The recent leak – then confirmation – that Abu Dhabi Commercial Bank, Al Hilal Bank and Union National Bank, three Abu Dhabi banks, are in talks to merge sent share prices soaring, and had market commentators cheering the news.
Consolidation in the regional banking sector is long overdue, and Abu Dhabi has already shown how to do it, with the creation in 2017 of First Abu Dhabi Bank (FAB), from the merger of National Bank of Abu Dhabi (NBAD) with First Gulf Bank (FGB). Markets like the story, with FAB’s share price having risen some 50% in the past year. All commentators agree that the region is overbanked – the UAE particularly so, with 49 banks for a population of just 9 million. Mergers are also underway in Saudi Arabia, Qatar, and Bahrain.
But why has it taken so long for the sector to consolidate? There is universal recognition of the need for consolidation. But the simple fact is that if banking mergers were easy, this urge to merge would have started long ago.
One of the major stumbling blocks to any merger or acquisition is valuation. What is the business worth? What is a fair price that both sets of shareholders will accept? And how do we structure any deal to ensure the combined entity is able to start trading and operating without a hitch?
These questions are not easily answered by banks in the region. They are not used to M&A activity, and while there is no shortage of analysts running models to provide valuations, the proprietary corporate knowledge required to undertake a deal is too often absent. Boards, CEOs and CFOs of regional banks are expert at running large companies or funds, managing risk and growing steadily through the economic cycle. Where they often lack experience is in M&A activity – simply because it is relatively unknown in the regional banking sector. And of course, once the conversation has started with a potential merger partner, it is already too late to start learning about valuation.
But there is a source of knowledge they can turn to: their own IR function.
If anyone inside a bank is familiar with the science and practice of valuation, it will be the IR team. They know and engage with the analyst community that values their firms every day; the best teams will be regularly benchmarking their valuations against their peers; the IR department should also know how much and where portfolio managers have made allocations in the banking sector; and the IR team holds a deep knowledge of what investors like about the banks – and what they dislike.
The current wave of mergers – SABB and Alawwal in Saudi Arabia, IBQ and Barwa Bank in Qatar, Kuwait Finance House and Ahli United of Bahrain, and in Oman Bank Dhofar and National Bank of Oman are in talks – is also a test of the strategic depth of the IR function among these banks. Those with a strong and well-resourced IR team will be at an advantage once the urge to merge takes hold in the Boardroom.
The strong IR team has a real strategic edge and role to play when it comes to valuation. Banks with a properly resourced, empowered, and sophisticated IR function will hold an advantage in times of M&A activity. They will be able to put together realistic valuations, structures and plans to ensure any deal is value-enhancing. And the flip side of this is that those banks without a strong IR function will struggle to negotiate a good deal for their shareholders.
The wave of banking consolidation is about to provide the IR profession with a fantastic opportunity to prove its strategic value.
Any merger is risky, and in a sector that has historically resisted consolidation, all proposed mergers carry the risk of failure. There are four main impediments to consolidation, and while Abu Dhabi is to be applauded for overcoming them, they still exist and will need to be beaten before more bank mergers and takeovers can take place.
The first is complexity. The sheer scale and difficulty of combining IT systems, customer records, workforces, branch networks, balance sheets and international presence, all in a heavily regulated sector, means that many mergers fall at the first hurdle. What looks simple in a Boardroom PowerPoint presentation often turns out to be far more complex and costly. As the benefits of a merger fade with every new layer of cost and complexity that is unveiled, appetite for change dwindles.
Second, a key driver behind any merger is cost savings and synergies, which means there are tough decisions to be made. While FAB has never confirmed the headcount reduction that followed its creation, in total 1,300 banking sector jobs disappeared from Abu Dhabi in 2017, according to Statistics Centre Abu Dhabi (SCAD). Many of these could have been a result of the merger. Add in branch closures due to duplication, rationalisation of suppliers, and some inevitable customer attrition, and a lot of blood must be shed before any benefits can be realised. For many Chairmen and CEOs, this attrition, with its potential for reputation damage and inevitable human cost, is a bridge too far.
The third impediment resides in the Boardroom. Ownership structures of banks in the region often include powerful family groups, government shareholdings, and quasi-state ownership (for example via sovereign wealth funds). The current example in Saudi Arabia of Alawwal’s merger with SABB is complicated further by the presence of HSBC and Royal Bank of Scotland as sizeable minority shareholders on both sides. When large institutional shareholders are added to the mix, with huge global experience of M&A, there should be little to stop a merger proceeding – but the valuation and final terms must be acceptable to all.
These large holdings can be hugely difficult to unwind, without the explicit and enthusiastic commitment of all shareholders. Once again, when the full scope of a merger is examined, and winners and losers begin to emerge, the desire for change can diminish.
The key to a successful merger is to keep one’s eyes on the prize. And the prize is potentially enormous.
Banks in the Gulf have a key advantage over their peers in many parts of the world: they are consistently profitable, and very prudently managed. Double-digit returns on equity are the norm in the region, while international players have struggled to reach 8 or 9 percent since the onset of the financial crisis a decade ago. Regional cost to income ratios are very low, often in the low 30’s, meaning they are highly efficient and lean. And balance sheets are conservative, with low leverage and high capital levels.
All of which has led to a fourth impediment to mergers: the notion that “If it ain’t broke, don’t fix it.”
But events have conspired to mean that the logic of a merger outweighs the fear of the pain it might induce. After several years of low oil prices and government cutbacks, profits are harder to come by. Global banks are mopping up the big ticket deals in the region, in advisory and underwriting roles, because they have the scale to do so. (Saudi Aramco is expected to issue the biggest corporate bond in history, for example, and there are no local banks on the advisors list.) The opportunity cost of not merging is becoming too high for a responsible board to contemplate.
And the final reason for the raft of mergers among banks is the presence of international shareholders on their registers. The performance of FAB since the merger is precisely the kind of game-changing return that emerging market investors are looking for. FAB became a major institution overnight, the largest bank in the GCC, meaning it can compete at home and abroad for business far more effectively than its peers. That is a key driver of including the bank in portfolios for investors around the world.
The pain of merging is not to be underrated; but the rewards of a successful merger can outweigh them, and we will see much more consolidation before long.