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M&A bankers are facing a tough situation currently. Rising interest rates and market instability have already complicated the process of closing big deals, and now there’s new worry that the European Central Bank has disrupted one of the few remaining chances to earn fees.
The so-called Danish Compromise is an EU regulation that was initially designed for a specific purpose: to lessen the capital burden on banks that own insurance companies. Nevertheless, it included a loophole dubbed “Danish Compromise squared,” which motivated banks to purchase different types of businesses, such as fund managers, through their insurance subsidiaries.
BNP Paribas became the most notable bank to utilize this opportunity when it announced a €5.1bn deal for Axa Investment Management last August. Similarly, Italy’s Banco BPM initiated a complete takeover of Anima, a local asset manager in which it already owned a minority stake.
Typically, acquiring a fund manager imposes a significant hit to capital ratios. Any premium over the fair value of the target’s net assets must be deducted from regulatory capital, thus limiting the bank’s ability to lend and invest. However, if the fund manager is nested within an insurer, it is classified as a risk-weighted asset that only consumes a small portion of the capital.
The ECB does not view this practice as aligning with the intended regulations. While the ultimate authority lies with the European Banking Authority, the ECB’s stance is still significant. Shares of BNP Paribas did initially drop when it was revealed that expected capital advantages might not materialize, but they quickly recovered.
Investors should remain calm. Although this change in approach raises the bar for potential mergers, viable deals can still be beneficial, and any that depended solely on capital manipulation might not have been worth pursuing in the first place.
BNP now projects that the acquisition of Axa will yield a return on invested capital exceeding 14 percent in its third year, expecting it to exceed 20 percent by the fourth year. While this outlook is less optimistic than before—originally projected at 18 percent in year three—the more pressing question remains: is it still a better option than others available?
The bank could opt to invest more in organic growth, an avenue they are already pursuing, but they have cautioned that beyond a certain point, diminishing returns become a problem.
Another straightforward choice would be to return surplus cash to investors via a share buyback. Considering its average share price and price-to-earnings ratio from the previous year, a €5.1bn buyback would theoretically yield a return on investment of around 14 percent. In contrast, an acquisition still appears to be a solid long-term strategy.
The only group really feeling the pinch from higher standards are the M&A bankers, who might find themselves working harder to ensure their projections are sound in their pitch decks for upcoming deals. However, it’s not like they have much else to occupy their time at the moment.
nicholas.megaw@ft.com
