Who pays for low interest rates?

 

Bank of England

 

So the Bank of England has cut interest rates again, to 0.25%, as ‘the outlook for growth in the short to medium term has weakened markedly’. It is also pumping £70bn new money into the financial sector, that is ‘monetary easing’ or ‘printing money’. Meanwhile, the government is denouncing businesses for running deficits on their pension schemes. These two, apparently unconnected, events are very much two sides of the same newly minted coin.

 

The last two governments, led by the Conservatives, have presided over a weak economy recovering from the financial crisis, arguing that the prime economic problem has been the budget deficit, necessitating cuts to government expenditure. They have left it to the Bank of England to boost the economy, by lowering interest rates and printing money. However monetary easing has had only limited impact. If people or businesses are worried about the future, and indeed the impact of government expenditure cuts, they won’t necessarily spend more, whatever the cost of debt. As the economy therefore grew more slowly than forecast, and consequently tax revenues languished, the budget deficit remained stubbornly high. Meanwhile the Bank of England has had to cut interest rates even further and pump even more money into the economy. The logic is to end up at zero interest rates, perhaps not so far away now.

However, even the Bank of England has now admitted that its monetary expansion is having limited effect now. Explaining the recent fall in growth estimates, it admits; ‘Much of this reflects a downward revision to potential supply that monetary policy cannot offset’.

Recent governments have refused to use their fiscal armoury to boost the economy, because of the supposed need to reduce the fiscal deficit. ‘You cannot spend beyond your means’, they still say. That is dogma, not economics. Of course you can – by borrowing. If you use that spend to boost the economy, the increased growth and jobs will provide the tax revenue to pay back that debt. How different is this really to printing an extra £70bn new money?

Actually, it is a lot different. If the government boosted the economy by increasing infrastructure spend or increased NHS funding, there would be an immediate boost to jobs and investment. With 10-year gilts now at 0.6%, it wouldn’t take much of a return on infrastructure investment to deliver a positive project benefit, even aside from the general economic boost. Increased NHS funding would deliver significant social benefits, as well as reducing sickness.

On the other hand, low interest rates have reduced mortgage costs and so pushed up house prices. High house prices may make the middle class feel good, but do nothing for the economy. In fact, their main result is to transfer wealth from younger, first-time buyers and renters to their parents and grand parents. This stealth wealth redistribution is no different to raising taxes on the young and the less well off, and then giving tax breaks to the middle class. Except that the government then describes the resulting reduction in home ownership as a crisis, which it blames on house builders and buy-to-let landlords.

The other big losers are company pension schemes. Longer life expectancy and recent poor investment returns have increased pension deficits. But so have low interest rates. Not only do they reduce expected returns on pension investments but, in a double whammy, they also reduce the discount rate on pension liabilities. Has the government admitted its role in the pensions crisis? No, it has condemned companies struggling to pay ever-higher contributions to largely closed legacy schemes.

Governments prefer monetary expansion over fiscal stimulus, partly because it enables them to blame others for the consequences. Printing money and reducing interest rates are down to the independent Bank of England. Fiscal deficits are the fault of the dim and distant Labour administration. The housing crisis is due to land-banking house builders, greedy landlords and banks not lending. Struggling pension schemes are due to corporate greed and governance failures.

Philip Green, for example, has a lot to answer for BHS’s 13,000 pensioners. But so has the government, and it’s time it accepted responsibility too.

New PM, but corporate governance is still a political punchbag

“I want to see changes in the way that big business is governed. The people who run big businesses are supposed to be accountable to outsiders, to non-executive directors who are supposed to ask the difficult questions, think about the long-term and defend the interests of shareholders.

“In practice, they are drawn from the same, narrow social and professional circles as the executive team and – as we have seen time and time again – the scrutiny they provide is just not good enough. So if I’m Prime Minister, we’re going to change that system and we’re going to have not just consumers represented on company boards, but employees as well.”

This speech was by Theresa May, not Jeremy Corbyn. It’s a topsy-turvy world. This is our new Conservative Prime Minister who is stooping to kick the corporate world – the dreaded ‘big business’ – as she strides into No10. Even madder, it was the Institute of Directors, not the Trades Union Congress, that welcomed her ideas. Let’s have a look at her charge sheet and her remedy.

“Non-executive directors… are drawn from the same, narrow social and professional circles, as the executive team”

It’s certainly true that non-executives are often serving, or more commonly former, executives. Normally that’s because running a company is a difficult, acquired skill, and so if non-executives are going to supply oversight, they too need to understand how companies are run. Pretty much all boards will have to have a chair of audit committee, who has to have a senior finance background. Similarly most will have a chair of remuneration committee who has experience of HR or corporate remuneration. Frankly, when it’s my money they are using, I want experienced non-execs looking after my interests.

“…time and time again – the scrutiny they (non-execs) provide is just not good enough.”

There are 3.5m active companies in the UK, of which 2,500 are listed on the stock exchange. How many companies have shown inadequate non-exec scrutiny? The banks perhaps in the financial crisis eight years ago? BHS? This was a private company through the recent scandal. Volkswagen in Germany perhaps?

We’ve seen many more scandals at the Home Office alone, let alone Parliament, in that time. Perhaps Mrs May could define ‘time and time again’?

“…we’re going to have not just consumers represented on company boards, but employees as well.”

When the Treasury Select Committee investigated Northern Rock’s failings, it highlighted a lack of banking qualifications on the board. It didn’t suggest that a consumer or worker on the board would have helped. Volkswagen does of course have worker representation, in line with the standard German model, of which presumably Mrs May is an admirer, although the Germans haven’t gone as far as a consumer director.

By the way, did she mean customer director, rather than consumer?

Where do we start?

Perhaps we can just ask Mrs May some simple questions;

  1. Do you believe that if I invest my money in a company, then I should decide who manages it, or do you think that Government needs to decide it for me?
  2. Do you believe that boards should be more diverse in composition than the Cabinet?
  3. How many corporate scandals have been due to poor non-exec supervision?
  4. What evidence have you got that worker and consumer directors would improve non-exec supervision?

Corporate governance is by no means perfect, and I, for one, would be delighted to hear new ideas to improve it. But this is the same old business bashing – ill thought-out and populist policy, backed by neither evidence nor analysis.

Le Roi est mort, vive la Reine.

Someone getting emotional?

index

 People are only human. Occasionally they fall in love with other people. Ideally, the ‘other person’ works elsewhere, but sometimes the two work together.

Many executives will have come across co-workers, who are in a relationship. This knowledge can vary from being a matter of mild interest to one of real discomfort. I had a boss once who was having an affair with their deputy in our small team. It was very uncomfortable most of the time, but also hilarious at others, especially when they tried comically to hide what everyone already knew. Most companies these days will have policies against relationships with subordinates, particularly as they could be construed as sexual harassment.

However, rules don’t guarantee compliance, especially in matters of the heart. So, as a non-executive, what do you do if you discover that there is a relationship at a company at board level or involving a board member?

Firstly look up the rules to establish the legal position. Is there a company rule that forbids or defines parameters for such relationships? The rules may well be different for relationships between co-workers as opposed to those between boss and subordinate.

The easiest thing for a non-exec is to ignore the situation. You may feel that you should ‘do something’ but if it doesn’t seem to be interfering with work and you don’t feel that it is exploitative, there may be plenty of other more important matters to worry about. Just keep an eye on it. If you don’t feel comfortable with this, the next step is to quietly mention it to the Chairman, and leave the ‘hot potato’ steaming nicely in their lap.

The most problematic relationship is often one a CEO and a senior executive. I have seem this a few times, and it is rarely a good thing. Inevitably other executives know about it, resent the special bond, and fear the pillow talk. This cannot, I think, be ignored. A non-exec would be wise to discuss it privately with the Chairman, and if they refuse to engage on it, raise it at a non-exec meeting. The very least you should aim for is that all non-execs are aware of the issue and can take it into account when they participate in board discussions and decisions.

If you feel that the relationship is exploitative, then you must raise it at board level. If the board declines to take any action, then you must decide whether to live with it or resign.

Beyond this, any non-exec has to apply their own discretion and judgement. How dysfunctional is the relationship to the company and its board? How concerned are the other non-execs? How much fuss do you want to make? There is no right answer here, but you should try to work out, all things considered, what is in the best long term interests of the company?

A final word on your due diligence when you join a board. When one Chairman asked me to lunch shortly after I joined the board, I assumed that he was being welcoming and that we could get to know each other a little better. In fact, he wanted to tell me that there was a relationship that I needed to know about. How kind of him to tell me a week after I had signed on. That taught me as much about the Chairman as it did about the participants.

I would recommend that in your final due diligence before being appointed as a non-exec, you ask the Chairman a direct question as to whether there is anything you should know about personal relationships in the senior management and the board. If you get an astonished denial, you can rest more easily. That’s what due diligence is for. But you might just find out something that could save you a lot of trouble later on.

Summary

  1. Relationship happen at work. They are not necessarily harmful.
  2. Check the company rules on relationships.
  3. You can ignore it, if it does no harm. If in doubt, consult the Chairman.
  4. If the Chairman doesn’t do anything, you can consult your fellow non-execs.
  5. If the relationship risks being exploitative, you should take action.
  6. Worth asking a question during your due diligence.

 

Notes from a non-executive director

A series of articles looking at practical issues and problems that arise on boards.

  1. Becoming a non-executive director
    1. What you need to know for your first NED interview
    2. How to choose your first NED role
    3. How to assess your NED Offer Letter
  2. Learning to be a non-executive director
    1. Your first 100 days as an NED
    2. “Marking our homework” – why execs resent non-execs
    3. What if you have no financial experience?
    4. What’s all the fuss about cash?
    5. What’s your favourite part of being a non-executive?
  3. Things it’s worth knowing as a non-executive director
    1. What are pre-emption right and why do they matter?
    2. What are dividends?
    3. To buy or not to buy – share buybacks or dividends?
  4. What to do if your company gets bid for
    1. What if you get an unsolicited approach for the company?
    2. Let battle commence. The unsolicited approach
    3. Just say ‘No’ – Assessing an offer for the company
  5. Difficult issues that board sometimes face
    1. Is management telling the whole story?
    2. Is someone getting emotional?

Is management telling the whole story?

Info graphic The company was in financial difficulties, as changing market conditions had seriously exposed the misplaced strategy. There was however no suggestion that anything improper had gone on. The external auditors were high quality, and there was a competent internal audit team with appropriate risk models.

Yet something didn’t feel right. Whilst the strategy had failings, the execution must also have been wrong, yet none of the KPI’s showed anything wrong. Eventually, management admitted that they had changed an accounting policy to capitalise losses, and then report the lower numbers. The figures that the board had been looking at, and relying on, were in fact useless and misleading.

Fortunately, outright distortion of data for a board is very unusual. However, a board can only work successfully if it knows all the salient information. A board cannot know everything that matters. It just doesn’t have the time. With luck, executive management will know most of what really matters. It will then brief the board on what it thinks the board needs to know. This will be supplemented by knowledge that non-executives glean from other roles and sources.

The prime source of information for non-execs is therefore what the executives choose to pass onto the board. NEDs can of course ask further questions, and this will elicit further information. Non-execs need to spend some time trying to crosscheck information. One way to do this is to look hard at the standard performance indicators (KPI’s) given in board papers.

A new non-exec might be surprised at how often a KPI appears to contradict what management is saying. It is worth challenging this, as the explanation is usually illuminating. It may well be that the KPI is being distorted by a one-off factor. Sometimes, this provokes a useful discussion as the distorting or one-off factor may be being forgotten. It may be that the question is followed by an awkward silence as the CFO starts flicking through his packs to find a reason. This may itself trigger a concern in your mind.

Management is likely to present information in a way that fits with its view of the world. This is perfectly natural. However one of the roles of independent non-executives is to be independently minded, and even to apply a little ‘devil’s advocacy’. The executive team is quite likely to be pulling one way under the CEO, so the NED’s can play a vital counter-balancing role.

If someone in management does decide to distort (or ‘re-present’) the data, it will be very difficult for a non-exec to detect. In my example, neither internal nor external audit spotted a change in an accounting policy, let alone reviewed if it was the right thing to do. Non-execs should not expect auditors to spot such problems. They may do so. They may well see such an event so early that it is corrected before the board even hears about it. But the auditors feel no responsibility for internal management performance data (even if, as here, the data was subsequently published). Internal auditors will only take responsibility if they are directed to review the performance measure itself.

You should expect any material change in accounting policies to be presented to, and approved by, the Audit Committee. This is an important check and balance for non-execs. It is also however worth asking whether any changes in accounting policies, treatments or estimates might have had an effect on important KPI’s.

If you spot an issue through advance reading of the board papers, it is good etiquette to ask the initial question before the meeting. If the answer is easy, then it can be dealt with quickly. If the response suggests to you that there is a real issue, it gives you a chance to raise this in the subsequent board meeting, at which management have had notice of the point you will raise and so will not feel ambushed.

If something doesn’t feel right, especially if the management narrative doesn’t seem to fit with some of the numbers or the KPI’s, it is worth asking questions. You may need to start out by asking apparently dumb questions. You will be surprised at how often an apparently stupid basic question elicits a very revealing reply. You may well find that one question leads to another and so on. It is worth persisting until you have an answer that satisfies you. Of course, it may be better to ask these question outside of a board meeting. Your colleagues will thank you for saying that you will take the issue up after the meeting and report back if anything material arises, rather than elongate a board discussion at the time. It may also be more comfortable for management to research the answers rather than to be put on the spot in the meeting.

 Summary

 

  1. Boards thrive on good information. Most of it comes from management and from regular board reporting, such as financial statements and KPI’s.
  2. Most management teams try to provide the best, balanced information that they can.
  3. Occasionally, information can have a little spin added or even be distorted, and this can be challenging for non-execs to spot.
  4. Try to cross-refer information with financials and KPI’s. If there are discrepancies, or things just don’t feel right, ask about them.
  5. Watch how any change in accounting policies might affect KPI’s.
  6. Keep asking questions to drill down to get the answer you want, but not necessarily at a board meeting itself.
  7. Look for help from auditors, but do not rely on them. If unsure, ask the internal auditors to do a specific project on the area concerned.
  8. Use the time between meetings to gain information and establish if there is an issue, but feel free to raise the issue at the meeting for discussion and to alert everyone to the point.

 

 

Just say ‘No’ – assessing an offer for your company

 

Hand of cards.jpg

In previous articles, I covered how a board should react to an unsolicited approach or offer for the company, how it would value it, valuing shares versus cash offers, whether it’s friendly, unfriendly or hostile, and irrevocable commitments. Here, I am going to look at the different sorts of offers that you might receive as a board and how you might respond.

The ‘knock-out’ offer

This is an offer that you think is so good, that you and your advisers want to accept it without much ado. You will want to be sure that the offer is ‘real’, ie that the offeror will carry through on it and has the means to do so. Assuming that you are happy with this, you can proceed onto the next stage, due diligence. Beware, of course that the bidder may use the information gained in due diligence to justify reducing their offer in the same way that house buyers sometime use structural surveys to negotiate a lower price.

The ‘interesting, but not enough’ offer

This is a very common type of offer. It isn’t high enough, but it’s enough that you can’t dismiss it out of hand. Typically every first offer is rejected as inadequate and very rarely do bidders put their final offer in first. Your advisers might describe this offer as ‘well judged’. It is high enough to show they are serious, and, since everyone assumes they would be prepared to go higher, it may be difficult for the target board not to engage with them.

The target board can respond in a number of ways;

  1. A straight ‘No, thanks’ and a refusal to engage. This is confusing for the bidder, as they want to know whether the board is refusing to engage at any price or whether it is just waiting for a higher price. Almost certainly there will be adviser-to-adviser contact as the bidder tries to understand this. Faced with a brick wall ‘No’, the bidder has a number of options; to move to a ‘knock out’ offer; to go away, at least temporarily; or to appeal directly to the target’s shareholders.
  2. A ‘Not at this price’ response. This is a come on, suggesting that the offer is close but not quite high enough. The bidder may then seek guidance from the target’s advisers as to what price would be acceptable. The target board’s advisers may or may not provide such guidance. It doesn’t really matter as this is now a negotiation. This is quite common and most ‘agreed’ mergers will have gone through a few private rounds of offers, refusals and improved offers.
  3. A ‘Not at the moment’ response. There may be a non-price reason why the target board doesn’t want to talk at that moment, and the message may go that the time isn’t right. This could typically be when a new CEO has just joined and the board wants to understand what the new person thinks they can achieve. Alternatively, the target board may be aware of a price sensitive development that it thinks will boost the share price, such as a new product launch or new contract.
  4. An ‘Interesting, but there’s more you need to know’ response. This can be linked to the last point, as for some reason the target board believes that outsiders don’t fully appreciate its value. It offers to ‘lift its skirts’ to tempt the bidder to make a higher offer. The target offers due diligence access to financials and/or commercially sensitive data on the clear condition that it won’t accept the original offer, but is prepared to help the bidder come to a higher value. This would be a common situation, particularly for a private or specialist company.

The ‘insult’ offer

There are several reasons why a board might receive an offer so low that it regards it as insulting. The bidder might be playing a PR game, prior to going hostile. The bid price mysteriously leaks into the market, which may hit the target’s share price. It can become accompanied by negative comments about the target company, its products or management. This used to be more common in the 1980’s when companies could take out adverts knocking target boards. Alternatively the bidder may just be trying it on, just to see how strong the target board is. If the target engages, the offer may yet be lifted to an acceptable level in time. Although the offer may feel insulting, the target company is best advised to react coolly and professionally, making great efforts to ascertain the real motivation of the bidder. However dubious the bidder’s methods, institutional shareholders rarely applaud a public fight about them.

 The ‘Spurious’ offer

This is an offer where the target doesn’t believe that the objective is to succeed. The most obvious would be where a competitor bids, perhaps with the objective of getting confidential information from the process. In this case, the target board may either refuse to engage, or decide that it is prepared to entertain an offer, but won’t provide due diligence information. The bidder will then have to bid with either publically available information only or heavily redacted private information.

The ‘I want to join the party’ offer

This is where an offer has been made by someone else, and others then also knock on your door. They may do so in order to gain information, especially if they are competitors or private equity interested in the sector. They may also do so if there is a regulatory inquiry. When Morrisons and Safeway announced a merger in 2003, Sainsbury, Tesco and Wal-Mart all announced their intentions to make an offer. This had the effect of ensuring that the original offer, together with the new ones, would get referred to the Competition Commission, and possibly blocked or at least delayed (ultimately by 14 months). It also meant that the competitors had a seat at the table with the Competition Commission, although the Safeway board refused to give those competitors any due diligence.

Non-price considerations

I have covered only the share price here for simplicity. The board may take other factors into account, although, especially in a public or private equity company, price is likely to be the dominant factor. Once the price has been broadly agreed, then non-price factors, such as keeping factories or production, may come more into play, as the final details are negotiated.

Summary

  1. Most first offers will be rejected, as the first offer is very unlikely to be the final one.
  2. ‘No’ can mean ‘No’, but it can also mean ‘yes, at a higher price’.
  3. Not all offers are equal. Some are real and some have different motives.
  4. Make sure that an offer is deliverable, especially if it looks too good to be true.
  5. Offering due diligence can be a key negotiating tactic.
  6. If you don’t think the offer is really genuine, don’t feel that you have to engage.

An unsolicited approach: Let battle commence

Boudicca soloMy earlier article talked about how a board should respond to an unsolicited approach for the company. This looked at a straight-forward offer that the board has to review and accept or reject. However it’s not always so easy, as much depends on the attitude and tactics of the offeror.

The chairman of one of my competitors, calling out of the blue, explained that they were about to offer for my company. They had already spoken to my two biggest shareholders, who had signed irrevocable commitments to vote their shares in favour of the offer. Since their combined shareholding was pretty much 50%, the chairman explained, it was just a matter of us handing over the due diligence they required, and the deal would be done. This is what is known in polite terms as a ‘bear hug’, and would be classed as an unfriendly approach.

Friendly or unfriendly?

The tone for an offer will inevitably be set by the offeror’s first contact with the target. That initial approach could be direct to your chairman or indirectly via your advisers. It can be made on an exploratory, friendly basis; such as, “We think that this is a good idea. Would you be interested in exploring it further?” It could be on a firm, but friendly basis; as in “Here is an offer at X pence per share. Would you consider it and perhaps we can talk about it further?” Or it can be delivered as an unfriendly ultimatum. A ‘bear hug’ is where either the initial price is a knock-out one or sufficient target company shareholder support has already been secured behind the board’s back. In either case, the offeror aims to position the target board so that it has no option but just to accept the offer.

So why do some offerors start off unfriendly? There are a number of possible reasons;

  1. The offeror believes that the target board will not act rationally in the interests of its shareholders. There is therefore no point in trying to be friendly.
  2. The offeror believes itself to be in such a strong position, through a high price or shareholder support, that it does not need to be friendly.
  3. Either the offeror or its adviser is innately aggressive and believe that being unfriendly is a good tactic.

In my experience, none of these reasons are very good ones. Most boards will, in the end be rational, and will be urged to be so by their advisers, acting in their own view of shareholder interests. A powerful offer is not weaker for being friendly. In this example, I think that the competitor believed it was in an unassailable position, and it was counselled by poor quality advisers to deliver the offer as an ultimatum.

What are irrevocable commitments?

To the man in the street, an irrevocable commitment is one that you cannot get out of. However, in the streets of the City, nothing is ever that simple. It is imperative therefore, that the target board gets hold of either the actual irrevocable document or an impartial summary. From my experience, you cannot rely on a summary produced by the offeror or its advisers.

The key point is that an irrevocable commitment can have conditions attached to it, ie actually be revocable.   The UK Takeover Panel, which tends to take a legalistic approach, will even allow a revocable agreement to be called ‘irrevocable’ in public announcements. However it can take a tougher line if an announcement adds more detail to the ‘irrevocable’ without also giving any explanation of material conditionality.

In my example, one of the ‘irrevocables’ was conditional on my board actually recommending the offer. This was not therefore a true ultimatum, as the board duly rejected the offer and the irrevocable fell away. The stranglehold that the offeror thought it had was dependent upon not revealing the true nature of the shareholder commitment.

Cash and shares

A cash offer has a value, which should be unchanging and clear. However, if the offer is in shares, neither of those may be true;

  1. The offeror’s share price may move on the announcement, either up or down, depending upon shareholders’ views of the attractiveness of the bid.
  2. The offeror’s share price may move during the process as a result of market moves or new developments.
  3. If the offeror’s shares are trading at a premium, the target board will need to consider what the ‘true’ value of their shares is.

A share offer is therefore inherently uncertain. Furthermore, if the nominal share offer is increased, it may not result in a higher effective price. For example, if an offer in stock is increased, but the offeror’s shareholders think that this is too high, then the offeror’s share price may fall. This then reduces the value of the offer.

The relative share-price premia need to be considered. Take a property company offering for another very similar one. The offeror is likely to feel strong enough to make the offer because it has a healthy premium to its net asset value. Let’s say that it has a 20% premium, whereas the target trades at NAV. The offeror may offer a 10% premium for the target’s shares, but in practice the target shareholders would still be left owning a lower NAV per share than before. The same could be true of earnings per share, but synergies may soften this.

Advisers

A board should ensure that it has good advisers. There is no substitute for good, experienced advice, and preferably from more than one source. The best chance of getting a deal done is also for the other side to have good advisers too. I have known situations where one side even recommended particular advisers to the other party. The worst situations are always when the other party (offeror or target) has inexperienced, out of their depth or macho advisers.

Summary

  1. If an offer comes in on an unfriendly basis, there is a good chance that it will end up hostile.
  2. Keeping the process ‘friendly’, at least initially, should be in everyone’s interests.
  3. ‘Irrevocable’ commitments can be anything but. Make sure that you know the full facts.
  4. Be especially careful of offers in shares and what they really mean for value.
  5. Employ good advisers, preferably more than one, and hope that the others do too.
  6. Whatever happens, stay rational and do what’s right for your shareholders.

My next article will run through what tends to happen next following the receipt of an offer.