Vendor Management Considerations in an Acquisition Environment

The CEO of almost every bank we talk to is either looking to sell or has his/her eyes open for the right acquisition opportunity. While things have slowed down from where they were during our recent “troubled bank” period, most bank decision makers feel there is further consolidation coming. It’s a rare CEO that isn’t getting a regular diet of exploratory “buy” or “sell” calls, and with a boatload of investor money continuing to be made available, bank CEOs are feeling the need to prepare their banks to take on another bank – whether or not they really want to.

So how does this play into vendor management? Consider this Reader’s Digest condensed “real-life” example:

Neighborhood Bank is pursuing acquisition of Corner Bank. Following a review by representatives from both banks’ I.T. and Operations departments of all of Corner Bank’s third party agreements, the merger is approved and the integration begins. Before long, Neighborhood Bank’s CFO gets that dreaded call: “We have a problem. We just learned from Corner Bank’s vendor that someone at the bank signed a seven-year agreement right before the merger became final. The buyout is $___ million.” Before even getting started, Neighborhood Bank kisses its first and/or second quarter profits goodbye. The bank’s board of directors is a bit troubled by this, and all of a sudden the CFO’s priorities shift to a new focus on vendor management.

We have seen this happen countless times with various price tags attached. Many CEOs have heard the stories, and they’ve prepared themselves for the possibility of this phenomenon with a typical knee-jerk reaction of cautioning staff to enter into very short agreements. We would like to recommend a more detailed direction that includes some best practices on both sides of the “acquisition fence.”

The Acquirer

As an acquirer starts to look at an acquisition opportunity, it will be calculating the earnings potential of the consolidated bank. To do this, it needs a birds-eye view of ongoing revenue from the combined institutions, the ongoing expenses, and the one-time expenses associated with the integration. The acquiring bank can look to its existing vendors to determine what its ongoing expenses will be, but it needs to look at the target bank’s contracts to know what the one-time expenses associated with setting aside those agreements will be.

With some careful consideration and the adoption of a number of tried-and-true best practices, an acquiring bank can minimize the likelihood of show-stopper contract surprises. Our recommendations follow:

1. The acquiring bank must look at the target bank’s existing third party agreements with the same care that it would use to look at loan quality. The CFO should get a list of what each vendor has been paid for the last year and identify the vendors with the highest spending. To determine the key vendors, the CFO should use the 80/20 rule to take the 20 percent of the vendors with 80 percent of spending.
2. The due diligence team should obtain copies of each agreement associated with the key vendors identified. If the target bank is unable to provide these, it absolutely must retrieve them from the vendors. This has been the single biggest “miss” that we have found in our review of the deals that went bad, i.e., the target bank could not provide the agreements, the decision making was far along and fast paced, and the acquiring bank decided to proceed with the acquisition without reviewing the agreements.
3. Once found, the agreements and the current invoices should be reviewed by the individuals who have been responsible for negotiating similar agreements at the acquiring bank. If James down in card processing has been renegotiating the debit processing agreement for the bank for the last two decades, it is James – not the CAO, the COO or the CIO – who should be reviewing the target bank’s debit processing agreement and invoices.
4. The liquidated damages should be estimated for each of these agreements. The best way to obtain a liquidated damages estimate is for the target bank to ask the vendor account rep to provide one. We totally get how confidential the process needs to be during the due diligence process. However, we would submit that there is no need to tell the account rep why the bank is asking for the quote. The vendor’s job is to provide this type of basic information, and they are getting many similar requests these days. Second best method is to do the calculations in-house and then validate with the vendors at the earliest opportunity.

As the due diligence team goes through the process of deciding what systems and services the combined institution will use, they will have at their fingertips the potential ongoing and one-time costs associated with the target bank. Decision making will be improved and surprises will be minimized.

The Target Bank

A note of caution: a bank’s long-term third party agreements can make it unattractive to potential suitors. Banks that may be in play for an acquisition should have an organized plan for managing these vendor agreements. Our recommendations:

1. The bank with an awareness of standard contract term lengths stands a better chance of obtaining competitive pricing. For most of the major services (core, Internet banking, debit processing, mortgage servicing, etc.), this would be three to five years, with five being the more commonplace. The bank should stick with these standards and focus on getting “best in land” pricing. Going shorter on term and paying two times market is not going to make for a more attractive partner. The reason? The liquidated damages can often be higher for a bank that is going short on term and paying premium pricing for that privilege.
2. The right vendor/services coupled with the best pricing in the land can make a target bank more desirable to a suitor. They can also increase the odds that during integration, the bank’s systems will be the survivor or at least considered for the consolidated bank’s business. There is value associated with a good long term agreement just like there is with a good lease of a branch.
3. Even if approached tomorrow for a merger, there will be a significant time period from the point of initial approach to when the agreements will be terminated following full integration. This time period needs to be taken into account when looking at potential term lengths for agreements. We suggest reserving 12 to 18 months for the total integration time period depending on the acquirer’s skills and experience in integrating acquisitions.
4. A bank that stands to be sold during the term of an agreement should negotiate heavily on termination penalties. It should also try to get a declining scale for liquidated damages in the latter years of the agreement.
5. De-conversion costs should be clearly defined in the agreement. This will paint a clear picture of what an acquirer would need to pay to move the bank to its systems.
6. The bank’s vendor owners/negotiators should all follow the same strategy for negotiating with the vendors regarding length of term and ability to execute agreements. All it takes is one person to go long on a bad agreement to make a big negative difference.
7. All of the bank’s agreements should be packaged and ready for a good due diligence look. This would include the master agreement and all addendums for each of the key vendors. While this is a good habit to get into anyway, it is extremely important that this step be completed prior to the start of serious discussions.

These tips and techniques were presented with the intent of helping management teams understand the different activities that take place during a potential or realized merger opportunity. Our goal is to help banks get all of the systems and third party agreements integrated without fanfare so they can concentrate on the really hard part of the integration – i.e., the people side.
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