In M&A, Special Attention Must Also Be Paid to Integrating Outsourcers’ Tech

Outsourcing is has become an everyday reality of the banking business. But with the economic crisis, the speed of consolidation in the financial services industry has been greatly accelerated. According to attorneys at the firm of Morrison & Foerster (London/San Francisco), this can lead to some challenges for the merged entities when it comes to rationalizing their IT departments and the vendors who supply them with various technologies and services, both in-house and on an ASP basis.

M&F issued a series of four reports on outsourcing trends designed to present businesses, such as banks, with some of the elements of which they must be mindful when dealing with service providers. The third report, "Outsourcing and the Economic Crisis," deals specifically with the implications around IT unification during merger & acquisition activity.

"The paper describes the main strategies for IT integration," explains Jon Edgell, partner and co-author of the report. "The five 'strategies' may be more correctly described as four options for IT integration—absorption, cherry-picking, co-existence, transformation—followed by an option for how one or all of those integration options may be achieved—through outsourcing."

There is no one size fits all strategy that banks should use when integrating their technology operations, notes Tim Roughton, associate and co-author of the report. Rather, the approach is determined on a case-by-case basis. What is a certainty, however, is the fact that there will almost always be a period of co-existence of the acquirer's and acquiree's systems while the merged company assesses its strategy.

"We have seen examples where the merged entity has combined the cherry-picking strategy with a transformational element—that is, keep the bits that work the best and that can be easily rolled-out to the whole merged entity while using the merger as an opportunity to transform the elements that either have not been working well or need to be transformed to 'fit' the new merged entity," he explains. "The challenge for the merged entity is to ensure that this period of co-existence does not exist for too long, otherwise any cost savings or improvements will not be achieved."

Due to the complex nature of many of these mergers, getting a handle on all of the vendor relationships at the acquired institution can become challenging. However, it is absolutely necessary for banks to follow through on the due diligence here to ensure the implications of the underlying contracts are understood, both attorneys emphasize. Some of the questions banks should keep in mind include whether there are early termination payments or intellectual property rights restrictions that might limit the merged entity's ability to swap vendors; the compatibility of the technology infrastructures and strategies of the two merging companies; and the cost to consolidate, if they are deemed incompatible.

"In reality, however, these questions are often left to after the merger and, even if they are asked at an early stage, have little impact or no impact on the wider merger decision, which is invariably determined by wider commercial considerations such as share price," comments Edgell. "Even if the analysis is carried out after the merger, it should be prioritized so that any resultant benefits are achieved as early as possible."

Furthermore, it's not just the technology itself that must be rationalized in a merger, but also the people who operate it. Rationalization of IT staff is almost a given when rationalizing the technology, relates Edgell.

"As technology is streamlined (for example, the merging of service desks or the consolidation of data centers), so will roles become redundant," he explains. "In fact, the reduction in headcount is often one of the biggest drivers behind any IT consolidation strategy as it is one of the most effective ways to drive out costs. Of course, where IT is not rationalized and there is co-existence, the impact will be much smaller, even though some more senior roles may not need to be duplicated in the merged entity."

However, he adds that a trend he is seeing is one where merged banks are choosing to in-source elements of their IT services that were previously outsourced. "This strategy will, of course, lead to a larger IT headcount within the merged organization, although with the IT staff likely to transfer from the incumbent vendor to the bank—not necessarily the creation of new jobs," Edgell says.

Achieving IT integration success post-merger has always been a daunting task. Add to that the current economic crisis, and banks must deal with additional issues. Given the new, tougher regulatory environment, the reputation of vendors is coming more into focus by banks. "Tighter regulation and a more conservative approach to risk management is likely to result in banks turning increasingly to vendors that have a proven track record and that are financially stable—the so-called 'flight to quality,'" says Roughton.

It is an unfortunate reality that important information on the target company is shielded by non-disclosure agreements prior to finalization of the merger deal, they agree. Additionally, with the accelerated due diligence schedules that are the result of crisis-related mergers, the unknowns of the acquired entity are even greater. This all adds to the complexities involved and limits the acquirer's visibility of the target entity's architecture and vendor relationships.

"Although this is not uncommon it is unfortunate, since it is the detail that is critical in achieving the hoped-for synergies at an infrastructure level," comments Roughton. "Unless you dig into the detail, something at the macro level can look like a good fit, but actually, when you look at the detail, it's quite the opposite of a fit."