Who pushed NatWest?

Dine or be dinner

Bancassurance takes a knock

Some banks are simply unlucky. National Westminster Bank, which ranks number eight in Europe by market capitalization, has shown the reverse Midas touch with a string of acquisitions over the past decade. Its ideas didn’t always seem stupid at the time. Other banks sometimes had the same notions. But somehow NatWest always ends up looking dumber than most when the pipe dreams turn to horror stories.

NatWest’s most conspicuous failure during the 1990s, after its foray into investment banking, has been its stubbornly high cost-income ratio. It stands at 68%, higher than a decade ago, while market leader Lloyds TSB’s ratio is 46% and falling. Lloyds’ internal discipline has delighted investors and thus allowed it to pursue a voracious acquisition strategy. NatWest, on the other hand, tried to seek a transforming deal before proving that it can put its own house in order. This may turn out to be NatWest’s last mistake.

The bid that backfired was a £10 billion ($16.7 billion) offer made in September for the insurance company Legal & General (L&G). NatWest’s urge to become the biggest bancassurer in town originated with its management. But it was adviser JP Morgan that misjudged the mood of its client’s investors in advising NatWest that the market would swallow its return to expansionism.

Terry Eccles’s story

The key adviser behind NatWest’s aborted acquisition of L&G is Terry Eccles, co-head of JP Morgan’s global financial institutions group. Although advisory work for UK financial institutions gets spread around among many of London’s investment banks, Eccles has established himself as the single biggest name in the market. The 1990s have been a story of progressively greater success for him. “Around the UK, there’s Terry and there’s the rest,” says a rival investment banker. But 1999 is the year the crown slipped.

Eccles was a highly regarded financial institutions analyst for JP Morgan until he helped found the bank’s global M&A advisory team in 1985, part of the firm’s evolution from commercial bank to investment bank. Lacking experienced corporate financiers, JP Morgan sought to transform its top researchers into advisers, and to market itself as a firm whose M&A ideas flowed out of analytical skills in valuation and sector strategy. At the time, this differentiated the bank from its competitors. JP Morgan’s enduring emphasis on analysis-driven advice, rather than aggressive dealmaking, makes it all the more surprising that it slipped up over NatWest and L&G.

For many years Eccles generated no major deals in the UK banking sector, but his employer kept faith. Eccles recalls: “It was quite a hard slog to get on the map.” The demutualization of the building societies – the UK’s traditional mortgage and savings banks – got JP Morgan moving. The breakthrough deal came in 1994-95, when Eccles arranged for mortgage lender Cheltenham & Gloucester to sell itself to Lloyds Bank. Eccles approached Lloyds chief executive Sir Brian Pitman with the idea, as a way out of Lloyds’ strategic stagnation.

Immediately afterwards, Eccles approached Peter Ellwood, boss of Trustee Savings Bank (TSB), which had just dropped Warburg Dillon Read as adviser and hired Morgan Stanley, fearing a possible raid. Ellwood knew TSB lacked critical scale and was frustratedly seeking to acquire a building society. Eccles began sounding out building societies but soon had a different idea: a merger with Lloyds. The two banks had similar cultures, both focused on lowering costs, and their customers were geographically and socially complementary. Most conveniently, the relative strengths and seniority of the banks’ top management created a neat fit: by 1996, Pitman had moved upstairs to become Lloyds TSB chairman, while Ellwood became group chief executive. A convincing leadership fit is as vital to viable deals as economic sense, as any M&A adviser knows. Eccles thought he had found a similar formula with NatWest and L&G – except that the market didn’t buy it.

In 1997, JP Morgan handled the flotations of two building societies, Alliance & Leicester and Northern Rock. A dry spell followed. In January 1999, Eccles sought to arrange the complex link-up of Alliance & Leicester with Bank of Ireland. “It made a lot of sense for both,” argues Eccles: both banks were short of viable scale in the UK, and Alliance & Leicester would be vulnerable to takeover after its five years of sheltering after flotation. The merger was a devil to structure, because Alliance & Leicester could not be subsumed before 2002, and national pride hindered any takeover of Bank of Ireland.

The answer was to retain two companies in law, quoted separately in Dublin and London, fully integrate their management and operations, and distribute the returns equally to the two sets of shareholders. This creative solution was scuppered when news of the impending deal leaked last May, leading Bank of Ireland to backtrack on the governance agreement amid recrimination. “Trust sort of fell apart at that point,” says Eccles.

Major recent UK mergers and acquisitions have involved life insurance and pensions companies, reflecting the strong growth prospects of long-term financial products as the British move from being a borrowing society to an investing society. But life and pensions providers are a sector where JP Morgan has fewer relationships than among former building societies. The exception was Legal & General, whose close relationship with Eccles dates back to 1987, when he advised the insurer on its application for credit ratings. In July this year, Eccles was presented with the opportunity to capitalize on this long-standing relationship, and blot out the Alliance & Leicester failure by arranging a far bigger deal.

David Prosser’s ambitions

Since becoming Legal & General’s chief executive in 1991, Welsh mathematician David Prosser has transformed the company from subscale mediocrity into arguably the UK’s best-performing insurer for shareholders and customers. L&G has long been eyed by continental Europe’s top insurance companies as a way to break into the attractive UK market. But for years Prosser has played hard to get, according to some of the frustrated investment bankers who have tried to talk him into deals with one of Europe’s insurance giants, such as Allianz, Axa or Aegon. “Prosser always wants to rule. He is not a team player,” says an investment banker who has witnessed explorative meetings between L&G and continental insurers. “He has quite an ego, and resists power-sharing agreements.”

By mid 1999, pressure had grown on Prosser to achieve a deal. L&G’s erstwhile head of investment may have sensed that now was a good time to sell. The share price, a star performer until this year, seemed to have peaked. L&G relied increasingly on an expensive method of distribution: the UK’s independent financial advisers (IFAs). Such agents work under onerous regulations following pensions mis-selling scandals, and pass on the costs to product manufacturers through steep commissions. To solve L&G’s distribution problem, Prosser needed to find a bank with a seriously big customer base. But L&G’s sky-high valuation meant that a merger would be earnings-dilutive for any UK bank.

Prosser needed a bank that wanted L&G very badly. The bank would also have to accept his contractual demands: he is not one to retire early or take a back seat in the management. When NatWest conveyed its enthusiasm through Prosser’s old friend, Terry Eccles, it was too good to be true. The bank was bursting for a deal and willing to splash out – and its chief executive was weak.

David Rowland’s strategy

In June 1999, Sir David Rowland, chairman of NatWest, hired Eccles to help him shake up the bank through a transformative and headline-grabbing deal. NatWest had succeeded in reducing its risk profile over the previous two years, ending most of its misadventures in investment banking. The equities business of NatWest Markets was sold off; M&A advisory subsidiaries Gleacher and Hambro Magan were sold to their own management. Chief executive Derek Wanless had managed thereby to pacify angry shareholders who until 1998 were voting with their feet.

However, Wanless had made less progress in reducing NatWest’s bureaucracy and inefficient retail operations, at a time when market leaders Lloyds TSB and HSBC Midland were hacking away at their costs. A former associate of Wanless says: “Derek is a very nice guy, intelligent, and understands the banking business. But he is not tough enough.” Rowland, who arrived at NatWest in April, had little regard for Wanless and the two men did not get on well. A source who worked with Rowland at his previous company, the Lloyd’s of London insurance market, says: “He is ruthless. He would sacrifice anybody.” Wanless survived for the time being, despite his association with NatWest’s past failings, but under Rowland’s merger plans the chief executive’s days appeared numbered.

Rowland, the former insurance broker, wanted to reshape NatWest’s product range away from deposit-taking and lending. He believed the future lay with selling assurance and pensions. NatWest’s in-house investment products were second-rate. Rowland wanted to buy a top-notch performer. The question was: who would play ball? The answer, JP Morgan knew, was Prosser.

Buying L&G appealed strongly to Rowland, because after adding it to NatWest’s existing fund manager, Gartmore, and private bank Coutts, the group would derive around 40% of its profits from wealth management. NatWest would leapfrog over its banking rivals into the investment game.

L&G had another attraction for Rowland: its proven top echelon could be imported into NatWest, redressing the weakness Rowland perceived next to him in the bank’s leadership.

When talks between NatWest and L&G began in July, JP Morgan found itself employed by both sides. L&G also had a second relationship bank, Schroders, so Prosser passed JP Morgan over to NatWest to advise Wanless during negotiations. The decision was made for, not by, JP Morgan. A senior London investment banker who was not involved in the deal is critical of this arrangement: “I’m amazed that Eccles was able to advise Prosser for a long time and then jump to advising NatWest all of a sudden. I don’t know how the board can justify taking the long-standing adviser of the target. Prosser was trying to do something very clever: he sent JP Morgan on a mission.” But if anything, NatWest viewed JP Morgan’s familiarity with its target as an advantage.

Prosser could not take over as CEO of the merged group right away, since he lacked banking experience. The plan was for Wanless to remain chief executive in name, but for Prosser to take over all retail operations and to govern the group in a triumvirate with Wanless and Rowland. Had he proven successful in his retail role, a source close to the talks says, he would probably have taken Wanless’s job. There was no formal agreement, but the path to the top was open. Prosser had extracted terms from his eager suitor as favourable as he could have wished.

What went wrong?

NatWest’s enthusiasm for its great, transforming deal blinded it to the drawbacks. One was the price. At £10.7 billion in cash and shares, NatWest was offering a 20% acquisition premium over a share price that valued L&G at about 33 times earnings, compared with a sector multiple of 25.

Some insurance analysts thought sufficiently highly of L&G to accept the valuation but some bank analysts thought its share price contained a lot of hot air.

Eccles, the former valuation specialist, argues: “A 20% premium over a fair market price was not excessive. We knew the deal was tightly priced, but it had to be to get it done.” The planned cost savings and revenue synergies just about covered the £1.8 billion premium offered to L&G shareholders. NatWest shareholders’ payoff would essentially be a better capital structure thanks to the 40% leverage in the offer.

The deal as NatWest presented it contained logical gaps. Claire Gouzouli, director of financial institutions specialist First Consulting, says NatWest’s quest for a committed passive fund manager like L&G was “completely incomprehensible, because they already owned Gartmore, which was famous as an active manager. They bought it at a premium. Then they go for L&G, the biggest index tracker after Barclays Global Investors. How do you put the two together? What do you tell the market about your stance on active versus passive management?”

Other observers criticized the apparent squandering of the L&G brand in NatWest’s plan to cross-sell pensions and assurance to bank customers under its own name. In contrast, Lloyds TSB aims to market the pensions of its own high-flying acquisition, Scottish Widows, without repackaging them.

Eccles defends these aspects of the plan: “There is an argument for active management and an argument for passive management. The new group could have offered both, as part of an overall wealth-management story. We didn’t think there was a contradiction there at all.”

The reason for the non-use of the L&G brand in NatWest branches, says Eccles, was the need to protect the value of the acquisition’s existing business. At present, L&G sells heavily via independent financial advisers. These IFAs might drop a brand that was available minus steep commissions from a high-street bank. Eccles says: “Nobody has yet tried to sell the same brand through their branches as through IFAs.” Under this view, the unusual tactic is not NatWest’s, but Lloyds TSB’s: “Lloyds is punting in the dark a little bit. The big issue for Lloyds will be: what will marketing Scottish Widows through Lloyds branches do to the IFA business?”

In early September, NatWest barely communicated its arguments. But even if the price and the commercial plan had been defended better, investors’ anger would have been fuelled mainly by the fact that the party paying top dollar was NatWest. Memories were stirred of its expensive and failed past acquisitions. The bank’s shares fell from £12.41 on September 2, the day before its quest for L&G became public, to £10.37 on September 22. Adding to the impression of a cock-up, NatWest said on September 6 that there had been insider trading in L&G shares before its bid announcement.

NatWest and JP Morgan had misjudged the market’s reaction to the bank’s renewed display of acquisitive ambition. Eccles says frankly: “There was an underestimation of the residual concerns that investors had about NatWest. It had done pretty well in restructuring itself in recent years, and the thought was that the time had come to make a positive move. Investors weren’t that forgiving.”

Instead, investors perceived another harebrained scheme. NatWest was gambling its money on putting bancassurance at the centre of its strategy, after gambling and losing on global investment banking. Acquiring L&G presumed that shareholders would give management the benefit of the doubt on the general question of bancassurance, a theory of hotly debated merits in the UK. A senior investment banker says: “Only Lloyds and HSBC have enough credibility to bet £10 billion on insurance.”

Wasn’t JP Morgan aware that its client had a reputation for mishandling acquisitions? Eccles says: “I don’t think we were gambling. We hoped that the rewards of bringing in a top company with a top-class management and reshaping the product range towards growth areas would balance out the risks. Where we were overoptimistic was in assessing NatWest’s rehabilitation in the eyes of the market.”

But the most fundamental criticism of JP Morgan, voiced by another investment banker, is that it failed to warn its client away from an adventure that ended up triggering a hostile takeover bid from the Bank of Scotland. “As an adviser, JP Morgan should have been more cautious, because it was obvious that a lot of banks besides Bank of Scotland were looking at NatWest.”

Eccles responds: “We looked at what it would mean for NatWest and L&G if anything did go wrong. We thought it more likely that L&G could then come into play, rather than NatWest. I don’t think that anybody in the market would have expected Bank of Scotland to come in with a hostile bid.”

Yet the fact that not one, but two Scottish banks coveted England’s underperforming giants NatWest and Barclays was not a secret.

In view of shareholders’ continuing low tolerance of signs of adventurism by NatWest, a more modest acquisition might have been a better first step. A senior investment banker argues: “NatWest needed to do a cost-cutting deal, a banking or mortgage deal.” Eccles concedes: “In retrospect, it would have been better received by the market. But you don’t just do a deal because you want to do a deal. NatWest had flagged that it wanted to develop the area of wealth management.”

In addition, Eccles argues against deals that simply cut costs and nothing more: “A cost-save merger is a one-off hike in value, after which you are back to square one on your strategy. The L&G deal wasn’t one of those no-brainers, where you say ‘let’s add £1 billion of value in one go’. But would it have added value over time? Yes it would.”

The problem was that even with the best-loved management, the UK stock market prefers a no-brainer, delivering its profit within two or three years, to an acquisition based on long-term strategic promise. Even Lloyds TSB’s share price sagged under investor apathy when it bought Scottish Widows in May. Lloyds has been held up as an ideal in recent years, but its bancassurance play was tolerated rather than acclaimed.

Peter Burt attacks

NatWest didn’t realize it was putting itself in play; it gave potential predators only cursory consideration. The UK’s other large clearing banks – Lloyds TSB, HSBC and Barclays – would be challenged by the competition authorities if they stepped in. Remaining players such as Bank of Scotland, Royal Bank of Scotland and Abbey National seemed too small to be taken seriously.

Little did NatWest register the determination of a group of Edinburgh bankers to prove that they could run something much bigger than their neat but regionally confined firm. Bank of Scotland chief executive Peter Burt recalls: “We first approached NatWest at the end of 1997 to discuss the idea of combining our businesses, but they weren’t interested in talking to us.” The somewhat piqued Scots subsequently hired a well-known firm of management consultants. Burt says: “We wanted to know whether we had transferable skills that we could apply to NatWest, or whether there was some deep-seated structural reason why Bank of Scotland and NatWest should not combine.” The consultants concluded that Burt and his colleagues, including chief operating officer Gavin Masterton, were well qualified to shake up the unfocused English group.

Burt says: “Having decided that we could create value, we waited for an opportunity to do a deal.”

One London investment banker who has talked to the players involved in the saga believes that NatWest’s dismissiveness in 1997 riled Bank of Scotland. “The Scots had a chip on their shoulder. They felt that they were good, and that NatWest was badly run, but that it had shown a typical English arrogance towards them.” If Bank of Scotland fails to raise its offer price high enough to win NatWest, the M&A adviser believes, it may indicate that the hostile bid expressed more irritation with NatWest than determination to own it.

Burt’s advisers in his raid on NatWest were Morgan Stanley and Credit Suisse First Boston (CSFB). An investment banker closely involved recalls beginning work in earnest on a hostile takeover of NatWest shortly before the target’s bid for L&G was announced. The possibility under consideration was an assault at some point late in 1999. “Peter Burt had already prepared a lot of figures. We were working on it with full intensity.”

When NatWest’s share price unexpectedly tanked in September, Burt suddenly confronted the opportunity he had just begun planning for. He and his advisers raced to draw up their bid in CSFB’s offices in London’s Docklands. On September 24, Bank of Scotland announced its £22 billion offer in stock and loan notes. On subsequent days, the raider spelt out how it would slash costs by over £1 billion a year. The Scots laid in to NatWest’s management with gay abandon, and swore to halve the allegedly luxuriant amount of space in NatWest branches to save on heating bills. They pledged with relish to reduce NatWest’s bloated headquarters in the heart of the City of London, adorned with the art of Rubens and Gainsborough, to a brass plaque. Even William Wallace was more sparing towards English bastions.

Takeover fever

The stock market at first loved the marauders, and welcomed the open season that had been declared on the underachievers of British banking, NatWest and Barclays. Speculation raged about whether Goldman Sachs was urging its client, Royal Bank of Scotland, to top its Edinburgh rival’s offer for NatWest. The target’s share price rose to above £14, surpassing Bank of Scotland’s bid, indicating that investors expected Royal Bank to enter the fray. But despite flying home early from the IMF meeting in Washington and indicating his interest in NatWest, Royal Bank’s chief executive, Sir George Mathewson, held back from an immediate counter-bid. Another option Mathewson is thought to be pondering is a raid on Barclays, if Bank of Scotland shows it can conquer NatWest. Barclays rebuffed Mathewson’s friendly approaches earlier this year, much as NatWest shooed away his Edinburgh neighbour, Peter Burt.

In apparent preparation for a potential counter-offer for NatWest, subtle noises emanated from the Royal Bank camp, aimed at investors. One market participant reported in mid October: “The vibe coming through at the moment is that RBS feels it could do £300 million more cost savings than Bank of Scotland.”

Intriguingly, another acquisitive banker to fly home early from Washington was Lloyds TSB boss Peter Ellwood. So profitable is Lloyds, with its 33% return on equity, that it generates more surplus capital than it knows how to spend on takeovers. Many bankers assume that the government would refer a Lloyds bid for another clearing bank, such as NatWest, to the competition commission. Other market participants believe that an attractive deal removing overlap could still be achieved, provided disposals were made in business areas where market share became too excessively concentrated.

Ellwood, however, dismisses the idea of Lloyds intervening: “I came back [from the IMF meeting] because it makes good business sense to monitor developments such as the Bank of Scotland bid for NatWest from the UK. We always keep a close eye on mergers and acquisitions – and are watching the market with interest.” As for the merger of two major clearing banks, Ellwood insists he sticks to the conventional wisdom: “I do not believe that competition authorities would allow this to happen, because of concerns about sufficient competition in the small business market.”

Rumours in the City of London also surrounded a possible role as NatWest’s white knight for Abbey National, which hired Lehman Brothers and Warburg Dillon Read to advise it. However, NatWest tended from the start to favour a stand-alone defence.

Before launching its raid, Bank of Scotland professed its belief in new technology as the future of banking. And at the same time as assailing NatWest, the Edinburgh firm was building up telephone-based services in Ireland and launching an internet venture in the Netherlands. Burt says: “We are selling mortgages in Ireland at no extra cost: Irish customers ring a local number in Dublin, and get put through to a call centre in Edinburgh.”

In that case, isn’t a traditional bricks-and-mortar bank like NatWest the wrong target for the futurists at Bank of Scotland? Burt makes a virtue of the fact that buying NatWest would digress from his prior strategy, since this way, by no means all of Bank of Scotland’s eggs are in the NatWest basket. “Our existing hens are still laying. Our core business doesn’t need NatWest. If we don’t get it because someone else is prepared to pay more, so be it. It’ll be unfortunate, but our existing business will go on.”

The thoughtful Burt speaks with the confidence of someone who has nothing to lose from having a go. “NatWest is like a run-down house which used to be beautiful. This is a wonderful opportunity to buy and restore that old house.” But NatWest’s share price rise since the battle began means Bank of Scotland would need a big hike in its offer to win.

On October 6, the day NatWest formally abandoned its offer for L&G, the bank’s management took the decision that the hapless Wanless would have to resign. Chairman Rowland assumed the role of CEO, and hired Ron Sandler as chief operating officer. The South African Sandler was Rowland’s partner in restructuring the Lloyds insurance market, and much of NatWest’s defence rests on the duo’s credibility as reformers.

NatWest hired Tim Shacklock, global head of corporate finance at Dresdner Kleinwort Benson, to defend it, on the recommendation of a non-executive director. JP Morgan kept its job, despite fostering the deal that put NatWest in play. There was internal pressure to replace JP Morgan with another US firm, according to a well-placed source. But maybe Rowland’s own part in pushing for the L&G deal might have come under scrutiny if he had sacrificed Eccles as well as Wanless.

Defending against Burt’s campaign to cut the flab off NatWest has required a thorough U-turn for Rowland. Disposals and downsizing have replaced expansion into investment products. Even if NatWest survives, it won’t be making any big acquisitions for a while.

Bank of Scotland’s weakness is that its merger plan has no strategic rationale. From its own investors’ perspective, the takeover of NatWest would be a simple value play: buy an underperforming company cheaply, amputate its feeble limbs, overhaul the core retail business. From NatWest shareholders’ perspective, the no-premium takeover bid has only one attraction: the insertion of the Scots’ management team, who promise to turn NatWest into the model of a modern retail bank.

Burt likens his plan to the takeover of Midland Bank, another British underperformer, in 1992. “Midland is a good comparison. [Former boss] Sir Brian Pearse, who was an excellent banker, could only slow down Midland’s decline. When HSBC came in, they put in whole teams and turned it around.” That’s why hiring Ron Sandler at NatWest, says Burt, “is not enough. You need entire teams of new people to transform a bank”. The drawback for NatWest shareholders is that they would be giving away 32% of the upside to Bank of Scotland. The question is whether they think the Rowland-Sandler double act will be 70% as good as Burt and co.

As for JP Morgan: the firm responded to its embarrassing new position as defender by wheeling in its biggest-hitting investment banker from New York, vice-chairman Roberto Mendoza. Mendoza, an English-educated Cuban émigré, founded and reared JP Morgan’s swaps business, M&A group and capital markets franchise, doing more than any other figure to turn Morgan into an investment bank. He also has experience of defence work in high-profile takeover battles, something lacking in the European financial institutions team.

A successful defence of NatWest would only partly soothe the sting of two major M&A failures in a year. Eccles can console himself with the fact that UK financial institutions – not just NatWest – have difficulty remembering past disasters. In 1997, Goldman Sachs botched the sale of Barclays Bank’s equities house, BZW, allowing its client to be outmanoeuvred by the eventual purchaser, CSFB. Nowadays everyone thinks Goldman is the bee’s knees.