The public announcement on Sunday April 6 of an intended merger between Bankers Trust and broker Alex Brown came a week earlier than planned. It had to. Rumours of a deal were beginning to spread. Earlier that weekend, Alex Brown salesmen were in Florida with the firm’s chief executive, AB “Buzzy” Krongard, for a morale-boosting get-together. Krongard was surprised to be approached by an excited employee expressing enthusiasm about the merger talks. The employee happened to be married to a Bankers Trust managing director.
There seems to have been more loose talk than a married couple’s breakfast conversation. On Friday the 4th there was frantic turnover in call options on Alex Brown stock, trading that may have set off an investigation by the SEC. (For the moment the regulator refuses to comment.)
It was a speedy, if inauspicious, start to the post-Glass-Steagall era. Previously, Krongard had appeared to rule out any deal with a bank for his firm, a national brokerage based in Baltimore best known for underwriting the equity of mid-cap and high-growth companies. And rumour had persistently linked Bankers Trust with other, larger securities firms such as Lehman Brothers and PaineWebber. But the logic for the combination that emerged was simple and compelling – to combine Bankers Trust’s strengths in syndicated lending and high-yield bonds with Alex Brown’s strength in equity financing for the same group of customers.
Notions of history-making were not foremost in the minds of Krongard or of Bankers Trust chairman Frank Newman as they negotiated terms during six hectic weeks from February. As Krongard says: “Bankers Trust is no more a bank than Alex Brown is. It has made the transition into a capital markets provider.” One leading US bank analyst even suggests the two firms will be a difficult cultural fit because Bankers Trust has traditionally shown a more aggressive, risk-taking approach to financial markets. “It is probably closer in culture to Salomon Brothers than to Alex Brown,” he says
But both Krongard and Newman are keenly aware of the difficulty of expanding into each others’ traditional territory and of the potentially high price for failing to do so. In the past seven years, Alex Brown has risen to become a top equity underwriter in seven key industries: technology, healthcare, consumer, media, financial services, manufacturing and transportation. It is particularly strong in technology and, in a busy year for that sector, was the number one lead manager of all US IPOs for 1996, ranked by number of issues. (It was fifth ranked by total proceeds.)
But Alex Brown’s weakness in lending and bond markets was allowing other firms to pitch for equity underwriting business from clients it considered its own. The firm reckoned it was losing mandates. As Krongard puts it: “Losing business in leveraged lending and high-yield debt allows competitors to get their nose under the equity tent.”
Building a high-yield debt and leveraged lending business, even if that were possible, would have meant handing over hundreds of millions of dollars of shareholders’ money to new hires from outside Alex Brown. This is anathema at such a tightly managed firm, where compensation as a proportion of revenue has averaged 56% over the past five years, never varying more than 100 basis points, and return on equity over the same period has averaged 24%, varying between 29% in 1993 and 20% the following year.
Bankers Trust had a similar problem. Throughout its recent troubles, the investment banking division has consistently been the best performing of the portfolio of separate businesses that make up the bank. In 1994, it earned profits of $135 million, less than risk management, the then driving force at the bank, which made $163 million. But in 1995, investment banking made $326 million, while risk management lost $74 million. And last year again, it made $323 million, while risk management lost $9 million. Over the same period, client-processing services have made a regular, steady contribution of just over $90 million each year, while sales and trading has been volatile, losing $95 million in 1994, making $105 million last year.
Investment banking at Bankers Trust includes a private equity group and a real-estate work-out division, but the mainstay is advice and financing for non-investment-grade companies. Here, challenges were looming. Many firms have recently picked high-yield debt underwriting as a business to grow in. Furthermore, according to Newman: “We were receiving a lot of feedback from our clients – especially from growing companies and those in rapidly changing industries – that having just one firm that could handle all their financing needs for them would be very valuable.” Bankers Trust had been building slowly in equity for four years, yet still found itself many years and hundreds of millions of dollars away from a strong equity market position. Newman decided the firm could not wait to build: it had to buy.
Newman waves off the old rumours that Bankers Trust had entered private discussions with other New York-based firms. “From time to time, I have lunch with the CEOs of other Wall Street firms and I may have been spotted doing so. But those lunches are just for keeping in touch and talking about industry matters. We never had serious discussions with any of those firms.”
Newman may not have realized that other officers of Bankers Trust had already identified the key challenges facing the firm and made the first tentative approaches to Alex Brown long before he joined the bank.
Prehistory of a merger
In late 1993, Yves de Balman, then Bankers Trust’s co-head of global investment banking, asked the head of its new equities business to produce a list of firms with which it might make sense to join up. Topping the list was Alex Brown. De Balman duly went to Baltimore for a preliminary meeting with Mayo A Shattuk III, the president and CEO of Alex Brown and Krongard’s number two. The two discussed each firm’s strengths and weaknesses. De Balman now says he recalls recognizing “in the way Mayo described their business it was clear that we operated in the same way and shared similar values”.
Another meeting took place in mid-1994. Discussions were now over how the two firms could cooperate. But there was little sense of urgency. The Federal Reserve still limited to 10% of total revenues the amount of so-called ineligible revenues – including those from equity underwriting – that the section 20 securities subsidiary of any bank could earn. No matter how the two looked at it, they could not fit any merger past that obstacle. But they agreed it made sense to look further.
When Newman arrived in 1996, he emphasized that there would be a push towards relationship banking and took a close interest in the bank’s efforts to build in equity. “I often ask our people what I can do to help make them more successful. Often they replied: ‘we need to have strong equity capabilities’.”
The notion of relationship banking was also significant. Alex Brown is not a risk-taking firm. It earns roughly half its net income from capital markets, mainly arranging equity offerings and conducting sell-side advisory work. The other half mostly comes from private-client brokerage and asset management. It has a small balance sheet with assets of just $2.5 billion at the end of last year (compared with Bankers Trust’s $120 billion), strongly supported by shareholders’ equity of $644 million (compared with Bankers Trust’s $5.2 billion). “Bankers Trust, under their new leadership, is committed to doing business our way,” says Krongard.
A side-benefit of the merger, for Bankers Trust, is that Alex Brown actually improves its Tier 1 equity ratio from 8.7% to 9% for the combined company. Management has hinted that it is more likely to park this new excess capital in low-risk, low-return assets than to use it to take on more credit or market risk.
Even more significant in 1996 was the Federal Reserve’s announcement that it would raise the ceiling on ineligible revenues to 25% of a regulated securities subsidiary. Some 40% of Alex Brown revenue counts as ineligible and, through its efforts in bond underwriting, so does 10% of Bankers Trust’s. Putting the two firms together would leave ineligible revenues at just 20% of the total, well inside the new limit.
In late 1996, Bankers Trust raised the tempo of discussions. The board had looked at a number of hypothetical acquisitions without talking to any outside parties, when one Bankers Trust outside director volunteered to set up a lunch with a personal acquaintance on the board of Alex Brown. This happened. The Alex Brown director duly reported back to Krongard, and Newman invited Krongard to drop by next time he was in New York. The two met late in 1996 and, they both say, got along well. “But, we were still a long way apart,” recalls Newman. What he remembers from the first meeting is Krongard pointing out that Alex Brown had operated independently for 196 years. “It wasn’t clear at that time that anything could be done,” says Newman. But in a follow-up call, Krongard conceded the logic of much of what Newman was saying and allowed that the two sides could talk more.
Krongard must have been attracted by the complementary fit with Bankers Trust that might reinforce Alex Brown’s grip on existing clients, help win new business from them and help win new clients. An obvious source of these is Bankers Trust’s large overseas network of 50 offices and growing investment banking businesses in emerging markets. These might be a source of new clients, since so many foreign companies are apparently attracted to the US equities business, in which Alex Brown is strong. This provides another side benefit to the merger. Alex Brown is mainly a domestic firm. Bankers Trust earns some 50% or more of its revenues outside the US, generating valuable foreign tax attributes which it can offset against domestic earnings. Alex Brown will provide a new way to use these. Its effective tax rate in 1996 was 41%, against 30% at Bankers Trust. For the combined companies the figure would have been just 32%.
But Krongard also had to ponder the lingering suspicion among American companies towards the Bankers Trust name. He says: “We thought about all that stuff. But I reasoned that any outside directors of Bankers Trust, having been through those problems, would have integrity at the top of his list of criteria in looking for a new CEO. Each subsequent meeting with Frank confirmed that. I cannot hold their past against them. If anything, they are probably more sensitive to these kinds of issues than other firms.”
There was also the pain of giving up Alex Brown’s independence. “This is a proud, somewhat insular, regional firm,” says a securities industry analyst. No sooner was the deal announced than senior figures at Baltimore-based banks were lamenting the conquest of another Maryland business by a New York suitor. Krongard admits: “Is there an emotional issue here? Absolutely. We had the capital, the history, everything to go it alone. We have a longer history than any London merchant bank. Brown Shipley is an offshoot of us. I talked to the sixth descendant of the founder, who was senior partner here when I arrived, and he said to me: ‘It’s tough, but if it’s the right business decision, we’ve got to do it’.”
By the start of the year, a series of meetings between the two firms was under way. The teams were small. No outside advisers were used, even to put fairness opinions on merger terms to the two boards of directors. Each side reasoned that deal-making was, after all, what they did for a living.
Shattuck and de Balman were charged with producing a plan to make the organizations fit together after the merger. Each will be a vice-chairman of Bankers Trust New York Corp and will jointly lead the integration. Both sides worked on a retention programme, including cash guarantees and restricted stock and stock option awards, for the top 20 or so Alex Brown staff who need to be tied in to make the deal work. The total cost of this will be more than $200 million, spread over four years. Much advice for this came from the Alex Brown side itself, following the logic that they know their own best people. Newman and Krongard negotiated the terms.
It looks as if Krongard got the better of that negotiation, striking a good deal for Alex Brown shareholders just as the business passed its earnings peak for this cycle. Between 1994 and 1996, Alex Brown’s pre-tax income more than doubled from $119 million to $259 million, laregly due to a hefty increase in revenue from equity underwriting. Simply adding the two firm’s 1996 results together shows Alex Brown producing 20% of the combined net income.
But, as officials of both firms have stressed, 1996 was an exceptional year and not one to use as a basis for future earnings forecasts. “Bankers Trust’s niche businesses, like high-yield bonds and leveraged lending, usually do well at the end of economic cycles. It may well be that Bankers Trust earnings will improve this year and Alex Brown’s will decline, my own models assume by 20%,” says Robert Albertson, analyst at Goldman Sachs. In addition, Bankers Trust expects some of its non-investment banking businesses to progress beyond simple recovery and provide decent contributions to earnings this year. It is unlikely that Alex Brown will continue to earn 20% of the two firm’s combined profits.
Bankers denies naivety
The deal was designed as a pooling of interests. Each Alex Brown share will be exchanged for 0.83% of Bankers Trust common stock. That will leave Alex Brown’s old shareholders owning 20% of Bankers Trust following completion of the merger. Taking the two companies closing share prices on April 4, that values the deal at $1.7 billion and implies a fancy price of 2.55 times book value for Alex Brown.
Two weeks after the merger was announced, the two firms each publicized their first-quarter 1997 results. Alex Brown’s net income was 23% down on the first quarter of 1996, reflecting weaker IPO volumes, especially among technology companies. Bankers Trust’s earnings were 24% up on last year, reflecting better performances from previous laggards, risk management services and sales and trading.
Newman deflects any suggestion that the bank was naive. “Dick Daniel and I have been involved in a number of mergers before. Rather than using rule-of-thumb type valuations, like price to earnings or price to book, we modelled the financial perfomance of our own firm if we did not do the merger, and of the combined firm if we did, using various assumptions for strong, weak or median market conditions. Then we explored different exchange ratios on the number of shares. In the end, we decided on an exchange ratio, not on a fixed dollar amount.” That made share price fluctuations less relevant than if Bankers Trust had to pay in cash for Alex Brown shares at the top of the market. In fact, the share prices of both companies had been falling in the weeks before the deal announcement.
A fundamental point of the merger is that Bankers Trust is not just buying the earnings stream of Alex Brown in order to add it to its existing portfolio of businesses and leave it to operate independently. That would strike a poor deal for Bankers Trust shareholders. Bankers Trust is paying a premium for the value it should produce from putting the two companies together.
Creative book-keeping
The firms went through each other’s books, business by business, customer by customer, trying to calculate what revenues they might win back from a Bankers Trust client that went elsewhere for an equity deal, or an Alex Brown client that used a different high-yield bond underwriter. Within two years, they hope to be producing anything from $120 million to $220 million in revenues from the two firm’s existing clients, predominantly from additional high-yield debt and equity underwriting. Even after the expense of added bonuses and other marginal costs, that should add $65 million to $120 million to annual pre-tax earnings, before considering possible earnings from new clients.
Newman is enthusiastic about one-stop shopping. “On the day of the merger announcement an equity client of Alex Brown was preparing to do a large high-yield financing with another firm. Just after seeing the news on the wire, the client contacted his account officer at Alex Brown to say that he would like to work together with Bankers Trust on the bond deal.” To make this happen regularly, the two firms will have to work well together. Can they?
The Wolfensohn group works almost as a separate firm within Bankers Trust. Wall Street gossips suggest many Alex Brown folk hope the firm will carry on running itself much as before. It has already been announced that the firm will retain a large presence in Baltimore. But Alex Brown has been run in a fairly decentralized manner. The head of its technology group, a key part of the firm, sits in its Boston office. “Alex Brown already has a very geographically decentralized business with over 20 offices in the US, and offices in Europe and Asia,” says de Balman. “Baltimore is one centre, the key centre to be sure and we certainly have no plans to change that.” Perhaps the issue is overstated. Why not have different operations in two cities a mere train ride apart, with each reporting to senior management?
There is no guarantee that people from different organizations will gel. However, much as senior executives point to similarities in each other’s cultures, they are taking this on trust. Senior executives on both sides know only each other. It is only now, after negotiating the deal, that they are introducing themselves to the “worker bees” inside the other firm. Even de Balman, who has been visiting Baltimore since 1993, had not met anyone much lower ranked then the chief financial officer until the deal was announced.
Krongard says that now the staff are getting acquainted they are all gripped with enthusiasm. He also admits: “Everyone’s first question is: ‘What does this mean for me?’ Everyone is saying this is the best deal we could have done, though some people are saying they wish we didn’t have to do any deal at all. But there is almost no overlap here, so there is plenty of opportunity for our people. There should be no politicking. This isn’t like putting two bulls in one pen. This is two bulls in two pens.”
The industry groups which the two have chosen to concentrate on are somewhat different. Bankers Trust never embraced the technology sector: Alex Brown is famous for concentrating on it. Bankers Trust retains strong links to financial investors from its days of lending to leveraged buy-outs and to industries like steel which Alex Brown has ignored.
Until the deal closes late this year, the pair will be betrothed but continue to operate as single, independent firms beholden to their own shareholders. They may cooperate on joint proposals and refer clients to each other but will make underwriting commitments and other key decisions separately. It will be a strange, testing time. No decision has been taken about names, other than that the Alex Brown name will survive, in some form of association with Bankers Trust.
Who’ll fill the job boxes?
Shattuck and de Balman are working on a blueprint for how the business will run, which they hope to put into practice as soon as the deal officially closes. “It is our desire to really run this firm in a manner where we can draw from the best of both firms,” says de Balman. “Alex Brown is very strong in its seven industries. We will build on that strength and the strength of BT and organize an integrated client coverage effort. We will have one integrated equity area, one integrated debt area and one research department.”
So far, the blueprint contains lots of boxes waiting for job titles. It doesn’t take a genius to suggest the head of equities will come from Alex Brown and of debt from Bankers Trust. But what will be the fate of the people Bankers Trust had hired in equity, and Alex Brown in debt? And on what basis will positions be filled in client coverage? Newman says: “We have hired some good people in equity but we needed many more, especially in research.”
De Balman hopes all the big choices will be taken by the end of this month. “In client coverage, we have very few industries which overlap, so the industry heads will fall easily into place. Of course, we will use our combined strength to build new industry expertise even in areas where we may not be well known, drawing upon the talent of both firms to spearhead those efforts.”
As to any fears among the Alex Brown staff of being swallowed in a huge new organization: “I’m sure those fears exist. But those first order concerns are being alleviated, as we get to know each other and work together.” Newman must hope so. The merger is a big step in fixing Bankers Trust: “It’s clearly one important component. Investment banking is our single biggest business area.”
On the weekend following the announcement of his firm’s betrothal to Bankers Trust, Krongard celebrated the wedding of his son. In assessing the chances for the merger to succeed, marriage was clearly on his mind. “They say that 55% of American marriages end in divorce. Which means that 45% don’t. Of those, maybe 5% are happy. We have the capacity to make one of the happy ones.”
