Welcome to Mastering Transactions, a new series that will introduce readers to the complex world of deals. Over the next four weeks, writers from the world’s leading business schools will explore various facets of transactions in their different forms.
In the age of globalisation, where business is defined by the movement of goods, people and finance, how well a company conducts transactions can be the difference between success and failure. Moreover, as investors demand higher returns, companies are increasingly being forced to look beyond organic growth for new opportunities to build their businesses. From a multi-unit conglomerate conducting a cross-border merger to a multinational corporation divesting itself of major units, every company needs to understand how to manage transactions for maximum benefit.
Despite these complementary pressures, however, the deal environment is not completely benign. In recent years, for example, a number of cross-border M&As have highlighted the difficult political and social issues that must be negotiated as part of any transaction process. Some recent examples include Daimler-Benz’s 1998 acquisition of Chrysler, the merger between AOL and Time Warner in 2001 and, earlier this year, Mittal Steel’s dogged pursuit of rival Arcelor. Although each of these transactions was eventually achieved, the opposition from a range of stakeholders, including national governments and some shareholders, was vocal and, at times, the path to success must have seemed tortuous for the protagonists.
How can companies ensure that they conduct transactions well? What measures can they take to ensure that the process does not end when a deal is signed but carries through to post-deal integration and implementation?
To understand some of these questions, the case of utilities is particularly instructive, not only because they are important industries in their own right, but also because they illustrate the range of factors that have been driving the move towards a transaction-based economy.
From public to private
Once famed for their boring predictability, utilities are now regularly the subject of the most sophisticated and complex transactions. These include new issues of debt and equity, acquisitions by domestic and foreign companies, recapitalisations, securitisations and private equity deals.
The shift from the public to the private sector involved massive sales of company shares for the first time – initial public offerings (IPOs). It began,in the UK, with the sale of more than 50 per cent of shares in British Telecom (BT) in 1984. At the time, this was the largest IPO the London Stock Exchange had ever experienced and its success laid the foundation for a series of even larger sales of shares in electricity, gas and water companies over subsequent years.
By today’s standards, the deals were modest; the capacity for stock markets to absorb large deals has increased substantially over the last two decades. Some of this reflects an increased appetite on the part of investors for riskier assets but, equally, it has to do with the way in which share sales are conducted. When BT came to the stock market, it was through the then standard procedure of a public offer for sale at a fixed price. In other words, the government and its advisers decided on a share price and then launched a major advertising campaign for individual as well as institutional shareholders to purchase shares at that price.
Today, few IPOs are organised in this way. Instead, they involve institutions going on road shows, both at home and overseas, to stimulate demand from investors and ascertain the price at which they are willing to purchase. This creates larger markets and reduces the degree of uncertainty about the willingness of investors to subscribe to new issues.
Mergers and acquisitions
The privatisation process was just the start. Within a short space of time, there was a new and unexpected development – the acquisition of utilities. In the UK, the water industry was the first to experience this with the rapid acquisition of smaller water companies by groups such as Vivendi, Saur and Suez Lyonnaise des Euax. Eventually, even the larger water and sewerage companies became targets of US and French conglomerates.
Clearly, these acquisitions were driven by the anticipation of large financial gain. The typical bid premium (the amount by which the share price of the target of the acquisition increases relative to what it was prior to the bid) in a friendly acquisition is about 15 per cent. In a hostile bid, where the acquisition is opposed by the management of the target business, the figure is about twice as much.
How are these large shareholder gains achieved? One answer that the acquiring companies give is the achievement of better efficiencies. In some privatisations, this has worked. But new owners frequently reckoned that they could extract greater efficiencies than existing owners, in some cases as part of larger groups of utilities. The rapid reductions in operating costs were, therefore, spurred on by the wave of transaction-based acquisitions that engulfed them.
However, a less positive interpretation suggests that profit gains come at the expense of other parties. Utilities illustrate this well because they are subject to higher levels of regulation than other businesses. The returns that shareholders in utilities earn are a function of the efficiency with which they are run and a reflection of the bargain that they are able to strike with regulators about the prices that they can charge customers. There is some concern that absorbing utilities into a larger conglomerate makes it harder for regulators to protect their customers and facilitates the transfer of assets and earnings from one part of the group to another. In other words, gains to shareholders come, at least in part, at the expense of customers.
Outside of utilities, in addition to customers, the parties that might suffer from acquisitions include employees and pensioners, with the latter being a particular cause of concern as companies find it harder to service their pension liabilities.
Disposals, break-ups and financial restructuring
Associated with acquisitions have been two other transaction-based trends. The first is asset disposals and break-ups. One of the most prominent UK privatisations was British Gas in 1986. At the time, it was criticised for the creation of a private monopoly and ten years later it announced that it was demerging the trading part of its business into a company called Centrica, leaving BG Group to focus on transportation, storage, exploration and production. In turn, BG was demerged into BG Group and a gas transportation company, Lattice, which has now been merged with the power transmission group National Grid to form National Grid Transco.
The driving force behind these break-ups and disposals is the view that companies need to focus on specific market segments. British Gas, for example, realised that the management of transportation is quite different from exploration and supply. An electricity transmission company is, therefore, a more natural partner for a gas transportation company than a gas exploration company. Furthermore, regulatory changes encouraged the restructuring as part of a process of isolating natural monopolies, such as national transmission companies, from markets where it is possible to introduce competition, such as exploration and supply.
The second type of transaction is financial restructuring. The privatisation of utilities involved the raising of large amounts of equity. Part of this was paid to the government, as the former owner of the companies, and some was injected into the businesses to ensure their financial solvency. As the privatisations flourished, they built up financial reserves, some of which they returned to shareholders in the form of steadily rising dividend payments. However, changes in the taxation of dividends in the second half of the 1990s in the UK made share repurchases an attractive low-tax alternative to dividends. In the US, until the end of the 1980s, share repurchases took the form of fixed-price tenders in which companies offered to repurchase shares from shareholders at a particular price. In the 1990s, open market share repurchases, in which companies made buybacks over a period of time at prevailing market prices, became more commonplace.
Share repurchases were attractive to utilities not only because of their tax advantages but also because they allowed companies to distribute some of the one-off benefits that arose as a consequence of restructurings. Unlike dividend payments, there is no presumption that there will be a regular stream of payments to shareholders. One of the effects of the repurchases was to reduce companies’ reserves and, therefore, raise their leverage (the ratio of debt to assets in their capital structure).
In this decade, this process has accelerated. In terms of utilities, the UK water industry went through a process of financial capital restructuring that saw levels of leverage increase dramatically. At the time of privatisation, at the beginning of the 1990s, UK water companies had leverage levels of about 20 per cent that were well below the economy-wide average. In the early part of this decade, however, several companies announced capital restructuring programmes that increased their leverage to about 90 per cent of assets.
In several cases, such levels of leverage were achieved through a new form of transaction known as securitisations. Securitisations involve the ring-fencing of particular classes of assets and the issuance of large amounts of debt against those standalone entities. The large amount of leverage is justified by the high degree of predictability associated with the income stream of the securitised assets. This could come from receivables or from mortgage-backed assets.
In the case of some utilities, the relatively safe income stream came from the utility’s customer base. Associated with the ring-fencing are strictly defined covenant clauses that prevent the parent company from exercising control over the securitised assets and, in particular, from extracting earnings or assets that might undermine the security of the bonds.
By doing this, relatively safe forms of securities can be issued at low cost in the form of bonds. This reduces the company’s cost of capital and thereby enhances its value. It might be thought that this would simply increase the risk of the remaining unsecuritised assets, but by focusing on different classes of risk, the overall risks appear to have been reduced and, therefore, the overall cost of capital is lower, too. Securitisation has generated a huge volume of transactions, all of which reflects a general move towards transactions-based finance. These include new equity issues, acquisitions, asset disposals, share repurchases, capital restructurings and securitisations.
Why transactions matter
One of the attractions of transactions is the information they reveal about valuations and prices. Again, consider the initial sales of public utilities. Before privatisation, it was almost impossible to put a value on a state-owned enterprise. Revenues and costs were opaque, and risk was difficult to estimate because of the lack of similar standalone quoted companies. As a result, deriving reliable present values was almost inconceivable.
After privatisation, the value that the market placed on utilities became transparent. This shift has, in turn, stimulated further transactions, including acquisitions. Takeovers occur when there is a discrepancy between the values that existing and prospective new owners place on control of the firm. The purchase of UK water utilities by French water companies illustrates the higher value that French companies placed on controlling UK utilities.
A second advantage of transactions is that they allow investors to impose new and more effective forms of governance. The leveraged transactions in the water sector are a case in point. They have allowed companies to carve out the relatively safe utility parts of the business from the rest. In the process, they have imposed strict covenants and asset partitioning between different parts of the business that overcome the governance to problems that afflict equity structures. Bondholders and banks impose legal obligations on borrowers that shareholders are not themselves in a position to enforce. These changes have accelerated the restructuring of these types of industries, although there are worries that some of the gains to shareholders have come at the expense of other stakeholders such as consumers.
Despite such concerns, the emergence of the transaction-based economy has expanded the range of opportunities for the corporate sector to enhance investor value. They allow companies to shop around between different investment houses and banks for the lowest-cost deals. They have increased competition in financial markets substantially and in the process they have driven down the cost of raising finance.
One of the clearest illustrations of this is the new equity market. Until a few years ago, the cost of underwriting IPOs were routinely fixed at 1.5 per cent of the size of the issue, irrespective of the terms on which the issue was made and the risk that the underwriting institutions incurred. Now, companies and investment banks shop around for the best deals and underwriting fees have fallen appreciably.
A second example is the development of the derivatives market, where companies whose income is indexed to inflation, such as utilities, have been suppliers of insurance through swap transactions to other companies that wish to immunise themselves against inflation or interest rate risks (for example, pension funds).
Some think that this has come at a price. Previously, companies raised finance from banks with which they had long-term relationships. In this model, in return for earning high returns during good periods, the banks would support their clients through less profitable bad times, too. Whether the corporate sector is yet to regret the passing of these relationships, however, is still to be tested by the onset of a serious bear market. Regardless, transactions, in all of their forms, are key to the way we do business and we hope this will be a useful guide.
Colin Mayer is Peter Moores Professor of Management Studies and dean at the Saïd Business School, University of Oxford. His research focuses on corporate governance, financial systems and regulation.
Julian Franks is professor of finance at London Business School, and head of the Centre for Corporate Governance. His research focuses on regulation, bankruptcy and financial distress, European corporate restructuring and mergers.