronger than we are apart,” says Kelly. “But the cost of that in the short term is taking on the integration risk.” Within the next month, interested parties – which include staff and clients at both banks, as well as shareholders – are promised what Kelly calls “a detailed, still relatively high level, time line on how we are going to put the two companies together.” Current Bank of New York chairman and chief executive Tom Renyi is heading the integration project, with the assistance of Mellon senior vice chairman Steve Elliott and Bank of New York vice chairman and head of operations and technology Don Monks as co-heads.
“We hope to be in a position very shortly to put together the organization structures for the new company – certainly at the next level down, and hopefully to announce the next level of management shortly thereafter, [and give] more of a sense [of] the major innovations [we are planning and the] time-lines we are going to require,” explains Kelly. “Our expectation too is we are going to publicise those, as we get a more detailed sense of how exactly we are going to integrate the companies.” One interesting pas de deux in the inevitable game of musical managerial chairs is evident already, with Tim Keaney of Bank of New York and Jim Palermo of Mellon currently both on the organogram as “co-heads” of asset servicing – an unstable formula in which the global investment banks have specialised for years. It is an interesting reunion for Keaney and Palermo on personal grounds: the two men started their careers in securities services on exactly the same day – at Boston Safe.
Keeping hold of customers is clearly a key consideration behind a detailed but slow-burning, process-driven integration plan. Kelly says it aims to enable the merging organizations to “provide the best service in the world” throughout the integration period, and so retain all customers and shareholders. “We will provide regular feedback on how we are doing vis–vis our original plans,” adds Kelly. We want to be as transparent as possible, for our employees, our customers, and also for shareholders.” Hassell sees a constant stream of communications with clients, shareholders, staff and journalists as means of ensuring that Bank of New York and Mellon – rather than competitors or the rumour mill – shape expectations during the transition. “We would be nave to think our competitors are going to sit on the sidelines and let this happen,” says Hassell.
Certainly other global custodians are not confining their analysis of the opportunities afforded to them by the deal to making jokes (sample: BONY + Mellon = Bony M). They are already talking up their chances of poaching clients from both Bank of New York and Mellon, and pointing out that the integration process will take the two banks out of the market for anywhere between two and three years. “No,” counters Hassell. “We can take on new clients.” This confidence may not be misplaced, or at least not yet. So far, according to third party observers, clients in transition to either bank seem determined to press ahead anyway. “We feel pretty comfortable we can continue to grow throughout the integration period,” says Kelly. He is reassuring clients that a lengthy three year integration period is incompatible with sudden and disruptive changes to people or processes or platforms. “We are not going to do anything dumb,” he says.
Hassell thinks the inevitable comparisons with the State Street-Deutsche Bank deal are misplaced, because both Bank of New York and Mellon are committed providers which have invested in the business, while Deutsche Bank had advertised its impending withdrawal from the global custody business for some time, and had a long tail of disgruntled clients as a result. “We do not have unhappy customers who are looking to leave,” says Hassell. Kelly derives further assurance from the length of existing custody contracts, which usually run over three to five years. “They don’t all come up at once,” he says. It will almost certainly be more difficult to get new clients to sign contracts of that duration during the transition period.
Hassell is reluctant to be drawn on the proportion of client relationships that are at risk, but says his experience with previous purchases by Bank of New York is that a 90 per cent retention rate is realistic. It sounds high, and probably is, and the exact proportion is bound to vary according to the nature of the business, and the relative influence of factors extraneous to the deal. But Hassell says the proportion of customers on both sides that are at risk for extraneous reasons is “relatively low” because of the complementary rather than competing nature of the client bases. Bank of New York is stronger among banks, insurers and central banks, he says, while Mellon is stronger among pension funds and fund managers.
“The two companies are very complementary from the custodial standpoint,” echoes Kelly. “We are strong in different spaces, which is terrific. Mellon is strong in the pensions space, particularly in the US, and we have good front-end technology and good analytic technology. On the other hand we did not have the scale or depth that the Bank of New York was able to bring, and their specialities in hedge funds and ETFs and financial institutions generally. They are in so many spaces that we are not in, like the corporate trust business, and the clearing business. In many ways, it was a wonderful fit.”
But perhaps not as wonderful a fit as the two banks would like the industry to believe. Among the documents released by Mellon and Bank of New York is a chart comparing the client bases of Bank of New York and Mellon. It purports to show that in only two areas – US public funds and hedge funds – do the Bank of New York and Mellon client bases overlap, but the exclusion of Mellon from the mutual fund co-ordinates of the chart is a curious omission. Mellon has a substantial enough mutual fund administration business on both sides of the Atlantic to be rated in the Global Custodian mutual fund administration survey in each of the last five years.
Hassell makes a stronger point when he says that many of the businesses on both sides of the deal will not be affected directly by the integration process at all. Only Bank of New York has a presence in corporate trust, ETFS and UITs, broker-dealer clearing and ADRs, for example. Likewise, folding the relatively modest Bank of New York asset management business (which consists largely of separate boutiques) into the Mellon asset management business (which also consists largely of boutiques) will be one of the smaller challenges. It will nevertheless create a $1 trillion fund manager, which is just large enough to propel Bank of New York-Mellon into the Top Ten asset managers in the world.
“One of the keys is being able to articulate to the market place what client segments might be impacted, and when, and making sure we are very transparent to the marketplace about that,” says Hassell, who believes that communication with clients is key to a successful integration process. “Where we have erred in the past has really been more on the communication side than the actual conversions or integrations,” he adds. “We are going to try very hard, if there is such a thing as over-communicating, to over-communicate.” Kelly says “we are trying to define what best-in-class communication is, not just for our customers but for our employees.”
It is not hard to work out which employees the management needs to communicate with most urgently: those working in the custody businesses of the two banks. Of the $1.3 billion in restructuring costs, $625 million is allocated to personnel changes. Hassell concedes that “by definition” most of the 3,900 jobs the two banks are promising to eliminate over the next three years will disappear from the asset-servicing businesses around the world. He hopes most will be shed by natural attrition. “We hope to grow during this time too, so there will probably be some absorption of that [number] as we continue to grow,” says Hassell. One reason Bank of New York executive chairman Tom Renyi has put himself in personal charge of the integration process is the hope that both he and the client-facing business people can continue to worry about customers rather than their own jobs. “This process is going to be very customer-friendly,” says Kelly. “We are taking our time, picking the best of both systems. We are going to be watching and speaking to our sales and service staff all the way along, so that they have tremendous input into this process. We are going to do it in a way that minimises the risk to our customer base.”
Achieving their goals of losing 3,900 staff and $700 million in costs over the next three years – at a cost of $1.3 billion in restructuring charges – without losing people and clients they want to keep is a massive challenge. Analysts noted before the merger was announced that costs (16.8 per cent in the first nine months) at Mellon were growing faster than revenues (9.7 per cent). Though one of the complementarities of the deal is meant to be the Bank of New York “culture of disciplined cost management” (it is juxtaposed in the documentation with the Mellon “culture of quality service and delivery”), the story was much the same at Bank of New York. Non-interest expense was up 8.8 per cent in 2005 and another 12.2 per cent in the first nine months of this year. That said, the proposed savings, which amount to 8.5 per cent of the combined expenses of the two banks, are within the post-merger norms (the range in the list of twelve deals since 1998 published by the banks runs from 5.4 per cent to 15 per cent, but averages 9.1 per cent). Securities services providers tend to look less efficient than ordinary banks anyway because so much of their revenue is fee-based – the fee income ratio at Mellon is 90.5 per cent, and that of Bank of New York 76.9 per cent – and fees are expensive to earn by comparison with interest. But the two banks have nevertheless set themselves a stiff task in reversing their existing momentum.
One challenge they have deliberately eschewed is a shift on to a single platform. Hassell says both banks are glad to retire from the technological “arms race” and spend both more and less together than they do separately. “Instead of spending a dollar or a pound each for that arms race, we will probably spend a pound and a half,” he explains. “We are not going to need the same level of duplicative infrastructure.” He notes that the two banks between them own six separate data centres. No more than three are likely to survive the rationalization process. Likewise, derivatives processing technologies will be merged into a single investment programme. The $1.3 billion restructuring costs include $350 million in technology and facilities. “Slapping together operating systems is not the core requirement to make this successful,” says Hassell. “That is not the issue.” In fact, he asserts that “there will not be one platform. You have different operating platforms for different market segments. We are going to select the best ones between the two organizations …and [those] that we have the ability to invest in for the future. That selection process will be based upon market segments, and the needs of clients.”
Of course, that still implies some transfer of clients between platforms. It presumably means pension fund clients will be serviced from the Mellon platform, and insurers and banks from the Bank of New York technology. Which front -end system – the reporting engine by which clients will experience the quality of the service at first hand – will be chosen is harder to guess. “We think we can make this additive for our customers,” says Kelly. “We can add more products and services as we come together and invest for the future. And when I say additive, I mean not just products but geography as well.” It is significant that, even when the revenues of the two banks are combined, just 25 per cent will be derived internationally. Despite the value of the deal – and a combined presence of 54 cities in 36 countries – Bank of New York buying Mellon is still largely a US domestic transaction.
But that may be just the point: Bank of New York-plus-Mellon can get serious abroad in a way neither could separately. Until now, the fact that geographical expansion at both banks has made use of joint ventures and marketing alliances is a measure of their near-equal lack of reach. But the future of those alliances and joint ventures is now obviously in question. “We are going to have to go through some level of rationalisation, if you will, at the same time recognising that they are very important clients to us,” admits Hassell. The knottiest problem is that Bank of New York has a marketing alliance with ING, while Mellon has formed a stand-alone joint venture bank with Dutch rivals ABN Amro. Although the ABN Amro Mellon venture is more successful as well as more formal than the Bank of New York relationship with ING – which has effectively done no more than transfer its global custody relationships to the American bank – the solution is not as easy as ditching the lesser relationship. “ABN Amro and ING do not really have to work together,” says Hassell. “Actually, both organizations are being used, one through a formal joint venture and one through a marketing alliance, as means for both of our organizations to get introductions to their clients. We can co-exist doing that.”
Bank of New York has a similar global custody marketing alliance-cum-outsourcing arrangement with Nordea in Scandinavia. “Their view is that it is going to be a powerhouse organization that can serve them well from a global custody perspective,” says Hassell. “They still have designs of being in the local custody business, and neither one of our organizations is in the local custody business in that region. So we do not see ourselves as being in conflict on that.” A third marketing-cum-outsourcing alliance in France with Natexis Banques Populaires is complicated by the fact that Natexis is itself now merging with Ixis, the wholesale banking arm of Caisses d’Epargne, to create Natixis. On the Mellon side, both Hassell and Kelly say the second joint venture with CIBC is unaffected. “The Bank of New York is not a custodian in Canada, so there is no conflict” says Hassell. Though Bank of New York does have trust operations in Canada, it seems CIBC does not have a problem with Bank of New York for any other reason. In fact, the Canadian bank has outsourced its trade services processing to Bank of New York. “CIBC is a major client of ours,” says Hassell.
Another set of relationships in need of rationalization is the respective sub-custody and clearing networks run by Bank of New York and Mellon. Hassell says the two banks are “still in the early stages” of analysing their respective networks, and that it is therefore “too early to comment.” However, he says the overlap between the two companies in general is “probably 30 per cent, and when you get into the 30 per cent, you [find you] are in different market segments often, either geographically, or by customer type. So I will be very interested to see the real, in-depth analysis.” A superficial analysis suggests that the overlap in use of agent banks in the major markets will prompt some painful decisions, though the politics of the problem are alleviated by the promiscuity of the Bank of New York (which tends to have multiple providers in every major market) and the deliberate shrinkage of the Mellon sub-custody network in recent years.
BHF BANK, which Bank of New York agreed to continue to use in Germany even after it left the ING Group, is one provider where a hard decision has already made itself. “That is a local custody question that we have to resolve,” says Hassell. “I will say that we have confirmed with them the continued use of them and, more importantly, their continuing to use us on a global scale.” Mellon uses BNP Paribas not only in Germany, but in France, Greece and Italy as well, so the French bank will be monitoring developments. In the emerging markets, there are bound to be disappointments, thanks to the Mellon preference for multi-market providers (such as SEB, Standard Chartered and UniCredit) that do not always match the Bank of New York choices in multi-market provision (notably Citigroup, HSBC and especially ING), let alone its penchant for working with local as well as international banks. But whatever their differences of view over network management, rationalising the joint list of agent banks will cause more pain for the sub-custodians than Bank of New York and Mellon.
For Bank of New York, the big question posed by this acquisition is whether it can learn from what it admits Mellon does better: the human side of the business. In theory, the combination of the Bank of New York talent for transaction processing with the Mellon gift for client service and relationship management should create a formidable competitor to JP Morgan and State Street. “The actual cultures are much more similar than dissimilar,” claims Hassell, but he accepts Bank of New York is not renowned for client focus. “It is something we have been working on and changing over the last eight to ten years,” he says. “Unfortunately, it is not perceived in the marketplace perhaps as well as we would like. But we have similar culture in terms of quality of service to our clients, our employees, high integrity, professionalism, that are all very similar to what the Mellon organization wants to stand for, and does stand for. I think the issue that is still perceived in the marketplace, and that we have been working hard to change, is the image of quality of service, and there is no question that, over the last few years, Mellon has moved up the quality curve. We continue to improve upon that but, given our scale, it has taken us longer. But the absolute commitment is there. So one of the values the combined organization wishes to stand for is first class quality service, globally, and that is one of our rallying cries to the organization, because we want to be the best in class in our area. And so if there is a culture to survive, if you want to call it that, it is centred around that issue. It is quality of service, and to be viewed in the marketplace as an incredibly professional, high quality organization. And that is not a difficult rallying cry for the Bank of New York people. They very much want to be viewed as the best in the world.”
For Mellon the challenge posed by the merger is really a counter-factual one. It is to prove that the management was right to sell the bank rather than seek to grow it. After all, Bank of New York has pursued Mellon for a decade – after its friendly overtures were rejected, Bank of New York made a $23.7 billion takeover bid for Mellon in the Spring of 1998 – and the former management of Mellon spurned its advances. That did not look so clever after the market value of Mellon was still drifting a third below that bid as late as the middle of this year. It was not only disgruntled hedge funds but bellwether pension fund CalPERS that helped to depose former CEO Marty McGuinn in February this year. The fact that Bob Kelly elected to sell the bank within nine months of arriving from Wachovia made many think he was hired specifically to do what McGuinn would not, because it was obvious long before he joined that the Mellon stock price meant the bank could not buy its way out of its shareholder troubles. So has Kelly done the easy thing or the obvious thing or the right thing?
He thinks the right thing. “When you think about Mellon, we have had 15 per cent EPS growth year on year,” he says. “We have grown rapidly. But this is not about the past. It is about the future. I am absolutely convinced we can create enormous shareholder value alone, but we are absolutely more convinced we can create a lot more together. And if we look through our four business lines, each and every one of those business lines will be strengthened. My job is a lot easier in one respect – it is easier for me, in some regard, in that the goals we had set for our shareholders will be more easily met, going forward. The downside is that, over the next two or three years, we are going to be taking on integration risk. But given the financial attractiveness of this transaction – our return is well in excess of any incremental risk they will taking on over the next two or three years. I feel very comfortable, and confident, that we are doing the right thing for all our stakeholders.”
Which leaves a last, obvious question about the balance between risk and reward: is financial attractiveness the same thing as integration risk? “No, no,” says Kelly. “Financial attractiveness is in terms of how enormously accretive this transaction is to shareholders. Over three years, it will be 20 per cent, or should be. [It is] immediately accretive, and you do not see many mergers that are immediately accretive [in earnings terms] to shareholders. The return, from an internal rate of return standpoint, is almost 20 per cent before revenue synergies, and we have enormous revenue synergies between the two companies. The point of all that being that one set of stakeholders will fare extraordinarily well – that is shareholders – so long as we execute well in the integration. They do take on integration risk. On the other hand, there is huge financial upside. Or think about our people. We are going to create much better careers for people, much more interesting careers. Our customers? It should be additive for customers as well. This will allow us to reinvest in systems more aggressively than we have in the past, as well as investing in geographies. We are not doing this to get smaller. We are doing this to get a lot bigger, and grow faster.” There was never a merger that was not inspired by such ambitions. Over the next three years, and perhaps longer, shareholders, employees and customers will have the opportunity to measure at first hand the size of the gap that separates that prospect from reality, or of course the margin by which reality exceeds the weight of expectations on which this acquisition is based.