THE
DEPARTMENT OF
TRADE AND
INDUSTRY'S
OVERSIGHT
The Department's approach to the oversight of
the acquisition
5. There have been changes to the regulation of the
Post Office[7]
but it remains the dominant postal service provider in the United
Kingdom, with the sole authorisation to handle letters and parcels
costing less than £1 (unless weighing over 350 grammes) having
regard to its public service obligations - universal service at
a uniform, affordable rate. It operates in competition for all
other mail. Liberalisation and deregulation of markets, privatisation
of national postal services overseas, and technological advances
mean the Post Office faces increased competition, particularly
for services to large business customers. These customers represented
about a quarter of the Post Office's turnover at the time of the
acquisition. There has been a trend for European postal operators
to acquire other companies and enter into international strategic
alliances to be able to offer such customers a seamless service
for letters and parcels, based on high quality networks.[8]
6. The Post Office considers that consolidation of
the industry will result in market domination by a few global
players and that it needs to become a global distribution business
to avoid losing market share, which in its view would affect its
ability to sustain its public service obligations and to fund
necessary investment. A programme of acquisitions is a key element
in the Post Office's strategy, which has been approved by Ministers,
to transform itself into a leading international business. German
Parcel, the third largest private parcel delivery network in Germany
with a dominant stake in General Parcel, a European-wide delivery
network, was the Post Office's first acquisition of a size that
required the Department's oversight.[9]
7. The key events relating to the Department's oversight
of the purchase of German Parcel are set out in Figure 1.
Figure 1: Chronology of key events relating to
the purchase of German Parcel
| Date | Event
|
| August 1998 | The Post Office informed the Department of its aim to purchase a parcel distribution company
|
| 2 October | The Post Office informed the Department and the Treasury that German Parcel was the target acquisition
|
| 16 November | Presentation to the Department and requested deadline for approval targeted as 15 December
|
| 24 November | Selection and initial briefing of adviser to the Department
|
| 19 December | Ministerial agreement to the purchase and offer to shareholders
|
| 31 December | Signing of the deal
|
| 11 January 1999 | Secretary of State for Trade and Industry announces the acquisition
|
Source: Figure 10 of the C&AG's Report The Acquisition
of German Parcel (HC 858, Session 1999-2000)
8. In reply to questions about their oversight of
the acquisition of German Parcel, the Department said that they
decided to carry out a high level review of the Post Office's
case for the acquisition. There was a strong desire by the Government
at the time not to second guess the Post Office's management nor
to crawl over every detail of a commercial proposition put to
the Department. The Department decided to rely on the detailed
work of the Post Office and its advisers in the preparation of
the business case for the acquisition and for managing the day
to day transaction processes, as they considered the Post Office
was better placed to undertake the research required.[10]
9. The Department said that they attached importance
to assuring themselves that the Post Office was being advised
by competent professional advisers. The Post Office had employed:
PricewaterhouseCoopers as corporate finance advisers; Ernst &
Young, who are its auditors, to provide advice on accounting issues;
and Clifford Chance to provide legal advice. The Department took
a conscious decision not to duplicate the range of expertise mobilised
and cost incurred (some £10 million) by the Post Office.
They employed an individual adviser with relevant experience in
the Department's Industrial Development Advisory Board and in
the private sector.[11]
10. Although the Post Office informed the Department
in August 1998 that it aimed to purchase a parcel distribution
company in Germany the Department only appointed their adviser
on 24 November 1998.[12]
Thus the adviser then had only three weeks to carry out his scrutiny
before Ministerial approval of the deal was needed. Asked why
they had not appointed an adviser earlier, the Department said
that in August 1998 they had believed that the value of the transaction
would be below the limit for scrutiny by the Department. German
Parcel was made up of a central company and 25 franchises. Initially
the Post Office had been thinking of a limited acquisition of
the central company. In reply to further questions, the Department
agreed that, with hindsight, it would have been better if they
had moved more quickly.[13]
11. The Department said that as a result of the work
of their adviser they had been able to assess how adequately key
issues had been dealt with. They said that the adviser had helped
the Department's team dealing with the acquisition to ask the
right questions, particularly in relation to risk. Assistance
was given on questions such as the likelihood of profits, the
risks involved and how the risks would be managed. This resulted
in contract provisions to minimise the risks including warranties
and guarantees and had allowed the Department to conclude that
the proposal to acquire German Parcel was carefully considered
and commercially robust.[14]
12. In the light of their experience in this acquisition
the Department subsequently appointed Deloitte & Touche to
lead and co-ordinate a multidisciplinary team to help them assess
future transactions and comment, as and when required, on the
Post Office's proposed strategy and on other issues arising from
any further major acquisition proposals. The Department admitted
that they would have preferred to have had that kind of advice
at the time of the acquisition of German Parcel. They also said,
however, that they were not sure whether they could have done
much to reduce the degree of risk to which they were exposed even
if this had been possible.[15]
13. The Department's scrutiny covered a range of
potential risks including the risk of disruption to the business
through change of ownership, the risk of losing key employees,
the risk of big unexpected capital requirements and the risk of
the cost base being understated or profits overstated. In their
view the limited problems which had emerged were already provided
for adequately in the purchase agreement.[16]
They said they had been concerned to reduce the amount of risk
in the transaction to the greatest degree possible and they went
about the appraisal in a professional way.[17]
14. The Department said that they would have liked
to have had longer to assess the deal but in a commercial world
that was a luxury and the Post Office had told them that, if the
deal was delayed, it would lose the opportunity. The acquisition
had picked up speed in the later stages but it was not a rushed
job and their team had covered the ground. The Post Office said
that it tried hard to do all the necessary work. If it had not
been able to convince the Department and the Board that the acquisition
was sensible it would not have gone ahead.[18]
15. Asked if there were any circumstances in which
the Department would have contemplated not letting the deal go
through, the Department said that consistency with the strategy
approved by Ministers was important. They would have thought very
hard about whether the deal should go ahead if it had cost more
than a price envelope, derived from an understanding of the future
cash flows of the business. A different conclusion on the risks
identified and the possible remedies would also have been relevant.[19]
16. One of the particular responsibilities of the
Department's Accounting Officer was to see that appropriate advice
was given to Ministers on all considerations relating to the acquisition.
The Department were asked whether they had accepted what the Post
Office proposed too uncritically instead of applying more rigorous
scrutiny. The Department referred to the greater commercial freedom
being given to the Post Office at the time and emphasised that
they had asked a series of probing questions and caused the Post
Office to make some changes to the case it had put forward.[20]
The balance of commercial freedom and financial
oversight
17. Many private sector companies combine a high
degree of commercial, operational and strategic freedom for their
subsidiaries with a very high level of financial control. A rigorous
financial assessment of significant acquisitions is also required
of companies quoted on the London Stock Exchange. In these cases
the Board assesses the expected impact of the proposed acquisition
on earnings per share for the combined business, which it then
makes known to shareholders.[21]
18. The Department set three principal financial
targets for the Post Office in 1998-99. The first target was to
pay £310 million cash to the Government from its overall
business profits. There were also targets for the return on capital
employed for Royal Mail (the business handling the collection
and delivery of letters) and for Parcelforce (its loss-making
United Kingdom based parcels handling business). Overall financial
targets for the business taking into account the new business
strategy were set in September 1999, nine months after the acquisition
of German Parcel.[22]
19. The Department accepted that a high degree of
commercial freedom combined with rigorous financial oversight
was the appropriate balance of responsibility between the Post
Office and the Department. Working with the Treasury they aimed
to carry out a rigorous scrutiny of performance. Asked about the
absence of financial targets for the whole business at the time
of the acquisition, the Department said that their review of the
proposed acquisition went hand in hand with discussions on the
new strategy.[23]
They had agreed that the Post Office could go ahead with the acquisition
provided that the financial appraisal showed that it would not
lose money, after taking into account purchase costs. They considered
this to be a rigorous approach because it did not take into account
the expected beneficial effect of the acquisition on the Post
Office's business as a whole, but confined the appraisal to the
financial position of the business that was being acquired.[24]
Board Assurance and Disclosure
20. The Chief Executive of the Post Office wrote
to the Department reporting the unanimous approval of the acquisition
of German Parcel by the whole Board. The Department also saw the
documents the Board received, but said that they were not very
detailed.[25]
21. The Comptroller & Auditor General's Report
recommended that the whole Board of Directors of sponsored bodies
should be required to provide assurance on their detailed knowledge,
approval and accountability for an acquisition, in line with private
sector practice. Companies quoted on the London Stock Exchange
are required, depending on the materiality of a transaction for
the business to send shareholders a declaration which includes
their responsibility for the completeness of the information sent
to shareholders and a voting recommendation. The voting recommendation
sets out that the acquisition is, in the opinion of the Directors,
in the best interests of the shareholders as a whole. Our predecessors
asked whether the Post Office agreed with this approach and, if
so, why it had not provided the Department with such assurance
including opinions from external advisers. The Post Office said
that it accepted Stock Exchange best practice and that it would
do anything needed to make clear that the Board had fulfilled
its role properly.[26]
22. On the completeness of the information available
to the Board, the Post Office said that the Department had only
seen the final paper on which the Board took its decision. There
had been earlier papers and individual briefings for non-executive
Directors, who had prior experience of acquisitions, on a face
to face basis. The external advisors had told the Post Office
that, in total, the information provided to the Board was in line
with private sector practice, though the Post Office conceded
that its advisers could be expected to say that.[27]
23. Companies quoted on the London Stock Exchange
are also required to disclose to shareholders, depending on the
materiality of the acquisition, information on the price paid,
the profits attributable to the net assets being bought, and the
expected effect of the transaction on the profit and loss account
and balance sheet of the purchaser.[28]
Our predecessors asked why in this deal the taxpayer was not given
what would be considered essential for any shareholder. The Department,
as the shareholder and representative of the taxpayer, considered
they had full information, but acknowledged that this was not
given to the market and Parliament.[29]
The Department said that they had accepted the Comptroller and
Auditor General's recommendation that when the Post Office concluded
a deal it should disclose information on the transaction as if
the Post Office were a quoted company in the private sector.[30]
Conclusions
24. The Department should ask their advisers to review
major investment opportunities at an early stage, like an active
private sector shareholder, to determine whether an acquisition
would be likely to enhance shareholder value; whether the revenues
arising from the acquisition would exceed the costs on realistic
assumptions; and to assess how well risks are being managed.
25. The Boards of companies quoted on the London
Stock Exchange are required, where a potential transaction is
of a size or nature to have a material impact on the business,
to provide shareholders with assurance on the implications of
the transaction for shareholders as a whole. The Board is best
placed to understand the full implications of a transaction and
to identify any divergence between management and shareholders'
interests. The Department as shareholder would benefit from obtaining
similar specific assurance from the whole Board, and its advisers.
26. The Post Office said that it would have no problem
in giving the Department any information necessary to make it
clear that the Board had fulfilled its role properly, including
assurance on the Board's detailed knowledge, approval and accountability
for an acquisition together with opinions from external advisors.
The Department should act on this undertaking for future transactions.
27. We welcome the decision that when the Post Office
concludes a deal it should disclose information on the transaction
as if the Post Office was a quoted company in the private sector.
VALUE
FOR MONEY
The Department's value for money test
28. The Department wanted to be satisfied that, after
taking account of investment costs, German Parcel as a stand-alone
business should not have an adverse impact on the Post Office's
financial position. They expected that there would ultimately
be financial benefits from synergies with the Post Office's businesses
in the United Kingdom and overseas. The Post Office had quantified
some of these benefits - estimating, for example, that the acquisition
could protect income that would otherwise be lost in its Parcelforce
business, in excess of Parcelforce's £25 million losses in
1998-99.[31]
29. There was nevertheless uncertainty over whether,
on a stand-alone basis, the acquisition would be worth less than
the purchase price. The Post Office's financial projections of
the value of the business showed a wide range, with both profitable
and loss making outcomes. They accepted that the range of £109
million was considerable on a £289 million deal and, by applying
various probabilities to risks, covered very poor and very favourable
results.[32]
30. The financial impact of the acquisition on the
Post Office was broadly neutral when evaluated at a discount rate
of between eight and eight and a quarter per cent. On the basis
of a discount rate of nine per cent the acquisition showed a negative
present value representing a strategic premium of between 10 per
cent to 20 per cent in the view of the Post Office. On whether
the criterion that the acquisition should not have an adverse
impact on the Post Office's financial position was a sufficient
test for the deal, the Department considered that the judgement
on value for money could only be made on the basis of the strategy
over a number of years. Their appraisal had been rigorous because
it had been confined to the German Parcel business, with proper
appraisal of risks, instead of taking uncertain strategic benefits
into account.[33]
The Post Office's ability to manage German Parcel
31. The Post Office's UK based parcel distribution
company, Parcelforce, provides a parcels service to domestic and
overseas customers. It handles some 140 million parcels a year,
with a turnover of £474 million in 1998-99 and a loss before
tax of £25 million in that year and £61 million in 1999-2000.
Asked about the Post Office's ability to manage German Parcel,
particularly given these significant losses, the Department said
that they had taken into account the losses being made by Parcelforce,
and that German Parcel was not a directly comparable activity
because it specialised in city-based business to business deliveries.
German Parcel had strong local management who had been kept in
place to run the business.[34]
32. The Department acknowledged that losses on a
worst case scenario would, in the last resort, have to be funded
by the taxpayer because the Post Office was a public sector owned
business.[35]
It had always been the case that when the Post Office was profitable,
a loss-making activity might have been financed from those profits.
The Post Office said that it had no track record of calling on
Government for financial support.[36]
Benefits arising from the acquisition
33. The acquisition cost included £235 million
for "goodwill" which the Post Office is writing off
in its accounts over a 20 year period.[37]
Asked whether this payment had been justified by subsequent performance,
the Department said that the acquisition was continuing to show
a small positive net present value. Together with subsequent acquisitions
of other companies it had given the Post Office the capability
of generating considerable growth. This had been a key element
of the strategy of building a network throughout Europe .[38]
34. Questioned further about the benefits of the
acquisition, the Post Office said that it offered a number of
advantages, notably access to the German market and the fast growing
cross-border market that would extend the range of Parcelforce
services across Europe. Since the purchase of German Parcel, the
Post Office had taken control of the General Parcel network and
negotiated for Parcelforce to replace United Carriers as the United
Kingdom partner. The Post Office said that it is now in a position
to compete very effectively with its main European competitors.[39]
35. Asked whether the UK postal system had benefited
from the acquisition, the Post Office said it had learned from
German Parcel's expertise and experience, in particular in running
a parcels service in a modern central sorting centre. It had also
learned from German Parcel's experience in running a parcel tracking
service using purpose built software, in which the Post Office
was now investing.[40]
Financing of the acquisition
36. The Department had proposed that the Post Office
should finance up to £238 million of the acquisition cost
from public sector borrowing but that, unusually for the public
sector, the borrowing should be at a commercial rate of interest.
The objectives of this arrangement included providing greater
transparency to assure competitors that the Post Office was not
acting in an anti-competitive way and to ensure that the Post
Office's commercial freedom was also accompanied by further commercial
disciplines.[41]
Our predecessors asked about the delay in setting the commercial
rate of interest which was only agreed two years after the transaction
had been concluded. The Department said that making the arrangements
to charge commercial rates of interest retrospectively had taken
longer than it should have done. The main reason for delay had
been the novelty of the procedure because the Treasury had wanted
to consult all the parties who drew on the National Loans Fund.[42]
37. The Post Office said that it would have preferred
the freedom to borrow commercially in the market, rather than
borrowing from the National Loans Fund at a commercial rate, because
this would have put to rest any competitors' suspicions of a subsidy.
The Post Office was very keen to show that it had not been using
past profits to invest in new companies and that the investment
had come from borrowing charged at a proper commercial rate.[43]
Evaluation and monitoring arrangements
38. A private sector competitor of the Post Office
in European parcels markets evaluates and monitors the performance
of its acquisitions using a notional interest charge based on
the company's weighted average cost of capital. This helps it
determine whether or not an acquisition is value enhancing, that
is whether future revenues from the business acquired are likely
to exceed the costs involved. The result—whether an acquisition
is likely to be value enhancing—is published in its annual
report and accounts. The Department expect the Post Office to
evaluate and monitor acquisitions in this way.[44]
39. Asked about the Department's continuing monitoring
of the acquisition, the Department explained that, together with
the Treasury, they were carrying out a rigorous scrutiny of the
Post Office's financial performance. They had quarterly meetings
modelled on the shareholders' meetings which large companies have
with City institutions and quarterly meetings with the Post Office's
Chief Executive and the Treasury to examine the Post Office's
results. The Post Office provided information for these meetings
in accordance with suggestions from the Department's advisers.
In addition every six months the Department check the performance
of each acquisition against the performance expected when the
transactions were approved.[45]
40. On the basis of appraisals made since the acquisition,
the Department considers that the payment of £235 million
in goodwill, within a total £289 million acquisition, has
been justified by subsequent performance. The Department recognised
that if losses arise the consumer, and ultimately the taxpayer,
might have to cover them.[46]
41. The annual report and accounts of the Post Office,
as now constituted as a public limited company, are required to
be laid before Parliament by the Department. Asked whether information
on the performance of major acquisitions such as German Parcel
would be contained in the Post Office's next set of accounts,
the Department said that the accounts would follow the normal
accounts reporting standards and thus were unlikely to go into
that kind of detail. The Post Office added that giving such detail
would be a problem and probably not what its competitors were
doing.[47]
Conclusions
42. The Department and the Post Office calculate
that the acquisition is showing a small positive net present value
and judge that the benefits of the acquisition are coming through.
But the Department's financial test, that the effect of the transaction
should be financially neutral without taking into account any
strategic benefits, was an undemanding target for an investment
of £289 million. A slight increase in the discount rate used
from 8.25 per cent to 9 per cent resulted in the Department's
analysis showing the acquisition as loss making. The analysis
carried out to assess whether the acquisition would meet even
this undemanding target was, therefore, finely balanced.
43. The Post Office believed that it had benefited
from the management, expertise and experience that it had acquired,
for example, through the purpose built software used by German
Parcel for parcel tracking and obtaining control of the General
Parcel network. There must, nevertheless, be a risk of losses
since the Post Office's existing parcels business is loss making
and the market is very competitive. If there are losses the consumer,
and ultimately the taxpayer, might have to cover them.
44. Parliament should therefore receive regular information
on how far such a major acquisition is meeting expectations. The
Department should seek a commitment from the Post Office to include
in its published reports information on whether or not major acquisitions
are value enhancing, and in particular whether future revenues
from the business acquired are likely to exceed the costs involved.
At least one of the Post Office's competitors publishes such information.
45. The greater transparency and increased commercial
discipline intended by the decision to charge commercial rates
of interest on Post Office borrowing for acquisitions may have
been diluted by the two year delay in setting a rate. We recognise
that this case was a new situation for the Department and the
Treasury but in future we would expect rates to be set more promptly.
1 The Post Office became a public limited company and
renamed itself Consignia plc on 26 March 2001 Back
2 C&AG's
Report 'The Acquisition of German Parcel' (HC 858, Session 1999-2000),
para 3. The final cost paid in three instalments may
vary because of movements in exchange rates. Back
3 ibid,
paras 3 and 2.7 Back
4 Post
Office Press Notice 26 March 2001(not printed) Back
5 C&AG's
Report, paras 5 and 1.6 Back
6 ibid Back
7 The
Postal Services Act 2000 created the Postal Services Commission
("PostComm"), the independent regulator of postal services Back
8 PostComm
Press Notice 26 March 2001 (not printed); C&AG's Report, para
1.3 Back
9 C&AG's
Report, paras 2-5, 10 and 1.17 Back
10 Qs
14, 20-21, 91 Back
11 C&AG's
Report, paras 2.8-2.9; Qs 20, 61 Back
12 Figure
1 Back
13 Qs
84-91 Back
14 Qs
14, 20, 48 Back
15 C&AG's
Report, para 13; Qs 48, 59-60 Back
16 Qs
50-51 Back
17 Q59 Back
18 Qs
20, 59, 72 Back
19 Qs
28-30, 62-63 Back
20 'The
Responsibilities of an Accounting Officer' HM Treasury April 2000,
para 14; Qs 48, 61 Back
21 Q95;
C&AG's Report, para 3.17 Back
22 C&AG's
Report, paras 2.14 and 2.21 Back
23 Qs
2, 95 Back
24 C&AG's
Report, para 7; Qs 11-12 Back
25 Qs
5-6 Back
26 C&AG's
Report, paras 18 i), 3.3-3.4; Qs 5, 9 Back
27 Q6 Back
28 C&AG's
Report, para 18 iii) Back
29 Q64 Back
30 Q7 Back
31 C&AG's
Report, para 2.15 Back
32 ibid,
paras 12, 2.14, 2.18; Q59 Back
33 ibid,
paras 2.14 and 2.17; Qs 11-14, 38, 70 Back
34 ibid,
para 1.16; The Post Office Annual Report 1999-2000; Qs 10, 67 Back
35 Q23 Back
36 Q58 Back
37 C&AG's
Report, Figure 1, note 2 Back
38 Qs
18, 50 Back
39 Qs
47, 68 Back
40 Qs
47, 68 Back
41 C&AG's
Report, para 14; Qs 36-37 Back
42 Qs
92-94 Back
43 Qs
36-7, 44, 55-7 Back
44 C&AG's
Report, para 2.23 Back
45 Q95 Back
46 Qs
23, 50 Back
47 Qs
7-10 Back
