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Birth of an M&A culture? Not yet

01 Nov 1997

The planned mergers between Bayerische Vereinsbank and Bayerische Hypothekenbank -- and, even more dramatically, between Krupp and Thyssen -- have sent shockwaves through the German financial and industrial sectors. Many predict a wave of takeovers in Europe's most M&A-averse market as whole sectors undergo rationalisation and as the leading players seek to generate cost savings, improve their competitiveness and raise their return on equity.It will not happen overnight. In a country where M&A -- like privatisation -- is synonymous with job cuts, such moves will encounter fierce resistance from workers, while there are also formidable legal obstacles to certain forms of Anglo-Saxon style takeovers. But change is in the air. And no one doubts that the German corporate and financial landscape will alter drastically over the coming years.

IT IS A measure of how far the German capital market has come over recent years that the middle of August saw unprecedented speculative activity in the German equity market.

While Frankfurt in the middle of the summer is usually comatose, stock exchange trading in Commerzbank shares reached feverish levels as rumours resurfaced about an imminent takeover bid for the bank being launched either by a local suitor or a foreign aggressor.

Much of the speculation surrounding the future ownership of Commerzbank (which would have been unthinkable a few years ago) stemmed, characteristically for Germany, from the announcement earlier in the year of the groundbreaking merger between the two giant Bavarian banks -- Bayerische Vereinsbank and Bayerische Hypothekenbank -- which is creating Germany's second largest bank, Bayerische Hypo- und Vereinsbank.

This new colossus will have total assets of almost DM750bn, placing it behind Deutsche Bank (with DM867bn at the end of 1996) but comfortably ahead of Dresdner Bank (DM561bn).

While the Bavarian initiative has inevitably monopolised the headlines both in Germany and overseas, it is by no means the only large scale merger in Germany's overcrowded financial services industry.

The insurance sector is also seeing sweeping if belated consolidation, with the planned merger of the Victoria insurance group and Hamburg-Mannheimer to form the new Ergo Group under the Munich Re umbrella.

Between them, these two will enjoy total premium income of around DM20bn, making Ergo the second largest insurance company in Germany. A smaller merger in the sector, announced at more or less the same time, is between Berlin-Kölnischer and Gothaer, which is to be named Parion and which will have combined premium income of DM67bn.

The importance of these initiatives should not be underestimated. As Dresdner Kleinwort Benson commented in the August edition of its monthly equity round-up: "The mergers represent a striking departure from the traditional conservatism of the giant Munich insurers. In each case, long-held, large minority stakes are being used as springboards for distinctly Anglo-Saxon deals, apparently chiefly driven by the search for synergy potential. Even if they do not herald further moves in the immediate future, they certainly point to a significant swing in corporate practice."

While change is therefore certainly in the air in the German merger and acquisition (M&A) sector, opinion about how far and how fast the momentum will develop is mixed.

Ask virtually any German banker whether or not the persistent rumours about Commerzbank are likely to be translated into action and the question often meets with an embarrassed smile twinned with a negative response. Some respond in vague terms with answers like "it couldn't be done", or "Commerzbank is too big," or "people wouldn't like it".

Another says that the importance of the Bavarian bank merger needs to be kept in perspective, and that it was largely a defensive alliance. "If the merger between the Bavarian banks hadn't take place, Munich's future as a financial centre would have been zero," says one.

"Deutsche Bank had its sights set on Bayerische Vereinsbank and Dresdner was looking at Bayerische Hypobank, so the merger was defensive up to a point."

But the view from bankers and analysts outside Germany seems to be very different, and suggests that in the German financial services sector the gloves are now very much off.

Following the announcement of the Bavarian bank merger, for example, Credit Suisse First Boston noted in a research bulletin that "Commerzbank is now a viable target for either Deutsche or Dresdner." This is a slight variation from the usual theme, which usually revolves around speculation of a foreign bid from a bank such as ABN AMRO or Credit Suisse. But its message is clear enough: nobody, least of all senior management at Commerzbank, should assume that the size of the bank alone will protect it indefinitely from an unwelcome takeover bid.

While periodic rumours of mega alliances among Germany's leading commercial banks will inevitably monopolise press comment about M&A activity in the country's financial services industry, in purely numerical terms there is likely to be much more activity among the smaller banks.

This is because Germany plainly remains overbanked relative to a number of its other European competitors. There were 3,725 banks in the country at the end of 1996, which equates to just over 1,600 people per branch, compared to more than 3,000 per branch in the UK.

But while some degree of consolidation seems inevitable, few analysts or even industry insiders yet have the confidence to predict how those changes will come about.

As Dresdner Kleinwort Benson notes in a recent report, "one could speculate endlessly about the likely shape of the financial sector a few years down the line. It is our belief that the changes will be drastic."

One sector of the German banking industry which seems a likely candidate for consolidation is the 600-strong group of savings banks or Sparkassen.

But, like Dresdner, observers of the sector still have no idea what form this consolidation will take. As Thomas Fischer, chairman and chief executive officer of the Stuttgart-based Landesgirokasse very frankly expresses it: "It's hard to guess what will happen, but one thing is for sure -- something will happen."

Landesgirokasse itself stands in the vortex of a highly complex banking structure in the state of Baden-Württemburg, where discussions about bank mergers are nothing new.

As a credit report on the bank published last year by JP Morgan explains: "During 1995, LG's management considered a possible merger with Baden-Württembergische Bank, a Stuttgart-based private bank. Although it has been reported that LG's management was favourably disposed toward this opportunity, this merger was ultimately rejected by LG's owners. A counterproposal involving the merger of LG with L-Bank and Sudwestdeutsche Landesbank was also rejected."

Part of the problem standing in the way of merger activity in the Sparkasse sector, says Fischer, is that the German public continues to confuse mergers with privatisation.

"If we and Sudwest LB and L-Bank were to merge, it would not necessarily mean privatisation," he says. "It would mean an increase in efficiency. But the horror scenario as far as public opinion was concerned would be privatisation."

The logic behind this is simple enough: in a country already beleaguered by the highest unemployment rate since the 1930s, privatisation is viewed as being synonymous with job cuts. And increasingly, the possibility of mergers will carry similar undertones -- which is why the planned Krupp-Thyssen merger led to thousands of German steel workers demonstrating outside Deutsche Bank's Frankfurt headquarters. For the steel workers, the protests paid off. After high-level political intervention, the hostile takeover bid was withdrawn. But the industrial logic of the union proved compelling and, in early November, the two groups announced they had reached agreement on a friendly merger.

Bank staff, in the context of an industry which worldwide is seeing consolidation fuelled by the need to reduce overheads, are also likely to feel the pinch.

The Bavarian bank alliance, for example, aims to generate cost savings of some DM1bn per year through a reduction in the new bank's head count of between 5,000 and 7,000 jobs. While bankers insist that there does not as yet appear to have been much public angst about the ramifications for jobs arising from the Bavarian move, there would almost certainly be widespread alarm at the prospects for similar alliances among the Sparkasse, which are viewed as performing essential social services in Germany.

As rating agency IBCA notes in a recent update on the German Landesbanks, the Sparkasse "are deemed to be essential to the continued economic well being of the smaller saver and of small and medium-sized industry."

Be that as it may, Fischer and others view some sort of consolidation in the sector as inevitable, although how long this will take is open to question. Fischer sees a protracted and piecemeal privatisation procedure, in which majority stakes are maintained in the hands of state-owned entities, as the most likely long term outcome.

Although the trend towards an acceleration in M&A activity in Germany has been most evident in the banking and insurance sector, there is no reason to suppose that manufacturing industries will not also see a substantial wave of consolidation.

As a Morgan Stanley report on German M&A published towards the end of July points out: "Even before the Bavarian bank merger, German M&A activity levels were running at an all-time high in 1997, on an annualised basis. The previous high was in 1991, with a level of $23.1bn of M&A activity involving a Germany company as a target. So far this year (including the Bavarian banks), we have seen $19.2bn."

It adds: "A second indication that the environment is hotting up is that, since the beginning of 1997, there have been six deals of more than $1bn announced. In fact, three of the four largest deals of the last five years have been announced in the last 12 months."

Others take a more sanguine view of developments. "I wouldn't necessarily call it a new M&A culture," says Werner Pfaffenberger, managing director at JP Morgan in Frankfurt, "but the development of an increased readiness to question and reconsider long established corporate structures."

In part, Pfaffenberger adds that this is being fuelled by virtual paralysis at a government level. "The political system in Germany is regarded as having become less flexible, which has resulted in industry looking to take a more proactive stance," he says.

As an example of this, take the straightjacket structures of salary frameworks in Germany. The country's time-honoured mechanism of centralised wage bargaining has meant that conglomerates have enjoyed very little -- if any -- flexibility in linking wages and salaries to corporate performance.

With union power continuing to dictate that salary frameworks must remain in place irrespective of individual firms' profitability, virtually the only way for some companies to dispose of the burden of unsustainably high wage bills is to spin off individual subsidiaries which they believe to be out of kilter in terms of staff costs with the overall group.

Another reason to suppose that M&A throughout German industry will continue to gather momentum, says Pfaffenberger, is that the eventual launch of private pension funds in Germany will lead to an increased and more pronounced emphasis on performance among investment managers.

With demand for equities growing, and with investment management companies clearly favouring the shares of those companies which are willing and able to unlock shareholder value by spinning off non-core businesses, there is every reason to believe that more and more companies will follow in the footsteps of, for example, Hoechst, which is now divesting virtually everything it perceives as being peripheral to its central business.

The expanding importance of M&A in Germany is likely to have at least two important side effects. First, if precedent elsewhere is anything to go by, it will provide an important fillip for the equity

As the Morgan Stanley note remarks: "The acceleration of M&A is important for the growth of an equity culture. A vibrant environment, where the threat of takeover exists, enhances the profit-generating motivation of management. Data from other major European stockmarkets and the US show that there is a linkage between the level of M&A activity, expressed as a percentage of GDP, and the return on equity (ROE) level."

Specifically, the Morgan Stanley research draws attention to the fact that in the UK market -- which is the European Mecca of hostile takeovers -- between 1991 and 1996 M&A activity accounted for an average 6.44% of GDP, and that over the same period ROE among UK companies averaged 15.36%.

In takeover-averse Germany, by contrast, M&A activity amounted to just 0.83% of GDP, and average ROE at 7.49% was less than half the UK's.

A second by-product of the growth in German M&A is that it is playing into the hands of foreign (predominantly US) banks that are well versed in the practice from experience in their home market.

"The market for using and accepting investment banking advisers has grown enormously in Germany over the last five years," says one US banker in Frankfurt. "Of the German banks only Deutsche Morgan Grenfell has seen much action. Dresdner Kleinwort Benson is a long way behind and that is about it."

The reason for this, he adds, is obvious enough and will continue to leave most German banks powerless to benefit from expanding M&A activity for the foreseeable future.

"German banks are much too close to German companies to be able to advise objectively on M&A issues," says the same banker. "The most important thing from the point of view of an adviser is independence, which the German banks don't have because invariably you have bankers sitting on the boards of all sorts of different companies."

For all the excitement now surrounding M&A in Germany, much still stands in the way of the development of a more fluid market. First, there are still legal impediments blocking some of the financing techniques viewed as the bread and butter of M&A practitioners in, for instance, the US. For example, as Pfaffenberger of JP Morgan points out: "To buy a big German company on a leveraged basis and repay the debt by selling the assets of the acquired company is on the borderline of being illegal. Enshrined in German laws is the preservation and independence of the capital base."

Second, although corporate governance has belatedly entered into the German lexicon in recent years, the practice remains underdeveloped. "It is true that the duties and responsibilities of board members and directors is being looked at more and more closely," says one banker. "But the structure of German boards is still very antiquated and continues to militate against maximising corporate profitability. Half of the board members of a typical AG will still be union leaders who have a very different agenda to, say, that of the finance director or head of investor relations, if the company has one at all."

Another obvious stumbling block to the expansion of the German M&A market is the very low level of foreign direct investment into the country which in many economies is usually a fertile source of M&A activity.

Deterred by the country's uncompetitive labour costs and other perceived bureaucratic restraints to doing business in Germany, foreign net direct investment into Germany in 1996 was a pitifully low DM1.1bn -- compared with DM17bn the previous year. That led the Bundesbank to note in its most recent annual report that "the declining investment by foreign enterprises in Germany [in 1996] was particularly striking".

Until Germany becomes more friendly towards direct industrial investment, bankers expecting a boom of cross-border M&A with German companies as targets would be well advised not to hold their breath. EW

01 Nov 1997