A new style of merger and acquisition activity could finally help reinsurers add value. By Roy O'Neil and Chris Gentle.
The financial services industry has seen better times. The vast majority of institutions are finding themselves flanked by challenges, on the one hand by the seemingly endless fall in equity markets, and on the other by the gradual maturing of many core markets. Conventional wisdom has it that these are great conditions to spark a round of consolidation amongst the myriad of financial services players across Europe, and this is likely to happen - but not as we have seen it in the past.
There are three main reasons why financial services executives need a step-change in their thinking around mergers and acquisitions (M&A). Firstly, domestic consolidation in Europe has largely run its course. Secondly, investors are extremely nervous and are likely to continue to lack confidence in backing mega-mergers - especially the cross-border variety. Thirdly, most major mergers have a pretty poor record of delivering increases in investor returns, and this is a critical point for marketers.
For decades the rationale behind virtually all M&As in financial services has been to reduce costs. By building bigger economies of scale, the institutions could operate more efficiently, largely through reducing headcount. Arguably, it wasn't until the takeover battle for the UK's National Westminster Bank three years ago that revenue-generation synergies were added to the overall benefits that could be derived from a merger. In future, marketing and distribution need to play a bigger role in putting the case for the revenue benefits of corporate transactions. In attempting to unzip the merger myth, analysts and commentators have long puzzled over why many corporate tie-ups have not delivered the expected returns. Little wonder, it could be argued, given the single lens used on most big M&A transactions. The questions still remain: where does the M&A market move next in Europe for financial services, and why has there been such a large focus on costs as opposed to revenues?
An overview of Europe shows that there are many major markets where a handful of domestic players dominate, such as Spain, Germany and France. In contrast, few pan-European giants have emerged. Although domestic consolidation is near its end, don't expect a flood of cross-border mega-mergers soon. We may see a few big deals come through, but no glut of pan-European players emerging over the next five years or so. Nevertheless, we are likely to see corporate activity. Increasingly management, investors and analysts are aware of these risks, and today's more exacting environment means financial institutions have to find new ways to operate in the M&A space.
Beyond traditional M&A
To be successful, Europe's reinsurers need to adopt a radical change in thinking away from old world consolidation and move beyond traditional M&A practices. This can be achieved by leveraging which a variety of transaction vehicles, such as asset swaps and joint ventures, to reshape and deploy investors' capital around the businesses, and such moves are becoming increasingly common. These types of strategies will mark out the successful reinsurers of the early part of the 21st century, but this means going beyond the binary approach of traditional M&A.
In the past, the majority of businesses have grown through mainly domestic consolidation based largely on cost reduction and integration plays. Sufficiently fat margins allowed firms to 'snowball' their growth by acquiring or merging with rival firms and reducing head count. The days of these consolidators, as we call them, are coming to an end, their path blocked by a host of obstacles, notably competition authorities preventing further in-country mergers, and increasing demands from investors for ever greater returns. The successful businesses of the future will be what we term the configurers. This shift requires a new approach to M&A, injecting corporate flexibility into business models.
Embracing corporate flexibility - the ability easily to reconfigure a portfolio of business activities to meet the demands of evolving market places through the use of a variety of transaction approaches - will be the critical factor in surviving and prospering in the future. To become configurers, and to gain the corporate flexibility required to grow shareholder value in today's demanding markets, organisations need to consider not only traditional M&A approaches, but also a range of collaborative measures across the M&A continuum. Among these measures is what we have termed the 'business merger', an approach that is well suited to today's business environment.
A business merger occurs when two or more organisations pool similar business units or corporate functions to create an independent legal and commercial entity. The new ownership structure reflects the relative size of the founding organisations and any new capital provided by third parties. Staff can be sourced from the constituent businesses, although senior executives may be hired from outside to provide particular skill sets or 'unblinkered' thinking. Technology systems should be based on 'best of breed' practices, enabling the new business to shed any sub-optimal legacy systems. The new organisation would comply with both local and international accounting, regulatory and capital requirements - relatively easy to achieve with a clean corporate sheet.
It is important to distinguish business mergers from other types of transaction, notably joint ventures. A business merger is a separate legal entity created to allow a company to exit a product market or competency area that it deems non-core. By contrast, a joint venture is usually established to exploit a specific market opportunity. Unlike a business merger, it is not typically created as a new separate legal entity or linked to the strategic refocusing and reallocation of capital within the business.
Advantages of business mergers
Business mergers offer several benefits to reinsurers by allowing the company to focus on areas that it believes can yield sustainable, long-term returns:
Rather than being bound by the old binary approach to mergers, current and evolving market conditions require reinsurers to adopt a new philosophy towards M&A. The ability of companies to reconfigure their business portfolios to allow the long-term release of sub-optimal capital using business mergers and other appropriate approaches in the transaction toolbox will be a key requirement for prospering in the future. The challenge for marketers is to ensure that brand and revenue issues are confirmed throughout the business case - regardless of the transaction tool used. Such a shift from a consolidator to a configurer mentality that leverages corporate flexibility requires a fresh approach, fresh thinking and new professional expertise that spans the breadth of approaches, enabling businesses to move beyond traditional M&A practices.
The successful reinsurers of the next few years will be those that have a radical, revised and refreshed view of M&A activity. This requires a change in mindset: the configurer philosophy is markedly different from that of the consolidator. The ability and agility to easily reconfigure a portfolio of business units and kick the consolidator habit will become an increasingly important differentiator.
By Roy O'Neil & Chris Gentle
Roy O'Neil is a Partner and the Reinsurance Practice Leader at Deloitte (Consulting UK) and Chris Gentle is Global Research Director of Financial Services at Deloitte Touche Tohmatsu.