FINANCIAL SERVICES

Madeleine James
Lenny T. Mendonca
Jeƒfrey Peters
Gregory Wilson

There are many deals and

more consolidation ahead

Ultimately, the model may

be airlines or aerospace

Size will count, but success

will require more than
empire building

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.

• In 1990, the top 25 mortgage originators did 26 percent of the business.

Today, they do 45 percent.
We would like to thank Tatsuo Kawasaki and Anthony Lee for their insights and analysis.

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.

THE McKINSEY QUARTERLY 1997 NUMBER 4 171

PLAYING TO THE ENDGAME IN FINANCIAL SERVICES

• 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.

The endgame approaches

The pace of consolidation is accelerating. The next five years will make the
past five look tame, as players jockey for position while the new industry
structure locks into place. The most eƒfective way to stake out territory in
the new landscape will be by means of M&A, which puts this issue squarely
at the top of the strategic agenda. Senior management should ask tough
questions about where their company is going in the next five years – and
seek brutally honest answers:
• What is our view of the future? What role should we play in the new
industry structure?
• Do we have the management talent, the market strength, and the world-
class productivity to be a buyer in the consolidation game?
• If so, what kind of companies should we buy, and how should we go about
valuing them?
• Do we need to sell part of our current business, and refocus?
• Perhaps most diƒficult of all: should we take advantage of generous
valuations and sell our company to the highest bidder?

172 THE McKINSEY QUARTERLY 1997 NUMBER 4

 PLAYING TO THE ENDGAME IN FINANCIAL SERVICES

Five years from now, finan- Exhibit 1

Financial services five years from now

cial services will be virtually
unrecognizable (Exhibit 1).
10–15 national

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

ing complementary or weaker Strategy

players and transferring sup-

erior management skills to create value. As in airlines and aerospace, these
behemoths will be tightly run; highly productive, innovative, and skilled at
M&A; and intensely competitive with one another.

In banking, for example, the removal of the remaining geographic barriers

to acquisition in 1997 has set the stage for a truly national marketplace. To
see what this might mean, consider California, Florida, and North Carolina,
where internal barriers were dismantled a long time ago. In these states,
the top three banks already control more than 50 percent of all deposits. In
the developed world as a whole, that share is 58 percent. By contrast, the top
three US banks command only 13 percent of the national market.

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).

Most of these mega-banks would be twice as big as today’s largest bank,

Chase Manhattan. Given the state of deregulation and the variety of banking
licences and corporate structures available, these six or seven mega-banks
≠ Jerrold T. Lundquist, “Shrinking fast and smart in the defense industry,” Harvard Business Review,
November–December 1992, p. 74.
≤ See Stephen A. Rhoades, “Consolidation of the banking industry and the merger guidelines,”
The Antitrust Bulletin, Volume XXXVII, Fall 1992: “The results [of the study] indicate that, under
current guidelines, mergers could occur to the point that the largest number of banking orga-
nizations in any single market in the United States would be six, and the average number per
market would be three.”

THE McKINSEY QUARTERLY 1997 NUMBER 4 173

 PLAYING TO THE ENDGAME IN FINANCIAL SERVICES

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.

Travelers Group is a prime example of an institution built on cross-industry

deals (Exhibit 3). Its recent acquisition of Salomon Brothers continues the
trend, and is also likely to spark similar deals by national competitors.
Exhibit 3

Travelers’ cross-industry acquisitions

Total cumulative shareholder returns
$ million; Index: December 1992 = 1.00
Travelers Group, Inc. S&P financial index
7.0
Acquisition of Shearson Sale of American Sale of RCM
6.0 by Primerica Capital Management
Acquisition of Aetna’s
Acquisition of Sale of P&C operations
5.0 remaining 73% Metra-Health
Sale of 10% of
of Travelers; Spinoff of Travelers/Aetna
Primerica changes Transport (TAP) stock
4.0
name to Travelers Holdings
3.0 Acquisition of
BankAmerica’s
consumer
2.0 finance
division
1.0 Acquisition of Salomon
Brothers announced
0 Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul
1993 1994 1995 1996 1997
Source: Compustat; McKinsey analysis

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 PLAYING TO THE ENDGAME IN FINANCIAL SERVICES

From the acquisition of Shearson in 1993 to that of BankAmerica’s consumer

finance division in 1997, Travelers’ deals have garnered additional revenue
of $16 billion (representing a compound annual growth rate of 43 percent)
and created value to the tune of $31 billion (61 percent CAGR). The company
shows great discipline in buying low (during down cycles or when companies
are in trouble), spinning oƒf unwanted businesses (such as Transport
Holdings), and selling high (as with American Capital Management). It has
proved it can cross-sell eƒfectively across perhaps the largest distribution
system in the industry, comprising Salomon Smith Barney Holdings,
Commercial Credit, Primerica Financial Services, Travelers Life & Annuity,
and Travelers P&C, among others. Over time, the model it embodies will
become more and more powerful – and more and more common.

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

Scale benefits in bank M&A

Size appears to be just as important Bank 5-year shareholder performance
Percent median; Index: 1991–96 = 1.00
in M&A. Our analysis of shareholder Sample
size
value creation during the past five S&P bank composite 1.00 27
years shows that big bank acquirers Smaller acquirers 0.85 185
– those doing deals at least 50 per- Big acquirers 1.14 29
cent of their own asset size – beat Source: Compustat; McKinsey analysis

smaller acquirers by almost 30 per-

cent. They also beat the bank composite by about 15 percent (Exhibit 4). Life
insurance tells a similar story. The top five consolidators accounted for
roughly half of all deals completed in the past three years. They all exceeded
the industry’s average shareholder return, and the top two, SunAmerica and
Aegon, posted nearly six times this average (Exhibit 5).

The role of rational economics

Unlike past merger booms, this consolidation wave is less about empire
building than about raising revenue, cutting costs, and locking in continuous
productivity gains to boost shareholder value.

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

THE McKINSEY QUARTERLY 1997 NUMBER 4 175

 PLAYING TO THE ENDGAME IN FINANCIAL SERVICES

Exhibit 5

Scale benefits in life insurance M&A

Top 5 consolidators’ combined Total shareholder return*
share of M&A activity Percent
Percent
56
47 49 SunAmerica 41
Aegon 41
Jefferson-Pilot 22
17
Conseco 20
American General 13
1993 1994 1995 1996 Life insurance industry 7
* Annualized performance of stock price and dividends between October 1993 and October 1996
Source: Conning and Company; Compustat; McKinsey analysis

Exhibit 6 of the current overcapacity. Many of

Cost curves in the banking industry* them can be expected to exit the
Percent industry, voluntarily or involuntarily.
100
Long-term winners will strive con-
80
tinuously for greater eƒficiency, and
Trend = 1% per year 1986
will help take out costs via acqui-
Efficiency ratio

60 1996 sition for those that cannot capture

eƒficiency gains on their own.
40

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.

M&A is an attractive proposition from the earnings perspective, too. In

recent large transactions, synergies from cost savings and revenue enhance-
ments ranged from 45 to 100 percent of a seller’s net income for in-market
mergers. The figures for contiguous market mergers were 30 to 65 percent,

176 THE McKINSEY QUARTERLY 1997 NUMBER 4

 PLAYING TO THE ENDGAME IN FINANCIAL SERVICES

and for out-of-market merg- Exhibit 7

Efficiency ratio gaps between consolidators and targets

ers 40 to 50 percent. When
cost savings and revenue en- Percentage points

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. The ineƒficient play- Source: FDIC; McKinsey analysis

ers at the far right of the cost

curve in Exhibit 6 have to keep their prices high to turn a profit. As long as
regulation protects them from competition, they provide a price umbrella
for the rest of the industry. In the early days of deregulation, this price um-
brella allows players with lower costs and higher productivity to earn huge
profits. Soon, however, price competition takes over, and as margins get
squeezed, the economics of ineƒficient players are destroyed, opening the
door to further consolidation by productivity leaders.

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.

While it can be diƒficult to discern real pricing trends in financial services

because of cross-subsidies and shiƒts in the yield curve and in the mix of
fees and spread income, we are already seeing the results of the price
squeeze. In retail products, for example, average spreads on 30-year mort-
gages have plunged from 250 to 129 basis points during the past ten
years when compared to 10-year Treasuries – a fall of almost 50 percent.
Over the past four years, spread income on credit cards has declined by
10 percent and fees (or dollars per account) have plummeted by 60 percent
in response to consolidation.

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.

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PLAYING TO THE ENDGAME IN FINANCIAL SERVICES

Our analysis suggests that a bank’s independence may be in jeopardy if its

eƒficiency ratio is currently above 55 to 60 percent – unless that ratio is the
temporary result of digesting an acquisition with higher costs. Those in the 50
to 55 percent range need to take immediate steps to improve their eƒficiency
in order to keep pace with the expected downward shiƒt in the cost curve.

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.

Consolidation is also being fueled by the treasure trove of excess capital

available to fund acquisitions and be diverted to more profitable businesses.
In banking, for example, at least $46 billion was theoretically available at the
end of 1996 (Exhibit 8). This translates into roughly $90 billion in market
capitalization at the 1996 median market-to-book ratio of 2.0. Such a sum could
support up to $1 trillion in future acquisitions if we assume the current leverage
ratio of about 12.5:1, which is actually below the median of the past 15 years.
Exhibit 8

Excess capital fuels consolidation

Median equity/asset ratio 1996 excess equity over long-run median = $46 billion
Sample: 70 banks

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

Why M&A skills are crucial

Because the consolidated endgame is driven by huge diƒferences in
productivity, many deals that appear at first sight to be overvalued or
uneconomic will, we believe, ultimately prove to be value creating. This is
not to say that some acquirers won’t pay too much or be unable to realize
the value latent in their targets; indeed, the recent history of M&A reveals
that many deals fail to return their cost of capital. But highly skilled,
productive players (those on the far leƒt-hand side of the industry cost curve)

178 THE McKINSEY QUARTERLY 1997 NUMBER 4

 PLAYING TO THE ENDGAME IN FINANCIAL SERVICES

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

Skilled acquirers capture more value

Percent of equity value of target company Unskilled player Strategic acquirer

Source of value Strengths of skilled player

Short-term gains 20 Sees investment yield
29 improvement

Medium-term gains 2 Finds revenue from cross-selling

7 and reduction in commissions

Cost of capital difference 0 Leverages capital

15
Long-term gains 0 Develops options to increase
11 revenues

Total 22 Higher premium results

62
¯ Seller captures ¯ Buyer captures
most value most value

Controlling your own destiny

Who will win as consolidation transforms the financial services landscape? At
present, many passive players are failing to stand out from the crowd, neither
building the necessary skills nor achieving the critical mass they require to
control their own destiny.
Exhibit 10

Strategic control map

For would-be winners with national
and global aspirations, market cap- Market capitalization

italization is the metric to watch. It is 9

the best indicator we have of how well 8

Savvy National and
but small global winners
managers are performing; indeed,
7
recognizing this, many companies
Market-to-book ratio

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

talent and insight will become scarce

0
$2

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

THE McKINSEY QUARTERLY 1997 NUMBER 4 179

 AFTER BANKING, INSURANCE
U ntil recently, the structure of the financial
services industry was the product more
of regulation than of economics. Banking,
insurance, and brokerage were governed at
both state and federal levels by an arcane
hodgepodge of protectionist rules that
let uneconomic players thrive. In spite of
underlying business economics, profound
changes in consumer preferences, and the
transformation of global capital markets,
no real restructuring could take place.
But today, regulation is finally succumbing
to these powerful market forces, and
restructuring is under way.
In banking, current market competition and
safety and soundness protections render
anti-growth relics like the 1933 Glass-Steagall
Act and the 1956 Bank Holding Company
Act completely irrelevant. A variety of more
market-oriented corporate structures and
financial services licences (including retail
bank charters such as a federal savings bank
or an industrial loan company) permit sound
customer strategies to be implemented
without unnecessary worries about product,
affiliation, or acquisition limitations.
Consequently, the industry is undergoing
vigorous restructuring, as recent acquisitions
of retail bank charters by such companies
as Merrill Lynch, the Travelers Group, and
State Farm attest.
A similar trend is coming in life insurance.
Industry cost curves reveal that the
opportunity to capture economic surplus is
far greater than in banking, partly because
of the deterioration in expense ratios over
the past five years (exhibit). If banking is a
valid analogy, life insurers should expect
their industry cost curve to shift downward
as consolidators (among them players from
related industries) continue to execute their
acquisition strategies. As much as half the
industry’s revenue may be up for grabs by
more efficient players, whether they are
traditional life companies or new entrants
such as commercial banks.
180 THE McKINSEY QUARTERLY 1997 NUMBER 4
Cost curves in the life insurance
industry
Top 100 life/annuities underwriters
Percent
70
60
Expense ratio
50
40
30
20 1995
10 Trend
1990
0
Life/annuities premium 100
Source: A. M. Best; McKinsey analysis
The publicly owned or stock insurers have
responded by purchasing other insurers with
their appreciating stock, in an effort to spread
more revenue over their cost base. In addition,
they have issued stock options as incentives
to agents and employees to improve growth
and cut costs.
Mutual insurance companies are a different
story. Owned by their policyholders and
with limited access to capital, they are
unable to grow through acquisition. They
also have a hard time hiring and retaining
talented employees without the benefit of
stock incentives.
The traditional way for mutual companies
to realize the advantages of public
ownership – to “demutualize,” or convert
from policyholder ownership to stock
ownership – is complex, time consuming,
and expensive. Unwilling to suffer the pain,
many mutuals have lobbied state regulators
to permit new holding company structures
that will allow some public stock issuance.
Demutualization in any form is likely to
accelerate the trend toward consolidation
in the insurance industry as more companies
become available for takeover.
 PLAYING TO THE ENDGAME IN FINANCIAL SERVICES

proxy for market acceptance of management capabilities) and size (book

equity). Your position on the map helps determine your ability to control
your own market destiny, whether nationally or globally. Few players are
safe in a dynamic, rapidly consolidating environment, however. Even long-
term winners need a strategy to improve performance continually.

The map identifies four categories of player:

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.

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PLAYING TO THE ENDGAME IN FINANCIAL SERVICES

A look at the performance of these three banks over a five-year period

demonstrates that a successful consolidation strategy makes a major
contribution to shareholder value creation. Banks A and B are the two
acquiring banks; bank C is their non-acquiring neighbor. At the outset, C
enjoys the highest market value, even though A and B have already launched
their acquisition strategies.

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

A tale of three banks

$ billion, 1995 Bank A Bank B Bank C (the non-acquirer)

Original 2.3
market value 1.6
(December 1990)
2.9

Value creation 4.3

implied by S&P 500* 3.1
5.4

Value creation 6.4

implied by bank 4.5
composite†
1.7

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

* Portion of additional value attributable to rise of S&P500 during this period

† Portion of additional value attributable to the bank composite during this period
Source: Compustat; McKinsey analysis

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.

182 THE McKINSEY QUARTERLY 1997 NUMBER 4

 PLAYING TO THE ENDGAME IN FINANCIAL SERVICES

Exhibit 12

A virtuous acquisition cycle

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.

When Travelers purchases a troubled company, for example, it vastly improves

both management and cost structures. Its sense of urgency and strategic
purpose is almost palpable. Its ability to meet ambitious cost and revenue
goals is in part the result of high employee ownership (its goal is 20 percent
aƒter five years) and of the fact that a large proportion of compensation for
senior management takes the form of restricted stock that cannot be sold for
three years.

Needless to say, the fundamental skill in doing deals is valuation. We believe

that to value a target solely on the basis of discounted cash flow (DCF) is
wrong, given the uncertainty of a dynamic market. In our view, options
valuation represents the best way to capture the full value of financial
engineering measures such as lowering the cost of capital, reducing
unnecessary regulatory costs, gaining tax and accounting advantages, and
restructuring assets through securitization. It is also the best way to evaluate
unique synergies in distribution and product lines.
≠ Thomas E. Copeland and Patricia L. Anslinger, “Growth through acquisitions: A fresh look,”
Harvard Business Review, January–February 1996; reprinted in The McKinsey Quarterly, 1996
Number 2, pp. 96–109.

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Using this more sophisticated valuation technique reveals that there is no

single “true” value for a company. The value – and hence what an acquirer
can rationally aƒford to pay – depends on who the buyer is and what unique
synergies it can capture.

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.

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 PLAYING TO THE ENDGAME IN FINANCIAL SERVICES

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.

Ultimately, most winners will be vigorous and profitable consolidators.

Identifying and capturing consolidation opportunities leads to a virtuous
acquisition cycle and thence to still higher shareholder value. The key
ingredients are management vision, market position, and skills, all of which
will be determining factors as we reach the highly consolidated, fiercely
competitive endgame early in the next century.

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