Buyout Of Uk Banks By Private Equity Firms Finance Essay
The global financial crisis which began in August 2007 is far from being resolved. Its impact on the United Kingdom Banking sector had left most financial institutions with no other option than to file for bankruptcy and hope for a reprieve from the UK government in the form of bailout funds (Accessed on December 19, 2009: http://news.bbc.co.uk/1/hi/7521250.stm). Despite interventions by governments and central banks, the return of United Kingdom’s banking sector to stability is still very remote. The United Kingdom government launched a second bailout rescue package as Royal Bank of Scotland recorded its biggest loss in United Kingdom corporate history (Accessed on December 19, 2009: http://www.reuters.com/article/idUSTRE4B70ME20090119). Liquidity still remains an issue and over the next five years, banks will have to come with a strategy to refinance over £1 trillion of wholesale funding, including the support funds from the UK government (IFSL banking, 2010).
A school of thought suggests that the intermediation function of banks is essential in the process of issuing credit (Leland and Pyle, 1977; Fama, 1985). Another school of thought also stresses that the payment systems will not work if customers do not have confidence to leave funds on deposits in banks (Hoggarth et al, 2001). Lending by UK banks has taking another dimension with banks becoming more risk averse to retail lenders and placing available funds with private equity firms (telegraph, 2007). This may not be unrelated to the entry of sovereign wealth investors and hedge funds, which now provide private equity firms with funds for investment buyouts. This explains the sudden rebound of the private equity industry despite the crisis (IFSL private equity, 2009). In the words of Simon Walker, the chief executive officer, British Venture Capital and Private Equity, “Now more than ever do we have to take a longer term view of things, to ensure stability and predictability for our industry, which will in turn help improve the health of the UK economy as a whole”(BVCA ,2008).
This statement may also explain the recent interest shown by private equity firms to participate in the UK banking sector. The bid for Northern rock plc by Virgin money, Tyne consortium, JC flowers and Cerebrus, the successful acquisition of Bankunited in the United States by a private equity syndicate and the application for a banking license in the United Kingdom by United states-based private equity investment group, Blackstone, are examples.
This research will attempt to explain the impact of private equity firms in entering the United Kingdom banking sector through leveraged buyouts of existing. Previous research focused on banks as lenders to private equity (Rochet, 2008; accessed on 21 January, 2010 (http://www.ecb.int/pub/pdf/other/largebanksandprivateequity200704en.pdf)). After reviewing the existing literature, the researcher identified the non-existence of research concerning private equity firms acquiring banks. This ideology is quite uncommon especially when a notion exists of such financial institutions being immune to such situations.
This study will involve a theoretical and statistical assessment of the benefits and consequences of leveraged buyout in the banking sector. The researcher saw a need for this study due to the streak of success achieved by private equity firms in previous buyouts. However, public perception of such institutions is not encouraging. The conclusions drawn from this research are aimed at the portion of the UK populace who view leveraged buyouts as the insensitive nature of private equity firms to destroy whatever value the firm has left and sell it for a scrap value.
Concept of Leverage buyout
Private equity as an investment asset class comprises of venture capital, growth capital, mezzanine capital and leverage buyouts. Although private equity can be considered to include the four investment activities, private equity has leverage buyout as its principal descriptor. Leverage buyouts is a process by which a significant amount of debt and a significant amount of equity is combined to purchase all or most of a company or a business unit (Stowell, 2010). It can also be termed as an acquisition of a company that is financed mostly by debt (Pandey, 1996). Private equity firms engaged in this process are also called buyout firms or financial sponsors. Such investments add value, involve an active investment strategy and require the expertise of an investment manger which is a key due diligence area for investors’ assessment of the fund management team. The buyout part refers to transforming a publicly held company into a private company. There are a number of reasons why this sort of transaction occurs. These include cost savings, flexibility and control, tax benefits. One of the main reasons why firms go public in the first place is to raise funds and exploit current investment opportunities (Kim and Weisbach, 2007).
History of Leverage Buyout
The first managed private equity investment can be traced back to the formation of the American Research and Development Corporation in 1946 by Boston –area civic elites in the United States (Hsu and Kenney, 2005).The founders were concerned about the future of New England, the ability of the United States financial system to recover from the great depression and the effect of new deals. The objective was to create a private institution that attracted institutional investors and, provide capital as well as managerial expertise to acquired businesses. It also involved raising funds from syndicates of wealthy individuals and institutions by investment managers on a deal by deal basis (Fenn, Liang et. Al).
The United States responded to the short supply of Private Equity capital by passing new legislations with the Small Business Investment Act of 1958. This move gave birth to Small Business Investment Companies (SBICs) which were licensed to provide professionally managed capital to risky companies. Although SBICs were eligible for tax benefits and have access to small business administration loans, they were restricted to certain sizes of companies to invest as well as taking controlling stakes in those companies. This was to avoid any form of oligopoly that could be detrimental to the business and the economy. However, this move made SBICs attractive to risk averse investors rather than risk taking investors. The Private Equity managers gained valuable experience with a modest compensation package. The prohibition of managers of publicly traded venture capital firms by Small Business Investment act (1957), from receiving stock options or any other form of compensation (Liles, 1977) incited the formation of venture capital partnerships as a way of dealing with the compensation issue. This new type of partnership however had its challenges. The major challenge was the weak state of the Initial Public Offer market between the mid 60s and mid 70s. This slowed investment and acquisitions of corporations. Managers were forced to redirect available Private Equity capital towards acquisition of established companies. Thus, leverage buyout emerged.
Figure 1: Source: Centre for management buy-out research
The figure above reflects the total value of investment buy-out/ buy-in (Black) and the Number of successful investment (purple). Private equity firms have been criticised by people like the German deputy chancellor Franz Müntefering who refer to private equity firms as a ‘swarm of locusts’ intent on extracting financial value at the expense of jobs and good working conditions (Jensen, 1989a; Bongaerts and Charlier, 2009). Unlike the stock market that performance data and accounting information is easily made available to the public, the private equity industry has sealed disclosure on both its deals and performance. The persona created by these firms has made them unattractive to the public, especially in the UK where most private equity deals take place. Yet, over the last two decades there have been over 10,013 acquisitions of private and public firms through leveraged buyouts, for an aggregate deal value exceeding $850 billion (Strömberg and Kaplan, 2007).
Academic research has alleviated such allegations to a certain extent by stressing the benefits of buyouts for companies and stakeholders. Private equity firms increase economic efficiency by restructuring and reorganising ailing firms over a medium or long term, with the objective of providing and securing employment opportunities as well as delivering good returns to their investors (Morgan, 2009). After which, such firms are put for sale with an enhanced value. As a new organisational form with distinctive characteristics, PE firms can be viewed as ‘active investors’ (Jensen, 1989a).
These owners perform close monitoring on the management and managerial incentive mechanisms are tightly structured to protect owner wealth from manager expropriation (e.g. Sahlman, 1990, Kaplan and Strömberg, 2003).
In sum, consistent with the traditional argument in support of leveraged buyouts, publicly held targets will try to increase firm value by eliminating inefficiencies arising from agency problems after a leveraged buyout.
UK banking industry
The last thirty-five years has shown the evolution of banking the world over. In the 1960s, UK banks were exclusive suppliers of financial services and the industry operated on an oligopolistic basis with price competition being a restriction (Howcroft, 1998; Llewellyn, 1996). In the 1970s and 1980s, legislations were introduced to encourage competition amongst banks and improve the quality of service to customers. The major elements of deregulation included: the Building Societies Act (1986 amended 1997), Competition and Credit Control (1971), the Banking Act (1979 amended 2009), and the Financial Services Act (1986 amended 2000). Howcroft (1998) sums up the overall impact of such legislative change as:
… effectively exposing the clearing banks and the retail banking market to the cold wind of increased competition by undermining the traditional demarcation lines which once separated different types of financial institution into discrete markets.
Since late 1970s, history has witnessed 112 systematic banking and financial crisis in 93 countries and 51 borderline crisis in 46 countries (Caprio and Klingebiel, 1997; Lindgren et al, 1996).
The graph above shows the state of lending in the United Kingdom before and after the recession. The financial crisis of August 2007 has renewed interest of research into the fragility of banks and remedial measures that should be taken to avoid a re-occurrence.
Leverage lending refers to the use of debt to magnify the returns on an acquisition. The industry defines leverage lending as the total asset ratio (The gearing ratio) or the Earnings Before Interest, Tax Depreciation and Amortization (EBITDA). In a balance sheet, to show the degree of risk a firm is exposed to the formula is calculated:
Gearing/Leverage= Fixed Interest Loans + Preference Share Capital
Ordinary Shareholders’ Funds
A highly geared firm is exposed to a degree of high financial risk but is likely to receive higher returns. A low geared firm is much safer, however it will attract a lower return.
The purpose of the study is to provide the general UK public mostly, the academia with a better understanding of the leverage buyout process. This study seeks to shed light on how such transaction, when properly managed, can benefit both the company and stakeholders. This thesis will focus on the all the stages involved, benefits and challenges.
In brief, the proposed dissertation shall provide answers to two closely linked questions:
R1: How effective will a change in management be in comparison to retention of previous management?
- Discuss the agency theory of leverage buyouts.
H1: Management change will influence public perception of banks
H2: Management change will not influence public perception of banks
R2: What impact will leveraged buyouts by private equities have on the United Kingdom banking sector?
-Define leverage buyouts. How is a target company assessed?
-How can performance after the buyout be measured?
H1: Leveraged buyout will enhance performance.
H2: leveraged buyout will not enhance performance.
The use of primary data collected from a cross section of the business populace using systematic sampling would have been adequate for this research. But due to the certain limitations like cost, accessibility to the respondents and the deadline for completion of the research, the researcher has decided conduct this exploratory study with the use of secondary data from various sources for the purpose of this research. This involves using multiple-source secondary data. The focal point of the research will involve the adoption of a deductive approach to validate the hypothesis. This choice was based on the difficulty of trying to convince respondents within a limited time frame to assist in the research.
The researcher has adopted an epistemological stance of a natural scientist (positivism).The reality perceived by the general populace of leverage buyouts may or may not be a social construct generated from circumstances which has been tailored to suit that individual’s perception. As a researcher, without any form of validated hypothesis, such generalizations can be deemed as subjective. Generating a hypothesis based on existing theories and testing the validity will create an opportunity to establish a law-like generalization which will constitute acceptable knowledge (Saunders et al, 2009).
The major challenge may be the probability of data manipulation since it may not be in the words of the respondent. This is why using a time series of data which provides surveys that have been repeated will help the researcher establish whether or not a pattern exists (Saunders et al, 2009).
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