Mergers And Acquisitions Performance Analysis In U K Banking Finance Essay
*Throughout this proposal, the term merger and acquisition are used interchangeably. In this paper we will not address the differences between mergers and acquisition and often refer to both as merger or acquisition.
1. Title: Mergers and Acquisitions, Performance Analysis in U.K banking, a case study of (Acquisition of NatWest by Royal Bank of Scotland).
Corporate strategy developers have in the past and today seen Mergers and Acquisitions as an effective tool to foster future growth and create sustainable value. As a norm, companies now aggressively seek and buy compatible businesses to gain from synergetic benefits and strengthen their core business operations, whether that is the Industry of Banking, Pharmaceutical, Information Technology, Construction or Retailing etc. “Expenditure on acquisitions in the UK by foreign companies increased from £9.2 billion in quarter four 2007 to £19.9 billion in quarter one 2008. Expenditure on acquisitions abroad by UK companies decreased from £25.8 billion in quarter four 2007 to £15.5 billion in quarter one 2008. Expenditure on acquisitions in the UK by UK companies increased from £3.2 billion in quarter four 2007 to £3.6 billion in quarter one 2008. The number of transactions reported for acquisitions in the UK by UK companies at quarter one 2008 is the lowest reported since quarter one 2003”.
Source: (http://www.statistics.gov.uk/pdfdir/ma0608.pdf- on 06-06-2008).
“In March 2000, Royal Bank of Scotland (RBS) acquired NatWest Bank, a bank three times its size. Shareholders were told that the merger would realise £1.1 billion in cost savings and income gains. The acquisition of NatWest by the Royal Bank of Scotland has created a larger group which combines scale and financial strength with an innovation and growth culture, and gives us strategic options to create additional value for shareholders”.
Source:(http://www.rbs.com/media03.asp?id=MEDIA_CENTRE/PRESS_RELEASES/2001/MARCH/RESULTS2000- on 02-06-2008).
The perceived motivation drives for this merger and acquisition activity are generally considered to be the acquiring banks desire to increase its return by expanding geographically. This perception is similar to Stewart’s premises of merger motivation. According to the Stewart; the actual motivating forces behind merger should be ones that will:
Increase financial performance (net operating profits).
Financial benefits through borrowing against the Seller’s unused debt capacity or against an increase in the consolidated debt capacity (lending capacity for banks).
Tax benefits derived from expensing the stepped-up basis of assets acquired or from the use of otherwise forfeited tax deductions or credits”. (Stewart, 1991, p 375).
2. BRIEF REVIEW OF LITERATURE
This chapter aims to discuss various literatures on mergers and acquisitions in order to provide a background for subsequent analysis. The literature identifies several economic and financial theories that justify Merger and Acquisition activity. In this review, we provide an overview of the literature that we use to guide our empirical work.
The interdisciplinary nature of the M&A discourse is reflected in the versatile definitions provided in the literature. Some definitions emphasize the organizational context of M&A:
“The term ‘merger’ has two meanings in the context of combining organizations. Merger can refer to any form of combination of organizations, initiated by different kind of contracts. The more specific meaning that separates merger from acquisition is that merger is a combination of organizations which are similar in size and which create an organization where neither party can be seen as acquirer”. (Vaara, 2000, p 82).
“The word merger refers to negotiations between friendly parties who arrive at a mutually agreeable decision to combine their companies. In general, mergers reflect various forms of combining companies through some mutuality in negotiations”. (Fred and Weaver, 2001, p 6).
“The word merger is used to mean the combining of two business entities under the common ownership”. (Arnold, 2005, p 1041).
“In Acquisitions a company buying shares in another company to achieve a managerial influence. An acquisition may be of a minority or of a majority of the shares in the acquired company. An acquisition is recorded on the date of the economic decision (formally agreed) even if the legal issues have not been fully finalised. If subsequent disputes, legal issues or a lack of supervisory approval were to interfere with a completion of the acquisition, it is held not to have been recorded”. (Eurpean Central Bank, 2000, p 4).
2.2 TYPES OF MERGERS & ACQUISITION
From the point of view of an economist, there are four main groups of Merger and Acquisition.
Horizontal: “In this one firm combines with another in the same line of business. In simple words, a horizontal merger occurs when two competitors combine”. (Gaughan, 2007, p 13). Horizontal merger reduces the number of the competitors in the market.
Vertical: “A vertical merger is the combination of successive activities in a vertical chain under common coordination and control of a single firm”. (Sudarsanam, 2003, p 140). In simple words, it is a merger between a supplier and the distributor company of the supplies. This is a cost saving merger as well. For example HSBC purchased JP Morgan’s dollar clearing business in 1996.
Congeneric: This involves related enterprises but not producers of the same product (as in horizontal merger) or firms in producer supplier relationship (as in vertical merger). “An example is when Lloyds Bank acquired Cheltenham and Gloucester in 1995 mostly to acquire its mortgage business, which is related to but different from retail banking”.
Source: (http://www.lloydstsb.com/about_ltsb/lloyds_bank.asp – 04-05-2008)
Conglomerate: “A conglomerate merger is the combining of two firms which operate in unrelated business areas. Some conglomerate mergers are motivated by risk reductions through diversification; some by the opportunity for cost reduction and improved efficiency, others have more complex driving motivations”. (Arnold, 2002, p 870). For example in 1996, Royal Bank of Scotland was expected to take control of Charles Church.
2.3 LITERATURE REVIEW- THEORIES OF M&A
There are might a number of motives that might play a role in merger activity, like efficiency, growth , synergy, financial and tax benefits, shareholders exploration, but two of the most often cited motives for mergers and acquisitions are faster growth and synergy. All these strategic motives shall be discussed in this part of the proposal for the better understanding of merger and acquisition.
2.3.1 Efficiency Theory
“The efficiency theory says that mergers occur because they improve the combined firms, operations, for example, by letting superior managers assume control, by exploiting cost reducing “synergies” or complementarities in the partner’s operations, or by taking fuller advantage of scale of economies and risk spreading opportunities, among other things in securing capital”. (Ravenscraft and Scherer, 1987, p 211).
In simple words, efficiency is an improvement in the utilization of existing assets that enables the combined firm to achieve lower costs in producing a given quantity and quality of goods and services.
2.3.2 Managerial Motives or Managerial Perspectives
Takeovers can also arise because of the agency problem that exists between shareholders and managers, whereby managers are more concerned with satisfying their own objectives than with increasing the wealth of shareholders. “The motive behind some acquisitions may be to increase managers’ pay and power. Managers may also believe that the larger their organization, the less likely it is to be taken over by another company and hence the more secure their jobs will become. Take overs made on the grounds have no shareholder wealth justification since managers are likely to increase their own wealth at the expense of the shareholders”. (Watson and Head, 2006, p 317).
2.3.3 Shareholders Expropriation
The important motive behind the consolidation has been maximization of shareholder’s wealth. In the neo-classical prospective, this mean that the incremented cash flows from the decisions, where discounted at the appropriate discount rate should yield positive or zero net present value. Under uncertainty, the discount rate is the risk-adjusted rate with a market determined risk premium for risk. “Draper and Paudyal (1999) found that shareholders in the target businesses benefits substantially from takeover activity, particularly where they are given the option to receive either cash or shares in the bidder as the consolidation. It seems that the bidder’s shareholders do not suffer from merger. They also found that the benefits to target shareholders have declined in the recent past. Bruner (2004) argued that the approach taken by many of the studies based on US takeovers were flawed in that the research results were unduly influenced by a relatively small number of failures that involved particularly large businesses. He claimed that all takeovers benefit target shareholders and the overwhelming majority benefit bidder shareholders as well.” (McLaney, 2005, p 395).
“Shleifer and Summers suggest a number of other motives for mergers and acquisitions in which shareholders may gain at the expense of other stakeholders. For example, some target firms may seek acquirers to escape financial problems or to break unfavourable labour contracts. Other firms may seek leveraged purchases of their targets to increase the surviving firm’s risk- return profile at the expense of existing debt holders”. (Shlfeifer and Summer, 1988, p 33).
2.3.4 Financial and Tax Benefits
Whether tax motives are an important determinant of M&As. Certain studies have concluded that acquisition may be an effective means to secure tax benefits. Gilson, Scholes and Wolfson have set forth the theoretical framework demonstrating the relationship between such gains and M&As. They assert that for a certain small fraction of merger, tax motives could have played a significant role.
Moreover, whether the transaction can be structured as a tax-free exchange may be a prime determining factor in whether to go forward with a deal. Sellers sometimes require tax free status as a prerequisite of approving a deal.
“In the U.K the rules are more strict for taxes; the losses incurred by the acquired firm before it becomes part of the group cannot be offset against the profit of another member of the group. The losses can only be set against the future profits of the acquired company. Also that company has to continue operating in the same line of business”. (Arnold 2005, p 1052).
2.3.5 Growth / Market Power Theory
One of the most fundamental motives for M&As is growth. “Companies seeking to expand are faced with a choice between internal or organic growth and growth through M&As. Internal growth may be a slow and uncertain process. Growth through M&As may be a much more rapid process. If a company seeks to expand within its own industry, they may conclude that internal growth is not an acceptable alternative, for example, if a company has a window of opportunity that will remain open for only a limited period of time, slow internal growth may not suffice. As the company grows slowly through internal expansion, competitors may respond quickly and take market share. The only solution may be to acquire another company that has a resource, such as established offices, and facilities, management and other resources, in place”. (Gaughan, 2007, p 117).
Some mergers may result in market power which redounds to the benefits of the merging firms. George Stigler argued that “such an effect might have been a primary motivation for many of the mergers and acquisitions during the last quarter of the 19th century and first half of the 20th century. He called the 1887-1904 merger wave “merger for monopoly” and the 1916- 1926 wave “merger for oligopoly”. (Stigler, 1968, p 23).
2.3.6 Synergy Theory
This refers to the fact that the combined company can often reduce duplicate departments or operation, lowering the costs of the company relation to the same revenue stream, thus increasing profit. “The two main types of synergy are operating synergy and financial synergy. Operating synergy comes in two forms: revenue enhancement and cost reduction. These revenues enhancements and efficiency gains or operating economies may be derived in horizontal or vertical mergers. Financial synergy refers to the possibility that the cost of capital may be lowered by combining one or more companies”. (Gaughan, 2007, p 124).
“Financial synergies result in lower cost of capital by lowering the systematic risk of a company’s investment portfolio through an investment in an unrelated business”. (Trautwein, 1990, p 283).
Below the list of reasons has been provided that are initiating consolidation in the form of merger and acquisitions in the U.K banking industry.
Competition from building societies.
New entrants into saving markets.
New technology and the internet.
Competition from the overseas banks.
Economies of scale & scope.
Managing branch networks.
2.4 MERGER AND ACQUISITIONS: BENEFITS AND DRAWBACKS
Lumby and Jones identified four key benefits and five draw backs of mergers and acquisitions as follows:
An acquisition allows the company’s newly formed strategy to be implemented rapidly. Through organic growth it will take the company much longer to reach the same level of business activity.
22.214.171.124 Critical mass:
The Company is able to immediately achieve the critical mass of assets and activity levels that might be needed to obtain the operating economies of scale that exist in the chosen business area. At the early stages of organic growth into a new business area, the operating economies enjoyed by large competitors will not be achievable; so putting the developed business activity at a significant competitive cost disadvantage, from which further progress may not be possible.
126.96.36.199 Own-paper financing:
An acquisition can be made without impacting on the company’s cash resources or on its liquidity, by financing it with an issue of new equity called the company’s ‘own-paper’. In contrast, organic growth will require the expenditure of the company’s cash and credit resources.
188.8.131.52 Intellectual assets:
In addition to the tangible assets of the acquired company, an acquisition will also bring with it intellectual assets such as the ‘know-how’, and business contacts of the management team, the skills of the workforce and its trading reputation. With organic growth, these may have to be developed ‘in-house’ over time.
In spite of the identified benefits, mergers and acquisitions have the following significant drawbacks as stated by Lumby and Jones:
Mergers and acquisitions have a significant risk of high-cost failure attached. This is because an acquisition represents a single, very large investment, which if it turns out to be a mistake, then the business will have lost a substantial amount of its value.
184.108.40.206 Acquisition premium:
Most acquisitions require the payment of an acquisition premium in order to persuade shareholders of the target company to sell their shares. This means that the acquiring company will be paying more than the economic worth of the company.
220.127.116.11 Steep learning curve:
The acquiring company will have to rapidly learn how to manage an unfamiliar business and they may not necessarily be successful in doing so. In contrast, the slower pace of organic growth allows the management far more time in which to learn the range of new skills required to successfully manage the new business area.
18.104.22.168 Post-acquisition problems:
Acquisitions could lead to a clash of management cultures between those of the acquired company and the acquiring company. This will often lead to key members of the acquired company leaving post-acquisition, resulting in the loss of vital intellectual capital. This may not be the case with organic growth.
22.214.171.124 Coinsurance effect:
In an acquisition where either the predator company or/and the target company has debt financing, then there is the risk of a post-acquisition wealth transfer from the shareholders to the debt holders. (Lumby, 2003).
3. AIMS AND OBJECTIVES
This Proposal has been built upon the analysis of the mergers and acquisition of banks in the U.K, like the acquisition (takeover of NatWest by Royal Bank of Scotland) in 2000.
In this research my effort is to attempt and cover all important issues related to Mergers and Acquisition, like what causes, and initiates a merger or an acquisition, the benefits accrue to the company, its employees and customers etc, and native aspects of M&A. This research investigates into the roots and causes of ever increasing consolidation activity and tries to critically evaluate merger and acquisition. Another aim of the proposal is to study the expectations of the stakeholders of the banks in the U.K, and the effect a merger or an acquisition has on them. Three stakeholders, namely, shareholders, employees and customers shall be studied in detail with the help of the case study.
As according to the Schweigher: M&As basically aim at enhancing the shareholders value or wealth, the results of several empirical studies reveal that on an average, M&As consistently benefit the target company shareholders but not the acquirer company shareholders. A majority of corporate mergers fail. Failure occurs on average, in every sense, acquiring firm stock prices likely to decrease when mergers are announced; many acquired companies sold off; and profitability of the acquired company is lower after the merger relative to comparable non-merged firms. Consulting firms have also estimated that from one half to two-thirds of M&As do not come up to the expectations of those transacting them, and many resulted in divestitures’. (Schweiger, 2003, p 71).
The conclusion from this case study support my hypothesis that, whether stakeholders benefit from the merger and acquisition, because on the one hand, sometimes the merger and acquisition is beneficial for shareholders of the merging /or acquiring bank. On the other hand, employees are left worse-off following job cuts and redundancies.
4. STATEMENT OF DESIGN AND METHODOLOGY
In order for the aims and objectives of the research to be fulfilled, it is essential to expand an understanding of the reason for growing tendency amongst banks in United Kingdom to pool together and the advantages of this pooling. The design of this project shall follow the deductive approach, like questionnaire, and the inductive research or the internal research will focus on interviews with the Managers and staff and customers of Royal Bank of Scotland and NatWest. In this regards, it is not an easy task to get an interview from the managers or the members of staff, but I shall try my best to do so. The external research will be carried out through the readings of books, journal and published data. Another difficult thing was access to annual reports, but I have already got the annual reports of both banks. The theory, annual reports and different analysist’s reports on the concepts of mergers and acquisitions shall be critically reviewed and thereafter compared and contrasted with facts gathered from the case study to confirm or disprove existing knowledge.
Finally, both qualitative and quantitative data shall be analysed to make desired recommendations and conclusion. (UWIC Guidelines, Red Book is read carefully).
5. SOURCES AND ACQUISITION OF DATA
“Research can be done through books, as everyone knows, as only some knows; it can be done by letters. It can also be performed through Conversation”. (Watson, 1999, p 52).
Sources of data adopted for this project include both secondary and primary data. A secondary data source enables a better understanding and explanation of the research problem. The literature review is a type of the secondary data, it involves the review of earlier studies on and around the research topic. Other secondary data includes the books on Finance, Mergers and Acquisitions, Strategy, journals, annual reports, analysist’s reports and different online resources like web pages of Royal Bank of Scotland and NatWest bank, should be used.
In addition to the secondary data stated above, primary data sources shall equally be utilised to gather data directly from the key players in the merger and acquisition process. This shall include the use of questionnaires and personal interviews with managers and members of staff of RBS and NatWest. The interviews must be focused on the research area and not delve into alternative areas. (UWIC Guidelines, Red Book is been studied thoroughly).
METHOD OF DATA ANALYSIS
Data analysis is the most difficult part of the project. Data analysis is the process of applying statistical, systematic and logical techniques, comparing the data and managing it. During the project both the qualitative and quantitative data will require analysis. In order to determine how well a company has performed in delivering stakeholders value, we need to make a comparison with its past performance. The first annual figures for The Royal Bank of Scotland Group following the acquisition of NatWest show the enlarged Group made a profit before tax, goodwill amortisation and integration costs of £4,401 million on a pro forma basis for the year to 31 December 2000, an increase of 31 per cent.
The period analysed would be broken into following categories.
1999 - The Pre-acquisition period.
2000 - The Announcement and bidding period.
2001 - The Post acquisition period.
The analysis shall cover some expense ratios, profitability ratios and balance sheet ratios. The expense and profitability ratios shall be used to analyse efficiency and profitability during the pre- and post-acquisition periods, while the balance sheet ratio shall be used to analyse changes that may have occurred that might have affected efficiency or profitability.
Review of Literature
Choice of Methodology
Binding & Submission
Arnold, G, 2005, “Corporate Financial Management”, 3rd edition, England, Prentice Hall, p 1041 & 1052.
Arnold, G, 2002, “Corporate Financial Management”, 2nd edition, Great Britain, PrinticeHall, p 870.
Fred W. J and Weaver S. C, 2001, “Merger and Acquisition”, 1st edition, Los Angeles, McGraw-Hill Professional, p 6.
Gaughan P. A, 2007, “Merger, Acquisition, and Corporate Restructurings”, 4th edition, New Jersey, John Wiley & Sons, Inc, p 13, 117& 124.
Gilson R, Scholes M. S and Wolfson M. A, 1988, “Taxation and Dynamics of Corporate Control”, 1st edition, New York, Oxford uni press, p 273.
McLaney, E, 2005, “Business Finance, Theory and Practice”, 7th edition, U.K, Pearson Education, P 395.
Ravenscraft D. J and Schere F. M, 1987, “Mergers, Sell-offs, & Economic Efficiency”, Washington D.C, Brookings Institution Press, p 211.
Red Book, UWIC Guideline.
Stewart, G.B, 1991, “The Quest for Value, A guide for senior Manager”, New York, Harper Business, p 375-382.
Sudarsanam, S, 2003, “Creating Values from Mergers and Acquisitions-The Challenges”, England, Pearson Education Limited, p 140.
Watson, G, 1999, “Writing A Thesis”, 1st edition, New York, Pearson Education Ltd , P 52
Watson, D and Head, A, 2006, “Corporate Finance, Principles and practice”, 4th edition, U.K, PrinticeHall, p 317.
Stigler G, (1968) “Monopoly and Oligopoly by Merger”, American economic Review (1968) by the organisation of industry, Vol 40, No 2, May, p 23-34.
Trautwein F, (1990), “Merger Motives and Merger Prescriptions”, Strategic Management Journal (1986-1998), Vol 11, No 4, May/June, p 283, by John Wiley & sons.
Shleifer. A and Summer, L. H (1988), “Breach of Trust in Hostile Takeovers; from Corporate Take over: Causes and Consequences, P 33-67, The University of Chicago Press.
Vaara, E, (2000), “Constructions of Cultural differences in post-merger change process: a sense making perspective on Finnish-Swedish cases”. M@n@gement Vol 3, no3: p 82.
Schweiger, D.M, (2003), “M&A Integration: A Framework for Executives and Managers,” Book Summary by Niranjan Swain, in The ICFAI Journal of Applied Finance, Vol 9, No 2, p 71-79.
European Central Bank, (2000), “Mergers and acquisitions involving the EU banking industry”, Available from, (www.ecb.eu/pub/pdf/other/eubkmergersen.pdf -accessed on 12-05-2008.
Powell, C, (2008), “Mergers and acquisitions involving UK companies”, First Release, P 1, Available from (http://www.statistics.gov.uk/pdfdir/ma0608.pdf, accessed on 06-06-2008).
http://www.rbs.com/media03.asp?id=MEDIA_CENTRE/PRESS_RELEASES/2001/MARCH/RESULTS2000- accessed on 02-06-2008
http://www.lloydstsb.com/about_ltsb/lloyds_bank.asp- accessed on 04-05-2008.
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