Opposition to Melrose’s bid for GKN is misdirected as wider corporate governance issues raised

26 February 2018

By John Dudding

8 minute read

Melrose’s hostile bid for GKN is not your typical takeover that exercises the mainstream media and general public. It is not the merger of two similar companies raising competition concerns and threatening jobs. More importantly it is not a foreign takeover where jobs may be moved abroad, national security threatened, or national pride dented.

Despite this, Labour, the Lib Dems, trade unions and elements of the media are calling for the Government to prevent the takeover. This blog examines the arguments behind these calls and finds they do not really concern the takeover, but rather are an inappropriate outlet for broader fears about corporate governance and regulation.

Why might government want to block a takeover?

To simplify, government will generally leave business to itself unless the interest of business, or specifically its decision makers, are misaligned with those of society – that is a market failure when it is an economic issue. Let us start by ruling out some common M&A market failures that clearly aren’t relevant to this case.

Competition – The only market failure where government (via the CMA) has clear remit to intervene is to prevent the significant lessening of competition. This is not the issue in GKN Melrose case.

Tax Purposes – When Pfizer bid for AstraZeneca one of the main reasons was to reduce its tax bill in the US – a clear case where the interests of the business do not match that of society (if we include the Americans in our definition of society). Once again, this is not the issue in the GKN Melrose case.

Movement of jobs abroad / Loss of British wealth / Artificial inflation of sterling – With two British companies, this is not the issue in the GKN Melrose case. Fortunately, this spares us the debate of whether and when these are genuine issues.

So then why block this takeover?

One issue that has been raised, both in the UK and the US, is national security. This is one of three areas where the government directly, rather than the CMA, can intervene in a merger. Typically, the concern would be that a key military supplier should not be allowed to move to foreign ownership, so that the UK can guarantee its defence independent of foreign powers. This is a foreign policy argument and outside the scope of this blog. However, the national security concerns that are being raised do seem to be economic in nature: they are not concerned with Melrose being controlled by a foreign power, but simply its ability to deliver its contracts. The US Congressman who is being cited for the US security concerns objected to Melrose’s lack of track record in the relevant businesses.

So this isn’t a national security risk because of foreign control, it’s a national security risk because of poor management. Now this is odd as it appears that, in this regard, the interests of GKN’s shareholders are very much aligned with those of GKN’s government clients: if Melrose can’t deliver contracts that GKN could, they will earn less money, the company value will reduce and the shareholders will lose out.

GKN’s other customers are in a similar position to national defence clients. Their interest in the takeover is which set of management could more successfully deliver their current contracts and be in a position to deliver future ones cheaper or better. The Telegraph reports that GKN’s major clients are in favour of the takeover.

Whilst the objectors in the UK are raising security concerns, you sense their real concern is that it will damage GKN, and thus reduce high value jobs and damage our industrial strategy. So it seems that concerns about this takeover boil down to the new Melrose GKN doing harm to society by doing harm to itself. On the face of it this is counter-intuitive: if Melrose want to sell the company for more than they buy it, they’ll have to convince their prospective purchasers that they’ve increased the value of it – as determined by its capability of delivering future profits.

Perhaps the most convincing explanation of why an owner might be able to benefit from devaluing their company is short-termism. This is behind the accusations that all Melrose will add is financial engineering – that Melrose can add debt to GKN without equivalently reducing its resale value. And it is behind accusations that they will cut R&D – that they can reduce value of the company without it equivalently reducing the resale value.

It is undoubtedly true that Melrose plan to run GKN for the short term; they mention five years in the offer document. But this should not mean that they are not interested in the long-term value of the company. The sale price they receive should, in theory, reflect the long-term value of the company, reflecting the structures they’ve left in place and the investments they’ve made. A sensible investor would not pay much for a company that has just generated profit by selling assets and not invested. But what if investors aren’t sensible? What if boards prioritise short-term profitability over sustainability to fool shareholders into thinking them successful. If this is the case, it’s not a problem with this takeover, it’s a problem endemic to corporate governance. If GKN itself did a similar thing, perhaps if it brought in a new CEO who said she wanted to concentrate on cash generation over growth, I cannot imagine a media outcry. As it happens, it just has.

One fear associated with private equity is the model in which private equity buys a company, piles up corporate debt to pay special dividends, and leaves it with a heightened chance of failure. This is what happened to Phones 4 U: their private equity owners BC Partners walked away with a profit despite putting the company into administration, thanks to a debt-funded special dividend. Again, if this is an issue it is not a takeover issue. Just look at the water industry for a modish example of excessive corporate debt and dividends exceeding profits.

Pensions is a similar story, except the losers here are blameless pensioners rather than bondholders who either were aware of the risk or weren’t but should have been. I won’t go into the ins and outs of GKN and Melrose’s record on pensions. Instead I’ll refer you to the opinion of the ex-CEO of the Pension Protection Fund: Yes, we do need tighter regulation of the pension schemes but, no, we don't do this by intervening in takeovers.

The final accusation levelled against Melrose relates to its intention to divide GKN into several smaller companies before sale. To avoid ground we’ve already covered let’s assume GKN’s shareholders are fully informed and interested in the long term. In this case their interests should be aligned with society’s: the division should only add value to the combined sale price if the businesses are more profitable when run separately. There is no obvious market failure in this separation – indeed the Carillion case highlights the dangers of large conglomerates concentrating risk for suppliers and customers. Moreover, this is a debate about how the company should be run and not one intrinsically linked to the takeover. It is something that the current board of GKN could well propose without being noticed by the mainstream media. As it happens, it just has.

So it seems fears about this takeover really reflect fears about corporate governance, about whether shareholders are capable of ensuring a board looks at the ongoing value of their asset. These fears should be addressed head-on, rather than trying to intervene in one particular takeover.