To some it may seem odd that Merrill Lynch had no financial adviser on a deal of this magnitude. But MerrillÆs CEO John Thain realised he had to negotiate it personally. It was critical that the US investment bank forge a deal with BoA. The fate of the 94-year-old firm, its debt and equity holders, 60,000 employees, clients, customers and various others hinged on a successful outcome to the merger discussions. At this critical juncture, Thain seems to have placed his faith in himself first and foremost.
And Thain delivered. On Monday morning he gave Merrill's stakeholders a merger deal, which based on FridayÆs close, valued Merrill at $50 billion, 1.8 times tangible book value and 12 times its 2009 consensus earnings. The ratio translated into $29 a share, a 70% premium to Friday's close, although the hammering the share had taken recently became evident when the price was presented as just a 29% premium to the average close of the past five days.
It is speculated that BoA approached Merrill Lynch in the summer with a takeover proposal and was rebuffed. It's likely that Thain subsequently went out on a round of capital raising and gauged the sentiment of the market to be quite poor. The sovereign wealth funds had all lost money on the equity investments they made in other global financial institutions since the subprime situation began in 2007. Bad news continued to emanate from financial firms, causing severe erosion of confidence among market participants, and showed no signs of abating.
Things may have reached a head on Friday, September 12, when US treasury secretary Hank Paulson attended an emergency meeting of financial institutions held at the offices of New York Federal Reserve Bank president Timothy Geithner to resolve the Lehman situation. A Fed spokesperson has confirmed that the meeting was held but not who participated. Media has reported that the meeting was attended by Exchange Commission chairman Christopher Cox and head honchos from most banks including CitiÆs Vikram Pandit, Jamie Dimon of J.P.Morgan Chase, Morgan StanleyÆs John Mack and Lloyd Blankfein of Goldman Sachs.
Thain confirmed in a press conference on Monday morning that he was at the meeting.
The meeting was convened to discuss Lehman but Thain had his own worries. Merrill's share price had closed at $17.05 on Friday, touching a new low. The contagion from Lehman had spread to Merrill û and the rest of the financial sector in the US û very quickly. And the Fed had made it clear in the meeting that it was not providing bailout financing or backstops. Thain probably realised after the meeting he had a chance to reach out to BoA CEO, Kenneth Lewis, but the window of opportunity was narrow.
It was also critical for Merrill that any potential deal be concluded quickly. Thain had watched events unfold at Lehman. Some sources suggest media reports on September 8 saying Lehman had not been able to reach a deal with Korea Development Bank were what spooked investors, who concluded that there was no financial investor who would bail out the US bank. Short sellers dumped Lehman shares, which lost almost 40% to reach a nine-year low on Tuesday, September 9. The market mayhem spread further when Lehman announced worse-than-expected third quarter earnings the following day. The earnings were released a week early û a move that, ironically, was meant to contain the panic.
Thain talked pricing and valuation on a principal-to-principal basis without involving advisers, says a source not involved in the BoA deal. Although Goldman Sachs and Morgan Stanley received league table credit as advisers to Temasek on its earlier acquisition of a stake, Merrill, not surprisingly, did not open its books or share its business plans with its closest competitors. And this time it was even more critical that no-one on the street get a whiff of MerrillÆs plans; it was a question of survival.
For its part, BoA helped by appointing J.C. Flowers as its financial adviser to review MerrillÆs books. Not only does Flowers not compete in MerrillÆs main business lines, but it ôhad done extensive due diligence over some time in reviewing other potential transactions, so they were very familiar with Merrill LynchÆs books,ö explained Joe Price, chief financial officer of BoA, during an analysts briefing on Monday morning US time, subsequently posted on www.seekingalpha.com.
Thain also knew that Merrill Lynch was valuable to BoA for two strong reasons: its US wealth management business with over 16,000 advisors and its investment banking franchise. Merrill's share price notwithstanding, Thain had a reasonable negotiating position.
Based on "revenues per financial advisor or assets per financial advisor, our wealth management system is by far the best in the worldö, Thain told analysts in a post-merger announcement. And Lewis agreed, calling the division ôthe crown jewelö of Merrill and adding that BoA could consider retention bonuses for the team.
Investment banking is a business BoA has tried unsuccessfully to break into, as Lewis was reminded at the Monday press conference by a reporter. "Just last October you said: 'IÆve had almost all the fun I can take in investment banking'." But Lewis had not given up on his ambition to run a financial powerhouse and Merrill Lynch provided the platform of his dreams.
ôFirst, obviously, Merrill Lynch is much, much more than an investment bank. ItÆs the best wealth management company in the world. But the frustration I think weÆve had is that maybe in some way we were in no manÆs land. This solves that. This creates the company instantly that would have taken decades to build and IÆm not sure in hindsight if in fact you would ever spend that much money as quickly as youÆd need to do it to get there,ö said Lewis while replying to an analystÆs question about how big an investment bank BoA wants to be.
ôThe fact that we have the breadth of products that we have now and capabilities û it has to be the largest corporate banking franchise in the world û is just an incredible combination,ö Lewis said.
ThainÆs alacrity in securing a deal with BoA is only the latest in a series of timely moves heÆs made since he took over as CEO of Merrill Lynch in December last year. One of his first moves, in the month of his arrival, was to issue $6.2 billion of equity to Temasek and Davis Selected Advisors at $48 per share, swallowing the discount to the $56 where Merrill traded at the time.
In January, Merrill Lynch sold $6.6 billion worth of convertible preferred stock to Korea Investment Corporation, Kuwait Investment Authority, Mizuho Corporate Bank and others.
And in July, it raised another $8.5 billion of capital at $27.52 per share. The July deal allowed the December 2007 and January 2008 investors to make use of a price reset on their earlier investments, which was still in force because Merrill chose to raise further capital within a year. Some market commentators criticised Thain at the time, noting that he had to wait only another six months for the price protection clause to lapse. But Thain wisely realised that the window to shore up capital might not be open for another six months.
Simultaneously, Thain entered a deal to sell collateralised debt obligations with a face value of $30.6 billion to US private equity firm Lone Star Funds for $6.7 billion. With the sale, Merrill reduced the aggregate CDO exposure on its books to $8.8 billion. The CDOs were valued on a face value basis at 22 cents for every dollar. Merrill financed Lone Star to cover around 75% of the purchase price so Lone StarÆs equity investment translates to just 5 cents for every dollar of CDOs. Again, a difficult decision and one which few of the other affected subprime banks had taken. But one which enabled Thain to tell analysts on the Monday call: "we have been consistently reducing the risky assets on our balance sheet".
Lewis' endorsement of the steps Thain had taken was even stronger: "...in comparing it [Merrill] to a previous review that is was night and day, that John and his team had made incredible progress since the first time they [Flowers] had looked at it."
Perhaps Thain learnt the value of acting quickly at his former employer Goldman Sachs, where he was president and chief operating officer from 1999 until he left to join the New York Stock Exchange in 2004. Goldman Sachs is one of the few Wall Street firms which has, to date, emerged from the subprime crisis relatively unscathed, attributed by specialists to the firm's early decision to stop trading CDOs and to mark down what was on its books to 20 cents to the dollar in the first round last year. This kind of decisiveness may be one of the reasons Merrill brought Thain on board. He was also rumoured to have been courted for the top job at Citi.
The merger is not yet through as it requires shareholder approval. BoA's shareholders initially did not share Lewis's assessment that the long-term benefits of the deal are overwhelming and the share price fell 21% on Monday to close at $26.55. Based on this price and BOA's offer to exchange 0.8595 of its own shares for each Merrill Lynch common share, Merrill shareholders are getting $22.82 of value for every Merrill share.
Meanwhile, Merrill closed marginally up at $17.06 on Monday, but opened strongly yesterday, gaining 12% to $19.40 in early trading and closing 30% up at $22.18, despite concerns plaguing equity markets regarding what will happen to insurance firm AIG. BoA gained 11% to close at $29.55, suggesting BoA's shareholders have come around.
The deciding vote lies with BoA shareholders, who will have to decide whether to endorse BoA digesting two acquisitions in the same calendar year. BoA in January bought Countrywide through another all-share deal that was completed at a fraction of the cost of the Merrill transaction. Analysts expect Lewis will be able to convince shareholders to back his vision of using the opportunity presented by subprime to build the largest US bank through takeovers.
Thain is likely to be seen as a saviour by Merrill's shareholders and other stakeholders, who saw firsthand what happened to Lehman, which did not sell itself or raise equity in time to avoid its demise. But the situations are quite different from one another.
In stark contrast to LehmanÆs CEO, Dick Fuld, Thain was not a Merrill veteran. He did not have the baggage that comes with things like options with a strike price significantly higher than the capital he was raising; a legacy with the firm; a historical attachment to the business and its employees; or excessive sentimentality regarding the Merrill Lynch brand. That could be why Merrill's board hired Thain last year.
BoA could choose to retain the Merrill brand. It's not unprecedented. After all it was the J.P.Morgan brand that survived the merger with Chase. But Thain probably realised that these nuances were far less important than closing the deal.
Ironically, this could also be the last major deal he strikes for Merrill. BoA will give Merrill three board seats, but it is not clear whether Thain will get one of those or what role he will play at the combined entity.
Whatever the outcome for him personally, Thain has struck the deal of a lifetime, which has forever earned him his place in the annals of Wall Street history.
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