1August 2005

Credit Union Demutualization

Kevin Davis

Commonwealth Bank Group Chair of Finance

Director, Melbourne Centre for Financial Studies

Chairman, Melbourne University Credit Union

2August 2005

THE DAILY FINANCIAL BUGLE

CREDIT UNION & BANK TO MERGE

By finance writer Watcha No

“A marriage made in heaven, a great idea”, said the investment banker advising on the merger.

Members of the Credit union will each get 200 shares in the bank. This windfall has got bigger since the bank share price has risen from $8 to $10 after the announcement of the planned merger.

3August 2005

Demutualization Methods

• Pure Distribution: allocate tradable shares to members free of charge according to some rule – e.g. equal amounts or related to years of membership/

value of relationship

• Subscription: sell tradable shares (perhaps some at a zero or subsidized price to members)

• Merger/Takeover: Non-mutual acquirer allocates or sells shares in itself to members of the mutual in exchange for their ownership of the mutual.

4August 2005

Demutualization Methods - Problems

• Pre demutualization the mutual’s market value is unknown – some multiple of net tangible assets – maybe 3-4

times• Post demutualization, the market value is determined by

the stock market price of its shares• Pure distribution doesn’t require estimating the value,

and 100% of it goes to members• Subscription requires estimation of value and risk that

outsiders get an inappropriate share of the value• Merger requires estimation of value of mutual, of

supposed “synergy” benefits and value of combined entity. Risk that owners of acquirer get inappropriate share

5August 2005

Some Demutualization Principles

• If a demutualization occurs, all the extant value belongs to, and should accrue to the membership– But is it past, current or potential members?

• Because valuation is complex, demutualization should be “pure”– Capital raisings can occur subsequently after market has

established the value of shares– Takeovers/mergers can occur subsequently after market has

established the value of shares

• Additional legal costs of two transactions probably less costly for members than value loss due to gains of external subscribers or acquirer shareholders in “non-pure” demutualizations.

6August 2005

Demutualization and Member BenefitA Cautionary Tale

• Announcement: Merger of mutual with non mutual.• Members of mutual get 200 shares in non mutual

– Pre announcement share price = $8– Post announcement share price = $10

• Mon-mutual is worth $8,000 and has 1,000 shares on issue

• Mutual was actually worth $4,000• Merged entity worth $12,000, has 1,200 shares on issue• Mutual members get shares worth $2,000 for “sale” of

mutual• Owners of non-mutual get increase in value from $8,000

to $10,000

7August 2005

What is a Mutual Worth (Part1)?

• How can the market value be determined?• Value often determined by “multiples”

– Capitalization (multiple) of earnings (P/E ratio)• But earnings (profits) are not the mutual’s objective• Past earnings not a good indicator of what the

demutualised profit oriented company would make– Multiple of Net Tangible Assets (P/NTA ratio)

• Value comprises both book value plus franchise value – the ability to use tangible and intangible assets to create value for owners

8August 2005

Price /Net Tangible Asset MultiplesAustralian Finance Sector: 26 August 2005

ANZ 2.9Bendigo Bank 2.3CBA 2.7Macquarie Bank 5.0NAB 2.6Suncorp-Metway 3.7Westpac 3.4Home Bld Soc 2.7

9August 2005

Credit Union Value

• Credit Union’s have built up– significant Net Tangible Assets by

accumulation of surpluses– Significant Franchise Value

• NTA (Member’s Funds) can be calculated

• Franchise Value is hard to estimate – but significant

• This value is owned communally

10August 2005

Credit Union Value

• For large credit unions, the total communal value is big enough to attract interest

• This communal asset is poorly protected from expropriation

• Converting communal wealth into private wealth by demutualization is attractive (to some).– But at what price to society, and which

private interests are best served?

11August 2005

What is a Mutual Worth (Part 2)?

• Mutuality is– A particular form of governance and ownership

structure– A structure which involves a particular

specification of the organization’s objective function

12August 2005

Mutuality benefits• The mutual governance structure

– Gives management significant discretion– Is suited to cases where activities are relatively routine,

transparent, low risk• Typical original credit union activities

• Scale and Sophistication– Bring professional ambitious management with other objectives –

including expansion into new areas– Mutual governance not ideal in this situation– Solutions

• Demutualise – loses other benefit of mutuality• Stick (return) to the knitting

– Probably too late in many cases – but not for the rest of the movement

13August 2005

Mutuality benefits

• Non-mutuals must have a profit focus– Attempts to impose social conscience and non-

commercial goals on non-mutuals are virtually impossible

• Inconsistent with their raison d'être• Competition and profit seeking causes lowest

common denominator to prevail• E.g. “Triple bottom line” hard to implement

14August 2005

Mutuality benefits

• Mutuals have communal benefits as their raison d'être– Benefits may be

• financial rewards for members of the community– Past, present, and future

• Community wide goals

• Mutuals focused on a particular community (a limited common bond) can better identify those goals– Bendigo Bank community bank model illustrates

15August 2005

Mutuality benefits

• Mutual governance structure gives managerial flexibility to identify appropriate mix of communal benefits and pursue them.– Better chance of good outcomes when

• community is relatively well delineated• Lots of communal organizations and

dispersion of managerial discretion across those organizations (rather than concentration in a few hands)

16August 2005

The Implications

• Continuing concentration into a smaller number of large credit unions signals the death knell of the movement.– Greater incentive for demutualization– Less ability to focus on communal goals– Managerial incentives to move into areas where

the mutual model isn’t the best form of governance.

17August 2005

The Future?

• The mutual credit union model is best suited for – Smaller, community focused, organizations– Specialized, simple and limited product range

organizations

18August 2005

The Future?

• Can smaller, limited product range, community based, institutions exist and survive?– Bendigo Bank community bank model seems to suggest so

• Has found a way of minimizing compliance costs• Has overcome capital constraint• Enables customers of community bank to access a

wider range of services from the parent organisation.

• Why can’t the credit union movement find a model which achieves the same good outcomes?

19August 2005

The Future?

• Two reasons for the movement’s inability to prevent mutual self destruction– The dominance of large credit unions and

professional managers in setting movement goals and strategy

– The concurrent growth of self interest, particularly when the identification with a particular community served by the credit union has disappeared.

20August 2005

The Future?

• The formation of mutual credit unions involved an implicit intergenerational contract, where social capital was built up to be passed on to future members of that community.– The commitment is a bit like that in marriage –

and we know what’s happened to that!

21August 2005

For ever !

THEN

22August 2005

Till I can do better !

NOW