Royal Mail Privatisation - Business, Innovation and Skills Committee Contents


3  Offer price

Background

15. As has been noted by the press, politicians and the National Audit Office, the performance of Royal Mail shares—both on the day of flotation and beyond—has been significantly above the 330p share price set by Ministers. This has prompted a lengthy debate as to whether the Ministers agreed on a price which was too low. The answer to that debate would have a significant bearing on whether or not the Government extracted an appropriate financial return for the taxpayer.

16. Our evidence sessions concentrated on how Ministers came to decide on that price, the factors affecting it and whether the advice they were given was accurate and in the best interests of the taxpayer. In coming to a decision on the share price, Ministers were advised by the Shareholder Executive (part of the Department for Business, Innovation and Skills) and by Lazard, who the Shareholder Executive appointed to be the Department's financial adviser. In addition, Goldman Sachs and UBS were appointed as the Global Coordinators to identify demand from institutional investors. We therefore also questioned these organisations on the advice that they gave. We also took evidence from a range of banks which were unsuccessful in bidding for those roles.

The Process

17. In written evidence to us, the Secretary of State set out the process by which the price was set:

    Our Global Coordinators (Goldman Sachs and UBS, together the "GloCos") recommended this price range following an exhaustive process culminating in a final price range recommendation provided ahead of the publication of the Prospectus. Our independent advisor (Lazard) endorsed the price range.[10]

18. When he came before us in October 2013, the Secretary of State explained that "various tests" were applied to fix the price range of 260p to 330p, which included:

·  A long-term process of consultation with the big, long-term institutional investors;

·  Metrics out in the market; and

·  Comparable situations including Belgium and Austria.[11]

19. The consultation with those long-term institutional investors took the form of "pilot fishing" in which the Global Coordinators sought to identify key investors who could ensure sufficient demand to "cover the book of shares to be sold".[12] At the start of that process, the Secretary of State told us that the demand indications were "generally in the lower part of the price range" (260p to 330p) and that "some were lower still".[13] Subsequent advice from the GloCos gave a more positive outlook and they advised that the top end of the range could be achieved. The final demand indications from the GloCos, resulted in the share price being set at 330p.[14]

RISKS

20. Although Ministers raised the possible price range for shares, the Government also highlighted two key risks as dampeners in terms of share price: the potential for a strike by the Communication Workers Union (CWU) and the possible default by the US Government. The prospectus highlighted the risk of industrial relations in the following terms:

    There is no way of reliably quantifying the financial impact (including the ongoing impact) for the Group of any industrial action with any certainty before the event. National industrial action, or the threat of national industrial action, affecting UKPIL could also have a material adverse effect on the success of the Offer and, if it occurs after Admission, could cause the price of Ordinary Shares to fall significantly.[15]

21. When the Global Coordinators gave evidence they also highlighted the potential of an industrial dispute as a key factor in the determination of the price. Goldman Sachs said that feedback it had received was that "industrial relations were a concern",[16] and that it "certainly impacted the price that people were prepared to pay".[17] UBS agreed:

    "From September [2013] it was the major risk factor in respect of the price and the achievability of the deal",[18]

22. According to the Secretary of State:

    IR position meant that there were some potential investors who stated that they were not willing to invest at all and many others who focused on the business and financial implications of strike action".[19]

23. Mr Fallon told us that he had met with the unions at regular intervals between 2012 and 2013 and "very intensely through the summer of 2013". He argued that it was clear from those meetings that the Unions had "had absolutely no interest in lifting the threat of strike action or in settling the pay deal". This led him to conclude that "there was no prospect of it being settled and being settled before privatisation".[20]

24. The Secretary of State told us that his Department had estimated that any strike would have cost Royal Mail around £30 million and that "after two weeks, the profits of the company would have been wiped out".[21] However, he acknowledged that the recent history of industrial relations was not particularly bad and that "relatively few" days had been lost to industrial action over the past 2 years.[22]

25. The performance of the share price before and after the settlement of the dispute does not appear to reflect the level of concern held by Ministers:

26. When questioned on whether it would have been better to have delayed the IPO until the dispute had been resolved, UBS said that it had considered this carefully:

    Ideally, we would have done an IPO when the pay and pensions discussions had concluded favourably, but the feedback that we got was that it was unlikely that was going to happen, even if we delayed until the following spring.[23]

    However, Michael Fallon confirmed that he did not have discussions with the Global Coordinators about delaying the IPO because:

    It was very clear to us by August that there was no point in waiting for a deal. There was no real prospect of any deal and nor was there really any interest or incentive, actually, on the side of the union to reach such an agreement before the IPO was launched.[24]

27. Ministers placed great emphasis on the negative aspects of the industrial relations between Royal Mail and the Communications Workers Union, and in particular on the threat of strike action. While this was a significant factor for investors, we believe that the Government over-emphasised the risk. The share price before, during and after the Union's acceptance of a pay deal demonstrates that industrial relations were less of an issue for the market than they were for Government.

Demand for Shares

28. Notwithstanding the threat of strike action, demand for shares grew in the run-up to the flotation. Increased demand became apparent in both the institutional share offer (which represented 70% of shares available) and the retail share offer (the remaining 30%).

29. In its Report, the NAO highlighted the fact that there was a high level of demand for both the Institutional Offer and the Retail Offer. In respect of the former, the NAO said that demand "accelerated rapidly":

    By the end of the first day of book-building the total demand from all institutional shareholders was 3.6 times the number of shares available for institutions at the top of the price range, increasing to 24 times at the final price by the end of the process.[25]

30. The NAO Report also noted that while retail demand grew slowly for the first five days it also increased rapidly during the final two days of the book building period:

    By the end of the book-building period on 8 October, the value of retail demand was seven times the number of shares available for individuals, and was sufficient to have purchased the entire 60 per cent being sold at 330 pence per share.[26]

The NAO further noted unlike the privatisations of the 1990s, the Government did not use this excess retail demand to put upwards price pressure on the institutional investors.[27] The Secretary of State, however, did not agree that demand could have been used to increase the share price on offer:

    The very strong unequivocal advice we received was that, if we had attempted to push the price beyond £3.30, the upper end of the range, there was a very high possibility that a large number of the people who had hitherto expressed interest would simply walk away from the transaction. That was the advice we received and accepted.[28]

31. This position was repeated by William Rucker, from the Shareholder executive. He said there was "no evidence" that there was enough demand in excess of £3.30, to raise the price.[29] When asked if all of the over-demand would disappear above 3.30, Michael Fallon replied "Absolutely".[30]

32. Both Mr Fallon and Mr Rucker used the experience of Facebook as a reason for not relying on demand as an indicator of price:

    Michael Fallon: We do not yet know whether the price was too low. What was really important here was to protect the six-day-a-week service and minimise the risk to the taxpayer that the taxpayer would have had to step in and finance this company if the price had flopped and the company had been unable to return to the capital markets, like Facebook.[31]

    William Rucker: If I just take an example, Facebook was 25 times oversubscribed—more heavily over-subscribed than Royal Mail—and within three months the share price had fallen 50%. The direct linkage between the level of over-subscription and subsequent share price performance is not there. The other thing to bear in mind is in a lot of the orders that go into the books to try to assess how much the thing is over-subscribed by, there is a heavy element of gaming. The three biggest orders were $1 billion each. That would have represented 20% of the company. Those institutions had no expectation of ever receiving anything like that quantum of stock.[32]

33. When questioned in the House on the share price on flotation the Secretary of State repeated his position that there was no demand above the 330p share price:

    A more aggressive approach to pricing would have introduced significantly greater risk. The advice that we received in this respect was unambiguous. There was no confidence that a sufficient number of buyers would offer a significantly higher price. A failed transaction and the retention of Royal Mail in public ownership would have been a very poor outcome for the taxpayer, as the NAO report confirms.[33]

34. The NAO did note the importance of a successful flotation, but it also called into question the return on the sale. It concluded that the process of identifying investor demand at a set price delivered a level of certainty in demand but at the cost of conceding price tension to the priority investors.[34] It went on to state that the process limited the options to obtain a better price in light of increased demand:

    Once book-building starts, bidders are competing to buy shares and at this point may have incentives to reveal higher levels of demand. But by announcing that it is willing to sell within the price range, the seller has effectively capped the price at the top of the range: there is no mechanism and only a limited incentive for bidders to reveal anything about demand at higher prices.[35]

35. The level of the upper limit set for the potential price of shares gave investors a price above which they had no incentive to declare an interest. The Government's advisers must have been aware of this but failed to gauge demand at higher price levels. The fact that many long-term investors bought shares later at a far higher price is evidence to us that there was demand for Royal Mail shares at a higher price. We therefore do not accept the Ministers' assertion that the demand for shares would have disappeared at an offer price above 330p. The fact that both Ministers and officials have refused to acknowledge any level of demand for a higher price is, to say the least, disappointing.

"Froth"

36. The concerns raised by Ministers about demand for shares at a higher price was not reflected by the performance of the shares, either on the day of flotation or since that day. When questioned shortly after the flotation, on the sharp increase in the share price, the Secretary of State dismissed it as merely the "froth" which often arose in the "immediate aftermath of an IPO".[36] He restated this view on the BBC on 11 October:

    You get an enormous amount of froth and speculation in the aftermath of a big IPO of this kind.[37]

His advice was to "totally ignore the froth that will arise in the immediate aftermath".[38]

37. On the 20 November, the banks were questioned on "froth" and whether they could put a price on it. Citi believed that it would take time to assess whether this was "froth" or whether the share price was "the fundamental value".[39] Goldman Sachs agreed, stating that the "sustainability" of the share price level would be proved over time. In a similar vein, Deutsche argued that it was "much too early to say where the stock will eventually settle".[40] UBS said that it was "not unusual to see those sorts of price rises" but went on to state that "the bulk of views were around £3.30".[41] JP Morgan said that the "huge profile" around the privatisation meant that there would be "a lot more volatility around this particular deal than perhaps other ones".[42]

38. The only dissenting voice was that of Panmure Gordon, who dismissed the Secretary of State's argument:

    I do not think it is froth. These shares have been trading on the market for nearly six weeks and several hundred million shares have traded hands. Today's value of the company is the value that the market attributes to it, and the markets generally are fairly efficient. This is not froth.[43]

39. While the banks gave their opinions on the current and future value of Royal Mail they were unable to shed any light on a definition for "froth". We therefore asked the Secretary of State to explain the term in more detail. He said that froth was a way of describing the "irrational exuberance" of the market, as argued by Robet Shiller:

    The simple point he is trying to make is that in these markets you get momentum up and down and the price of these assets/shares diverge enormously from underlying value for quite prolonged periods of time. That is a rather formal way of describing what I described as "froth".

He went on to argue that while there were "some people who believe that stock markets are efficient, in the language of economics", he did not. In his view, the markets are "extremely volatile and often highly irrational".[44]

40. When asked what the value of shares would be without the "froth", the Secretary of State gave the following response:

    Circumstances change. The valuation of shares reflects the information that is available at the time, and that is based on fundamentals, which are going to change. As Mark Russell said earlier, the whole purpose of this exercise was to improve the performance of this company by allowing it to invest, and that would raise its value. At some point, that will be captured in the share price. It would be utterly foolish for me to start predicting price or predicting turning points.[45]

41. In his first appearance, the Secretary of State described "froth" in the context of the "immediate aftermath". When he returned to us in November, the Secretary of State extended the timescale:

    It would be useful to start reflecting on this three to six months out or possibly a year.[46]

This time frame is far longer than "immediate aftermath" of the flotation to which the Secretary of State first referred. The long-term value of Royal Mail shares will be affected by a wide range of factors, many of which have been discussed at length by our witnesses. However, those longer-term influences are of little relevance in answering the question of why the share price rose so markedly on the day of the flotation and in the subsequent weeks and months.

42. The Secretary of State noted that the valuation of shares reflected the information that is available at the time. He also argued that "froth" had, in some way artificially inflated the share price. Unfortunately, he was unable to provide us with a meaningful explanation of its impact on the share price in terms of time and value. The Secretary of State's initial use of the term referred to the "immediate aftermath" of the flotation. This was subsequently extended to months and then possibly years. As a result we do not find the argument of "froth" as a credible response to the significant increase in the share price.

Level of discount

43. A different explanation for the rise in the share price is the practice of discounting in an IPO. Discounting is an established process in which the share price is set at a value lower than the true value to ensure a successful flotation. Royal Mail was no different, and Mr Fallon pointed out to us that the Government "expected [the share price] to go for a premium on the first day".[47] However, as our witnesses pointed out, discounting is more of an art than a science. In any IPO there can be a debate over whether the subsequent rise in the share price after an IPO reflects an appropriate level of discount, or indicates that the shares were under-priced.

44. When they came before us, the representatives of the banks gave a range of discount rates they would expect for IPOs. Citi and JP Morgan believed that a discount of 10-15% would be "reasonable", in particular in terms of the first day's trading.[48] Goldman Sachs noted that "20% of the IPOs that have been executed globally this year have gone up by more than 30% on the first day of trading".[49] Deutsche said that in respect of Royal Mail, it had quoted a discount of between 5% and 10%.[50]

45. UBS also highlighted the fact that volatility of the market was also a factor in considering share price. As examples it highlighted a number of recent UK IPOs:

    Four of them are trading above 60% more than their IPO price; two of them more than 25%; and two of them are down 20%".[51]

46. Michael Fallon also emphasised the volatility in the share price of IPOs:

    Of the 43 major flotations in the last four years, 21 of them fell below the offer price on the very first day. 23 of them in fact are still below the offer price. Four of the six large flotations since Christmas are below their offer price at the moment. Floating a company successfully is not a particularly easy thing to do. Most flotations that are successful involve some kind of premium on the first day, and Royal Mail was no exception.[52]

47. In its Report, the NAO compared the flotation of Royal Mail to other UK flotations over the past 3 years and found that:

    Royal Mail's 38 per cent share price increase on its first day is greater than that of recent IPOs on the main UK market. Based on data for recent UK IPOs, Royal Mail performed much more strongly on the first day than the IPOs that preceded it.[53]

48. It went on to note that this was not a short term rise and that the price increase and the trading range throughout the subsequent five months indicated that:

    Royal Mail's shares are worth much more than this process was able to extract.[54]

49. Despite this, Ministers, Lazard and the Shareholder Executive all refuted the suggestion that the share price was set to low. When challenged on the share price, Mr Fallon asserted that he had "not seen any evidence that the shares were undervalued at the time of flotation",[55] and disputed the assertion that a 38% rise in the share price was evidence of any undervalue.[56] Equally, William Rucker declared "I do not accept that we were wrong".[57]

50. It is accepted that all IPOs will be floated at a discount, with the share price expected to rise when shares are traded. This is important because a fall in the share price on flotation would inhibit the company from raising further investment. However, the rise in Royal Mail shares in the immediate aftermath was significantly higher than the normal percentage increases described by the banks.

Conclusion

51. Our scrutiny of the possible failings in the share price have been met by a blanket refusal from Ministers, officials and advisors to acknowledge any shortcomings in the process. The following extract is a helpful summary of the arguments:

    Mr Binley: Can I question you on that, Mr Rucker? I feel desperately sorry for the Secretary of State and for the Minister of State, because I think that both the civil servants and particularly the book­builders let these good people down. All the evidence that came from those two sources was evidence of fear. That was the prime motive that you two groups of people were operating on. Let me put this point: Michael Fallon said that he had not any evidence that shares were undervalued on the day, a quote that you made earlier on in this particular set of questions. Yet when the Secretary of State went back to the book­builders about price on Thursday 3 October, those shares were already 10 times over­subscribed. On the next day when those discussions were still taking place, Friday 4 October, they were over 15 times over­subscribed. Are you genuinely telling me that all of that over­subscription would have fallen away if those shares had been priced at higher than £3.30? 15 times over­subscribed according to the book on 4 October, and nobody would have paid more than £3.30 with that level of demand in the market. Are you really telling me that?

    Michael Fallon: Absolutely.

    Mr Binley: Do not advise my company, Mr Rucker. I find that remark amazing.

    Michael Fallon: Can we just answer this, Mr Binley? Facebook was over­subscribed 25 times. It fell 10% on the first day of trading. There is no link between over­subscription and the actual price.

    Mr Binley: In the marketplace there is no link? Mr Fallon, in a marketplace there is no link between the number of customers and the value of the price of the goods?

    Michael Fallon: Why do you think Facebook then fell 10% on the first day?

    Mr Binley: I have no idea about Facebook and we are not talking about Facebook. We are talking about this particular offer and, at the end of the day, all of the evidence suggests to me that you were motivated by a fear of failure. I understand that; I am happy with that viewpoint, but at least the general public needs to know that that is the motivation. By all accounts, the taxpayer lost between £1.1 billion and £1.2 billion. Whatever you say about supporting your argument, you were wrong. The very fact that it sold at the price it did and the way the shares moved thereafter prove that you were wrong. Are you going to admit that, so that at least the taxpayers can have some satisfaction in knowing that the advisers have learned a lesson?

    William Rucker: I do not accept that we were wrong.[58]

52. We conclude that the Department underestimated the market value of Royal Mail and that the sustained increase in the performance of Royal Mail shares points to a pricing decision that was too influenced by perceived risks and fear of failure rather than maximising value for money for the taxpayer.


10   http://www.parliament.uk/documents/commons-committees/business-innovation-and-skills/2013-18-10-Vince-Cable-to-Adrian-Bailey-BIS-Inquiry-into-Royal-Mail-Privitisation.pdf.pdf  Back

11   Q6 Back

12   http://www.parliament.uk/documents/commons-committees/business-innovation-and-skills/2013-18-10-Vince-Cable-to-Adrian-Bailey-BIS-Inquiry-into-Royal-Mail-Privitisation.pdf.pdf  Back

13   Ibid Back

14   Ibid Back

15   Royal Mail Prospectus, Summary, page 13 Back

16   Q166 Back

17   Q167 Back

18   Q169 Back

19   http://www.parliament.uk/documents/commons-committees/business-innovation-and-skills/2013-18-10-Vince-Cable-to-Adrian-Bailey-BIS-Inquiry-into-Royal-Mail-Privitisation.pdf.pdf  Back

20   Q397 Back

21   Q396 Back

22   Q395 Back

23   Q179 Back

24   Q339 Back

25   National Audit Office, The Privatisation of Royal Mail, HC (2013-14) 1182, page 38, para 4.4 Back

26   National Audit Office, The Privatisation of Royal Mail, HC (2013-14) 1182, page 40, para 4.5 Back

27   National Audit Office, The Privatisation of Royal Mail, HC (2013-14) 1182, page 40, para 4.5 Back

28   Q 407 Back

29   Q 420 Back

30   Q421 Back

31   Q368 Back

32   Q300 Back

33   HC Deb, 1 April 2014, col 725 Back

34   National Audit Office, The Privatisation of Royal Mail, HC (2013-14) 1182, page 36, para 3.29 Back

35   National Audit Office, The Privatisation of Royal Mail, HC (2013-14) 1182, page 41, para 4.8 Back

36   Q17 Back

37   http://www.bbc.co.uk/news/business-24488144  Back

38   Q 17 Back

39   Q189 Back

40   Q189 Back

41   Q188 Back

42   Q189 Back

43   Q189 Back

44   Q360 Back

45   Q353 Back

46   Q352 Back

47   Q389 Back

48   Q157 Back

49   Q158 Back

50   Q158 Back

51   Q157 Back

52   Q387 Back

53   National Audit Office, The Privatisation of Royal Mail, HC (2013-14) 1182, page 45, para 4.15 Back

54   National Audit Office, The Privatisation of Royal Mail, HC (2013-14) 1182, Summary, page 10, para 18 Back

55   Q387 Back

56   Q387 Back

57   Q423 Back

58   QQ421-423 Back


 
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Prepared 11 July 2014