Friday 24 June 2011

Macro Level Trends - UK Auto-Industry - Government Assistance: Granting Pertinent Patronage.

As has been well publicised and recognised, the UK is moving through perhaps an unprecedented period in its economic history. It is one - as the national agenda rhetoric highlights - in which the country must quite literally 're-produce' itself, a re-orientation of national productivity that increasingly counter-balances sectors such as financial, retail and services, toward that which has greater industrial content.

The coalition government now seeks to address this issue, but must also do so relative to the character and dynamics of the UK's capital markets, those crucially 'systemic' arenas that prove themselves to be such boosters or barriers to industrial innovation; though in practice it is the sentiment and actions of the intermediary banking sector, institutional investors, hedge-funds and indeed stakeholder company directors that are the ultimate arbiters of success or failure, depending upon their incentives and indeed executive and managerial capabilities.

The fundamentals of economic theory dictates that capital is automatically drawn to those companies which best perform for the stock-holder, and withdrawn from those that do not perform. Yet reality and theory have been proven time and again to be out-of-kilter.

At the micro-level an example might be the ability to 'window-dress' effectively for an IPO launch guided by an influential NomAd might bring-in an oversubscribed book-run so able to either pitch a higher listing price or sell a greater number of shares. Whilst at the macro-level the ramifications of (typically geo-political) 'Black Swans' massively affect market bearishness, and so the ability to finance or re-finance.

Whilst capital markets are re-energised and corporates view stock-buy backs as best use of their cash-piles, the after-effects of the massive volatility created by the 'Great Recession' is still undoubtedly with us, and has created sub-surface ripples that have in turn created economic, social and cross-border political fractures. The national government interventionism of 2008/9 that saw administrations 'step-into and save'' to varying degrees systemically important national sectors across the US, UK & Europe. That action in turn led to a markets focus toward the exposure and sustainability of sovereign debt levels, which in turn highlighted the need for varying degrees of national economic re-structuring across the West.

Hence, in physiological terms, we have seen the immediate need and availability of 'financial plasma' (liquidity), superseded by a bandaging of what are essentially open-wound problems, the Grecian case thankfully both the worst and smallest example (relative to national productivity measures, typically GDP).

The notional Western world now ostensibly demonstrates itself as akin to region of 4 very different economic areas, the US, 'core' EU, 'periphery' EU and the 'integrational' EU (the recently joined member countries). The European financial implosion means that the previous economic ties created in the 1990s and 2000s are today being politically tested, Germany of course acting as the EU guardian.

Set within this western context, there may be yet another dichotomy growing, possibly creating yet another area of interest conflict.

It involves the increasingly global (ie EM) outlook of the corporate profit agenda set against the structural timeline necessary for many western countries to 're-inflate' themselves. This time around, those countries cannot necessarily rely on the previously expected 're-buoying' of their economies by the multi-national corporates.

[NB An example is GM, global-reach in nature but in a cyclical sector and so cannot escape the global headwind, thus for the last 3 months slipping 10% below its IPO launch price and so undermining short-term stock purchase and thus now negating the idea of a powerful 'productivity push'].

This then puts greater onus on national-centric SME's and governmental ability to orchestrate economic re-inflation.

Whilst the liquidity for SMEs has improved their typically right conservative mindset means that business are running intentionally as self-funding enterprises, arguably limiting their growth potential but also importantly limiting their exposure to business risk during this slow-growth period. The drip-fed liquidity passing through the banking sector at the behest of government toward SMEs appears to be being proactively worked by investment banking to push M&A activity in the SME realm, a greater opportunity for faster growth - on paper at least - through mergers and acquisitions.

However, even with the M&A upturn, such a picture of slow growth across much of the West typically generates calls for further governmental economic expansion efforts.

The UK's industrial base is undoubtedly back in the spot-light, the BBC tasked to 'educate, inform and entertain' giving us a nation-trotting Evan Davis to demonstrate that our apparent post-industrial age still has gleaming examples of world-class manufacture. Cited examples: BAe, GKN, McLaren, Land Rover and Brompton bicycles.

The programme titled 'Made in Britain' then is a blatant and very necessary exercise to re-generate national self-belief.

But equally it should not unintendedly and accidentally deceive, as may have been the case with the illustration of 'superior brazing' technique on Brompton's bicycle frames. Brazing whilst a craft of sorts is in real terms a world-wide, low-value, labour intensive applicational activity; something that can be seen from the street repair shops of India to the factories of China. What may be described as a 'premium quality' lost craft in the West is anything but in the rest of the world – a staple of everyday manufacture and repair.

The first episode was however peppered with further contradictions of its broader argument. Including the fact that high-value manufacturing employs less workers, so is not an automatic answer for the unskilled jobless and unskilled. And that the housing boom swallowed much of the lost industrial heartland via property development, when that boom actually gave a new lease of life for what were defunct character buildings; a sizable proportion of the New Labour funded 'new business' schemes using such properties flailing as white elephants as a result of poor business acumen / execution].

'Made in Britain' was not of course tasked to provide a truly reflective assessment of each company within regional & global competitive contexts, (ie to demonstrate UK manufacturing within the detailed global scheme of things).

This is however, industry's & government's role.

As such Whitehall mandarins will find themselves posited between those optimistic (television & factory tour) demonstrations of UK technical prowess and advantage, whilst simultaneously pressured for "vital" financial and general assistance. Companies doing so will subtly and knowingly convey themselves as 'regional heros' and even 'nation-savers'.

When it was necessary the UK government stepped into the fray to support the economy and important manufacturing sectors. Monies have historically been directed to support both 'supply-side' and 'demand-side' aspects, the most obvious being incentive 'green-field' and 'brown-field' developments' for large VMs such as Nissan, Honda & BMW Mini, whilst latterly the vehicle scrappage scheme which spurred the automotive retail sector.

Government assistance then is most visibly directed at large scale business, attracting and keeping multi-nationals that play a major part in the national economy by virtue of their export value, and in the regional economy by virtue of the trickle-down of workers' earnings into housing, shopping and leisure activities in the region.

At the polar opposite government rightly directs funds toward R&D aimed at true and directly applicable 'breakthrough' learning and technologies which can provide the UK with the potential for international competitive advantage.

What government should not be called to do is to act in the role of a business support device for those medium-sized companies that operate in the broad middle-ground, yet over the years have failed to prove themselves as truly capable by virtue of comparison against their international peer group. Such companies will have probably been established for decades to reach such operational maturity, yet have not created the firm foundations required from which soundly judged expansion can proceed. Such companies typically outwardly espouse a specialist capability that differentiates itself from competitors, yet their histories may show multiple expansions and contractions in that middle ground, which have proven unsustainable, to the detriment of not only the growth prospects of the firm, but to the stability of employees at all levels, and as such probably not served as the economic cornerstone to its region, and the broader economy

Such firms will have instead been through multiple 're-generations', the financing made available very probably based upon the historic goodwill, and / or initial achievements, of the brand. But in contrast to a well orchestrated and proven rise to superiority over its competitors (through technical & operational competence) such firms have proven themselves to time after time failed to deliver their rhetoric.

Unfortunately, many quarters of the City (& Wall St et al) tend to have an overtly warm-hearted attitude toward the fringes of the auto-sector, especially those that operate in the 'sexy' arena of motorsports, sportscars and luxury cars; unsurprising given that such expensive products and event past-times hold such personal appeal to a coterie of bankers or private equity executives etc. Becoming involved in this sphere where real items of social interest are designed, assembled and driven seems a world away from the 'dryness' of corporate accounts, IRR & ROE rates and the like for say a paper manufacturer or the plethora of service-based companies.

Hence historically a desire to be part of the sector, thus an influential individual or team at that, has often created an air of overt-enthusiasm about the SME auto-company, one in which management can relay overtly optimistic business plans that come under lesser scrutiny than might otherwise be so. Indeed investment professionals can be drawn into believing a company's planned future sales forecasts, these based upon the seeming enormous current or trended sales in a specific sportscar or luxury segment or segments set by the major VMs, accompanied by the legendary phrase "we only need a tiny percentage of that segment".

The fact is that the business plans created by niche manufacturers in the UK have tended to be optimistic so as to make the project and business numbers work. Thus the numerous failings over the years which have both undermined the sector, regional economic confidence and from a Whitehall perspective national economic confidence.

Instead, the better long-term path to 'glory brand' niche vehicle growth has been stewardship by a powerful VM parent. But even this simple formula does not provide automatic success, much depends upon the innate capabilities and (internal political) interests of that parent. Hence we saw Aston-Martin strengthen impressively under Ford's previous ownership, and we witness Rolls-Royce and Bentley grown and now protected by BMW and VW respectively,

In unfortunate stark contrast we see that Lotus Cars has made little true progress (even with its co-company Lotus Engineering as a supposed aid) under Malaysia's largely state-owned Proton. The initial mutual expectancy of Malaysian-UK FDI propelling both the VM's development capabilities to become a global player and the NM's path to Ferrari-like success proving wholly empty over the last 15 years. (Note that F1's Team Lotus and Group Lotus, the holding company of 'Cars and Engineering', are not commercially linked).

Additionally, the success story that was Noble Cars lost its originator in a board-room tussle, whilst the previously 'lost' Ginetta Cars has been reborn thanks the patronage and funds of an entrepreneur who made his wealth in the retirement-home sector. And as a sad recent story has been the fall into administration of that venerable marque Bristol Cars in March this year, now bought by Swiss-based KamKorp, formed as a holding company seeking to mix and match automotive brands and technologies (including Frazer-Nash and ICE & EV, then reportedly sold to China's Xinjiang No1 Tractor Company, a state-owned enterprise).

Two shining examples however appear in the form of McLaren Cars and Morgan Motors, the former demonstrating the ability to commercialise F1 race-track success and the latter ever the demure steward of heyday yesteryear British motoring, though it too offers advanced engineering solutions wrapped in retrospective tailoring.

The automotive sphere is then for the external investor complex indeed, very often ironically the smaller the firm the more complexity, often borne from a mix of unrealistic ambitions mixed and personal/management egos which influence intra-company political infighting and hinder both the strategic and operational. Furthermore, increasing cross-border ownership may also create a frictional effect between owners aswell as owners and managers, though this is not always the case when partial foreign ownership resides with 'hands-off' owners as seen with McLaren and Aston Martin and their Middle-Eastern PE and SWF owners.

It is into this world that government officials and the civil service at large - carrying the promise or intent of assistance - must tread both open eyed and carefully.

The recent call from Lotus Cars for an assistance package highlights the caution required. The Norfolk company was unsuccessful in its 'first-round' application from the £1.4bn Regional Growth Fund. Monies were however provided for JLR, Bentley and Nissan. A 'second-round' application is available to those who were unsuccessful, Lotus now submitted an application for £10m funding as a tiny fraction of a stated £500m business expansion plan. This finance requirement is apparently split as £120m from parent Proton, and £270m of which comes from a conglomerate of Asian banks.

However, add the government's £10m to the seemingly 'assured' pot and it only reaches £400m, thus £100m short. Presumably this would be raised either by seeking notes or debentures from the City, selling additional company shares privately or even by offering a partial IPO. If this is the case it makes no sense for the firm to be legally & no doubt obligation bound to the government for such a small sum. If the business case for a major vehicle portfolio expansion is compelling, so requiring the necessary infrastructure build, then Proton, the Asian banks and the City would be happy to offer the funds more easily than a cash-strapped government, albeit at a higher cost of capital. Equally given the scale of the necessary investment the threat to otherwise 'off-shore' additional assembly jobs (to Magna Steyr in Austria or Valmat in Finland) appears odd.

This then would follow in the footsteps of Jaguar Land Rover's recent £1bn bond offer (@8% yield), and also that of Aston Martin's latter £304m bond offer (@ approx 9% yield). This demonstrates the present buoyancy in the City for backing soundly prepared business cases.

Additionally regards production outsourcing: both Magna Steyr and Valmat would undoubtedly seek to take a greater slice of unit-margin profits recognising they can do in-lieu of a client's CapEx savings. This also goes against the rational that sees Aston Martin relocate its Rapide production from Graz to Gaydon, and Porsche's decision to return its fringe production from Finland to Germany so as to make use of ironically lower cost homeland capacity and production schedules.

Industrial policy-making and any grants that accompany it must of course be both informed, balanced and be critically truly assistant in nature, providing a valuable fiscal resource for both the strategic prospects of the firm in question, and providing an assured trickle-down to other co-related commercial third parties also working in a pioneering field, or able to offer a 'multiplier-effect' through a company's employees to boost the local economy. Ideally both. Thus any single grant provided must make contextual sense, 'inwardly' relative to a truly convincing business rational presented by a firm's executive, and 'outwardly' relative to its socio-economic impact.

The groundwork must be under-taken thoroughly by government departments such as the Business Innovation & Skills (BIS) and its sub-divisional Regional Growth Funds (RGF), acting with the same due-diligence that any professional investor would undertake when parting with large sums.

The required slimming of government staffing to redress the budget deficit should not be used as an excuse when delivering what are now critically valuable public funds into the hands of private industry.

The past has seen a flood of public monies wasted on companies and projects that would have been seen as undeserving by private investment eyes, the then Regional Development Agencies (RDA) whose remit it was to nurture new commerce, but seemingly more adroit at forwarding funds toward enterprises and enterprise ideas which had little in the way of truly critiqued business plans so little hope of survival. The evident moral hazard for public funds channeled via state resources is that the process drives the outcome, when of course the reverse should be the case.

The other danger is that once funds are signed-off and provided, any delay in the work and progress made due to unforeseen occurrences beyond a firm's control (often relating to the actions of 3rd parties) means an ultimate drain of initial cash without agreed delivery. Here, governments can find themselves caught in a situation were they are induced to throw good money after bad to ensure the promised outcome.

Alternatively, having initially been convinced and 'bought-into' a scheme, the very act may well tempt additional private finance which sees government involvement as providing a security blanket of sorts even if not explicitly offered. This only adds to the moral hazard, and can give the incentive to a less than honest firm to stretch-out the work at hand – a well recognised theme that runs from small firm R&D projects to major PPI contracts for IT or construction.

Therefor it seems only sensible that in this age of public funding constraint, the rule-book be re-assessed with a possible tighten of grant provision terms and conditions.

It is stated that investment-auto-motives is unfamiliar with this arena, and has no deep knowledge of the present system, but addenda and possibly even new rules may need to be drafted and inserted into such agreements to ensure that funds are indeed used wisely and have accountability.

Any new rules should have powers that are concomitant to the level of funding sought, and the type of project and company to which they are to be directed. If not already in place, a stepped or tiered governance system providing increasing transparency as the in sum in question rises should be the ethos reflected in the provision structure. The level of oversight should also be tied to the likelihood of enterprise failure, higher propensities to do so more typical relative to start-up and early-phase companies, such as incubator-type efforts or those with typical VC type characteristics.

This is not the place to provide a detailed description of such an improved and more accountable system...but if not already in practice, a very basic yet powerful element should be that any company seeking a grant (or indeed loan or other financial instrument) should be willing to open its books: both submitted accounts [P&L, Balance Sheet & Cash Book) and its management accounts. For standard analysis, and if deemed necessary, forensic-type accounting examination, for the period spanning the former 5 years, or if younger since inception. It should also provide a full description of any sub-divisional companies with agreement that these accounts be also made available for inspection. Equally, the credibility of the BoD and company officers should be reviewed, from both the perspectives of previous general conduct (ie having no 'strikes' against them relative to previous failed businesses, especially questionable collapse) and that a majority percentage of the BoD (possibly 70% or near) have professional track-records that relate directly to the sector the business operates within.

This would be important yet simple matters to review, but ideally the BIS and RGFs would create a due-diligence template based on the prime principles that investment banks and private equity use, with a level of accordant leeway as deemed necessary, thus able to ensure that near best practice or adapted benchmark practice is deployed.

The issue of government grants is a broad and deep issue, but as perhaps an important socio-economic enabler, depending on the business type, the provision of grants might also be connected to the corporate provision of allied new housing schemes in areas of either high-priced housing or of inadequate housing (capacity & standard) within the area. So re-emphasising the kind of yesteryear CSR that has been absent for decades, the loss of that ideal bemoaned when Kraft bought Cadbury given its Bournville village history.

[NB Though this 'social hook' has in recent years been integrated into the planning permission consent requirement relative to major supermarkets' development sites].

The future of the UK's prosperity undoubtedly rests on its ability to reduce its manufacturing cost-base, both for domestic and export demand maximisation and to re-invigorate company accounts so aiding the long-term investment story.

Thus today at a time when government is struggling to pay-down the deficit and maintain public contentment, the provision of government grants to industry should have not only better targeting, oversight and outcome analysis, but critically – as and when feasible - have a social dimension that aids the country's social and economic cohesiveness.