Appendix 7 - Inside the Bank that ran out of money

In 2001, Frederick Goodwin became CEO of the then relatively small regional bank, Royal Bank of Scotland. His tenure at the top of the bank can only be described as eventful as RBS grew from a small Scottish bank to become the largest bank in the world in terms of assets before it all came crashing down in 2008.

Having initially expressed an interest in taking over Barclays (before being told where to go), RBS took over NatWest in 2000, which was the biggest hostile takeover in history at the time. 3 years later RBS had become the 5^th largest bank in the world as a result of investing NatWest’s savings and deposits in various areas such as an insurance company and a 2^nd hand car franchise. Despite the focus on growth, Fred proved particularly effective for shareholders as the bank delivered strong profits.

However, by 2005, RBS had acquired 25 businesses and spent nearly £30 billion and shareholders demanded an end to this. There was a perception among some that Fred was a maniac who went after size as opposed to shareholder wealth. Looking at this it seems as though Fred was motivated by dominating the industry through growth. He was more interested in controlling a bank that were the largest in the world, rather than focusing on internal controls and high shareholder returns.

Goodwin had been given the nickname of ‘Fred the Shed’ as a result of his tough approach to work and his reputation for making hard decisions. The fact that employees at Clydesdale Bank had allegedly celebrated Fred’s departure to join RBS for three days was possibly a sign of things to come. Put yourself in RBS’s employee’s shoes who had heard this, would you be excited to work for Fred?

During his time in charge of the bank, Sir Fred as he was known (before he had his knighthood removed in 2012), created an atmosphere where even senior board members were reluctant to express their views, so much so that the morning meetings had become known as ‘morning beatings’ as Fred grilled executives. Having a culture such as this has the potential to be extremely damaging as employees may not express their concerns over something in fear of being criticised. I have a feeling this may have been the case in RBS as people did not do anything about the way the bank was being run before it was too late and a bailout was required.

The takeover of Dutch bank, ABN Amro in 2007 was the final nail in RBS’s coffin. Fred decided that they should go ahead with this deal without conducting the necessary due diligence, a decision which would come back to haunt him. It seemed as though Fred himself wasn’t sure what ABN Amro were involved in, in one interview he denied that they were involved in sub-prime lending, again a sign of RBS’s failure to properly look into ABN Amro’s operations. Consequently billions were written off the value of RBS’s investments with analysts convinced they would have to ask shareholders for more cash, which Fred denied. Several weeks later, he did just that by asking for £12 billion to stay afloat. This clearly showed how Fred didn’t understand and realise the enormity of the situation. This may have been as a result of the culture he had installed as employees were reluctant to express their concerns.

The outcome of all this was that RBS came within 2 hours of running out of money, and were forced to accept a £20 billion bailout from the British Government. Could this have been avoided? Personally I feel the collapse of RBS could have been avoided if Fred had focused on shareholder wealth and not purely expansion. Although the risks taken by RBS had helped them to become a huge global player in the financial market, in the end it came back to bite them extremely hard.

Appendix 6 - Record breaking year for Mergers and Acquisitions

There is a strong chance that at some point in the past year you have heard about a merger or acquisition. In fact, it has been hard to avoid them in the news this year with a total value of $4.2tn in transactions in 2015 alone. What is interesting, or possible concerning depending on your view point, is that this figure beats the previous record which was set in 2007 on the eve of the financial crisis.

So why have mergers and acquisitions (M&A’s) become so popular? Well quite simply, there are several advantages that a company can benefit from. From operational efficiency’s to increased market power, entry to new markets and industries as well as tax benefits (something which I will look at closely later).

One particular merger which caught my eye for a few different reasons was the recent announcement that US pharmaceutical company, Pfizer, have agreed a $160bn deal to takeover Irish based Allergan. Having read many articles on this deal, including this one on the FT, the thinking behind this seems clear. In moving the company to Ireland, Frank D’Amelio, Pfizer’s CFO said that the company’s effective tax rate would fall from the 25.5% it was in 2014, to somewhere around 17-18%. As a result of this, Pfizer will be able to save around $21bn (yes, $21bn!) on their future tax bills.

Having been offered a role working for Pfizer and visiting their UK head office in Surrey a couple of years ago, I learnt a lot about the company and ever since then I have kept an eye on how they have been doing, so as you can imagine I was intrigued by this announcement. From the company’s perspective, the tax savings would be hugely beneficial and as CEO Ian Read stated, it would allow the newly formed company to increase investment on research to discover new drugs, which in the future could be potentially be lifesaving. In an industry such as pharmaceuticals, where the main objective is to produce drugs which can help deal with illnesses, surely all companies should be encouraged to reduce their costs which could then enable them to develop new medicines.

So this can only be a good thing yes? Well, don’t be fooled by this because the company themselves have announced that they are going cut $660,000 from their R&D budget in order to save costs. So despite stating they could potentially invest the tax savings in developing new drugs, they are planning to go the other way and reduce investment in R&D. This brings me on to negative aspects of M&A’s, with many US politicians stating their opposition to allowing this deal to go ahead. Hilary Clinton voiced her concerns by saying ‘This proposed merger, and so-called ‘inversions’ by other companies, will leave US taxpayers holding the bag’. I agree totally with this because in the allowing a multi-national company, such a Pfizer, to re-locate to another country will have a huge impact on tax revenues received by the US government, which will have to be replaced from other avenues.

In order to try and get around this problem, the two companies have stated the deal will be a reverse merger, where Allergan will takeover Pfizer, but rename themselves Pfizer and continue to operate on the NYSE as PFE. So basically, what they are suggesting is that on paper it will say Allergan have taken over Pfizer but in reality it is the other way round, sneaky.

Although people will have differing views on this deal, I can’t blame Pfizer for wanting to do this. If you can potentially save $21bn in taxes from relocating why wouldn’t you? If this deal goes ahead and becomes a success, I can see more and more US companies going down the same route and I for one cannot blame them.

Appendix 5 - Inside Job – Shameful Truth behind the Financial Crisis

After watching the award winning film Inside Job, I came away with one question stuck in my mind; how were individuals not held accountable after bringing the global financial industry to its knees, whilst taking millions of dollars in payments in the meantime? What I found even more astonishing than this was that the people involved of the running the failed organisations were then employed by the US government to run and regulate the country’s financial industry.

The film, directed by Charles Ferguson, starts by looking at the level of regulation in America over time. In the 1930s, banks were heavily regulated following the infamous Great Depression.  In 1981, President Ronald Reagan chose the CEO of Merrill Lynch, Donald Regan as Treasury Secretary. This began a 30 year period of financial deregulation, allowing investors to take risks with depositors’ money. By the end of the decade 100’s of loan companies and peoples savings had been lost, consequently costing the taxpayers $121 billion. It doesn’t take a genius to realise this wasn’t the greatest decision ever made.

One interesting point to show how far the levels of deregulation went was the merger between Citicorp and Travellers to form Citigroup. This merger was set to form the largest financial services company in the world however it violated the Glass-Steagall Act (a law passed after the Great Depression). This meant it was illegal for Travellers to be acquired; nevertheless the chairman of the Federal Reserve, Alan Greenspan, said nothing. Citicorp were given a one year exemption and then the law was passed allowing the merger. Straight away this said to me that the most powerful people in the industry could bend the rules to suit them, regardless of the consequences.

Looking back at the financial crisis as a whole, it seems more than likely that the high levels of crime and deception within the industry led the world down the path to adversity. Investment banks were giving inaccurate credit ratings out in public, different to what was being stated privately. In December 2002, 10 investment banks settled a case surrounding this issue for $1.1 billion and promised to change their ways. Since deregulation was introduced, several firms have been caught involved in criminal practices. Citibank helped to funnel $100 million of drug money out of Mexico, whilst Fannie Mae overstated its earnings by more than $10 billion between 1998 and 2003.

By the late 1990s, derivatives had become a $50 trillion unregulated market, despite attempts by the likes of Brooksly Born to bring in some form of regulation. These attempts were blocked, with a lot of the decisions being made by Government officials who had experience of working in the financial industry. Now this seems pretty convenient to me. How could the people who were making the monumental errors in the financial sector be held accountable if those very people had a say in the governing body?

As well as criminal involvement, investment banks combined thousands of mortgages and other loans to create complex derivatives called Collateralised Debt Obligations (CDO’s). These were then sold to investors, with many given the highest rating of AAA. As financial institutions noticed how much money the CDO’s were making, they started to give out riskier ‘sub-prime’ mortgages. Many of the sub-prime lenders were wrongly given an AAA rating, causing investors to believe that they were somewhat risk free investments. Some people may not see the issue with this, and it is all well and good doing this whilst house prices are on the up but as soon as prices begin to fall, massive problems arise.

The main issue was that if people defaulted on these loans when house prices were rising, the costs of this could be recovered. However, when prices were falling there was no way that they costs could be covered and CDO’s had no value. The consequences of this were massive, people who invested in CDO’s lost out big time. Furthermore, people who had issued insurance on these (Credit Default Swaps) had to pay out and AIG for example paid out $61 billion to the owners of the CDS’s the day after they had been bailed out. Having read this blog so far, you may not be surprised to hear that this was another unregulated market and speculators were able to bet against CDO’s which they didn’t own.

During the bubble, investment banks borrowed heavily to buy more loans and create CDO’s, so much so that they were leveraging at up to 33-1. This meant a tiny decrease of 3% in their asset base would leave them insolvent. It seems to me as though investment banks had the intention of trying to make as much money as possible, as quickly as possible, without thinking about the potential consequences. In my eyes Goldman Sachs were the biggest offenders, they bet against their CDO’s with CDS’s, they were selling CDO’s which meant that the more money the customer lost, the more they made. This is unbelievable, and to think that they got away with this is astonishing. Richard Fuld, CEO of Lehman Brothers, managed to take home $485 million despite the collapse of the bank.

To conclude, I believe what has occurred in the US financial market is a disgrace. I would be extremely interested to see what would happen should some of the events occur again. Will regulation prevent the collapse from occurring? The fact that many of the top executives who contributed significantly to the financial crisis were not only able to walk away unpunished, but they kept all their bonuses they had earned whilst running the industry into the ground, is unbelievable.

Appendix 4 - Dividend Irrelevance

In this week’s blog I am going to cover dividend policy’s, which will include another theory from Modigliani & Miller. Once again, their theory assumed everything was perfect, there was no tax and the markets were efficient. M&M’s theory was titled Dividend Irrelevance; however do not be fooled by this because they do not argue that dividends themselves are irrelevant.

M&M do not argue that whether or not dividends are paid is irrelevant to the company’s valuation; if dividends are never paid then the shares in a company will be completely worthless. They argued that shareholders are indifferent, because if a company does not pay a dividend, and chooses to invest in +ve NPV projects, then the share price will rise and therefore the shareholder can create their own dividend by selling some shares. On the other hand, if a company does pay dividends then the shareholders can use that payment to buy more shares. M&M’s key point in this theory is that +ve NPV projects should always be undertaken, which is something I completely agree with.

Put yourself in the shoes of a shareholder, would you rather receive a small dividend today, or instead of paying dividends, the company invested into projects that have a positive rate of return, which in turn will help to increase the company’s value. I know if I had that choice, I would prefer for the funds to be reinvested. The shareholder will benefit from the rising share price of the company and can receive a dividend that way.

Nowadays fewer companies are choosing to invest their profits in the business. Instead they are serving the short term interests of shareholders by paying dividends, according to Andrew Haldane, the chief economist of the Bank of England. He believes this is having a damaging impact on the growth of the economy. It is believed that between 60-70% of profits are now being returned to shareholders, a huge increase from the 1970s where the figure stood at 10%. I found an intriguing article on the FT website on this subject, which can be found here.

Why don’t companies invest 100% of their profits? Surely, it would make sense to do so in order to grow. Well investors sometimes look at dividend payments to see how a company is performing; high dividends are good whilst small dividend payments are bad. As there is no insider information available, investors have to base their decisions on what is publically available. Therefore some companies may believe paying dividends is a way to grow as people are more likely to invest as a result. This is a very short-term view; something which Andrew Haldane believes is damaging the economy.

In another article on the Financial Times, Terry Smith said that if you opt to spend the dividend or you do not invest it then you will not perform as well. The graph shows that it is the rate of return that you make on the reinvestment or dividend, which makes the biggest difference. Company A does not pay any dividends and reinvests 100% of profits, with a 20% rate of return. Company B has the same return but only invests 70% of profits, with remaining 30% used for dividends. Whilst Company C also reinvests all its profit, the rate of return is lower at 10%.

So to conclude, I believe that it is in the best of interests of both the company and the investor that profits are reinvested in order to grow and increase the company’s value. Although dividends may be demanded by some shareholders in the long run they will get more back from investments which will generate wealth.

Appendix 3 - What is the Optimal Capital Structure for Companies?

Finding the right balance between debt and equity can be problematic for a company. Choosing debt is seen as a safer option, as lenders offer large amounts of finance for a relatively small return. On the other hand, equity is more expensive and viewed as the riskier option. Because of this increased risk, shareholders demand higher returns and reduce the owner’s control of the business. Dividends are tax deductible whereas debt isn’t, this suggest that companies should take on more debt in order to increase gearing. Increased gearing will reduce the WACC which would then increase the overall value of the company.

At this point it would seem a straight forward decision; debt is the much safer choice than equity. You only have to repay the loan plus interest, which can be offset against pre-tax profits before the calculation of the corporation tax bill, therefore lowering the amount of tax paid. Whereas with equity, shareholders own part of the company and therefore they will also receive part of any future profits. Raising capital through equity is also costly due to the transaction costs implemented on the stock market.

You are probably thinking why do companies opt to raise capital through equity rather than debt? Well, equity doesn’t have to be repaid and of course, debt does with additional interest. If a business is losing money, they are still faced with the loan repayments but it wouldn’t have to pay any dividends out to its shareholders. A highly geared company will have higher risks of financial distress as a result. Furthermore if a business already has high levels of debts, then it would not be an attractive proposition for lenders to lend even more money. The company may be seen as high risk, which could also have a negative impact on the company’s overall value.

An example of a company who struggled with their capital structure was American Apparel. According to reports in the Financial Times, the company has recently filed for chapter 11 bankruptcy whilst they seek to restructure its debt. American Apparel’s debt rose to 11.6 times its annual earnings and consequently their credit rating has fallen deeper into junk territory of Caa3. A plan has been outlined with creditors to swap $200m in debt for equity which shows they did not have the right balance of debt and equity. This restructure will help to reduce interest payments by $20m which shows how damaging debts can be.

Modigliani and Millar argued in 1958 that a company’s structure does not have an impact on the WACC, therefore no optimal structure exists and the value of a company was dependent on business risk alone. This theory assumed that capital markets were perfect, with no tax, no transaction costs, there was no financial distress and that individuals could borrow as cheaply as corporations. In reality, could this theory work? When comparing these assumptions to real world business, the theory can be easily argued against. M&M’s theory in 1963 incorporated these assumptions and suggested that as you increase gearing you will reduce the WACC, which will then increase the company’s value.

Having studied capital structures, personally I believe funding a company simply through debt is a bad idea. Although it does have its benefits, debt still has to be repaid regardless of how well the company is performing. The level of debt a company has should be suitable for the industry and at the same time, be accepted by the shareholders in order to increase value. The balance between debt and equity will vary depending on the industry a company operates in, however I believe that equity and other ways of financing should definitely be used.