Strategic M&A in US banking: Creating value in uncertain times

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After a record-breaking year for US banking M&A by volume of deals, conditions changed in 2022. Although it has been a strong year relative to previous years, deal making slowed in response to economic headwinds, a potential downturn, and geopolitical uncertainty. Banking M&A deal volume was down 37 percent for the first nine months of 2022 compared with the first nine months of 2021.

However, if history is any guide, the current environment may present an excellent opportunity. Deal makers with the conviction to act during uncertain times have been much more likely to deliver strong total shareholder returns (TSR) than those who confine their deal making to bullish periods.1The power of through-cycle M&A,” McKinsey, April 30, 2020. In addition, M&A professionals in US banking predict that the near future will be a good opportunity for banking deals. In a recent McKinsey survey of 20 corporate-development professionals at US banks of different sizes and with different strategic priorities, 60 percent said the next 18 to 24 months will offer banks value-creating M&A opportunities that are better than those of the last two years.

For banks that pursue M&A, two broad themes are likely to dominate the agenda: we expect to see continuing consolidation and scaling of the banking business, along with fintech acquisitions to augment banks’ product propositions, access new customers, and expand technology capabilities. Based on our conversations with M&A experts, advisors, and banks, we have identified four actions banks can take to help them maximize the value they capture from M&A in the next 18 to 24 months.

Taking stock of the last 15 years of deal making

For most of the past 15 years, M&A activity in the US banking industry was minimal. Many banks were wrestling with challenging integrations and “shotgun” combinations from the financial crisis era. There were also regulatory constraints from Dodd-Frank. Starting in 2018, the pace of deals started to pick up in both value and number. By 2021, the value of deals was six times what it had been in 2017 (Exhibit 1). This uptick in deal activity occurred for several reasons: a partial relaxation of regulatory constraints for banking M&A, lower interest rates, strong balance sheets and income statements, and plenty of liquidity among potential acquirers after years of conservative lending and purposeful capital building.

Deal value and number of deals in the US banking sector surged between 2017 and 2021.

According to our research,2 deals done during times of economic challenge have had a higher probability of creating value. More than 50 percent of deals announced during the height of the financial crisis (from September 2007 to 2009) resulted in positive TSR two years later, compared with roughly 33 percent of deals done from 2010 to the first nine months of 2022 (Exhibit 2).

During the financial crisis, a majority of deals had positive excess total shareholder returns.

Why would returns be better for deals executed during down markets? First, there are usually more assets available to choose from during downturns, and valuations tend to be lower, giving more headroom for positive returns. Second, in times of uncertainty, absent regulatory interventions to “save” an institution, nearly all potential deals face a significantly higher level of internal scrutiny, so those that get approved and executed often boast an extra strong business rationale.

Another observation is that as deal activity picked up in 2018, the strategic intent of those transactions began to shift. While more than half of deals still pursue scale, the desire to build capabilities accounts for an increasing number of deals, as banks seek to enhance or expand their digital services and product offerings. By the 2019–22 period, deals to acquire capabilities accounted for 28 percent of transactions, up from 11 percent in 2010–12; 71 percent of these deals were successful, compared to the average of 28 percent for all deals (Exhibit 3).

US banking transactions increasingly have a strategic intent to add capabilities; fewer aim for geographic expansion.

The outlook for banking M&A

Several forces will determine how banking M&A will develop in the coming two to three years. Factors leading to an increase in deal numbers and size include current muted valuations (particularly in the fintech space), tighter capital markets that reduce available funding critical for growth fintechs, and margin pressures on lower-performing banking institutions caused by inflation and higher reserve requirements ahead of a potential recession (which tend to make these lower-performing banks more amenable for deal talks). Among the forces potentially suppressing deal activity are rising interest rates, geopolitical tensions, as well as the fact that in the current conditions, fewer bank executives may believe they have sufficient free capital to pursue M&A.

In this context, we believe that for well-capitalized banks, the moment may be right to act on two broad strategic M&A opportunities: further inorganic scaling of the business and leapfrogging on capabilities and talent by buying fintechs. At the same time, acting will require thoughtful consideration and courage.

Consolidating and scaling the business

As we have previously argued,3Realizing M&A value creation in US banking and fintech: Nine steps for success,” McKinsey, November 15, 2019. conditions are ripe for further consolidation of the banking market in the United States, given its still-high level of fragmentation. While the pace of consolidation has slowed recently—with only 160 banking institutions being acquired or exiting the industry from 2019 to 2021, versus an average of 240 banking institutions acquired or exiting the industry between 2013 and 2015—more than 4,000 banks continue to operate in the United States.

An important condition that favors consolidation is that banking is becoming an increasingly fixed-cost business, due to necessary investments in technology to meet ever-rising customer expectations, as well as marketing to attract clients who are becoming more open to move or fragment their banking relationships. Larger institutions can afford to invest significantly more. For example, banks with more than $250 billion in assets in 2021 spent, on average, $1 billion on marketing; banks with $100 billion to $250 billion spent just $25 million, and banks with less than $100 billion in assets spent only $2 million. The largest banks are also able to achieve significantly better outcomes in digital. For example, compared with smaller banks (based on data from Finalta), they enjoy more than twice the share of sales through digital channels.

In addition, in many consolidated and mature markets (for example, Australia and Germany), the largest banks enjoy efficiency levels almost three times better than those of the smallest banks.4McKinsey’s Global Banking Annual Review,” December 1, 2021. In the United States, this dynamic is not as prominent, possibly because smaller US banks still achieve significant scale compared with banks in other markets. Another reason may be that the market structure historically allows smaller banks to generate solid margins through the low cost of funding secured by their granular deposit base.

In the longer run, however, we expect the consolidation pressures to become ever more prominent in the United States as well, in response to adoption of digital and the growing mobility of customers who rely less on physical channels. Along with these pressures, overall bank valuations have declined—for example, the S&P Composite 1500 Banks (Industry) took a dip of 22 percent in price-to-book ratio and 25 percent in market cap from January 1 to June 30, 2022—which also should drive continuing consolidation.

Acquiring fintech expertise, customers, and talent

Financial institutions have been focused on building digital capabilities for more than a decade now, both organically and through M&A. As fintechs struggle to raise capital and suffer valuation declines, near-term opportunities for these kinds of acquisitions will likely proliferate. Indeed, in our recent survey of US banking corporate-development professionals, some 75 percent expect banks in general to buy more fintechs in the near future than in the last two years.

Is it also likely that in the coming 18 to 24 months more fintechs will become open to acquisition by banks? Our analysis shows that publicly traded fintechs lost on average almost 60 percent in valuation from December 21, 2021, to August 22, 2022, with the change in individual subsectors varying from -32 to -88 percent. With privately funded fintechs, the story is different: companies that could raise funding gained in valuation, but the total number of rounds of funding and their value have dropped dramatically for all categories of fintechs except players focused on cryptocurrency and decentralized finance (Exhibit 4).

Public fintechs have lost in valuations; private ones have undergone major declines in deal activity and total funding volume.

Despite recent headwinds, fintechs are on track to raise the second-highest amount of capital ever in 2022, and venture capitalists have plenty of dry powder, so investing might come back quickly. If this proves to be the case, the window of opportunity for banks to acquire capabilities may be narrowing quickly. As one survey respondent put it, “We’ve realized that acquisitions are the only way to compete effectively with disruptors and big banks; now we intend to become a programmatic acquirer.”

Creating value through M&A in times of uncertainty

Given that deals completed during times of economic challenge have had a higher probability of creating value, we believe it is incumbent on banking leaders in the current environment to carefully examine M&A opportunities, and responsibly consider those they believe can efficiently generate positive returns for shareholders.

Based on our recent survey of US banking corporate-development professionals, we identified three main challenges to successful bank-led M&A in the current context:

  • finding the targets to support programmatic M&A
  • integrating acquired technology
  • integrating acquired talent

We then interviewed our own M&A practitioners to distill a set of practical actions to address these challenges. These actions are relevant for banks of all sizes, but particularly so for regional banks with less M&A experience, especially when the deal involves complex tech integrations.

To find targets, revisit your M&A blueprint—now

Times of uncertainty can be opportunities for a bank to greatly step up its M&A blueprint—that is, to explicitly define M&A’s role in achieving its corporate strategy. This point is especially true today, given that the current cycle is strongly driven by inflation and interest rate movements, which have a disproportionate impact on financial-sector valuations.

Best-in-class banks ensure that each business unit continuously reevaluates options to make, buy, or partner to deliver on its strategy and constantly identifies and cultivates potential target candidates. The best bank acquirers leverage challenging times to refresh and greatly expand their M&A target list by identifying hundreds of potential candidates; they challenge themselves to bring in two or three times more new names than the number of usual suspects reviewed in the past.

Given recent market developments, such as higher volatility, lower valuations, less venture capital funding, and fewer IPOs, now is an opportune moment for potential acquirers to broaden their M&A thinking and spread the net as wide as possible. They should greatly expand efforts at cultivation such as get-acquainted meetings. Not only are doors open much more in these times, but even if this cultivation does not end in an M&A transaction, it often can lead to partnerships that enhance the bank’s understanding of growth sectors and put stakes in the ground, in the form of equity investments initially, that may raise the probability of deals later on.

To acquire and integrate technology, emphasize it during due diligence

Before any due diligence of a target can begin, it is advantageous for a bank to know its own aspirations and target state in technology. Too many players dive into M&A without knowing where they are heading and what is important for them. This makes it harder to perform good diligence and test whether the acquisition candidate is the right fit and whether the combination of IT integration costs (which tend to be material and often higher than initial estimates) and the attractiveness of technological assets justify doing the deal.

A good process for due diligence should enable a high-level view of the path to integration. That path typically can take one of three directions:

  1. Merge fully to one bank stack. This is the fastest and least risky option.
  2. Create a “best of breed” combination of technology—for example, combining the wealth management platform of the target with the acquiror’s existing tech platform.
  3. Use the merger as a trigger for a more profound tech transformation. Given the costs of integration, in other words, why not try to build the “dream bank”? Note, however, that in our experience this path rarely leads to success.

Due diligence often overlooks technical issues that can cost many millions of dollars and take years to fix.

It is often the case that this high-level view of the path to integration is disproportionately focused on finance, risk, and legal issues, overlooking technical issues that can cost many millions of dollars and take years to fix. Diligence needs to help understand target’s current architecture, infrastructure, talent, data assets, and technical debt.5Demystifying digital dark matter: A new standard to tame technical debt,” McKinsey, June 23, 2022. Accomplishing this requires the involvement of the CIO from the buyer’s side and one or two key IT experts early in the due-diligence process. This can ensure that their input is taken into account when quantifying the potential deal impact (in terms of both synergies and integration cost) and, more importantly, can help the bank understand what it would take to achieve the deal rationale—say, integrating enterprise resource planning systems, given the need to operate as a single entity. Involving the technology team early on and including their input when assessing the impact of tech value creation (either positive or negative) also allows for accountability across the technology organization. That will be the key to ensuring minimal discrepancies between the due-diligence estimates and the actuals.

In contexts where technology is particularly important to the deal thesis, organizations set up a clean team early in the process. The core outcome of such team’s work should be target architecture, integration/run costs, and estimated timeline. Development of the timeline should consider the upgrade path of both the target and the acquirer; in at least one merger, both companies had outdated core banking systems, so integration could not proceed until after one had completed an upgrade. Achieving these elements of the core outcome requires close collaboration between business and tech experts in the process of due diligence.

This level of technology due diligence is a prerequisite to an effective integration and value capture. Typically, the IT road map determines a large part of the synergies achieved.

Further support technology integration by rewriting the integration playbook

In our experience, 40 to 50 percent of M&A value capture is enabled through technology integration—and for fintech acquisitions, the percentage is even higher. Yet several of our interviewees said banks are often slow to start integration planning for technology. As a result, they miss the opportunity to get an early start on cataloging key processes and systems to support cost and revenue synergies, identifying and responding to change management needs when they are most impactful (for example, during the first 100 days after the close), and establishing a plan to tackle divergence issues.

Involving the CIO and technology teams early in the diligence phase allows for a smoother technology integration planning. During due diligence, the business will have already been aligned with the technology team, and they will have established a high-level understanding of which tech migration and integrations are required, as well as of financial benefits and the cost and timing required for the integration. These conditions allow for better prioritization and sequencing of tasks. In our experience, tech integration costs are always material but often underestimated; they can amount to as much as 5 percent of target’s revenue.

Another significant challenge that banks face during technology integration planning is that they overestimate their capacity to achieve the change needed across three fronts. First is integration delivery capacity, because during technology-heavy integrations, banks have more tech projects than ever before. Second, the target might have critical technology knowledge that will be difficult to replace if the talent decides to leave. Finally, acquiring banks may discover a lack of integration capabilities. Overestimating the bank’s capacity makes any kind of change management difficult at a systemic level.

These pitfalls threaten the bank’s ability to realize the benefits of the acquisition in both the short and long term. We have seen banks that continued operating on multiple core banking systems more than five years after a deal closed. This can impede data access, hurt customer service, and create larger technical debt.

Banks can alleviate many of these challenges by deploying a comprehensive integration-planning framework early. Such a framework would take parallel paths: a future-state blueprint and a road map to reach it, along with integration of the IT function itself. To proceed quickly, players in other industries adopt agile practices—for example, by running planning as a series of intense multiday sessions, during which experts from both sides detail the future tech architecture, the new product road map, and the true cost of integration.6How to find and maximize digital value in any M&A deal,” McKinsey, November 9, 2020.

To integrate and retain talent, use science to define decisive action

Even the most experienced acquirers struggle to integrate talent and combine cultures during an acquisition, and this is particularly true for fintech integrations. Banks’ siloed environments and more hierarchical decision-making processes can frustrate acquirees and cause serious cultural shock—especially for smaller fintechs that are used to a more entrepreneurial setting. The consequence is a high rate of talent attrition. Banks should streamline decision making and provide greater operational freedom. Before the COVID-19 pandemic, many banks didn’t let engineers work remotely, for example.

We have observed the following practical solutions to this difficulty:

Deal makers who act during uncertain times are more likely to deliver strong TSR.

  • Be data driven in identifying key talent and diagnosing gaps in culture (including decision-making approaches, communication style, and norms for collaboration and knowledge sharing).
  • Decide on the truly necessary degree of integration to avoid hugging the acquiree to death. For example, to what extent must a bank’s risk, compliance, financial, and other controls be extended to the acquiree’s teams? Translate that decision into considerations on how and to what extent the ways of working (such as the use of tools and the product development process) need to be unified.
  • Give the acquiree’s leaders a meaningful role in the new organization and secure their commitment to retain talent and engagement. In one case, the CEO of an acquiree became the permanent head of a massive product line, bringing his product development and commercial expertise.
  • As soon as possible before the close, parachute in full-time leaders for critical roles as ambassadors and sources of information for integration planning. For example, select a finance partner for a secondment to align financial controls and compliance.
  • Align quickly on top-management practices, including decision making and accountability norms, performance management and application of key performance indicators, and talent development.
  • Double down on communication. Assign a full-time communications leader to cover all groups of internal stakeholders.

Deal makers who act during uncertain times are much likelier to deliver strong TSR than those who confine their deal making to bullish periods. The next 18 to 24 months should offer ample opportunity for value-creating deals. Success, however, will depend not just on confident action but also on robust due diligence and planning.

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