Paladin Blog

The M&A Analysis: The Impact of Core IT Contracts on M&A

Posted by Aaron Silva on Oct 10, 2014 4:03:12 PM

Chapter 1 - The M&A Analysis (Special Edition)

Special Edition MA Analysis

Two annual studies by the BPI Network (June 2013 and July 2014) include specific details from several recent merger deals and proves that Core IT contracts are increasingly, and now more than ever, ambushing unwitting bank leaders and negatively impacting mergers. In some instances Core IT contracts are outright killing deals before they can even start.  Bank leaders are usually the cause due to a lackadaisical approach toward these business concerns - mainly because few of them understand this area of Non-Interest Expense nor have they previously received training on how to negotiate these areas of an agreement. 

More than a Thorn in Your Side

The last thing you want on your plate is something, anything, that gets in the way of your potential merger (buy or sell).  A merger strategy can take many months or years to execute. The number of experts, lawyers and outside advisors can be daunting to manage.  Keeping internal morale high, shareholders in line and the board on board increases the time suck.  The bottom line matters more now than ever when trying to calculate tangible book value or the long-term accretive impact of a deal or the operational efficiency it might add on day 2 of the merger.  A thorough read of more than 200 Core IT contracts from popular service providers illustrates the problem with legal terms and conditions as it relates to mergers. The table below details the result of this research:

To access a full version of the table please click here.

MAtable

A read of the table shows that your friendly vendor/partner controls their merger interests lock, stock and barrel.  Frankly, they deserve to control the market and your merger transaction because for too many years the industry has ignored the fine print in these contracts with leaders queuing up obediently; signing inch-thick contract renewals every 5 to 7 years for decades. 

There are no CIOs running Banks and Credit Unions

Vendors have massive teams of lawyers, experts and thousands of years experience negotiating these agreements with Bankers (yes, you). Bankers are professionals who understandably have little experience or formal training on your resume to understand what in the heck it all means, what’s missing and what to ask for differently.  Many bank leaders understand their limitations and delegate the study of Core IT contract impact from a potential merger to their IT folks inside the Bank or Credit Union. Problem is too often that few of these professionals are qualified to understand the business and legal terms found in Core IT agreements, let alone how to calculate the negative and positive impact of combining the contracts from two entities together and then advising the leadership and board on what to do.  The facts are that with institutions under $2 Billion in assets there are few classically trained CIOs within their ranks.  A real CIO not only is the head geek of the franchise but they also understand the business and legal implications of these complex relationships in the short and long-term. In many of my talks around the country, at banking conventions, I will ask C-level bankers to raise their hand if they delegate the assessment and negotiation of Core IT contracts to the internal IT leader.  Then I ask them to put their hands down if they also allow that IT leader to sign the same multi-year, multi-million dollar deal…very few hands go down.

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Recently we worked with one entity in the mid-west where the CEO actually believed that the 80% contract value termination penalty associated with “Termination for Convenience” only applied to when the Bank voluntarily left their core processor for another competitor, conveniently.  In his mind termination penalties for selling the Bank was something completely different – it was not convenient -and therefore they thought that the vendor should provide a less aggressive termination schedule (including 0%) if they sold the bank!  If one of your customers buys a 6-year CD and then comes in a year later and wants all their money back – do you give it to them?  The reality is a services contract is not a real contract if there is not some penalty for exit. 

The Prospect of a Hanging Can Focus the Minddead_suicide_fingers_hanging_finger_desktop_1440x900_wallpaper-140926

A merger is certainly not a hanging but screwing one up can certainly get you hanged.  Too often these contracts do not come into focus until due diligence begins.  After an LOI is signed, both institutions setup a data escrow or sharing folder and begin to hike up their pant leg providing details on loans, operations, financial performance and invariably Core IT contracts specifics. The art of assessing the impact of these contracts on the merger operationally and to your shareholders is not limited to the termination for convenience expense but more so the hidden terms and details about the cost of exit and entry into a new services agreement.

Remember that when two institutions merge one contract dies and one survives.  Or, in some instances, a portion of both contracts survives and dies which can make the complexity difficult to calculate.  Your institution may want to abandon some of your current services in exchange for services your target may be using.  If the vendor is different you can expect a pound of flesh to exit a market-inferior product for a stronger option on the other side of the fence. My initial advice is that waiting until the LOI is signed and due diligence underway is way too late. In any negotiation you must always find ways to preserve and build leverage and if you approach your vendor in the midst of a transaction they know they’ve got you right where they want you. Their strategy reduces immediately to protecting their interest, holding their ground and adding premiums wherever they can. 

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Only about 1 in 5 institutions buy another franchise and then switch to their processor and incumbent vendors are well aware their vulnerability is still manageable. Few Banks have the juice to operationally handle the HR impact of a merger while also converting systems away from the tried and true partner.  The smart banker negotiates terms, conditions and pricing into their existing contract much earlier than the actual event, and ideally during a renewal period, typically 24 to 18 months in advance of expiration.  In this window the vendor is most vulnerable and since a transaction is not imminent they must speculate on the future with you. The uncertainty converts into leverage that can be used by your team – assuming you know what to ask for in the first place – to get what you want into the contract ahead of the merger. The table above outlines the absurd unfairness of most all contracts issued across the country. If you buy, the price of acquisition is either undefined or very high.  If you sell, the price of exit is very high and undefined. Both scenarios add material risk to the transaction.  If something goes wrong during the conversion or de-conversion, installation of new services or integration between bank systems – in 96% of the contracts we studied the limits of liability are mastered by the vendor – your bank or credit union is fully exposed.

Be Proactive, Not Reactive

This is hardly a new notion – we’ve all heard it many times before but that really is the key here.  If buy or sell is in your strategy in the next 3-5 years you need to get those contracts studied now.  We routinely perform merger readiness assessments  here at Paladin to help institutions understand where the vulnerabilities are and if anything can be done about it.  Access the Paladin Blue Book through our experts to understand the premium being paid for services and determine if any of these can be optimized, improved, tiered or adjusted to make future merger activity more accretive, faster. Don’t let a call to the dance floor surprise you – it could cost your franchise a lot of money and headache.

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Topics: Paladin Research, vendor merger, M&A