| Editor, Deal Analysis leader: Andrew Liew WeidaSupported by: Haley Chen, Linda Chen, Hosei Hemat, Amy Hu
1. The Gist: Great bargain
Being a victim of its own success for developing CDO, ML faced not only rapid mounting losses but also difficulty in raising capital prior to the merger. Unravelling the unprecedented significant losses after the deal was initiated in Sep’08; BoA faced a ‘velvet glove and iron fist’ treatment by the regulators to seal the deal in Jan’09. After exhausting all available options, ML chose merger as the last way out and quickly marry to BoA over other suitors at that time. The ‘threat and help’ by the government, the approval by the shareholder, and the initial Ken Lewis’s biased delusion that ML was a great bargain for its standalone valuation and greatest perceived synergies over other potential deals sealed the deal. Valuing the deal was especially challenging. Triangulation analysis indicated $30.14 per share that comes from a suite of valuation tools: Discount Cash Flow Equity, Multiple Valuation, Real Options and Synergy. Total Present Value of the synergies worth $1.64 per share comes from Universal Banking Network Externalities, Operational efficiencies- I.T & HR & Financial synergy. BoA’s track record on M&A indicates that synergies are likely to be realized, considering both are distinctive firms in culture and market horizon. In addition to that, the market seems poised for an upturn and the new entity is likely to rise up to new rivals like Cititgroup Inc and the in new world its has created for itself. Considering everything at hand, the deal is a great bargain. Holding the stock reckon returns in the long run while merger arbitrage also reap return at time of announcement!
On the 15th Sep 2008, BoA announced its marriage to ML. According to Ken Lewis, CEO of BoA, ML was the perfect bride for his ‘family’ and paid $50 billion. ML was the last piece, consisting of its wealth management and investment banking units, to BoA complete banking ‘family’. Like the father to the marriage, the market supported the deal[i]. This marriage is the fastest announced ‘shotgun’ marriage[ii] in the financial history, curiosity questions the marriage as to whether it was a blinded moment of love or a timely seize of opportunity. The story will be uncovered as follow:
3. External Reasons: Situations that led to the merger
E1: Being a victim of its own success for developing CDO, ML faced not only rapid mounting losses but also difficulty in raising capital prior to the merger
In the early 2000s, ML flourished on Wall Street because its ex-CEO, Stan O’Neal aggressively pursued growth via CDO securitization[i]. However, the CDO market collapsed due to rapid defaulting sub-prime mortgages.[ii] Consequently, institutional investors bank-run on ML and revenue losses started marking down ML financial position. Even then, CDO has always been only a part of its portfolio. Because of its poor risk management in controlling CDO losses, the damage overshadowed its legacy. Despite selling its prized assets and dumping its CDO at fire-sale price, ML still remained in bad shape. To exacerbate the downfall, ML burned losses faster than its speed of raising capital.[iii] In addition, the deteriorating investor confidence in the banking industry started to create drought in the debt and equity markets that became expensive avenues for ML to raise capital. Therefore ML was not only bleeding heavily but also struggling to keep itself afloat before the merger. Even then ML can sell its business and not the whole group. This possibility is implicitly exterminated by the fact that ML faces a ‘horrendous market hurricane’.[iv].
E2: Unravelling the unprecedented significant losses after the deal was initiated in Sep’08, BoA faced a ‘velvet glove and iron fist’ treatment by the regulators to seal the deal in Jan’09.
Prior to the merger, BoA initially ran a healthy business and had a comparatively good position for acquisition in the industry supported by regulation[v].After the deal was announced in Sep’08, both firms prepared to get the BoA shareholders to seal the deal.[vi] The twist came when massive losses on ML 4th quarter annual earnings. This meant that BoA was in a position to invoke a “material adverse effect” clause from the merger contract to cancel the deal. However dealing with the regulators, Lewis faced the threat of being ousted from his position and a rescue package to complete the merger.[vii]
4. Internal Reasons: Choices to make and Actions to commit
I1: After exhausting all available options, ML chose merger as the last way out and quickly marry to BoA over other suitors at that time.
Hurting ML cash position and endangering ML, the CDO mess damage to ML was humongous. ML key financing measures prior to merger were selling its 20% stake in Bloomberg, dumping its CDO to hedge fund, talking to sovereign wealth funds and receiving capital from mega important investors.[viii] Less than 1 year on the job as the CEO of ML, John Thain has exhausted possibilities to keep ML independent when Lehman Brothers bankrupt[ix]. Despite his knowledge of possible termination of his job as CEO, he took all the consideration and started to seek a merger.[x] Furthermore, JP Morgan pushed ML off the cliff should the merger failed[xi]. Morgan Stanley refused the offer because its request for more time was rejected by John Thain[xii]. Before other parties replied, CEO of BOA, Lewis accepted the deal within 1 week in September 2008. In addition, John Thain saw the strategic value of the deal and was supported by his top executives to pursue it[xiii].
I2: The ‘threat and help’ by the government, the approval by the shareholder, and the initial Ken Lewis’s biased delusion that ML was a great bargain for its standalone valuation and greatest perceived synergies over other potential deals sealed the deal.
Initially, Ken Lewis was concerned that the recent discovered losses (in Dec’09) of ML not only greatly destroyed the expected value of the merger but also BoA market value, so he met up with the federal regulators on 17th Dec’09 to indicate abandoning the takeover. However, after being given the ‘velvet gloves and iron fist’ treatment by regulators, Ken Lewis agreed to move on with the deal[xiv]. The rescue package included a $20 billion in additional capital, some form of insurance against losses on $118 billion in trouble assets and others[xv]. Eventually BoA shareholder approved the deal in Jan’09.[xvi] Prior to that, BoA rejected the offer from Lehman brothers because of a lack of perceived synergy and government support.[xvii] Prior to the Dec’09 ML announced losses, Ken Lewis coveted ML because the combined entity would create a global financial giant to rival Citigroup Inc[xviii], the biggest U.S. bank in terms of assets, expand global skill and leadership position in markets globally, realize an expected value of $7 billion in pre-tax expense savings by 2012 and achieve integration of overlapping technology. Is it a good deal? Or Ken Lewis continued the deal just to save his skin? we attempt to answer them by estimating the value of the synergy and standalone value of ML.
Valuing BoA-ML: Perspectives, Difficulties, Limitation and Rationale
BoA-ML is a unique deal because ML is a highly leveraged, highly distressed bank with 2 years of reported earning losses and is supported by the regulators. Furthermore, the deal was completed in 2 days and was lacking critical information from deal agreement to take any model for absolute judgement[xix]. Complicating matters further, the regulators aided in closing the deal on a level of anonymity. Hence, the following models are chosen: Multiple Valuation, DCF equity & Real Options. DCF equity is theoretically robust but the lack of critical information makes this model very superfluous. Real Options is adopted to value highly distressed firms that are in negative earnings[xx]. Referring to the appendix , Multiple valuation was adopted as the best applicable model. The calculations and results are in section 10.
Referring to the Appendix Synergy Analysis, the total present value of the synergy is $1.64 per share in a conservative scenario. This comes from gross synergies worth $23 billion, consisting of revenue enhancement synergies, cost saving synergies and financial synergies, and will be realized within the next 5 years.
Revenue Enhancement Synergies:
Universal Banking Network Externalities (NW.E) worth $2.5 trillion or more
The new member of BoA family, ML adds breadth and depth to BoA banking ‘mega-mart’. ML transforms BoA from the largest retail & commercial banking leader in the USA into a Universal International Bank by adding the wealth management and investment banking businesses of global reach[xxi]. The NW.E consists of new geographical markets, new & highly value added customer base, new value chain of products and services and new dynamic sales force. The most coveted components of this NW.E are the 20,000 wealth managers and $2.5 trillion managed asset and these are expected to add $16 billion of synergy to the combined titan over the next 5 years.
Cost Saving Synergies: Operational efficiencies- I.T & HR
$7 billion of pre-tax savings comes from removing redundancies of similar functions and streamlining both operations into 1 combined entity. ML’s world-class I.T system allows BoA to facilitate information & processes more effectively and efficiently.[i] Restructuring into a lean organization, unnecessary compensation, which is the largest variable cost, will be trim. [ii] As such, lowering cost means increasing earnings.
Financial synergy: Tax Benefits
Post-acquisition of ML also incurs tax benefits. Lower taxes on earnings will apply due to operation loss carry-forwards. Furthermore, the acquisition will be tax-free due to the US Treasury Department’s rescue proposals.[iii]
7. Synergies Materialise: Dream or Nightmare?
Getting Along? History says it so!
Dogs and wolves belong to the canine species but they don’t necessary get along. This describes the distinctive cultural differences & perspectives for BoA and ML respectively, and that affect the entity to milk the $2.5 trillion worth NW.E for any real revenue. Although Ken managed to keep the 20,000 advisors via complying with an agreement on compensation and work expectations, this agreement is on paper and will be tested soon. Given Ken’s track record for successfully growing BoA via M&A and post integrating them, ML ‘herds of bull’ will most likely mingle with the BoA ‘eagles’, albeit an almost sure success in realizing the $7 billion cost saving synergies. Then the next triggering concern for the realized synergies will depend on any further surprising losses by ML.
Faith for no more losses? Government is the new lifeline.
Revenue synergies might not be realized if ML burdens the new entity with unprecedented losses. Further write-down can not only, lost the capital to stay competitive in an upturn, but also lost the confidence of investors and customers. Even if losses arise, the government will step in as it has always been for fear of market panic. Hence this plaguing uncertainty to fail the revenue synergies is unlikely. Nonetheless, the government concession comes with surveillance and compliance. Contrary to helping BoA to realize the revenue synergies, any heavy intervention by Congress as in the “90% tax on AIG bonus” case can potentially cause the exodus of 16,690 financial advisors to its competitor that are less dependent on bailout. While such episode can repeat to BoA, this is unlikely to repeat after the congress recognised the nature of Banking Industry via the cry-out from the Industry Movers and Shakers.
Yes, we can! But at what rate?
Ken’s M&A track-record and Ken’s first reaction to keep the ML ‘herd’ indicate realistic cost saving and revenue enhancement synergies upon considering the government’s safety net and its associated risk. Even if the synergies are realistic, the value to be harnessed will depend on its rate, which greatly depends on forces such as the industry operating structure, economic outlook and its competitive rivals.
8. Externalities on the Dynamics of Deal
Getting used to both sides of the horizon? How fast?
Although the likelihood of realizing the synergies is high, concerns for it to be successful depends on how fast can the giant respond to its new arena. BoA is the gladiator in the consumer & commercial banking arena. His key challenge lies in optimising the balance between the short term obligations of his depositors from the middle income group and the long term claims of his borrowers from the small and medium enterprises. ML is the pageant in the investment banking & wealth management competition. Her key challenge lies in beautifying herself with leverage and high paying human capital to engage her customers, who are high net-worth affluent nobles and sophisticated institutional investors for more businesses. Bigger doesn’t mean better for this situation because the new management needs to be as nimble as before if not faster. One possible situation is that instead of having the effect of the ‘Incredible duet’, the outcome will be a ‘Batman and Robin’. If that happens, the new entity will appear lopsided to its competitors in being only a Hero and his sidekick for the new world it has entered into!
Upturn coming up. Ready to rock and roll?
Referring to Appendix Chart IB , The banking industry in general is cyclical and tracks very closely to the Global GDP growth (IMF) and the Government Bond spread. As of now, the market seems to be bottoming out which indicates the new entity is preparing itself for the upturn and that will probably means positive earnings that will drive the momentum of the synergies to be realised. However, as it tries to do so, its competitors will also hunt for the ocean of opportunities. With competitive dynamics in position, the question will be whether the newborn can rise up before the bullies do. Failure to do so will be danger for the upcoming downturn in the future!
9. Final Analysis and Recommendation:
Having considered the expected value of the deal, the potential possibilities and risks of realizing the synergies, the verdict for this story appears to be a monumental conquest for BoA. Although subsequent information on ML’s huge losses that wiped out the gains and even endangered the new entity, such valuation risk was unforeseen at that moment. Even then, given the huge potential systemic risk posed to the US economy should ML new losses wreck the combined entity, this valuation risk was expected to be cushioned by the regulators. At that moment, evidence and expert opinion viewed the industry was at its nadir of the cycle. The section 10.3 triangulation analysis indicated that BoA gained by at least $1.14 per share and that fortify the gut that Ken based on to seize ML. Had not ML been forced by the market to pay for its dear mistake, Ken might not even have the chance to cut the deal instantaneously. Involvement in the deal would reap the most return in the long term by holding BoA shares but a merger arbitrage can also reap quick return at the time of announcement.
10.1 Multiple Analysis
11.1 DCF Analysis and Parameter
11.2 Chart IB (Investment Banking Outlook)
11.3 Synergies Analysis Chart
11.3 Multiple Valuation Analysis
ML reported negative earnings and highly leveraged balance sheet between the years 2006-2008. Valuing this entity on a standalone basis using DCF showed up a few challenges. Given that ML is a financial services firm, the standard DCF model is not simply and easily applicable because the following parameters such: Cost of Goods Sold, Interest Expense and Depreciation, are unique in banks especially ML. ML raw inventory is debt and ML interest expense is structured in the form of income and expense at the same time. In addition, most banks are measured using DCF equity based on forecasting the balance sheet changes in conjunction with risk capital, which is stated by the regulators. Furthermore, the deal was completed in 2 days and there was a lack of critical information from deal agreement to apply DCF equity effectively. Complicating matters further, the regulators aided in closing the deal on a level of anonymity that make DCF equity a superfluous model to apply. MV is adopted with greater emphasis because this model can provide a reasonable value to ML using the public information that is less difficult to extract and compute. Experts also supported MV.
11.4 Real Options Approach:
Sanford C. Bernstein analyst Brad Hintz said: hedge-fund assets will decline by 18.2 percent this year[i] As Merrill Lynch is the largest brokerage in the world, we assume that its brokerage earning fluctuation is consistent with the industry fluctuation. Therefore, we expect that ML’s prime-brokerage earnings will fully recover by 2013. We assume that the cash inflow caused by the recovery will all occur in 2013 and the amount will equal to the decline in 2009, which is 52% multiply the brokerage earnings in 2009: 52%* 7,578.2 million (see pro-forma income statement) = 3940.66 million. By discounting the cash flow 3940.66 million in 2013 back to 2008, using cost of equity 10.58%(see DCF) and T=15, we got the PV of the cash inflow 3940.66/ (1.1058)5≈2383 million. However, the real recovery value could fluctuate below or above the expected value 872 million as the relation between hedge-fund asset and brokerage earnings could change over years. We assume that the PV of cash flow follow Normal Distribution and the probability to drop between 750 million and 1000 million is 95%.
1. Jim. ML, CDO’s, risk and experience. 25th October 2007 [cited; Available from: http://www.smallbusinessboomers.com/merrill-lynch-cdos-risk-and-experience/.
2. http://crisisofcredit.com/, J.J., The Crisis of Credit: Oneline Podcast, in The Crisis of Credit, J. Jarvis, Editor. 2008.
3. Comlay, E., Merrill now in shorts’ sight as Lehman crumbles, in Reuters News. 13th September 2008.
4. News, D.J.B., Merrill Reportedly Seeking More Capital from Foreign Investor, in Done Jones. 2008.
5. Carrick Mollenkamp, S.C., Serena Ng and Aaron Lucchetti, Crisis on Wall Street as Lehman Totters, Merrill is Sold, AIG Seeks to raise cash – Fed will expands its lending arsenal in a bid to clam markets; Moves Cap a Momentous Weekend for American Finance, in The Wall Street Journal. 15th September 2008, Dow Jones: New York.
6. Carney, J. Blood On The Street: JP Morgan Pushed ML Into BoA Merger. 7th October 2008 [cited; Available from: http://www.businessinsider.com/2008/10/blood-on-the-street-jp-morgan-pushed-merrill-lynch-into-bank-of-america-merger.
7. Gearino, G.D., Like déja vu all over again, in Business North Carolina. March 2009, Red Hand Media: United States of America.
8. Craig, S., Thain Fires Back at BoA, in Wall Street Journal (Eastern Edition). 27 April 2009: New York.
9. Davis, P.S., Steven; Adler, Joe; Flitter, Emily, Partnership Frayed in Government Crackdown in American Banker. 24th April 2009.
10. Tully, S., DIVORCE BOA STYLE. , in Fortune. 16th Feb 2009.
11. SORKIN, A.R., Lehman Files for Bankruptcy; Merrill Is Sold, in The New York Times. September 14, 2008
12. Sorkin, A.R., BoA in Talks to Acquire ML. 14th September 2008, Deal Book.
13. MATTHEW KARNITSCHNIG, C.M.a.D.F., BoA to Buy Merrill, in The Wall Street Journal. 15th September 2008.
14. May, J., Shareholders of ML and BoA sign off on combination, in New Jersey Business News. 5th December 2008.
15. Shen, D.M.a.L., BoA’s Lewis, Board Win Shareholder Value. 2008, Bloomberg.com.
[i] ‘Hedge-fund industry recovery unlikely until 2013’ available at ‘http://www.reuters.com/article/euHedgeFundsNews/idUSLNE52C01M20090313’, accessed on 26/05/09
[i] BoA Press Release,2008[ii] CEO John Thain said he expects thousands of job cuts after the company is acquired by BoA, which will contribute to overall savings .Bloomberg News, “Merrill Chief Thain Expects `Thousands’ of Job Cuts Sean Evers”, 20th October 2009, available from: http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=a.nzwKlVEC0U , accessed 28/04/2009.[iii] CFO News, “BOA Could Find Merrill Deal Taxing” by Marie Leone, 3rd November 2008, available from: http://www.cfo.com/article.cfm/12543329/c_2984293/?f=archives , accessed 22/05/2009.
[i] Refer to Appendix 1. Jim. ML, CDO’s, risk and experience. 25th October 2007 [cited; Available from: http://www.smallbusinessboomers.com/merrill-lynch-cdos-risk-and-experience/.[ii] Refer to Appendix: 2. http://crisisofcredit.com/, J.J., The Crisis of Credit: Oneline Podcast, in The Crisis of Credit, J. Jarvis, Editor. 2008.[iii] Refer to Appendix 3. Comlay, E., Merrill now in shorts’ sight as Lehman crumbles, in Reuters News. 13th September 2008. ; 4. News, D.J.B., Merrill Reportedly Seeking More Capital from Foreign Investor, in Done Jones. 2008.[iv] The collapse of Lehman brother and Bear Stern, the constant news of reporting losses for its peers: UBS, Credit Suisse, the bailout of Fannie Mae and Freddie Mac, compounded by the nationalizing of AIG stirred up the storm driving all banks equity and debt downward. The investor’s confidence was so low and sceptical that one can logically conclude greater valuation risk for a single business unit than that for the group. Deductive analysis refer to source in Appendix: 5. Carrick Mollenkamp, S.C., Serena Ng and Aaron Lucchetti, Crisis on Wall Street as Lehman Totters, Merrill is Sold, AIG Seeks to raise cash – Fed will expands its lending arsenal in a bid to clam markets; Moves Cap a Momentous Weekend for American Finance, in The Wall Street Journal. 15th September 2008, Dow Jones: New York. ; 6. Carney, J. Blood On The Street: JP Morgan Pushed ML Into BoA Merger. 7th October 2008 [cited; Available from: http://www.businessinsider.com/2008/10/blood-on-the-street-jp-morgan-pushed-merrill-lynch-into-bank-of-america-merger.[v] BoA was the top 3 US Commercial deposit banks. It has been giving out positive dividends even during the occurrence of the sub-prime crisis. Refer to Appendix: BoA financial position. Even after absorbing losses via acquiring Countrywide: a problematic mortgage lend, it still met its capital requirement stipulated by the Federal regulators. Federal regulators have always been supporting deposit bank due to the Federal Deposit Insurance scheme and this support was not applied to investment banks. This is also one of the key reasons why ML peers like Goldman Sachs and Morgan Stanley started becoming deposit banks. Refer to appendix: 7. Gearino, G.D., Like déja vu all over again, in Business North Carolina. March 2009, Red Hand Media: United States of America.[vi] “By the end of November, Merrill’s losses were ballooning because of deteriorating market conditions and write-downs on various mortgage-related investments. Still, the daily emails sent to executives at both companies summarizing the deal’s status said “status green,” according to Mr. Thain, signaling that the takeover was on track.” Quote: 8. Craig, S., Thain Fires Back at BoA, in Wall Street Journal (Eastern Edition). 27 April 2009: New York.[vii] Iron Fist: Paulson threatened to fire Lewis along with the rest of B of A’s board if they pulled out of the Merrill deal, according to an investigation by New York Attorney General Andrew Cuomo. Refer to appendix: 9. Davis, P.S., Steven; Adler, Joe; Flitter, Emily, Partnership Frayed in Government Crackdown in American Banker. 24th April 2009. Velvet glove: Bernanke and Paulson said they would provide a rescue package for BofA to ensure that it had adequate capital to complete the deal. Washington has provided BofA and Merrill with $49 billion in preferred stock; BofA also has another $31 billion in preferred shares outstanding. BofA must pay $5.4 billion in annual dividends on its preferred-money that comes out of earnings and is not tax-deductible. Refer to appendix: 10. Tully, S., DIVORCE BOA STYLE. , in Fortune. 16th Feb 2009.[viii] [viii] Refer to Appendix 3. Comlay, E., Merrill now in shorts’ sight as Lehman crumbles, in Reuters News. 13th September 2008. ; 4. News, D.J.B., Merrill Reportedly Seeking More Capital from Foreign Investor, in Done Jones. 2008.[ix] Refer to details in appendix: 11. SORKIN, A.R., Lehman Files for Bankruptcy; Merrill Is Sold, in The New York Times. September 14, 2008[x] Refer to Appendix 12. Sorkin, A.R., BoA in Talks to Acquire ML. 14th September 2008, Deal Book.[xi] JP Morgan instructed ML to put up billions in new collateral or risk having its account frozen. Such a huge collateral call would have likely to spark a liquidity crisis at ML if a deal to merge with BOA had not been worked out. Refer to appendix6. Carney, J. Blood On The Street: JP Morgan Pushed ML Into BoA Merger. 7th October 2008 [cited; Available from: http://www.businessinsider.com/2008/10/blood-on-the-street-jp-morgan-pushed-merrill-lynch-into-bank-of-america-merger.[xii] Refer to Appendix: 13. MATTHEW KARNITSCHNIG, C.M.a.D.F., BoA to Buy Merrill, in The Wall Street Journal. 15th September 2008.
[xiii] Refer to Appendix 8. Craig, S., Thain Fires Back at BoA, in Wall Street Journal (Eastern Edition). 27 April 2009: New York.
[xiv] Refer “velvet gloves and iron fist” treatment in footnote 7.
[xv] Bernanke and Paulson said they would provide a rescue package for BofA to ensure that it had adequate capital to complete the deal. Washington has provided BofA and Merrill with $49 billion in preferred stock; BofA also has another $31 billion in preferred shares outstanding. BofA must pay $5.4 billion in annual dividends on its preferred-money that comes out of earnings and is not tax-deductible. Refer to Appendix: 10. Tully, S., DIVORCE BOA STYLE. , in Fortune. 16th Feb 2009.
[xvi] 14. May, J., Shareholders of ML and BoA sign off on combination, in New Jersey Business News. 5th December 2008. ; 15. Shen, D.M.a.L., BoA’s Lewis, Board Win Shareholder Value. 2008, Bloomberg.com.
[xvii] Government refused to take responsibility for losses on some of Lehman’s most troubled real-estate assets. In addition, Lehman reputation and customers are different from those of ML implied from a quote: “Merrill has the nation’s largest brokerage force and its name is known in towns across America, while Lehman’s main customers are big institutions.”
[xviii] 12. Sorkin, A.R., BoA in Talks to Acquire ML. 14th September 2008, Deal Book.
[xix] ML ppt term deal. The powerpoint slides only reveal the strategy and the method of payment. There was no assumptions, forecast or profoma statements. Paradoxically to most deals which have bidder’s statement, ML, the target presented its target statement and John Thain actually wanted Ken Lewis for a 10% stake. However the deal was concluded and announced within 48 hours!
[xx] 1. Damodaran, A., Investment Valuation Tools and Techniques for Determining the value of any asset. 2nd Edition ed. 2006, New York.
[xxi] Atlanta Business Chronicle, “Bank of America customers may have long-term opportunities” by Anonymous, 17th September 2008, available from: http://www.bizjournals.com/atlanta/stories/2008/09/15/daily63.html , accessed 22/05/2009.
[i] Refer to chart 1.[ii] This deal was announced after both chief executives met and discuss for 2 days. Most deals will take 6 months to 2 years to be announced for merger.