Opportunities for Action in Financial Services. Banking à la Nike and Dell: Achieving Scale Without Acquisition Premiums

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1 BankingNikeDell 5/27/03 11:52 AM Page 1 Opportunities for Action in Financial Services Banking à la Nike and Dell: Achieving Scale Without Acquisition Premiums

2 Banking à la Nike and Dell: Achieving Scale Without Acquisition Premiums Lower growth rates, accelerating consolidation, and increasing pressure on margins are forcing many financial-services institutions to rethink their vertically integrated business models. This is happening not only to medium-sized players whose profitability is frequently lower than that of the largest banks due to a lack of scale but also to larger players that seek to be the dominant force in a given product or business area. The problem is how to enhance scale without traversing the minefield of mergers and having to pay the high premiums that acquisitions often require. An attractive option for many financial institutions is to create joint ventures aimed at sharing external sourcing, operations, and platforms for systems and delivery. Although such initiatives are relatively new in financial services, they have proved to be critical differentiators for top retailers. Companies such as Nike (athletic footwear and clothing) and Dell (computers) have realized that their core competencies lie in business strategy and in the management of brand, customer experience, distribution, and risk not in manufacturing. Forward-thinking banks are now following their lead, forging joint ventures to gain scale in numerous noncore activities, such as procurement, operating processes, business processing, selected products, delivery channels, and information technology. The Boston Consulting Group s case experience indicates that if partners are reasonably close in size within 30 percent of each other in terms of such criteria as number of branches and employees these ven-

3 tures can be extremely effective in cutting costs, gaining economies of scale, and boosting profitability. Broadly speaking, there are two models. The first seeks to maximize within-market synergies by combining and sharing processing and delivery platforms across products or functions among two or three domestic players. The second seeks scale in a more focused way, through shared processing of a specific product or business area. With retail and corporate banking likely to deconstruct from an integrated model into one resembling Nike s and Dell s, successful players will position themselves as orchestrators leveraging their strategic capabilities in customer relationships, distribution networks, and brand management while achieving scale in many other areas through a joint venture model. This era of coopetition is in its nascent stages in financial services. Therefore, fast-moving players that get a head start on the venture assessment process may be best positioned to structure the most attractive deals with the most alluring partners and achieve sustainable profitability and competitive advantage. Anatomy of a Venture The history of the financial services industry clearly shows that the majority of acquisitions and joint ventures fail to create real value (although ventures have a better track record than acquisitions). 1 That s why it is critical for potential joint-venture partners to address the difficult business issues up front and ensure that the agreement makes sense from the standpoint of value creation, fairness to both parties, and posi- 1. A BCG study on this topic was featured in Mergers: Why Most Big Deals Don t Pay Off, BusinessWeek, 14 October 2002.

4 tioning for future growth. The factors that will be crucial for success and those that could lead to failure need to be identified and examined. In our experience, venture structuring should be a sequential process for any two partners, with a fundamental decision made at each juncture regarding whether to proceed forward. We recommend six steps: Envision: Develop a shared view of the endgame, the strategic rationale behind the venture, and the importance to each party of its success. Define: Clarify the venture s objectives and scope. Shape: Assess success factors, define partners contributions, and decide how to position the venture vis à vis the parent companies and the market. Forge: Hammer out the detailed structure and terms of the deal, its financial and strategic value, corporate governance, and IT parameters. Implement: Put the main work streams in place, establish communication and contingency plans, and launch the venture. Evaluate: Manage and track the venture s progress. Any two players considering a joint venture can start with a preliminary step: a detailed benchmarking and economic modeling to compare each other s competitive positions. Even if a venture is not ultimately pursued, such an exercise allows the players to have a close look at their respective operations, to develop a granular, inside-out competitive assessment, and to adopt appropriate best practices from each other. It can also lay the groundwork for an exploration of synergies and value creation that could lead to a possible

5 venture especially if the parties become comfortable with their ability to work together. Although the potential benefits of joint ventures in noncore activities typically do not reach the scale gains of a full merger 50 to 60 percent of total expenses are out of scope the risks are not as great as those of a full merger either. Moreover, joint ventures often uncover initial scale-related cost-reduction opportunities of about 20 percent of the combined cost base. Such ventures can also be positioned to generate new revenue streams by processing for third parties. The Case of Tiger and Leopard We know two banks in an emerging market let s call them Tiger and Leopard that found themselves caught in what we call the trap of the medium-sized bank. Each exhibited attractive efficiency ratios, but their cost structures compared with those of the largest players in their market were putting them at an increasing disadvantage. Finding a pragmatic solution had become a strategic imperative. With BCG serving as a venture catalyst and navigator, Tiger and Leopard decided to assess the viability of the Nike-Dell strategy of outsourcing their operations to jointly owned processing ventures. They began an in-depth operational benchmarking project to define best practices and to build a business case around cost-reduction and efficiency-enhancement opportunities in their processing, IT, support, and business platforms. Although the agreed-upon scope of the venture meant that only one-third of the companies respective cost bases could be addressed effectively, value creation initiatives were identified that cut the cost gap versus the market leaders in half. The main opportunities included:

6 Joint purchasing of goods and services through strategic sourcing levers (mainly standardization and pooling of volumes) Common processing for scalable products (such as checks and documents) and services (such as collection) Shared processing platforms and infrastructure, including data centers and backup sites This new paradigm views the banker much like a retailer, sourcing quality products and services from the market and delivering them effectively through a superior customer experience. (See Exhibit 1.) Exhibit 1. The New Banking Paradigm Core Competency Levers Distribution Management Brand management Risk management Products Business strategy Consulting Services HR strategy IT strategy Finance/ control Shared Processing Ventures Procurement Strategic sourcing Collection Scale New abilities Processing Scale Lower costs Security Products Scale Rapid introduction Lower costs Basic products Technology Scale Basic solutions Lower costs Partnership in value creation Applications development SOURCE: BCG case experience.

7 The Forging of Eurohypo A prime example of a product-oriented joint venture is Eurohypo, the successful real-estate financing business formed by Commerzbank, Deutsche Bank, and Dresdner Bank in Eurohypo was created in response to increasing return-on-equity pressures for the parent companies, low margins in the real-estate Exhibit 2. Cost Synergies at Eurohypo 1 Cost structure (slope effect) Fixed Variable 100% 100% 2 Efficiency (intercept/vertical move) EM 1 EM 1 Unit cost Volume 3 Volume 2002 (scale effect) 2005 Operations and infrastructure Work force reduction Corporate center Distribution networks Back-office functions IT systems Early agreement on a common system Accelerated migration Reduction of redundancies SOURCES: Eurohypo analyst presentation; BCG analysis. 1 Efficiency metric.

8 financing business, and the need to achieve scale. In essence, the three German commercial banks bundled their real-estate financing businesses into a separate venture and largely terminated their own individual activities in this area. The goal was to achieve processing scale (Eurohypo currently has around 25 percent of the German market), deliver factory-style processing and administration of private-home loans, and offer an open platform. Eurohypo has also enabled third-party providers to convert their fixed costs into variable costs through outsourcing and to concentrate real-estate financing expertise in one optimized unit. The cost synergies of Eurohypo are mostly driven by operations, infrastructure, and IT. The venture effectively leverages best-practice processes, combined volumes, and a higher degree of automation. (See Exhibit 2.) These synergies will likely amount to around $120 million per year beginning in Assessing the Options Despite variations from country to country, the intensity of the global forces reshaping the financial services landscape is having a profound impact on both developed and emerging markets. In the former, ventures along product lines such as Eurohypo are more likely. In the latter, ventures such as the one between Tiger and Leopard which is benefiting both parties and still evolving will be more applicable. Why do such joint ventures present an attractive opportunity? Because other methods used to escape the trap of the medium-sized bank (or for a large player, to achieve market scale advantage in a given product area) have issues of their own. Organic growth, for example, takes time and does not offer

9 the opportunity to jump-start critical mass and process efficiencies from a venture partner s best practices. Acquisitions, more often than not, destroy value. Streamlining one s business presents very tough choices regarding which products and markets to compete in. Although these initiatives can bring considerable value if executed well, the venture option better suits institutions that want to retain their franchise and control their core assets, customers, and competencies while achieving scale benefits relatively quickly. Moreover, bringing in third parties as junior partners or customers can enhance the margin impact of such ventures. And additional value can be created by expanding the venture s scope once the founding partners have built a joint track record. If you believe your institution s core competencies reside in customer management, brand, and distribution and that processing scale is becoming a critical competitive issue we urge you to consider the following three questions: Do you share a Nike-Dell endgame vision in financial services? Are cost reduction and moving to more variablecost-driven formulas top priorities for your organization? Is building your core customer-centric capabilities a strategic focus? If your answer to any of these questions is yes, your organization may benefit from an initiative aimed at identifying potential partners and assessing the feasibility of joint ventures in noncore business processes and activities. A deep operational benchmarking exer-

10 cise with a relevant peer to mark to market your efficiency and business-process practices is a low-risk option that can allow you to better assess your competitive position. Our experience has shown that the essential success factors in such ventures are common vision and trust. There are also sure-fire deal killers, such as failing to address cultural differences, agreeing to unbalanced value sharing, and allowing the venture s interests to be overshadowed by those of the parent companies. But if the partners can find a way to work together, their respective competitive positions and profitability can be significantly enhanced. Antonio Riera Robert Davies Gustavo Wurzel Jürgen E. Schwarz Antonio Riera is a senior vice president and director in the Boston office of The Boston Consulting Group. Robert Davies is a vice president and director in the firm s São Paulo office. Gustavo Wurzel is a manager in BCG s Buenos Aires office. Jürgen E. Schwarz is a vice president and director in the firm s Frankfurt office. You may contact the authors by at: riera.antonio@bcg.com davies.robert@bcg.com wurzel.gustavo@bcg.com schwarz.juergen@bcg.com The Boston Consulting Group, Inc All rights reserved.

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