Why the Largest Takeover in Financial Services Industry Is Supposed as Worst Ever Made Deal - Case Study Example

Introduction One of the much discussed and debated merger and acquisition case during the recent corporate history is that of RBS and ABN Amro Bank. During first half of 2007, RBS along with other banks started to show interest in acquiring ABN Amro Bank for a deal which was equivalent to £49 Billion and still dubbed as the most expensive acquisition in the corporate world. During the month of November 2007 the deal was completed hence RBS led consortium of banks acquired majority shareholding in the bank after overtaking the similar bid by Barclay’s Bank. Key Players As discussed above that this acquisition was done through an RBS led bank consortium comprising of The Royal Bank of Scotland, Fortis Group NV of Belgium & Santander Central Hispano SA of Spain.(Forton,2007). However, during this whole process during which the efforts to acquire the bank were undertaken, Barclay’s- one of the oldest banks in UK- also remained active for the acquisition of the bank. It is also important to note that negotiations between Barclays and ABN Amro were almost finalized and Barclays was on its way to become the largest banking group in the world worth £94 Billion however, due to certain legal complications and higher bid by RBS led consortium, the deal between Barclays and ABN Amro could not be materialized. The Deal The actual deal between both the firms was to be materialized through 70% of the cash and 30% of the RBS shares given to ABN Amro shareholders. Since this deal was brokered through a consortium therefore as per the mutual understanding of the consortium members, the operations of ABN Amro were to be divided. The Royal Bank of Scotland- as the main player in the deal- therefore planned to take over the Chicago operations of the bank, its wholesale operations while other two banks would take its Brazilian as well as Dutch operations. Barclays in its bid also agreed to shift its headquarters to Amsterdam and was even ready to cut most of its UK workforce as a part of the deal. However, RBS was able to attract the attention of investors because of high value of cash involved in the overall deal. RBS promised to pay £16 Billion for the wholesales operations of ABN which was considered as 32 times higher than the profits of that segment of the business. At that time, it was considered as the bargain as RBS was banking on the possibility of cost saving through restructuring of the operations. Industry Both ABN and RBS were working in the same industry at the time of acquisition and the industry as a whole was faring well. It is also however, important to note that this merger took place just before the financial crisis started to hit the financial services industry and many still consider this acquisition as the biggest strategic mistake made by RBS. These concerns proved correct as RBS along with other financial institutions were bailed out by UK government to keep them solvent. It is also important to note after the merger flurry financial industry, in the past, also attempted to rebrand themselves and banks became universal service providers offering various under one roof.( Lambkin Muzellec, 2008) Literature Review Why do companies acquire each other and merge is an important debate in the field of corporate finance. It is also one of the most debated topics in the field because of its unique nature and overall impact on the organizational effectiveness and efficiency. Mergers and acquisitions are often therefore done on the assumption that organizations will be able to achieve their strategic objectives.(Berk & DeMarzo, 2007). There are critical differences between a merger and acquisition as in merger two companies merge with each other to form one company however, in acquisition a company acquires another company. It is also however, important to understand that underlying these differences are different factors which depend upon the nature of the deal. The financial, strategic as well as cultural aspects of each deal therefore are relatively different and even vary from firm to firm and deal to deal.( Vishwanath,2007). One of the fundamental aspects of mergers and acquisitions lies in the strategic questions of whether a firm will be better off with buy and build decisions. (Brealy, Myers & Allen, 2008). Though in services oriented organizations such question may be hard to answer however, where manufacturing organizations the question of whether a firm will be better off buying a new asset or business matters a lot. Thus the companies will have to decide whether they want to grow organically and with the help of its own internally generated capabilities or rather grow through the buying and making acquisitions. Thus from strategic management point of view organizations have to look for these strategic variables. Within the context of the RBS-ABN deal this question therefore may lead to the question of the strategic choices that RBS made by taking over ABN. Subsequent discussion will therefore focus on some of the reasons as to why firm go into acquisitions and mergers and how this whole process can be applied to RBS- ABN deal. Classification of Acquisitions There are various methods in which a firm can acquire another firm and merger is one type of the way a firm is acquired. In a merger, two firm actually merge together and form a new company thus through consolidation phase, a new firm is often created as a result of this merger. Acquisition can also be made through a tender offer wherein one firm actually offers to purchase the overall or part of the outstanding stock of other firm by offering a particular price. However, this offer is often communicated to the shareholders. Once it is approved, the target firm can be acquired. There is also another type of acquisition where business is purchased by its own management and is called as management buyout and when this happens a firm usually does not remain public and goes in private hands and under private ownership. If such transaction takes place predominately with the help of more debt, it may also be called the leveraged buy-out. It is also important to note that managers may also strike deals which directly favor them rather than creating direct value for the firms.(Jensen & Meckling, 1976). This aspect is called agency problem and most of the mergers and acquisitions The above discussion therefore indicates that a target firm can be acquired in different manner and depending upon the mutual understanding and agreement of both the parties, the modus operandi of the whole transaction is decided. If a firm wants to wholly purchase the target firm then such target firm can either work as the subsidiary of the parent firm or may completely cease to exist and work under the management and brand name of the acquiring firm.(Watson & Head, 2006). The RBS-ABN deal therefore was done through a firm tender offer wherein RBS offered a price of almost £50 Billions for acquiring all the outstanding stock of ABN. This deal was to be concluded with 70% cash and 30% share transfers of RBS to existing ABN shareholders. The Process It is important to understand that acquisitions can be done in either friendly or in hostile manner depending upon the situation and intentions of the acquiring firm. Friendly acquisitions are often welcomed and discussed by the managers of the target firm and acquiring firm. Usually the acquiring firm offers a price which is higher than the market price of the firm and thus tends to acquire the firm in most cases. It is also important to note that the difference between the market price and the acquisition price paid is called acquisition premium and firms often pay this premium despite the fact that they claim to purchase or acquire undervalued firms. It is also important to make a comparison between the book value of the firm and the acquisition price paid for the purpose of valuation of the target firm. (Brealey, Myers & Allen, 2008). It is important to note that in order to acquire a firm, the acquiring firm systematically follows different steps which lead to the apparently successful acquisition of a target firm. The first step involved is the development and following of a plausible acquisition strategy in order to take a cogent and rational decision to acquire a firm. This strategy therefore may outline or indicate the overall strategy and manner in which a firm is ready to acquire new assets or firms. One of the important steps in this process may be the targeting of an under valued firm however it requires a greater managerial acumen to spot such firm. Undervalued firms One strategy that can be adapted the purchasing of an undervalued firm and than as the price of the target firm increases; the acquiring firm can pocket the differential amount. However, in order to carry out such strategy, it is important that the firm must have the ability to spot such firms. This capacity can be generated with the helping of having more information and ability to process that information. Secondly, it is important that the acquiring firm must have the access to the funds required to clear such transaction. It is not necessarily easy that spotting an undervalued firm and subsequently acquiring it will be cheaper and it is important that the firm must have access to the funds. Similarly acquiring firm should have the skills to execute such transaction. Risk Diversification Another important reason as to why a firm may acquire another firm is to diversify the risk across the different markets or industries. Risk diversification is therefore considered as the prime motive behind the acquisition of new firms. Firms willing to execute such strategy therefore need to rely mostly on the classic risk and return model to clearly establish the risks involved and what returns can be obtained from following any such strategy.( Ross, Westerfield & Jaffe, 2004). It is however, also critical to note that in presence of higher premiums paid and the overall transaction costs involved it becomes relatively more expensive and the return may not remain as high as expected by the investors and same diversification could have been achieved in much cheaper manner. Creation of Synergies Finally, firms also look to create both operational as well as financial synergies by acquiring a new firm. Synergy is therefore believed to be the addition in the value of acquiring firm that will be a direct result of the target firm’s inclusion into the portfolio. Operating synergies often result into the growth in market share as well as operating income therefore firms which look for this type of synergy often bank on the idea that through operational synergies they can achieve better market position. Operational synergies for the firms can be achieved either through tapping into economies of scales of the target market and resultantly increasingly own economies of scale. Similarly, firms may also look into the possibility of gaining access to new and untapped markets through the acquisition of a firm and therefore expand themselves into new markets. Financial synergy is often created either with the intentions of achieving tax benefits or increasing the debt capacity of the firm. Tax advantage can occur when the acquiring firm can potentially relocate itself to a new location where taxes are low and laws are less stringent. Debt capacity can also be increased with the combination of two firms because when they both combine their operating earnings as well as cash flows become higher and more stable. Thus investors or financial institutions willingly lend to such firms because of their higher cash flows and low level of overall risk profile achieved as a result of the acquisition. Financial Valuation One of the most important and significant aspect of the acquisition and merger is the determination of the value of the target firm. Though fundamentally there is very little difference between valuing a normal firm and the one which is to be acquired is complex because issues such as acquisition premiums as well as valuation of synergies create significant hurdles in ideally valuing a firm. There are two important components of the valuation that need to be performed in most effective manner in order to value the target firm- First is the valuation of controls and other is the valuation of synergy. Most of the acquisitions and mergers take place because investors of the acquiring firm want to control the management of the firms which are poorly managed therefore the underlying assumption is that the firm is not optimally managed. The valuation of control therefore is obtained as : Value of Control = Value of optimally managed firm – Value of firm with current management More fundamentally the value of takeover can be estimated in following manner: Value = Value after merger – [(Value of firm A) + (Value of Firm B)] There are two more important valuation issues i.e. the valuation of the premium in a cash bid and the calculation of premium in share bid. Valuing synergy however relatively difficult as it will involve the consideration of issues such as assessment of whether after the acquisition, the firm will grow- anticipating growth rates, assessment of higher economies of scale in the shape of higher profit margins, lower taxes, creation of high debt capacity etc. To assess the value of synergy, therefore levered and unlevered beta is calculated in order to determine the combined levered beta of the new firm and based on these calculations perform the valuation. Explanation In the light of the above discussion the acquisition of the ABN Amro can be explained in greater details and the overall details of the deal can be further explored. A closer look at the overall deal might suggest that RBS acquired ABN Amro in order to gain access to the new markets. RBS was traditionally concentrated into UK market therefore it lacked the clear market position in other markets such as EU and US. According to the deal, RBS was supposed to takeover the US operations of ABN also besides taking over its wholesale operations. It was probably because of this reason that RBS also went into those markets where it was not already present. For example, ABN has successful operations in countries like Pakistan and India however, RBS was not present in such countries. By acquiring ABN, RBS basically made an entry into new markets. However, RBS also faced various litigations and was forced to pay off on behalf of ABN.(Brent, 2010). Access to new markets often therefore results into increased market power as well as more bargaining power. Thus an increase in the size through the acquisition of ABN was perceived as an effort which will increase the market power of the firm and allow it to gain access to the markets which were traditionally less served. It is important to note that RBS took over the wholesale operations of the bank while giving away Brazilian and Dutch operations to other two members of the consortium. This strategy therefore indicates that RBS was only interested in gaining accesses to the markets outsides Europe where ABN had its successful operations. As for as the valuation part of the deal is concerned, it is important to note that ABN was reporting losses for some period of time and consistent reporting of losses resulted into the decline in the share prices. However, despite this, ABN had strong fundamentals, ABN may still be considered as an under-valued firm and this may be the biggest temptation for RBS to go for the deal by paying a higher premium for a firm which might have been perceived as an under- valued firm. Further, firm also failed to achieve the relative synergies as a result of this acquisition as RBS was forced to acquire the toxic debt carried over by ABN. This therefore resulted into increase in overall costs for RBS as RBS written down most of this toxic debt through provisions to clean its books. Thus the cost reduction as well as the improvements in profit margin could not happen due to mispricing of risk by RBS and its wrong valuation of the firm’s future cash flow generating capacity. Another important issue which needs to be discussed is the pricing and assessment of the risk as most analysts are of the view that RBS failed to take into account the actual risks of going into this transaction. ABN was running into losses and it also acquired toxic debt which forced RBS to initiate massive write downs therefore reducing its profitability to a great extent. (Ram, 2010). The financial crisis added more fuel to this step by the RBS as bursting of subprime bubble coupled with the acquiring of toxic debt in the form of subprime mortgages and mortgage based securities, RBS was actually forced to takeover and assume the risks of ABN. Acquiring of the debt as well as the higher premium paid by RBS therefore served as the key trigger point that resulted into the failure of this deal and subsequent impairment of the capital of RBS which was supported by massive bailout package from UK Government. This deal however was subsequently investigated by FSA also.(Singh, 2009). Literature also indicate that the firms often acquire other firms in order to control the market and take substantial control over the market dynamics in order to carve out a superior market position for itself. In case of this deal, this may not be the case as RBS was forced to enter into those markets where it probably never intended to enter. For example, it has been in negotiations with other local banks in countries like India and Pakistan to sell off its operations which were acquired as a result of this deal. This action therefore may indicate that the firm either failed to achieve the significant market control over other markets or it had to enter into the markets for which it was not strategically ready to enter. Conclusion The deal between RBS and ABN was the largest deal in financial services industry however; its failure is also one of the spectacular examples of mispricing the risks. It is because of this reason that this deal is also dubbed as worst takeover ever made. (independent.co.uk, 2009). RBS failed correctly value the fair value of ABN and resultantly acquired its toxic debts which resulted into heavy write downs. The apparent reasons for this deal might be the fact that RBS wanted to enter into new markets and gain access to those areas where it traditionally lacked presence however, this acquisition miserably failed. It is also however, important to note that the impact of external environment shall also be taken into consideration as this deal took place at a time when world’s financial markets started to slid into deep troubles and developed economies faced recessions. References 1. Berk, J, DeMarzo, P (2007). Corporate finance. Illustrated. ed. New York: Pearson Addison Wesley, 2. Brealey, R., Myers, S., and Allen, F. (2008). Principles of Corporate Finance,. International Edition. ed. New York: McGraw-Hill 3. Brent, K Former ABN To Forfeit $500 Million In Fraud Case.. (2010). Wall Street Journal, 05/11/2010, p.PC6. 4. Fortson, D (2007). RBS closes in on €72bn ABN acquisition as the lawsuits fly [online]. [Accessed 9th August 2010]. Available from: . 5. Jensen, M. Meckling W (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics. 3 (4), pp.305-360. 6. Lambkin, M, Muzellec, L (2008). 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