Culture, the Slow Killer

To set the scene for this blog, I watched a documentary called 'Mercedes Goes to Motown' which was about the 1998 merger between Daimler-Benz (Mercedes) and Chrysler. I thought this would be the perfect documentary to watch as I am currently looking through the assignment on Fiat where CEO Sergio Marchionne would like to merge with another company in the automobile industry, but more that I just bought a German made car too (not a Mercedes, I wish). This of course leads onto Fiat, as the merger dissolved in 2007, Fiat later took them over. I thought this would be really relevant and help me when looking to be more informed at whether a merger would increase shareholder value.

M&A activity as I have mentioned before is one of my favourite topics in business, it is exciting watching what happens. It was obvious that culture killed the merger in this case (I have touched on cultural importance in previous blogs). I have read many FT, Economist, Forbes and Harvard Business Review articles on culture being really important to merger success. I can name so many more mergers that have failed due to or experienced cultural problems; AOL - Time Warner, HP - Compaq, BMW - Rover, Kraft - Cadburys (do I need to go on?).

I believe that bad culture can be the silent, slow and costly killer in a business or merger, as if I was to measure culture, how would I do this? You could undertake employee satisfaction surveys, but who is going to tell the CEO they hate the company? (they think Sir Alan Sugar will come in and say 'You're Fired!'). This was the second problem of the merger, Daimler did not undertake proper due diligence which was a big mistake. I have mentioned this before, but I believe due diligence is the most important factor when thinking about M&A activity; financial checks, cultural checks (if possible) and market checks at a minimum I believe. Take myself for example, when choosing a university I went to both Northumbria and Newcastle open days. My mind said I wanted to go to Newcastle as it is considered by league tables as 'better', but in the end I chose Northumbria because once I got there it fit me better and the culture felt better. If I hadn't gone to the open days, I would have been at Newcastle for 4years. Back to business, this is what Daimler needed to do, they needed to assess whether they would be able to survive a partnership into the future and if the culture fitted them.

One part of the documentary that we had learned about in the module was M&A premiums that one company can pay for the others shares. One of the most important things for management is 'the price', if the price is too much, your shareholders will react badly. In the documentary, the CEO of Chrysler wanted 28% more than the shares were worth, which increases the overall price. What I was thinking when that figure came us was that if I was a Daimler-Benz shareholder, I would be really annoyed that the company was going into a 'merger of equals' but the Chrysler shareholders get 28% more than I do. Other M&As also have paid high premiums such as when Pfizer acquired Vicuron Pharma in 2005 and paid 78% premium on the shares.

Finally, it was obvious to see that styles of leadership and workmanship were different in the USA and Germany. Just from my own view without looking into it, I perceive German manufacturing to be efficient and good quality (which is why I bought a German made car) and US manufacturing to be not as good quality, which I do think these styles would have caused conflict for management. If management from another company/country are taking over when it is supposed to be a 'merger of two equals', employees are naturally going to resent the leadership and may become increasingly dissatisfied and demotivated. When employees are demotivated, productivity will decrease which will also lead to a failed merger.

The Missing Ingredient

In this part of the module I have learned ethics for the finance professional. This subject is relevant for myself in three areas which is why I am really interested in it. Firstly, over the past 6 months, I have been writing a dissertation on how there is hope that new audit regulation will improve audit quality and I have looked into accounting scandals and what it means to be ethical in the audit profession. Secondly, I am going to be an auditor (far flung from when I wanted to be a fireman when I was a child) when I leave university, so I need to understand that ethics are really important. And finally, in semester 1 of this year, we learnt about ethics and normative ethical theories (Kant, Rand etc) and it is interesting to be able to apply that thinking to real case studies.

I myself have been aware of a lot of ethical scandals and news reports over the past few years and further into the past which really bring to light a couple of things. After each scandal, new regulation is passed to stop it from happening again (but it always does) and that business leaders are not learning from past mistakes. I have noted a few scandals below:

In the table above, you can see that scandals will happen, then a series of regulation will be passed, then it will happen again. This will continue to go like this probably forever. I did some investigation and it was clear to see what I am talking about. So, in 2001 (Enron) and 2002 (Worldcom) scandals happened, then the Sarbanes-Oxley (SOX) Act 2002 was passed. Then in 2010 (Lehman Brothers), the financial crisis was happening, more regulation e.g. Financial Services Act (FSA), and then a few years later we have more scandals. When will it stop?

Many columnists and accounting professionals who look into scandals report that scandals are still increasing year-on-year, with one saying that there was an increase of 46% in account fraud from 2013 to 2014. This is worrying because new regulation such as SOX was passed to try and protect stakeholders from accounting errors and fraud. I would like to ask a question to whether any regulation could be passed to stop it? or will businesses just try and find new loopholes?

What I found when doing my dissertation and which I have also learned from the lectures is that there are certain reasons to why accounting scandals happen between businesses and financial professionals. I have learned about the PIPCO acronym (Professional Behaviour, Integrity, Professional Competence, Confidentiality and Objectivity) which shows a few reasons (I am sure there are more) why finance professionals may fail their duty. The one thing I find when conducting my research was that Objectivity was the main reason into why finance professionals did a poor job. If they become to familiar with the client (known as lack of independence, such as going on holiday together or being 'mates' at the pub) then they are more likely to let things'slide' as it is said. I do believe that this is the biggest risk and probably the reason why a lot of scandals happen. 

For example, I read an article about how Arthur Andersen auditors of Enron were treated 'as if they were employees of Enron' and they were invited to company picnics and so on. If this is not a lack of independence then I do not know what it; and we all know how that turned out.

My belief is that being ethical in your role as a finance professional is the most important factor in being successful, and not about how much money you earn or how big your bonus is. If you cannot be ethical, you may be jepardising someones pension or rainy day fund which could cause a lot of harm and unhappiness. In relation to ethics being the missing ingredient, I think that the finance professional (a minority rather than a majority) sometimes misses thinking about ethical considerations.

One final note that I was really interested in when listening to this lecture was a question the lecturer mentioned was "should white collar crime be punished as harshly as murder?". This was interested and provoked a lot of thought because of a video of Dennis Kozlowski (former Tyco CEO) who for his crime may be in prison for 25 years (longer than some murderers). My thoughts to the question are that murders should obviously face more time in prison, but white collar crime can hurt people in different ways and can cause a lifetime a distress and suffering for some people, so definitely should be treated more harshly than it currently is. I feel CEOs of these companies are not put off because they see the rewards (bonus etc) outweighing the risk (prison).

Buying, but for the Big Boys

The topic of Mergers and Acquisitions (M&A) is probably one of my favourite subject areas in business. I think it is because it would be so exciting to spend millions of pounds on another company then have the challenge of trying to integrate them to create the synergies and culture you have promised the shareholders (that might be crazy to hear I want to face the challenges). I remember in my GCSE and A-Level studies learning about some notable M&As:

Creating wealth for shareholders through M&A activity must be really difficult, you can do all the due diligence in the world and look at all financial indicators, but areas such as culture and employee motivation (which you can not physically see) may be your downfall which would be really unfortunate. Research conducted as far back as the 80's such as by Jensen and Ruback (1983) show that the target firms gains more than the bidding firm. I would be angry if my management based on hubris, their own self-preservation and hunger to build an empire would enter into a merger and then I wasn't gaining as much as someone who probably was not bothered.


One thing I remember from my business teacher at school was, she always stressed about culture, culture, culture (dare I go on?) was the single most important factor that could lead to the failure of M&A activity. In a sense I believe that, because you can not physically see the culture, but the financials are the starting point. My last blog (Blog 5) focused on culture which you can take a look at if you get time.


What I find really exciting (well exciting in my head) in this topic is the defence tactics that target firms can put down to stop firms bidding on them (the names are strange too). These poison pills in my head feel like they would be a little petty war like we would play at school such as flicking elastic bands at each other. How fun these poison pills may be, they can cause significant damage if a bidder does not spot them. Say a target decides to make a 'scorched earth' policy; load the firm up with debt, sell key assets to disrupt efficiency; if the bidder still goes for them they will ruin their shareholders value. I have learnt many poison pills; Pac Man Defence (who even makes up these names?), Greenmail, White Knight.


It is quite pertinent that today's blog is on M&A activity when there are two big ones in the news; Deutsche Boerse - London Stock Exchange and Three - O2 . From learning the material in this module and reading publications such as the FT, BBC to try and get all sides of the argument, I have seen that there are good and bad points for myself as a consumer and a member of the EU economy.


Firstly, the good. The Deutsche Boerse and LSE 'merger of equals' I believe will help the economy by providing better opportunities for European Companies to gain capital as well as companies from the US and Asia as London, Germany and Spain merged could help compete. However, how will the UK's EU referendum affect the benefits of this merger? I am undecided, but will continue to look.


Secondly, the bad. Three (CK Hutchinson) are looking to merge with O2, basically making the UK market for Telecom shrink to Three, EE and Vodafone (creating an oligopoly situation). Three want to pay £10.5bn for the merger (that is an exciting amount as I said before). How will it affect myself and you the consumer? Well, I think it really could, shrinking the market may lead to increased prices for the same service. When I go to look for new contracts, I currently think that there a lack of differentiation, so this will surely decrease more? Surely if they are creating better cost synergies they will reduce the prices (well this is what should happen), but I really do not think they will.


I never understood how a company would pay for the acquisition either (transfer through the banks Iphone app? Set up monthly instalments? Pay in 10p's?). But let me get serious, so the company will either pay using cash or shares. If I was a shareholder, I think I would the company to pay through cash as I would have to same amount of control and my shares won't be diluted. But if I was the target firms shareholder, cash may mean I pay a hefty sum of tax if I own a lot. Tough choice right?


As there will always be hungry managers, there will always be M&A activity in the market. Whether these are successes or failures will depend on how much research the company has done and whether they can integrate cultures. As consumers we will always be put as risk through M&As that we could be forced to pay more for the same service through lack of choice, however, we can only hope such mechanisms such as the Takeover Panel and Competition and Market Authority (CMA) regulators will help protect us.


Inside Job - A Culture of Dysfunction

This weeks blog will focus on my learning from the documentary 'Inside Job' by Charles Ferguson. What I like to do when watching something like this is identify a key theme of the documentary and then that is what I will talk about. The theme from this show was Culture.

The documentary went into detail about the dysfunctional behaviours of Wall Street and the Investment Banks in the US which led to the financial crisis (yes, again you have to hear about the crisis, sorry). These Wall Street bankers were selling sub-prime collateralised debt obligations (CDOs) to other institutions for their bonuses. This led to the collapse of Lehman Brothers and the need for Morgan Stanley to need bailing out.

What was really clear to see were people making terrible decisions and going for risky projects so that they could get their next bonus. This can be seen even after the financial crisis. For example, in 2012 RBS made a loss of £5bn and Lloyds a loss of £570m, but they both paid their top management bonuses of £607m and £375m. I just think that is absolutely ridiculous, how can you pay people bonuses for the losses they were making. Bloomberg made a nice quote that said that bonuses pre-2008 were incentivised for 'greed and risk'.

The second thing that was apparent was familiarity. You may ask why familiarity was a route cause of dysfunctional behaviour, but I think it is apparent. Familiarity between the CEO and Board, Leader of Country and Advisers or Investment Bank and Rating Agency (S&P, M, F) will create behaviours that will lead to bad decisions being made. I am currently doing a dissertation on audit quality and new regulation and I have found in my results that familiarity is one thing that reduces audit quality and this was another cause of the 2008 crisis. I don't think you can do a good job if you are supposed to be independent but also 'good mates' with the person who owns the company.

I am going to be an auditor after university (so exciting I know), so I have to be independent, I am sure subconsciously my opinions would change if my best friend owned to company rather than someone I did not know, I would place more 'trust' in what he said or did than a stranger. But it was clear to see in the documentary that people were not independent and making an ex-Goldman Sachs CEO Secretary of the Treasury helped benefit Goldman Sachs by $14bn in the bailout (yeah so independent right?).

Culture

Culture is so important in any firm, and is usually more of a reason why it is successful or a failure than any other in my opinion. Take Morgan Stanley for example, they had around 50,000 employees but a culture which was only looking for achievement of their next bonus which made them act so dysfunctional they were having cocaine and going to strip clubs every night.

Culture is important if you are wanting to undertake a merger or acquisition too. If I was a CEO and we found out that all the employees were really unproductive or taking high risks, this could cost us a lot of money and make the acquisition fail. But I think that it is so hard to actually think of how to measure the culture in a company unless you are there.

As a student and not having a full-time job before, I got the opportunity to undertake a placement. I could have tried to apply to a Big 4 accounting firm, but instead chose to go for Grant Thornton (who are number 5). The reason I did this was because I got told their 'culture' was a lot better (thank god is was a really great culture). But if the company has a horrible culture then I would have not succeeded in what I wanted there, and that would be the same with an acquisition.

Failures can be seen through recent history where companies have acquired others and have failed or had problems due to culture clashes:

• AOL - Time Warner
• Daimler - Chrysler

I think that a business leader in the organisation needs to set the tone for organisational culture. I believe this will help increase shareholder value by not putting it at risk, which would also be the case for a successful merger/acquisition as successful culture integration is said to be the most important factor for M&A success.


I just want to touch lastly as what my optimal culture I believe would be for a firm. I think a firm where you are recognised for things you do well, even a simple 'thank you' I found helped motivate me. Secondly, I think openness when explaining what I have done wrong, I hate when someone says 'oh, [this guy] said he didn't like you doing this', why didn't he just tell me? What is your optimal culture?



How will the New Dividend Tax in the UK Affect Dividend Policies and Investors?

Whilst many of us 'average Joe's' will not have had to worry about paying tax on dividends before, come April 2016, taxpayers will have to declare any dividend earnings over our tax free personal allowance (£11,000 16/17) and the £5,000 tax free dividend allowance (another tax I hear you cry out, the government always finds another way to dip into our pockets). The table below shows the changes that will be made from current dividend tax-rates to the new tax-rates. 

So how will/will this affect the common investor and company dividends policies in the future under the new laws? This is what I will be trying to evaluate in this blog.

I would first like to start with the individual common investor (as it could affect me in future, so where better to begin?). Under the new law, as a basic-rate investor, I would have a £5,000 dividend allowance before the taxman would then take 7.5% off me. So therefore I believe it will affect a common investor to an extent as before the tax-rate on dividends for basic-rate was 0% (any tax at 0% is absolutely fine with me, not 7.5% though).
Before I use an example, it must be noted that to get dividends of over £5,000 you would need a considerably high amount of investments in high dividend paying companies (£63,000 portfolio according to Clare Walsh, a financial planner from Aspect 8 (Telegraph, 2015)). Take myself for example; when I finish university I will be in a graduate job which pays above the personal tax-free allowance (a lot of other investors will be on more). Therefore I would be within the dividend allowance (as I do not have enough investments). But if I did, I would pay Income Tax of 20% and Capital Gains Tax of 18% (if I had investments large enough) on top. I really believe that for the risk I would be taking, some form of investment 'gain' should be tax free.

Of course, I believe it will affect the higher-rate taxpayer or basic-rate with a large portfolio more. I found an interesting article on Accountancy Age (I started using this when doing a placement in a Top 10 accountancy firm) which was talking about how SME owners (the individuals in the business) are "in a race against time to benefit from a special dividend pay-out" (Accountancy Age, 2016). This is understandable as the higher tax rate will really damage the value they have created if they want to take dividends out after April 2016. Of course, from what I have learnt in the module, the 'realised profits' have to be there before they can pay-out the dividends. If the owner of the SME took out £100,000 (for arguments sake, an easy number), with them being a high-rate taxpayer, they would pay £25,000, under the new system they would pay £30,875 (quite a lot more really if you scale it up).

Second on the agenda is how the new Dividend Tax will affect company's policies. In my opinion I do not believe it will affect their dividend policies and they will not switch to share repurchase schemes to help investors. This is due to many large companies' main investors being institutional investors such as pension schemes or insurance companies who would not be affected. As this is the case, I have learned that managers will use 'catering theory' to cater to the wishes of investors (such as those institutions) who want both higher share prices AND dividend payments to grow their funds.

Also, a company that says 'we are not going to give anymore dividends' will have a dramatic drop in their share prices due to their investors having certain tax preferences; known by researchers as Clientele Theory. If I have learnt something from this module it is that investors do not think rationally. See British Airways as an example, in 2010, they did not pay a dividend due to a pension obligation, this resulted in people selling of their shares and the price being reduced (I think that if a company does not have to reduce dividend payments, then they won't do it).

To conclude, in my opinion, the new dividend tax will affect the common investor and high paid investor who has a job which pays above the personal tax-free allowance, however this will not affect companies at all. I find this really unfortunate as it is always the public who suffer rather than the large companies that can afford it and will just try to avoid the taxes anyways.

References

Accountancy Age. (2016). SMEs set to take Advantage of Dividend Pay-outs. Retrieved 29th February 2016, from http://www.accountancyage.com/aa/news/2448321/smes-set-to-take-advantage-of-dividend-pay-outs/

Telegraph. (2015). New Dividend Tax: How it Works - and How to Avoid it. Retrieved 29th February 2016, from http://www.telegraph.co.uk/investing/shares/new-dividend-tax-how-it-works--and-how-to-avoid-it/ 

A Hard Balance

I have found Capital Structure and the concept of trying to optimise the WACC (weighted average cost of capital) quite hard to get to grips with. From what I understand, it is basically about trying to manage the amount of debt vs equity a company has to ensure it can make profit and continue with projects in order to grow; and of course try to reach the optimal WACC figure. It can be seen all the time, currently, Hilton hotels are going to 'spin-off' 70 of their hotels into separate company 'Hilton Grand Vacations' as it will allow Hilton "to have capital structure better suited to their needs" (FT, 2016).


There is a lot of debate as to which is best and if an optimal structure exists. If I was the CEO of a company and followed Modigliani & Millar's (1958) ideas, I would chose debt over equity as the first port of call as it is cheaper and that is surely a good thing, right? Cheaper capital equals more projects the company can undertake and better profit for the company due to less tax and transactional costs. They believed there was no impact on the WACC, so therefore as CEO I would go for debt over equity. A measurement of the debt/equity is the gearing ratio. I find the gearing ratio really useful when assessing the 'riskiness' of a company and have used it at work and in University when doing an assignment to conclude whether I would invest in a FTSE 350 company (the answer was no as their gearing was over 400%). In theory, the concept using gearing that I have learnt is the 'trade-off' model where you can have gearing up to an optimal point before problems will be seen. In the case of the FTSE 350 company I analysed, 400% was obviously over that threshold.


However, when you get your capital structure decisions wrong financial distress signals can be released, especially in the way of high debt and it will not only be the lenders who know you are in trouble. Shareholders will be aware that their share value may be destroyed through auditors giving a going concern report a long with the accounts. I was an auditor for a year during my university placement (exciting accountant I know) and we had to give going concern reports which made nobody want to invest in that company. This unfortunately will have stopped them from gaining investments they needed in order to expand and grow into new markets until they got their affairs sorted. Look at Areva in France (FT, 2016) currently, they delayed their results to try finalise a 1.1bn euro loan so their shareholders would not lose confidence. Now becoming 4 grades below investment grade status, Areva will find it hard for new investments. I touched on Anglo American mining in a previous blog, but they are a good example of what I am trying to explain. They have too much debt and now have junk bond status which will hold them back in the future (have they made wrong decisions on capital structure? Or is it industry factors?).


If I was the CEO of a company, I think it would be a really hard balancing act to make sure you always had an optimal level of debt to equity. I don't think there can be a theory that can be put for all companies to abide by and the level of debt vs equity that is optimal for one company will not be optimal for another company. I think that it really depends on the industry, the level of long-term debt in a pharmaceutical company would not be optimal for a company in the service industry.

Empty Vaults - The RBS Collapse

The Royal Bank of Scotland (RBS) which found notoriety in 2008 when it was apparently '2 hours away from running out of money' and losses of £24.1bn (I can't even comprehend this figure). It was clear from my own viewing that I could conclude RBS had serious problems which included to rate of acquisitions, due diligence of these acquisitions and Fred Goodwin's leadership. As you can see below, this is the result of RBS management decisions.

RBS Share Price (Yahoo! Finance)

Acquisitions
RBS I feel really fell down on their rate of acquisitions, I think they over expanded too quickly and this can't be good as they ultimately had 'a finger in too many pies'. They were involved in Insurance, Hospitals, Airports, second-hand cars and asset finance (I can't see where some fit into banking). I thought that these acquisitions were a waste of money and there was no need to diversify from their core business of banking. The acquisition of ABN-Amro was obviously their biggest downfall. They had no idea about the level of sub-prime mortgages ABN held and therefore I do feel I can reach a conclusion that this was why they failed.

Fred Goodwin said "we don't do acquisitions for fun", but I thought that them buying a second-hand car company, this did not seem like it was done to 'better the core business'. RBS was not the only company undertaking failing acquisitions; HSBC's acquisition of Household (2003) fell victim to the sub-prime collapse and AOL's acquisition of Time Warner took less than 2yrs to fail.

Due Diligence
Watching the part where Fred Goodwin said that there was no real scrutiny of ABN-Amro's books really made me annoyed. I would have thought someone with all that business knowledge wouldn't have gone with the 'we did Natwest well, so this will be fine' mentality. Even myself, a final year business student looks into everything I buy; if I purchase a TV, I will be looking into it for a week at least to see if it is worth it (and that only costs £300 not £49bn).

Due Diligence is key when acquiring a business. It makes sure you're not buying 'junk' and will reassure you that you are not paying over the odds. I am currently looking to buy a car for work, I wouldn't want to pay £10,000 for something that is actually worth £6,000 or a car that has been written-off in the past. This is why you undertake due diligence. Anglo American mining is another example, they have really underestimated the challenges they would face when going to Brazil in 2009 and other projects where now their share price has dipped below 1999 listing level and have been given 'junk' bond status by credit firms such as Moody's (FT, 2016) (would they have been more successful if undertaking more due diligence?).

Leadership
One thing that was apparent when watching the documentary to me was Fred Goodwin's management style. Morning meetings were called 'morning beatings' and managers were intimidated to say if they believed something was wrong. I don't think you can run an organisation like that. Listening to others is the most important thing, especially when dealing with a public interest sector.

When I was in my placement working in the audit department, listening to what I was doing wrong and what I could do better was important to help me do a quality job and make sure every part of the audit was correct. This helped shareholders/stakeholders base decisions on true and fair information. If not, I could have been misreporting values and making wrong decisions which may have lost people money. This is exactly what Fred Goodwin did with RBS and definitely I believe another reason for their demise.

A Final Note
I think what really hit me the most when watching the documentary was that ordinary people (which I probably know a few) who have saved for years and were unfortunate enough to invest in RBS (where they thought their money would be safe) lost around 90% when RBS collapsed. These are the people who I really feel for.

References
Financial Times. (2016). Anglo American’s credit rating downgraded to junk, retrieved from http://www.ft.com/cms/s/0/1f989c28-d409-11e5-829b-8564e7528e54.html#axzz40cHUmspG 
BBC. (2011). RBS - Inside the Bank that Ran out of Money (documentary).