Introduction
The global financial crisis started to impact the UK financial environment in the middle of 2007 and into 2008 (Shah, 2010). The impact was, however, not felt by the UK alone. Around the world, large financial institutions collapsed - including Lehnman Brothers, the fourth largest US investment bank (BBC News, 2008a) - or bailed-out by their governments or other businesses (including RBS which was bailed-out by the UK government in tune of £20bn (BBC News, 2008b). Consequently, stock markets fell and governments of nation, including wealthy nations, had to develop rescue packages for their financial systems (Shah, 2010).
During the peak of the financial crisis, new loans to large borrowers fell by 47% (Ivashina and Scharfstein, 2008). New lending for investment such as capital expenditure and working capital also fell by 14%. After the collapse of Lehman Brother, short-term lending by banks was limited to many businesses in the UK and Europe - and around the world (Ivashina and Scharfstein, 2008). This resulted in a merger and takeover opportunities in the UK and Europe - and around the world.
One of the most notable mergers to have taken place in the UK marketplace in the last two was the merger between Lloyds TSB and Halifax Bank of Scotland (HBOS) - creating a the largest banking institution in the UK. HBOS, the biggest mortgage lender at the time, saw the value of its shares suffer losses after the collapse of Lehman Brothers (The Independent, 2008). This prompted HBOS to accept a takeover bid from Lloyds TSB.
Theory
Takeover (or acquisition) refers to the purchase of controlling stake of one or more companies by another (Hirshleifer and Titman, 1990). In "Mergers", the joining companies come together to form one company - usually the names of the two companies are joined together to formed the name of the resulting company (Kar, 2009).
M&A usually results as a reason to create synergy, diversification and strategic growth reasons. There are several types of efficiency gains which may come out of a merger and acquisition deal. The most efficiency mentioned is increased cost efficiency (Amihud and Miller, 1998, p.61). Mergers usually come around as there is a belief that significant levels of redundant operating costs could be removed by joining operations or activities.
Acquisition also provides a way to enter new market at relatively low cost or reduce competition. However, gaining tax advantage is not a significant reason considered by shareholders in an M&A deal (Auerbach and Reishus, 1988).
The financing of mergers tend to differ from that of takeovers - this also enables them to be differentiated (Global Oneness, 2010). In mergers, usually a stock swap is used - here, shareholders of the target company receive the same amount of shares from the resulting merged company. However, an acquisition can only be done when the acquiring company either buys the shares or assets of the company it has targeted (Global Oneness, 2010). Financing of acquisition deals are usually done with debt borrowed from banks - termed leveraged buyout (Taylor, 1988).
Chapter Two
Event
In September 2008, Lloyds TSB announced it had reached an agreement to acquire HBOS - under the terms of the acquisition, shareholders of HBOS will receive 0.83 Lloyds TSB shares for every 1 HBOS share. The offer valued HBOS at £12.2 billion based on Lloyds TSB share price at close on 17 September 2008 of 279.75 pence (p) (Lloyds Banking Group, 2008a). This meant that Lloyds TSB was paying 232.2p for every HBOS share. HBOS share traded at 140p before the announcement, therefore Lloyds TSB were prepared at the time to pay a 65% premium over the market price for HBOS share price. The price was still seen as a bargain as HBOS was valued to be worth £70bn in 2007 (Market Oracle, 2008).
Reasons for Acquisition
The Boards of both Lloyds TSB and HBOS believed that the acquisition would have substantial benefits for customers and shareholders. From Lloyds TSB's view, the acquisition would speed up their strategic aim of being the UK's leading financial service company by focusing on growing sustainable earnings streams, based on deep customer relationships (Lloyds Banking Group, 2008a). Another reason for the acquisition was that Lloyds TSB believed by combining the two companies, they would be better positioned to serve customers in the difficult economic markets and increase lending for both UK mortgages and small and medium enterprises (SMEs) (Lloyds Banking Group, 2008a). Horizontal integration of both Lloyds TSB and HBOS also meant that the new formed company will benefit from a wider range of products. Lloyds TSB estimated that cost synergies from the acquisition to be in the excess of £1bn per year by 2011 (Lloyds Banking Group, 2008a). There are potential synergies to be realised from the acquisition, a study by Sudarsanam (2003) found that shareholders of the acquiring company - Lloyds TSB in this case - on average suffer either significant wealth losses. The best that they achieve is breakeven from the acquisition. This is not always true but in the HBOS acquisition, existing shareholders are yet to make any substantial gains from the deal.
Investment Decision: Setting a price - possible risks and gains
However, due to uncertainty in the UK financial market, in October 2008, Lloyds TSB was required by the UK government to raise more capital - leading to the bid for HBOS being revised. Under the new terms, HBOS shareholder would receive 0.605 Lloyds TSB shares for every 1 HBOS share. In addition, £11.5bn and £5.5bn of new capital would be raised by HBOS and Lloyds TSB respectively (Lloyds Banking Group, 2008b). HM Treasury, representing the UK government investment arm, subscribed to 2.6bn new Lloyds TSB ordinary shares at 173.3 pence per share - amounting to £4.5bn in equity capital. HM Treasury also purchased £1.0bn of Lloyds TSB preference share at 12% annual coupon - resulting in the £5.5bn new capital required by Lloyds TSB. The £8.5bn required from HBOS resulted in the issue of 7.8bn new Lloyds TSB ordinary shares, which was purchased by HM Treasury.
HBOS raised capital making up of £8.5bn in equity and £3bn in preference shares. (Lloyds Banking Group, 2008b). The pecking order theory (Myers, 1984) assumes that a company will use its retained profits (cheapest form of capital) ahead of borrowing (more expensive form of capital). This was evident in the HBOS takeover where capital from the UK government was split into ordinary and preference shares in a ratio of 4.5:1 (for Lloyds TSB) and 8.5:3 (for HBOS). For most companies, transaction cost has been found to be an important determinant of finance - in both equity and debt sources of finance (Siefert and Gonenc, 2008).
Long-term Finance
The Lloyds Banking Group was created following the acquisition of HBOS by Lloyds TSB in January 2009 (Lloyds Banking Group, 2010a). Lloyds Banking Group is now the largest retail bank in the UK - representing about a third of bank account holders in the UK. The group is owned by HM Treasury (43.5%), existing Lloyds TSB shareholders (36.5%) and existing HBOS shareholders (20%). In November 2009, Lloyds Banking Group issues 36.5bn new ordinary shares in a right issue to raise more capital. Under the right issue, new shares were sold at issue price of 37p on the basis of 1.34 new shares for every 1 existing ordinary share held (Lloyds Banking Group, 2009a).
In order to avoid handing over the control of the company to the UK government, through another bail-out, Lloyds Banking Group raised a further $2bn in capital in December 2009 payable over fifteen years at a cost of $3.6bn (Bloomberg, 2009b). Equity shareholders require a higher level of accountability than debt financing holders (Morris et al, 2007). Lloyds TSB had to carefully think about the ratio of debt:equity shareholders in order to retain control on the Group. The Group's beta is now 2.01 - indicating an aggressive risk appetite in a banking industry where the average beta is 1.23 (Reuters, 2010).
Performance Analysis
In February 2009, Lloyds Banking Group reported a loss of £11bn at HBOS. The week before the announcement, the share price of the Group had fallen by 42% as concerns rose about the scale of the losses. Following on from the announcement, the share price fell by almost a third to 61.4p (Bloomberg, 2009a). The Lloyds TSB side of the group, however, reported a pre-tax profit of £760m. Overall, the combines businesses reported a loss of £6,713m. The combined assets for both HBOS and Lloyds TSB in 2008 were £1,126,718m and total liabilities for the both companies were £1,091,065m - representing a net asset of £35,653m. Net Assets for Lloyds TSB alone was £9,699m and £13,499m for HBOS. By combining the two companies, assets for Lloyds TSB have increased by almost 400% and 270% for HBOS.
Furthermore, the target of cost reduction for the first year of the integration was £450m - this was however, exceed by the £84m to £534m. Evidently, the company is benefiting from cost reduction from synergies of the acquisition and as a result, the target for cost reduction from synergies was increased to £2bn in 2011 (Lloyds Banking Group, 2009b).
The Group returned to profit in 2010 - reporting a pre-tax profit of £1,603m for the first half of 2010 compared with a loss of £3,957m in the same period in 2009. However, earnings per share (EPS) - which is a ratio is earnings to a company's outstanding shares - dropped from 22.0p to 0.9p. The net margin for the group also increased from 1.72% to 2.08% - equivalent to 26 basis points higher year-on-year (Lloyds Banking Group, 2010b).
Impairments or bad loans for the Group reduced significantly from £13,399 to £6,554. The Group's share price rose by 3.6% to 74.49pence upon announcement of the results and analysts' expectations of £694.5m were exceed (Bloomberg, 2010).
Trend Analysis and strong Capital ratios
Over the last four years before the acquisition in 2009, Lloyds TSB paid out dividends of 16.97p in 2005 and 2006, 17.82p in 2007 - at the peak of the financial boom - 11.4p in 2008. However, the last two trading years, 2009 and 2010, the company has failed to return dividends to its shareholders. EPS was also above 10p between 2005 and 2008. In 2009, however, EPS for the full year came in at 7.50p and to 0.9p in the first half of the trading year in 2010 (Digital Look, 2010).
The Group's capital ratios had increase significantly with a total capital ratio of 13.4%, a tier 1 ratio of 10.3% and a core tier 1 ratio of 9.0% in 2010 (Lloyds Banking Group, 2010d). The increase in capital ratio is a result of reduction in balance sheet liability management transactions, lower risk-weighted assets and improved underlying performance. Risk-weight assets reduced by 6% in 2010 (Lloyds Banking Group, 2010d). Furthermore, £2bn from core tier 1 capital has been moved from insurance group to the banking companies to through implementation of capital management and restructuring programmes (Lloyds Banking Group, 2010d). It must be noted that this has no impact on the Group's core tier 1 capital requirement under the current Basel regulation - this also supports the pecking order theory.
Assets sell-off
In 2009, plans were finalised for the Group the sell-off at least 600 branches, a fifth of its UK network, were approved to meet concerns by the European Commission (Scotsman, 2009). This reduction should help the company achieve its balance sheet reduction target. In 2010, the company reported reducing assets by a further £23bn for the first half of the trading year. The current total reduction since acquisition stands at £83bn. Overall, the Group aims to reduce the size of their balance sheet by £200 by 2014 (Lloyds Banking Group, 2010b).
Upon the successful acquisition of HBOS, which came with its insurance brands, Lloyds Banking group sold a 70% stake in sure - an insurance group in the UK founded as a joint venture with Halifax - for £185m (FT, 2010). The sale means that the Group can focus on its insurance brand which they already provide through the Lloyds TSB and Halifax brands.
In July 2010, the Group also announced the sale of its Ecuadorian operations for $25m. The sale was part of the Group strategy of divesting assets which are believed to be non-essential to the Group's overall strategy. In the last year to July 2010, the Group sold seven businesses raising over £750m (Lloyds Banking Group, 2010c).
Dividend Policy
The European Commission has blocked the Group making any coupon and dividend payment following the bail-out rescue package from the UK government (Lloyds Banking Group, 2010c). As such, over the next few years, ordinary shareholders will be paid dividends. The Group expects its public capital and senior funding issuance to be £20bn to £25 per annum (Lloyds Banking Group, 2010d). It would be interesting to observe whether the issuance of dividends will have any impact on the share in the future - does it follow the 'Dividend Irrelevance Theory'?
Chapter Three
Conclusion
Without a doubt, the global financial crisis has had huge implications on the UK financial environment. The crisis led to the collapse of big financial institutions and governments around the world had to intervene to save their banking systems. During the peak of the financial crisis, new loans fell by almost 50%. Moreover, lending for investment capital expenditure and working capital also fell by about 15%.The shortfall in investment capital, together with low liquidity in the markets, resulted in the creation of opportunities for mergers (usually for struggling companies) and acquisitions (for the cash-rich companies) in the UK and around the world.
One of the most notably acquisitions during this period was the takeover of HBOS by Lloyds TSB to create Lloyds Banking Group. Although this created the largest banking institution in the UK, it came at large cost for Lloyds TSB. Soon after the announcement of the takeover, the company [Lloyds TSB] need to raise extra capital. This resulted in a revised takeover bid where HBOS, then struggling and a brink of collapse, had to raise part of the needed capital and also accept a lower price for its shares. Both companies were bailed-out by UK government in raising this capital. As a result, the UK government currently has over 40% stake in Lloyds Banking Group.
In order not to hand over control to the Group to the UK government, the Group issued preference shares, at 12% annual coupon, and a Right Issue. To make the Group successful, it has undergone a major change in reducing its balance sheet. The company is currently achieving profits and also benefiting from cost reduction from synergy of the acquisition. The failure or success of Lloyds Banking Group will ultimately depend on the company being able to reduce its toxic assets and the UK financial environment not experiencing another banking crisis.
