Virtually every day the business press features a story detailing another huge private equity deal. This Monday’s papers discussed the acquisition of TXU, a Texas-based utility, by a group of investors lead by the famed KKR. However, except in the case of some roll-ups of community banks and startup entities, private equity and hedge funds have not dramatically affected how the banking industry manages itself…yet.
In effect, banks have been largely protected from the advances of these groups by the regulatory environment in which banks operate. Many investors do not want to take on the regulatory hurdles that banking entails; at the same time, unwanted advances by investors can be fended off due to the threat of a protracted legal tangle in which bank management may benefit from a protected position.
However, as growth becomes more difficult to achieve and bank performance weakens, the investor’s voice is increasing in volume. Recently, Citicorp has been targeted by investors, including hedge funds that believe that the bank’s breadth of activity exceeds its management’s capabilities. Similarly, Monday’s Financial Times published an article concerning a London-based fund named, remarkably enough, The Children’s Investment Fund. In what the FT says is the first time “an activist shareholder has directly taken on one of Europe’s large banks,” the fund “asked ANB to consider breaking itself up to reverse years of poor share performance.” Apparently, once again the regulators, in this case the Dutch, are setting up roadblocks to the fund’s aggressive stance.
Private Equity Yourself
What does KKR’s focus on the utility industry or a London investor’s attack on a big international bank mean for a US bank operating in an increasingly tough environment? For the smart bank executive, quite a lot, actually.
Private equity firms bring an independent perspective, fierce analytics, and a bias for action to any transaction; banks often lack these characteristics. While, at least in the near term, banks may be safe from the unwanted advances of this type of demanding investor, bank executives should learn from them and adopt some of their best practices.
Three examples should suffice.
* Evaluate and act on the numbers. Banks often make decisions on a maximum of anecdote and a minimum of quantification-based facts. Outside investor groups bring an analytic bent to their decision-making that exceeds what we see at many clients. While many of the bigger banks in the U.S. have now instilled this discipline across their banks, it remains inconsistently applied in decision making. Both the analytic rigor and its application need to be developed further at regional and community banks.
* Intensify your business focus. Banks dabble in too many businesses, all too often continuing to try to be all things to all people. However, usually, the numbers show that profits rest on a select number of segments and customers. Outside investor groups pull apart their investments to understand the key factors driving overall profitability and assess the profit dynamics of key customer segments. To this day many banks are operating with the severe handicap of not knowing customer and/or product profitability, a significant competitive disadvantage.
Given the squeeze on margins and an uncertain credit environment, banks cannot afford to maintain value-destroying clients while at the same time failing to generate as much revenue as possible from their best names. In our experience, evaluating customer profitability at a client bank almost always results in a chart showing that 20-30 percent of customers are value destroyers while only 10-20 percent provide the vast majority of the profit. The other 50-60 percent are marginally profitable and provide a great opportunity for cross-sell and re-pricing.
* Create a sense of urgency. The best private equity and hedge fund investors analyze closely, evaluate objectively, and then develop action plans for immediate execution. Speed of action plays an important role in their maximizing the return on their investment.
I have worked for or with banks for 30 years (a frightening admission). Whether as a banker or as a consultant to banks, it is usually very difficult to introduce change with any speed. An exception to this occurs when management feels under intense threat, either due to poor performance or because of an anticipated overture from a potential acquirer. Recent years have been particularly good ones for the banking industry, making change all the more difficult to introduce.
However, now the stars are aligning against the banking industry, allowing management to push for faster change in order to address lower margins, a tougher deposit-raising environment, real estate woes, and, overall, a less kind operating environment. Frankly, in many cases it may be the Board that needs to step in to require action.
Concluding Thought
The easy money in banking is gone. Inaction is hardly an option. Evaluating your bank from the perspective of an independent, tough-minded outsider may be an effective way of challenging established approaches and entrenched ideas. Better that bank management evaluate itself with a high level of rigor and some skepticism about past ways of doing business, rather than waiting for an outside investor to do so.