Escape from the Rock


I gave a nervous laugh. The headhunter asked me if I would like my first non-executive director role, joining the board of Northern Rock. It was October 2007, a few weeks since the first run on a UK bank for 150 years. Struck by an uncharacteristic sense of adventure, I did indeed agree to serve on the Northern Rock board for the next year, becoming Chair of the Audit Committee, through the various bids, nationalisation and the rebuilding of its business model.

Northern Rock was a highly successful and fast growing UK bank that predominantly offered domestic mortgages. It financed itself by a mix of retail deposits, wholesale borrowing, asset-backed bonds and securitisation of mortgage portfolios. In September 2007, as the credit markets tightened, it found itself unable to raise enough on the wholesale and securitisation markets to cover the mortgages that it had already issued, and so turned to the Bank of England for support. This was leaked to the BBC, who reported it in such a fashion that a run developed almost immediately. The subsequent £12bn cash outflow ensured that the bank would need long term help, becoming nationalised four months later.

Much has been written what went wrong at Northern Rock, particularly now that we are at the 10 year anniversary. Very little, perhaps understandably, has been heard from those inside the business. So with the benefit of 10 years distance, I thought I would list the lessons I learnt from the sad demise of Northern Rock.

1. Retail banks lend long and borrow short

Some say that this was Northern Rock’s problem. It relied too heavily on wholesale market funding, and not enough using retail deposits from savers. However it is not as simple as this. Half of the wholesale funding was more than 1 year maturity, whereas the bulk of the retail deposits were effectively on demand (hence the £12bn cash outflow in the run). Few banks could withstand the liquidity drain from a run, however well funded they are.

 2. Don’t rely on the Regulator

There was a lot of fuss at the time about relative blames of the Tripartite regulation of the Treasury, Bank of England and Financial Services Authority (FSA), but in practice they all missed the systemic risk incurred by the credit crunch on Northern Rock. The FSA even wrote1 on 14 September 2007 (the day the run started);

Northern Rock is solvent, exceeds its regulatory capital requirement and has a good quality loan book.”

The Bank of England, under the academic Mervyn King was still worrying about the ‘moral hazard’ of bailing out Northern Rock as the bank was failing. That was a bit like calling off the fire fighters because the householders shouldn’t have let their house catch fire in the first place.

In my experience on the board, after the run, the FSA was still singled-mindedly pursuing its ‘Treating Customers Fairly” campaign with the bank even as those customers were fleeing out the doors with all their savings. The FSA gave me an exit interview as I was stepping down from the board, but didn’t ask a single question about the run and its lessons.2

Regulators like to establish rules and processes and then operate within these limits. They are not generally blessed with great insight or entrepreneurial understanding, so they cannot be relied on to protect their target industries or customers. They do however have a knack of closing the door shortly after all the horses have bolted.

3. Don’t rely on the auditors

Why didn’t the auditors identify the risks in the Northern Rock business model? In practice, auditors very rarely find the ‘big holes’ in the accounts. These are usually found by management eventually, or events reveal them as here. This is true from Enron to Northern Rock to Tesco.

Auditors review the accounts. Their job is not to challenge the business model. They reviewed the Going Concern statement, but they failed to challenge the underlying assumptions in Northern Rock as, just like others, they saw an extreme credit crunch as highly unlikely. Even if they had, it’s hard to imagine that they would have qualified the accounts for what seemed such an unlikely risk. This is why auditors hardly ever get sued for their role in business collapses.

4. Sometimes the risk is hidden in plain sight

The 2006 Northern Rock Annual Report stated that, whilst it had £8bn of assets maturing in the next 3 months, it had £33bn of liabilities maturing, giving a liquidity gap to be filled of £25bn. An ING analyst report3 in 2006 noted;

“The inability to fund cheap wholesale funding given its huge reliance on the market to fund its expansion would impact our outlook negatively.”

In 2007, the Bank of England admitted4 that most banks’ reliance on wholesale funding had risen in recent years.

It may have taken hindsight to spot it, but Northern Rock’s liquidity risk was clearly and publically stated. I have since gone into two companies that had massive derivative black holes that were clearly laid out in their Annual Reports, but no-one noticed them.

5. Think the unthinkable

All the risk models in the world are useless if what happens was not envisaged to be possible. Nobody in Northern Rock, nor anywhere else in authority, seems to have believed that a credit crunch would lead to an implausible freeze, where even banks wouldn’t lend to each other. The repeated mantra was that a crunch would instead lead to a ‘flight to quality’, and that would be fine as Northern Rock’s paper was rated highly.

In 2006, the FSA was explicit5, asking that management; “takes severe but plausible scenarios into account…”.

Hector Sants, then CEO of the FSA, said1 later;

No reasonable professional would have anticipated the complete closure to them of all reasonable funding mechanisms…I think that the set of circumstances …were highly unusual…”

Academics call this underestimation of ‘thick tailed’ – or ‘black swan’ – events. A 1 in 100 year event has a high probability of happening once in your lifetime. There have even been two world wars in the last hundred years. It is too easy to dismiss a risk as implausible or a very rare event. Rare events do happen and usually more frequently than people expect. Every risk model should work through how the business would react and survive every highly, unusual and implausible, event.

When evaluating a company’s ‘risk appetite’, it is worth asking the question whether there is a 1 in 100 year event that could destroy the company. As an investor you would need to accumulate your share of those risks. Say you invest for a pension over 20 years in 10 companies that are willing to tolerate a 1 in 100 chance of a terminal threat. You, as an investor, would then have the likelihood of two of those companies suffering a catastrophic event in your pension pot.

Of course, hindsight gifted politicians and media with the clear knowledge that it should have been obvious to the Northern Rock Board that its model was fatally flawed. It wasn’t however obvious to the participants at the time because they, like almost everyone-else, blinded themselves to the extreme risks.

6. Risks are multiplicative not individual

People have a tendency to think about risks in isolation. However, this assumes that the risks are completely independent, whereas in practice the worst events happen when two risks crystallise at once, either randomly or because one risk tends to increase the likelihood of another.

In Northern Rock’s case the freezing of the wholesale markets caused a liquidity problem, but this could possibly have been handled by the Bank of England support facilities. However the proposed use of these led to a leak that caused a loss of confidence among savers. The former problem became multiplied by the second.

The typical business risk model has one axis for probability of a risk happening and one axis for resulting financial impact. But this static model is woefully inadequate if more than one risk can occur at a time, particularly as the result may well be multiplicative – much more dramatic even than the sum of the two independent risks.

7. The reassuring herd

Northern Rock was an outlier. It did things differently to other banks. Its retail deposits in 2006 were 27% of its total funding, against 49% at Bradford & Bingley and 43% at Alliance & Leicester. Northern Rock was taking a 25% market share in new mortgages and growing its balance sheet much faster than others.

Instead of querying how its model was so uniquely successful, Northern Rock argued that its excess reliance on such funding would only be appropriate for a growing bank and so that’s why others didn’t follow. There doesn’t seem to have been much challenge to this circular thinking.

I’m not arguing for businesses to follow the herd all the time. However, it ought to be an immediate amber light for risk when one business is doing things radically different to others, even if that appears highly successful for a long period.

8. Success is intoxicating

Northern Rock was growing rapidly and its share price reflected this. Large salaries and bonuses were being awarded to executives. Who would be a Cassandra against this success? Businesses need a certain paranoia when they are very successful to ensure that this performance doesn’t contain the seeds of its own destruction. When very successful businesses falter, it can happen very quickly, as shown by the whole banking system, Enron, Worldcom, Polly Peck and so on.

9. Group-think is a powerful drug

The Board considers that Northern Rock is a well-controlled, risk-averse business that continues to adopt a prudent stance in the management of risk.” 6

Although Northern Rock did have reasonable business controls, it was in fact taking on massively more risk than it appreciated at the time. But management believed what they were saying at the time.

You can’t underestimate the tendency of people to adopt group-think, and accept conventional wisdom. This is particularly true when things are going well. There was no evidence to prove that a severe credit crunch was very unlikely. The fact that there hadn’t been such a credit crunch since the 1930’s meant that people believed it couldn’t happen (as opposed to believing that it was a 1 in 80 year event). There was no evidence that a credit crunch would lead solely to a flight to quality. It’s just that the more people said it, the more it was believed.

The Treasury Select Committee report1 made much of the Northern Rock CEO not being a ‘qualified’ banker. This was irrelevant as the CEO understood banking very well. There is no evidence that having taken some exams twenty years previously would have made him address risk differently. The issue was that there was too much conventional wisdom being accepted as proven fact in mass group-think, and far too few people anywhere were ever sceptical or open minded enough to challenge it.

10. A very powerful Chief Executive is dangerous

This is pretty well acknowledged in corporate governance now, but it needs reiterating. It is not just that you end up with too much power in one person, but that it tends also to attract ‘yes men’ to the business, who may not be of the highest quality. If you then layer on great success and high rewards to this, group-think and lack of challenge is almost guaranteed.

11. Don’t always believe the answer, especially if you don’t ask the right question

I have lost count of the times in my life that I have received a reassuring answer to a question, only to later realise that the answer was misleading because the question wasn’t quite right or too vague. When I tried to understand the liquidity position at Northern Rock, I was told that the average mortgage lasted only three years. It seemed a little low, but I accepted that. It was only much later that I realised that this referred to the average length of a mortgage package. In reality, an average mortgage lasts something like seven years, but during this period it may be switched between deals (such as a particular rate fix), so the answer I got was very misleading even if technically accurate.

Sometimes it takes the same question asked several times in different ways to be sure that you have got the whole truth. Sometimes you are just not told the whole story. Northern Rock underreported its mortgage arrears, claiming them to be half that of the industry. In fact it was treating many arrears as being rescheduled over the remaining life of the mortgage, effectively increasing the size of the mortgage rather than being classified as being in arrears7.

12. Organisation matters

Internal audit and risk teams are major protections for a company in understanding their risks. However, reporting lines can frustrate this. One of the major governance improvements over the last few years has been raising the profile and importance of such teams. But they must be heard at the right level (usually the Audit Committee) and without operational management acting as a filter. At Northern Rock, the Treasury Risk team reported into the Treasury function, not Group Risk. This meant that the Group Risk team was not in a position to offer a robust challenge to Treasury.

13. Once public, stories have a life of their own

The run started after the BBC ran a high profile story about the Bank of England’s support for Northern Rock. Robert Peston, the journalist, claims that he handled it in a responsible way. This may be true, but the prominence of the story on the BBC was such that it emphasised to the public that this was a major event, much more so than anything he actually said. He got the story from a leak. It’s difficult to imagine anyone benefited from this leak. Some think that it came from the Labour government itself, anxious to show the country how it was having to bail out irresponsible bankers. If so, it back fired, because once out, the leaker couldn’t control how it would be reported, and it became almost certainly a much more dramatic event than anticipated.

14. Get it in writing

This is advice more for executives that are involved in difficult situations. When asked to do something that you are not sure is right, somehow make sure that there is a written/email reference to it, even if you do the writing. If something is not quite right, the instructions are far more likely to be given verbally than in writing. When Northern Rock had been underreporting its mortgage arrears, on investigation there was nothing in writing confirming that senior management knew about it.

My conclusion

There are many lessons from any corporate failure, but the best ones are not generally those identified by politicians and the media. Sadly, the real lessons are also rarely understood by corporate regulators either, as they tend to be most sensitive to the clarion calls for action from those politicians and commentators. Rarely do you see corporate failures analysed to provide governance insights. I have listed some cultural and practical lessons I learnt from what really happened.

Ten years on, I have kept to another, more personal, lesson. Being a non-executive director on a bank is an extremely difficult, detailed and risk-prone job. I escaped from the Rock, vowing that I wouldn’t ever serve again on the board of a bank. There are easier ways to earn a living.


1 ‘The run on the Rock’ – Treasury Select Committee, January 2008

2 The FSA did in fact hold an Internal Audit inquiry into its own conduct, which looked at its own internal processes rather than understanding why the bank failed.

3 ‘Northern Rock. The train has left the station’ – ING September 2006

4 Bank of England Financial Stability Report – April 2007 Issue No 21

5 Letter from the FSA to Northern Rock – 9 October 2006

6 Annual Report Northern Rock 2006

7 Two Northern Rock directors were subsequently fined by the FSA for this.

Image by Alex Gunningham from London, Perfidious Albion (UK plc)


To buy or not to buy, that is the question

Money scales


Whether ‘tis nobler to buy back

shares or pay a dividend?




Maybe Hamlet was not so concerned with shareholder distribution, but most modern company directors certainly are. In an earlier article I reviewed why and how companies make shareholder distributions and in particular pay dividends. However there is another form of distribution, the share buy-back.

Share buy-backs

Companies can purchase their own shares, using cash that otherwise could have been used to pay a dividend. This requires shareholder permission, and it is common for an AGM resolution to be put routinely annually to give boards the power to undertake share buybacks. The company also has to comply with the same rules about having distributable reserves as when paying a dividend.

Why do a share buy-back?

If a company buys back its own shares, this will reduce the issued share capital. In the first instance this shouldn’t have any effect on the share price, as the company loses the cash, and thus value, proportionate to the reduction in the number of shares. However any further gain in the value of the company would be spread over fewer shares, boosting earnings per share (EPS) or net asset value per share growth.

The buy-back, like any distribution, also signals management confidence in the future, which may boost the company valuation and thus share price. This is particularly true if the buy back is part of an established ongoing programme of repurchases. A buy back may also be initiated as a one-off, if for example a significant part of the business has been sold off or the company gets a one-off receipt of cash. In this case the benefit is likely to be one-off as well.

Share buy-backs or dividends?

Share buy-backs fundamentally offer capital gains in place of dividend income. Some shareholders (such as growth funds) may prefer capital gains and others (such as private shareholders or income funds) may favour income. Most tax authorities levy lower rates of tax on capital gains than income, so there may be tax advantages to buy backs over dividends. Buy backs also enable shareholders to defer tax paid as it is charged only when shares are subsequently sold.

On the other hand, some shareholders may favour cash in hand, so they may prefer dividends to buy backs.

Dividends tend to be ‘sticky’. Shareholders don’t like the dividend being cut, so management is reluctant to reduce the rate of pay out unless there is a lasting downturn in profit expected. Buy backs, on the other hand, can be more flexible, as there isn’t necessarily the expectation that they will be repeated at the same level.

Share buybacks are more likely to benefit earnings per share. This is because, although the company loses interest from paying cash out in any form, the buyback offsets this by reducing the number of shares in issue. Management may be incentivised to grow EPS, and so may prefer buybacks.

Is there evidence that favours either buybacks or dividends?

Any evidence is difficult to assess as it’s a bit circular. If a company is doing well, it is more likely to pay higher distributions. Separating out the underlying cash flow performance from the impact of the subsequent distribution is difficult. However the best data comes from the US, where buy backs are fairly common.

Shareholder distributions are a large factor in total shareholder return (TSR – the sum of shareholder distributions and share price appreciation). Over the last 80 years, 44% of the TSR of Standard & Poors 500 companies came from distributions1.

Buybacks have become a more popular form of distribution in recent years. Until the early ‘80s, less than 10% of shareholder distributions in the US were buy-backs, but nowadays they are 50-60%2.

McKinsey2 found that there was no significant relationship between growth in TSR and whether the company paid dividends or bought back shares. It did conclude that companies that did frequent buy backs did best. However this seems a little circular. Only very successful, cash generative companies can afford to do frequent buy backs and they are likely to be companies whose share price is likely to reflect that performance!

Some argue that companies should buy back shares when the board feels that the company is undervalued. However, this would suggest that the board must have a better understanding of market value than the market. McKinsey2 concludes that they have ‘rarely seen companies with a good track record of repurchasing shares when they were undervalued; more often than not, we see companies repurchasing shares when prices are high.’


The theory is that, unless shareholders put a significant weight on the tax benefits of buybacks, they should be indifferent to share repurchases compared to dividends. The statistics, such as they are, back this. The form of distribution has no significant impact of shareholder returns.

The underlying financial performance plus the decision to pass some of the success on in shareholder distributions, in whatever form, are the key drivers of shareholder return. It is strong financial returns plus the determination of the board to reward shareholders that delivers total shareholder return.

Managements who don’t take account of shareholders’ interests in this way risk getting punished. Or as Hamlet put it;

And enterprises of great pith and moment

With this regard their currents turn awry

And lose the name of action.



 1 CFA magazine

2 McKinsey



What are dividends?

Twenty pound notes edited 

A simple question, I’m sure you’ll reply. Everyone knows that a dividend is money paid to shareholders by a company to reward them for owning its shares. However, a non-executive director needs to know a little more than this, as dividends can prove surprisingly complex.


A dividend is a form of shareholder distribution. However it is not the only form of distribution, the main alternative being a share buy-back. I’ll come back to that in a later article.

The first question that needs to be asked is whether a shareholder distribution would be legal.

Is a dividend legal?

 A company can distribute only profits to shareholders, so there must be sufficient accumulated profits in the balance sheet. This is shown by whether there are sufficient ‘distributable reserves’. If you look at the bottom of the balance sheet, you will see a number of reserve accounts listed, some of which are distributable and others not. The accounting bodies have conspired to make this highly complex, so I won’t go into the details here. However an alert non-exec will ask the CFO or Audit Partner to list out the distributable reserves to show that they exceed the shareholder distribution being proposed.

Be careful here, in that the distribution is made out of the top company accounts, not the group consolidated ones, so look at these (it may be the only time you look at the ‘company’ accounts, usually buried right at the back of an Annual Report). Also be aware that it has to be the last filed accounts that show sufficient reserves. Management accounts don’t count, nor does any profit earned after the last set of accounts filed with Companies House.

It is illegal for UK companies to pay a shareholder distribution that does not meet these conditions. If you subsequently find that an illegal distribution has been made, you will have to either claim it back from shareholders (not a great idea) or pass a retrospective EGM resolution to absolve shareholders from any claim from the company to get the money back. Best not get yourself into this position, although it does happen, especially since the law has been tightened.

Do shareholders like dividends?

There’s not much point in paying a dividend unless shareholders want one, but it’s pretty rare for them to be unpopular. Dividends do three things;

  1. Pass some of the profits onto the owners of the business (ie shareholders)
  2. Reduce cash balances or increase net debt for the company
  3. Signal confidence in the future to the market

Dividend cover: Companies normally pay out a proportion of their annual profits. This is shown by the dividend cover. A common level is a cover of 2.0 meaning that the profit after tax is twice the dividend, or to put it another way, the company is paying out half its post tax profit. As a rough rule of thumb, a non-exec should be wary if the company is paying out a lot more than this (ie cover well below 2.0). Shareholders value a stable and predictable dividend flow, so you should satisfy yourself that this level is sustainable. It is possible to have an uncovered dividend (ie the dividend is higher than the profit, a cover of less than 1.0), but it is very difficult to keep this going for long.

If the cover is 3.0 or above, shareholders may query why more isn’t paid out. There may of course be good reasons, perhaps the company is trying to reduce its borrowings or is nervous about the future.

Dividend yield: The other way to look at dividend return is expressing the annual dividend as a percentage of the share price. This is the dividend yield. It can be compared to an interest on a savings account. Shareholders might expect a yield to be higher than a savings account to take account of the risk of fluctuations in the share price. A typical dividend yield at the time of writing is 3.5%, well above most savings returns.

Shareholder might be happy with a lower dividend yield if they expect the share price to rise, perhaps as the company is investing its cash resources into expanding the business. On the other hand, a higher dividend yield may not be good news, as this may suggest that the market expects the share price to fall and indeed that the dividend may not be sustainable.

Different shareholders look for different returns. Most private (“retail”) shareholders look for income, and so favour stocks that deliver at least a market average dividend yield. This would also be true of institutional income funds. However growth funds are more focussed on the share price, and so may be relatively indifferent to the dividend.

Do dividends matter?

Theoretically dividends shouldn’t matter. It’s all shareholders money whether its distributed (dividends) or kept in the business (share price). Shareholders should worry only about total shareholder return (TSR), which is share price appreciation plus dividends paid. A higher or lower dividend should not affect TSR.

However, in practice, dividends do matter:

  1. A shareholder might have tax advantages in receiving capital gains from a rising share price, rather than income from dividends.
  2. Shareholder distribution may be part of the company moving to a different capital structure, such as increasing debt and leverage. This alters the risk profile of the company and may move the valuation of the stock.
  3. A rising dividend is sending the market a sign about management confidence and this may be reflected in a higher share price. Alternatively a cut in the dividend suggests that management is foreseeing more difficult times ahead.

Other kinds of dividend

Dividend in kind: Some companies offer investors to receive dividends in shares, either through a scrip issue of new shares or a ‘DRIP’ scheme (whereby the company purchases existing shares to give to investors). The advantages to shareholders are that, if they don’t need the cash immediately, they can reinvest the money in additional shares with no dealing costs. The advantage of a scrip issue to the company is that it preserves its cash, effectively issuing new equity. The DRIP uses cash, but slightly reduces the shares in issue, with some benefit to earnings per share. In the UK there is no tax difference in taking a cash dividend versus shares. If a new scrip or DRIP scheme is being launched, a non-exec should just ask what level of take-up is expected in order to justify the modest additional costs for the company.

Special dividend: Sometimes a company will declare a special dividend. The description ‘special’ simply implies one-off. It is typically where the company wishes to pass on the proceeds of a sale of a major asset or division, or where it wishes to increase significantly its gearing or reduce its spare cash. In other respects a special dividend is the same as an ordinary dividend.


 Dividends can be a surprisingly complex area. They need to be thought about and pitched at the right level for the cash resources, strategy and future expectations of a company.

  1. Always ask the question about distributable reserves before approving a shareholder distribution.
  2. Ask how the share register is made up, especially between income and growth investors.
  3. If the proposed dividend cover is less than 2, ask the question why such a high pay-out and is this is sustainable?
  4. If the proposed dividend cover is higher than 3, ask why the dividend is restricted to this level and could a higher payout be afforded?
  5. If the dividend yield is higher than 4, ask why. Does the market expect a dividend cut in the future?
  6. Asking the question doesn’t mean it’s wrong. It will just elicit the information a non-exec needs to understand before approving a shareholder distribution.

“Marking our homework” – Why executives resent non-execs

Management scribbles001


It won’t be long into your first non-executive job when you start to feel as if the executives resent you. It’s okay. You haven’t become paranoid. They really do resent you. Why?




Being an executive director is a tough job. You work all the hours that the Working Time directive allows, then you opt out and work some more. The market is very tough and competitive, and you end up making numerous difficult decisions. You do this for a couple of months and try to summarise what’s happened and why for the Board. Then a few part-time directors waft in and criticise the papers, ask stupid questions and lecture you about governance. What’s not to hate about that?


But being a non-executive director is also a tough role. You are invited to join the board of a company about which you probably know little and possibly in a sector of which you know nothing. You may get a cursory induction programme and then it’s straight into a board meeting. The performance information may be either perfunctory or so detailed that you can’t get any sort of meaningful overview. Management may be defensive, resentful and resistant to questions. You ask yourself, how can I add value to this board?


Executives often say they feel that non-execs come to board meetings ‘to mark their homework’. This is very difficult to avoid. Execs usually work very hard and in their heart of hearts, really want the non-execs to turn up and applaud them. There are few things more irritating than having a non-exec appear and come up with a good idea or question the execs hadn’t thought of. Even if it’s helpful, human nature means that you may resent it.

Here are some suggestions to help harmonious board discussions.

For the executive:

  1. Remind yourself that the non-exec is trying to understand your position and making sure that you have thought of all the angles.
  2. Don’t react immediately, but let the board discussion continue. The initial comment, even if naïve, may lead to a useful discussion.
  3. Remember that you are paying the non-exec to be there. Whether you like it or not, you might as well listen to something you’ve paid for!
  4. Pause a while, as what may seem initially as a strange comment from a non-exec may turn out to give a new insight or angle into a common issue. They won’t necessarily use the same jargon as you, but may still understand the problem.
  5. If the non-execs are well chosen and sensible, remember that their comments are likely to be, or at least intended to be, helpful.
  6. Avoid being defensive at all costs, and watch out for sounding defensive.


For the non-executive:

  1. Avoid stating the obvious or asking a question implying that executives don’t know their job.
  2. It is tempting to review paperwork and point out errors. If this is necessary, do it privately outside meetings, rather than in board discussions.
  3. I think that it is good practice to ask questions that arise from reading advance paperwork directly of executives before the day of the meeting. This can be in person, by telephone or email.
  4. Questions should generally be asked in board meetings only when they have just occurred to you or will elicit an answer that you would like everyone to hear. If the latter, you could also warn executives in advance that you intend to ask the question and give them time to prepare a good response. This will make them much less defensive as they won’t feel that you are trying to catch them out.
  5. Keep interventions and questions short. The longer you go on, the more pent up anger may build in others.
  6. Don’t confuse asking a question with making a speech. There’s a time for both, but not at the same time.
  7. Try to put important questions or points early in the discussion, rather than dropping them in like a depth charge, just as the Chairman is drawing the discussion to a close.
  8. Use cautious language, with plenty of conditional tenses and get-outs (“I was wondering if…” ,“Perhaps this might be an issue…”)
  9. Offer to meet separately (”offline”) if the discussion goes on for a long time or has generated some unwelcome heat.
  10. Remember that when you leave this meeting, you can go onto other things, but the executives are stuck dealing with the same issues full time until the next board meeting.


I have been in executive and non-executive roles on quite a few boards, and even temporarily moved from non-executive to executive on some boards, so I have seen these issues from both sides. I am grateful (and would like to apologise) to all my boards for allowing me to make all the mistakes listed here, and now to write from bitter experience!


Board meetings can very sensitive affairs. A good one informs all participants and pools their knowledge and experience to come up with good decisions. A poor meeting just stokes resentment between the various participants. Directors should remind themselves that it’s not an aural exam and board papers are intended to be the genesis for a two-way discussion. There is no marking of papers required!


Sir Ken Morrison – a retail giant, but still human

mrw-high-wycombeSad news came last week with the death of Sir Ken Morrison. It made me reflect on his tremendous lifetime achievements. His career is sometimes viewed as 50 years of success, until at 73 he led the 2004 Safeway acquisition followed by four difficult years until retirement. He built up a leading supermarket chain making £320m pa. Few people will, or can ever, achieve such a feat. The last four years should never lessen that achievement, but inevitably the latter attracts more interest, as it is the story of how things went wrong and why, even when led by someone as talented and experienced as Sir Ken.

I met Sir Ken quite a few times during the Safeway take-over, as I was the CFO. He was always very polite and proper, even warm. However, he never let that Yorkshire reserve go, so you were never sure whether you were seeing what he was really thinking. He always seemed to agree with you, even when you expected to disagree. Eventually, I realised that this was how he handled situations with people he wasn’t comfortable with; his close associates and subordinates. He would listen carefully and politely to what people said, nodding and smiling, but saying very little. You would think that he was agreeing, but in fact quite often you would hear later that he completely disagreed.

It is well-known he despised consultants, analysts and non-executive directors in equal measure, but he knew every one of his 100 store managers, how his business ran and, above all, what his customers wanted. When you met him, you knew you were in the presence of a retail giant.

So why did it all go so wrong? Why did the £600m combined profits of Safeway and Morrisons, not to mention another £300 odd of synergies, dissolve into a £300m loss two years later? To be fair, by the way, by the time Sir Ken retired in 2008, profit had recovered to over £600m, which is incidentally more than twice the profit today.


The Morrison success story was built on a simple concept

We all know that simple businesses have the best chance of success. Morrisons was a chain of near-identical stores built largely in downmarket demographic areas in the midlands and northern England. Sir Ken loved simplicity and wanted all stores to be very similar to adhere to that principle. Morrisons offered great ‘everyday value’ with low base prices and around 1,000 promotions, largely multi-buys (perfect for growing families), with many service counters offering variety and a ‘good honest quality’ feel. Little went to waste, as food near its sell by date would be used in the customer and staff restaurants or recycled in a service counter (eg prime meat as mince).

Sir Ken didn’t believe in complex systems. He told me once that he designed their ordering system one day in a store canteen. He described what he meant. I said but that’s just a stock & order card. Yes, he agreed, and that’s all the system is. But how does this do forward ordering, I asked. Ah, he replied, we are just trialling a system now. This was in 2003, some 10 years after the other majors, including Safeway, had automated re-ordering.


Sir Ken dreamt of growing faster

The Safeway takeover started when Safeway approached Sir Ken. Safeway had struggled as No4 in the UK grocery market, and had tried a number of strategies without any lasting success. Eventually the board concluded that scale was the major issue. A couple of attempts to merge with Asda failed, and it was considered highly unlikely that the competition authorities would allow such a merger of No3 and No4 anyway. That left Morrisons. I had presented a number of competitor analyses to the Board over the years and every one concluded how well Morrisons performed. The answer was obvious, to put the two businesses together to rival Sainsbury and Tesco in size.

Sir Ken, however, had less lofty ambitions. He wanted to grow faster and coveted the Safeway superstores and hypermarkets. He was initially very cautious, not wanting to threaten what he had created so far, and took many months to agree to explore the idea. Sir Ken told us, at the time, that it was his fellow executive directors that were more ambitious. It was they who were urging him to go for a takeover and who were so confident of making it a success.


Simplicity has its own challenges

Morrisons was a simple business run in an efficient uncomplicated way. Reordering was manual. Ranges were near identical in all stores, each with very similar layouts. Sir Ken made almost all the decisions in a Thursday morning weekly meeting in his office. He didn’t need complex processes. He claimed that new store development decisions were made by counting chimney pots, ie driving round the neighbourhood for a while, at a time when the other chains were using sophisticated geographical databases. He spent a lot of time visiting stores and fixing problems there and then.

Sir Ken didn’t believe in sophisticated management. He had confidence in his own judgement on decisions. He didn’t need strong management around him. He needed people who would implement his decisions. As a result, his colleagues on the board were not the strongest, and there was very little middle management. This made for a simple lean structure, but also contained the seeds of future problems. It was not a structure that could cope easily with complexity or a heterogeneous store portfolio and customer base.


Safeway was a complex business

 Morrisons acquired a difficult situation when it acquired Safeway;

  1. Safeway was a much bigger business than Morrisons, with 500 stores and a turnover of nearly £9bn, against 120 stores and less than half the turnover.
  2. Safeway was a much more heterogeneous business. Almost all Morrisons stores were bigger than 2,400 sq m, barely the average size of the Safeway stores. Safeway was a multi-format business, with five formats (hypermarkets, superstores, supermarkets, convenience stores and BP petrol stations), where Morrisons had one.
  3. Safeway had a very diverse customer base with slightly upmarket demographics, across all UK regions including Scotland, whereas Morrisons had a more homogeneous, downmarket customer base principally in the midlands and northern England.
  4. Safeway had built itself complex logistics and IT systems, while Morrisons had experience only of relatively simple IT and two regional distribution depots.
  5. All Safeway formats were profitable, so selling off small stores, as Morrisons did, wouldn’t improve profitability, even if it reduced complexity.

This complexity was one reason why Safeway had struggled over the previous decade. Itself the product of a takeover, by the Argyll Group (Presto supermarkets) in 1988 of the UK arm of US Safeway, initially this new group had performed very well until the downturn in 1993. Under Sir Alastair Grant, Argyll managed to merge the range excellence and customer service of Safeway with the canny northern financial and cost management of Argyll. Safeway Group, as it became, flourished with a management and culture that was roughly a third Safeway, a third Argyll and a third new recruits from other businesses.

However, the synergies of the merger hid for a while the longer term problems of lack of scale and complexity/heterogeneity of the resulting business. This became evident in the mid 1990s, when not even the advice of McKinsey, which ironically also played a lead role in the contemporaneous turn around of Asda, seemed able to lift Safeway’s stagnating profit. Later a new CEO, the glamorous Argentinian Carlos Criado-Perez, similarly struggled.

Carlos added significant extra complexity himself. His vision was for a Safeway that had a warmer, Mediterranean feel, where; cream replaced white colour; real pizza ovens provided theatre and ambience; large fish counters established food credibility; overflowing ‘misted’ produce counters literally dripped fresh food allure; and block colour merchandising made grocery lines impactful. He also understood that Safeway couldn’t offer lower prices than Tesco or Asda (not least because of lesser scale buying), and complained that Tesco immediately matched any significant Safeway promotion. To counter this, he devised a rolling series of deep promotions across different sets of geographically disparate stores. Whilst very complex, these promotions proved impossible for any competitor to match effectively.

The promotions then developed into a portfolio of transaction-driving (ie loss-making promotions exciting enough to draw in new customers) and basket-driving (ie an existing customer would buy additional products on promotion). In business school jargon, this was an extreme, local form of high-low pricing.

Carlos believed that a No4 player had to be high-low, i.e. promotional, because it would lack scale benefits of larger players. However, the extreme nature of the Safeway version was intended to be temporary. It was a holding action while the new formats were being developed and would generate customer trial when the formats were refitted and rolled out. However, it later became clear that not only did the new formats not bring significant additional sustained revenue, but they brought permanent extra costs. In the end, this failure bequeathed extra complexity for the incoming Morrisons team.


Safeway customers didn’t shop at Morrisons

 Safeway, in the run up to the takeover, did some research that showed that in areas where there were both Safeway and Morrisons stores, Safeway customers tended to be Morrison-rejectors. The Safeway customers would also shop at Tesco or Sainsbury, but rarely Morrisons. Morrisons dismissed this evidence, but it would come back to haunt them.

Almost all grocery customers have a choice of where to shop. Indeed, maintaining this was at the heart of the later competition inquiry into and remedies for the takeover. Safeway attracted customers who liked strong, largely price-led (ie not multi-buy) promotions. They appreciated a wide range with upmarket lines tailored to their demographics. These were the key factors why Safeway customers were choosing to go there, rather than to Morrisons and, to a lesser extent, Sainsbury and Tesco.

It was therefore quite a brave decision by the incoming Morrisons management to stop the price promotions, replacing them largely with multibuys. They then reduced range, especially on fresh lines, and put in a more generic downmarket product range. As the Trading Director asked us: “Why do you stock balsamic vinegar?” We explained that it is regarded as an essential in Sutton and Reigate, southern towns of which she knew little. In another example, they replaced freshly squeezed orange juice at £2 a litre and a 45% gross margin, with Morrisons entry-level orange at 40p and a 30% gross margin. If customers wanted that type of juice, they were already shopping at Lidl and Aldi, but if they wanted upmarket orange juice they now had to go to Tesco, Sainsbury and Waitrose.

And they did. Post takeover Safeway suffered a dramatic loss of customers, who fed revivals at all its rivals. The transaction loss was somewhat offset by an influx of very price sensitive customers who did want the lower ‘everyday’ prices of the new range. However, these customers often could not afford to spend very much money, targeting only cheaper, lower margin lines.

This represented a victory for simplicity and less fresh food wastage, but it was a somewhat pyrrhic one as customer numbers dwindled.


Morrisons wanted to purge Safeway

There was to be no merger of management. Initially Morrisons agreed to ‘best man for the job’, but the reality was different. Safeway’s head office, west of London, was closed progressively and employees could either take redundancy or apply for a job in Morrisons head office in Bradford. Few took the latter, fearing for their long-term future. As a result, Morrison lost the people who knew how to manage the complex Safeway business.

Morrison simplified the supply chain by disposing of the automated replenishment system, explaining to store managers that they would have to go back to writing their own forecasts again. The core multimillion-pound ERP system that Safeway had just finished installing was cancelled (a consultant later told me that he loved Morrisons. Why, I asked. Because, he said, it was the only company that had, as Safeway, paid him to install an ERP system, then paid him to remove it after the takeover and then paid him a third time to reinstall it later when they realised their mistake).

Morrisons rejected Safeway’s promotional strategy. They disliked, with some justice, that supplier funding for the promotions tended to come in as lump sum monies at the year-end, with other volume and activity-related rebates. The year-end sum was around £600m, twice the annual profit, so you can understand why this disturbed them so much. Controlling such an accrual was a very tricky task for the finance team, but Morrisons management went further and said that they didn’t believe the (externally audited) sums were real and that they didn’t approve of collecting them. They were men and women of their word. They stopped trying to collect these monies and then fired the finance team and the buyers, who knew where the money was.

There is an established principal for a retailer when it moves from high:low to everyday low price (ie reduce promotions). You add up promotional funding and then tell suppliers that you want that same money now taken directly off invoiced cost prices. However Morrisons management lost control of the funding sums, and lost the people who could have retrieved the situation when they realised their error. They then did the only thing they could do, and blamed Safeway for fiddling the numbers. In fact, one supplier told me that all his Christmases had come at once. Morrisons had apparently forgotten that he owned them a couple of million pounds and he was able to reverse his accrual to the direct benefit of his bonus. He was not alone.

This was not an error of strategy, as reducing the promotional weight was very sensible, but one of execution by the people Sir Ken had charged with managing the integration.


Simplicity plus complexity results in more complexity

Sir Ken had built a brilliant model. His was a simple, homogeneous business with a thin management structure under his clear management. However, this also limited its growth. Morrisons didn’t want to develop new stores that were significantly smaller or larger or in different demographics. There was a limit to how many stores Morrisons could run with this model, not least as Sir Ken couldn’t know and visit each one regularly. There was a limit to its scaleability.

Safeway had been complex partly because it struggled with a variegated store portfolio. It wasn’t possible to simplify the combined business just by imposing the Morrison model. In so far as this happened, the result was then not what the Safeway necessarily customer wanted.

The Safeway acquisition didn’t cause these problems for Sir Ken, but it revealed them in spectacular fashion. Trying to impose Morrison simplicity on Safeway customers and processes was like trying to herd cats into one of Ken’s cowsheds.


Maybe managing Safeway was just too tough for anyone

We can analyse the Safeway acquisition with 20:20 hindsight, but maybe this was a business that was too difficult for anyone to manage successfully. Two successive CEO’s at Safeway struggled and Morrisons then laboured. Grocery retailing is a tough business and scale takes a toll on the smaller players.


Sir Ken – a retail giant of his time

You have to admire the entrepreneurial and retail genius of Sir Ken Morrison. Maybe in another time, he would have retired with Morrison as a growing successful fifth player. Perhaps he cursed the day that David Webster, Safeway Chairman, darkened his door with a siren call to merge. However no one is perfect and Sir Ken is not, and won’t be, the last entrepreneur to be seduced by a tempting corporate acquisition.

The best tribute to him is to learn from the experience:

  • To appreciate the value of strong independently minded executives and a few challenging non-executives:
  • To move with the times, embracing change and new methods. The development of IT and the digital economy simply cannot be ignored.
  • To balance the huge benefits of simplicity with the necessary complexity of the business you actually have, rather than the one you wished you had.
  • To evaluate acquisitions, without understating the risks of upsetting customers, losing key staff, setting the right inclusive culture and understanding the different business models.








Tesco and Booker – The Great British Food Merger?


I was just leaving the room on Friday, when I thought I heard on the radio that Tesco was merging with Booker. I smiled as I’d clearly misheard. When I realised it was true, my mind drifted back to the past.

The UK grocery chain, Safeway, used to own both a cash & carry and a delivered wholesale chain. I was a non-executive director of both these, as well as finance director at Safeway itself. So I have direct experience of managing both wholesale and retail in one group. This made me a bit surprised that Tesco is so keen to try the same thing.

What does it tell us about Tesco?

Tesco has struggled with both accounting scandals and weak grocery sales growth in recent years. The former revealed a poor culture in the business, but the latter will have been the more significant issue weighing with the board. Grocery has become more centred on internet/home delivery and convenience stores. The former is lower margin, as customers are not prepared to pay the full picking and delivery costs. Convenience stores are less profitable as they have higher costs than larger stores. Meanwhile the grocery market has been stagnating, not helped by low sales inflation.

Supermarket non-food has not produced much growth in the economic downturn and is also affected by the growth in online retailing. So Tesco has been in search of growth from somewhere outside grocery retailing.

The fact that Tesco has not bought a general retailer tells us that it doesn’t have much faith in non-food retailing for growth. As with its own non-food offering, general retailing has been struggling. The obvious partner for Tesco, M&S, was probably considered too expensive and too difficult. Sainsbury has already secured the leading bricks/online combo retailer, Argos.

Tesco has been eyeing the catering market for some time as a growth opportunity. It took however a misstep by buying Giraffe and Harris + Hoole – too small and with too much complexity to move the needle.

This also tells us that the strategy to grow Tesco internationally is being put more on the back burner. After the expensive debacle of launching in the US, Tesco feels suitably cautious.

Tesco now is trying to buy a cash and carry and delivered wholesale business. This will bring it exposure to catering (£1.9bn Booker revenue and growing) as well as small grocery retail supply (£3.1bn and flat).

Is it a merger or take-over?

This is a takeover in all but name. Tesco is paying a 15% (24% on a 3 month average basis) premium, and only the talented Charles Wilson, CEO, and the Stewart Gilliland, Chairman, are joining the Tesco board, in neither case as CEO or Chairman. Booker will contribute 14% operating profit in return for 16% of the equity. The premium however looks a little low for a takeover, which would usually be 30-40%. This tells you that Booker is pretty keen for this to happen, possibly an indication of their own concerns about future growth.

Has anyone else tried running retail & wholesale food?

Tesco may have been inspired by Germany’s Metro Group, that does indeed include a cash & carry and a hypermarket business, Real. However the performance of the Real hypermarkets has been disappointing and Metro sold the Eastern European Real businesses in 2012. There appear to be few synergies between the cash & carry and retail businesses.

The Big Food Group, a merger of Iceland Frozen Foods and Booker, lasted only five years.

Will the merger actually happen?

It looks as if the main block will be the competition authority (CMA). Tesco will explain to them that the only overlap is on retail, as catering is a different market. The CMA will look at the degree to which Tesco will use its ownership of Booker to influence small retailers. Small convenience stores will protest about this, and Tesco will almost certainly have to offer pledges that it will behave itself and not try to influence retail prices. Suppliers would do well to protest, not least as the largest element of the synergies is from ‘procurement’ ie squeezing them. The CMA will need to look hard at the prospect of Tesco getting access to wholesale cost prices. The investigation is likely to look at the market for convenience stores, although this could be broadened out to all grocery retailing, and the market for grocery supplies. This could take a year, potentially even longer, delaying the deal considerably.

The end result of this takeover would undoubtedly be a significantly stronger grip by Tesco on the grocery market. Will the CMA approve it? Logically, it probably shouldn’t allow it, but my three years experience at Safeway spent dealing with the Competition authorities is that bare logic is rarely the determining factor. I’d give this 50:50 at best.

What’s the benefit?

Take-overs are generally justified by synergies. In this case, they are a modest £200m pa after 3 years. It’s always good for an acquirer to focus on a Year 3 target, as after 3 years everyone has forgotten about the synergy target or dismisses it as irrelevant given all that has happened since.

Revenue synergies are given as £25m by year 3. At a marginal profit margin of say 20%, this implies additional revenue of £125m. With a current sales level of £60bn, that’s an uplift of 0.2% after 3 years. Blink and you’ll miss it. This is clearly just a notional number, so they either can’t justify, or they don’t believe in, any significant revenue uplift.

The cost synergies of £175m are the heart of this deal. Given that Tesco seems to have been working on this deal since June, it is very noticeable how lacking in detail these synergies are:

Procurement: Over half the savings are from procurement. This means two things; comparing different cost prices and using the combined volume to demand new lower cost prices from suppliers. On the former, it has been a holy grail for retailers to get access to wholesale prices, and this would appear to offer wholesale prices to Tesco. However, in my personal experience, suppliers are very aware of this issue and have in the past refused to give wholesale prices to retailers. They monitor sales to wholesalers and will stop supply if they see demand suddenly increasing as deliveries are being shipped onward from wholesale to a large retailer.

Tesco talks about ‘full crop procurement’ as a key, if obscure, benefit, but this is likely to be a red herring. This will be about pressurising branded suppliers. Tesco undoubtedly wants very much to get access to Booker’s cost prices, and if it does, it probably will be able to use its huge muscle to exploit this information. On top of this, Tesco will almost certainly be successful in just using its bigger scale to get better deals from suppliers generally.

Other cost savings: £60m odd from logistics seems a lot, especially as no detail is given. However, joint logistics costs are probably around £1.8bn, so this would represent a saving of some 3%, which is frankly not very much synergy! About £17m from other costs is also barely a rounding error, maybe 1.5% of other costs. The big issue will be whether they close the Booker head office and merge all the support functions.

What are the risks?

  1. Distraction: Booker will be the new shiny toy that all Tesco managers will want to play with. It will be very difficult keeping focus on the Tesco brand, only slowly now recovering, when there will be so much focus on another business, the integration and inevitable redundancies.
  2. Cost drift: This is a key reason that supermarket operators don’t run discount chains or cash & carries. When Safeway owned the discount chain, Lo-Cost, the moment anyone from the supermarket business got anywhere near the discount chain, they wanted to add cost. A cash & carry business has to have a very lean cost structure, even more so than a discounter, so Tesco management will have to work very hard indeed not to avoid extra costs creeping into Booker.
  3. Daddy knows best”. The acquirer’s management always tend to think that they are cleverer and more gifted than the acquiree’s. Functions move to the acquirer business and redundancies are concentrated in the acquiree business. This has already happened in the “merger” of the two boards, with only two Booker men surviving.
  4. Retailers think they understand cash & carry and catering. Charles Wilson will have his work cut out keeping Tesco management away from a very different business, of which they know next to nothing.
  5. Internal focus. It is inevitable that on a merger, focus tends to turn inwards as integration teams drive out synergies and managers jockey for position. It would be challenging for the combined group to keep developing the customer offering of both businesses over the next few years.
  6. Not understanding the risks at the start. It would have been more reassuring for the launch presentation to have at least mentioned possible risks!

Conclusion – is this a marriage made in heaven?

We are likely to have a competition inquiry that will last a year before we know if it will happen. If it gets approved, the businesses will then spend a couple of years integrating and settling down. If in this period, Tesco starts to lose out to grocery rivals in its core chain, then the synergies could easily be lost in weaker like-for-like sales growth.

Retail take-overs, as in other sectors, have a very mixed record. Iceland/Booker failed and was unwound. When Morrisons bought Safeway and merged two grocery retail chains, it decimated the combined profits of over £600m operating profit (excluding any synergies). Today Morrisons still only makes just over £300m, half that of the different businesses 13 years ago. A failed takeover generally proves very expensive.

On a £20bn joint market capitalisation, the synergies would be worth some £1.6bn (less tax, using a 10x multiplier), so this is an 8% opportunity. This is pretty much the uplift in Tesco’s share price after the announcement this week.

I suspect that the synergies are well grounded and sufficiently discounted that the target £200m in 3 years will be delivered. However investors need to consider four other questions;

  1. Will it get competition approval?
  2. Will Booker accelerate Tesco’s medium term revenue growth, especially in catering?
  3. Will combining wholesale and retail be disruptive to the two businesses?
  4. Will management distraction damage core performance of either business?

Overall the deal gives immediate one-off consolidation growth to Tesco, justified by cost synergies. But it also raises major risks in competition clearance and execution. This doesn’t feel like a marriage made in heaven, but very much made of convenience.