The great float flop
Backers of the MDIS flotation lost pounds 190m. But a syndicate led by Barings, its financial adviser, made pounds 48m. Paul Rodgers explains stand firsty standfirsty
Sunday 20 August 1995
The episode of the video proved to be a minor symptom of a much deeper malaise. The flotation of MDIS was a full-blown disaster, and Mr Causley's departure last week was just the latest in a string of news bubbles to emerge from the sinking company. Three consecutive profit warnings, the departure of executive after executive, the replacement of Barings as its merchant bank . . . By this weekend, the shares had sunk to 70p, just over a quarter of the value they were assigned at the company's flotation last year. Investors have lost three-quarters of their investment of pounds 260m in just over 17 months.
The sinking sent out ripples that touched other stocks. Along with Aerostructures Hamble, the MDIS fiasco put paid to the 1994 bull market for new issues, achieving fame as one of the notorious "flotation flops of '94". As the largest UK flotation of a computer company, it was particularly hard on other hi-tech issues. The chief executive of the data company MAID blamed MDIS's problems for his own company's poor performance on the market after it floated.
Some investors have tried to stir up the authorities to launch an investigation, so far to no avail. But the tale of MDIS is a tangled one, from which few players emerge with credit. The murkiest involvement is that of Barings, leader and dominant player in a syndicate of venture capitalists that saw its equity stake soar in value from pounds 5m to pounds 110m. Between pounds 40m and pounds 50m was taken in profit, although Barings itself hung on to 9 per cent of the company. Barings, as well as being a leading shareholder, was also the company's adviser on the flotation. No one has produced a shred of evidence suggesting impropriety, but that has not stopped City institutions from crying foul over the apparent conflict of interest and questioning the efficacy of the City's vaunted Chinese walls. "There have been comments about the windfall made by the buyout team," said one.
McDonnell Information Systems had an impressive pedigree that stood it in good stead when it went to the markets. It was originally a British company called Computer Machine Company Leasing, but went through a series of changes after being bought in 1979 by McDonnell Douglas Corporation, the blue-chip defence aviation contractor in the US, to become its computer arm. Particularly hard hit by the end of the Cold War, MDC decided to concentrate on core activities, and moved to sell off the computing division.
Initially it looked at floating MDIS for around pounds 180m to pounds 200m, but the market for new issues was not strong. Instead, in March 1993, it sold out to the management, led by Mr Causley. The funds were raised partly as debt and partly as equity, and the total sale value was pounds 121m. The investors were led by Baring Capital Investors, the venture arm of the distinguished merchant bank.
The buyout looked solid, and the newly independent company was given lustre by such non-executive directors as Sir Terry Heiser, former permanent secretary at the Department of the Environment, and Peter Macfarlane, finance director at Allied-Lyons. It had some of the most reputable City advisers: Barings on finance, National Westminster as broker, auditors Ernst & Young, and Freshfields and Linklaters & Paines as solicitors.
The managers appeared to have a hot property. The company was large by the standards of computer services groups, with 1,630 employees, a turnover of pounds 148.5m and operating profits of pounds 22.3m. It specialised in selling or leasing complete packages - hardware, software and support services - to large customers. It had a solid customer base, with 800 UK clients including local authorities, police forces, health trusts and corporations.
It was a big player in a fast-expanding industry. But even before the buyout, there were warning signs. Even though its operating profits had climbed steadily from 1991, its turnover had fallen.
Immediately after the buy-out, management dusted off the flotation plans. Many MBO teams have sold out quickly, sometimes making a thumping profit - but it is unusual, to say the least, that managers should start planning a flotation almost before the ink is dry on the original deal.
That was not, however, something that bothered the City, where deals mean fees. The job of principal adviser was expected to go to SG Warburg, but the new owners decided to put the financial adviser's role up for tender, and Barings won. That meant it was both the biggest shareholder and financial adviser to MDIS - but this was not considered a problem, because "Chinese walls" are supposed to keep the two sides well apart. NatWest was given the broker's job.
Work on the prospectus was carried out at Barings palatial office on Bishopsgate, a short walk from the Bank of England. The bank's team was led by director Anthony McGrath, the deputy head of corporate finance, now on sabbatical. A soft-spoken proponent of the old school of banking, Mr McGrath had years of experience behind him. The key player, though, was Mr Causley. A career computer man, he had risen to the top in MDIS because of his forceful personality. He was, above all else, a salesman capable of closing a deal.
"The success story of the three years prior to that had increased his power. He was very autocratic, and capable of being quite short," said one participant in the planning.
Even though Mr Causley's style - and video - brought its share of friction, there was no disagreement between him and his City advisers on the price at which MDIS should be floated. "It just wasn't contentious," said one insider. Feedback from the institutions came in a surprisingly tight range around the 260p at which the issue was made. In hindsight, it might have been priced a little lower, but nowhere near the level at which the shares now languish. The final decision was taken in Barings' main boardroom, virtually an art gallery on the top floor of the bank, just before the offer was made public. The figure chosen valued the company at 18.2 times its earn-
nings, giving it a market capitalisation of pounds 260m.
There was remarkably little concern that the value of the company had doubled in a year for no apparent reason. One reason was that the managers themselves had faith that the price was right. They could have cashed in some lucrative chips: but neither the chairman, Ian Hay Davison, nor Mr Causley sold any shares in the flotation. Other managers put up at most a quarter of their holdings, hardly jumping ship. The big winners were the venture capital investors in the MBO, including Baring Capital Investors: this was normal, because venture capitalists always bail out in a float.
Between the offer going public and the start of trading on 24 March last year, the stock market slid, so it was little surprise that the issue got off at a small discount rather than a premium, with much of the 30 per cent set aside for small shareholders failing to move. But the company and its advisers were confident the ground would be regained. It was, but only briefly.
In August, the board received an alarming report from its finance director, Ian Knox. The company was not going to make its first-half targets. A few weeks later, it issued a profits warning, blaming its problems on contracts coming in too slowly. First-half results were down 33 per cent, and the finals would be bad, too. Urgent action was called for.
Then fate stepped in. During a business trip to Australia Mr Davison fell ill with pancreatitis and spent the next four months on a drip. By the time he recovered, a second profits warning had been issued, Mr Knox had resigned, and the company seemed rudderless. Mr Davison called in German consultants Rowland Berger, part of Deutsche Bank, which recommended a new focus on core activities and tighter internal financial controls.
The financial problems stemmed from a shift in the company's business. Before the MBO, it was primarily a hardware company, selling equipment at a fixed price and banking the profit right away. But a price war between computer makers was driving margins down, so MDIS began moving its emphasis to long-term software contracts. These required accurate estimates of how much a job would cost, careful oversight of the amount of work done, and precise billing of customers. The controls were just not there.
By the time the third profits warning was issued last week, the company claimed it was at last pointing in the right direction. But full implementation of a system of financial controls may not be complete until the end of 1996, almost 18 months away.
The grumbling among City institutions, meanwhile, has been growing louder. Mercury Asset Management even went so far as to punish NatWest by cutting its commission. Others boycotted stockbrokers that had brought turkeys to the market at about the same time as MDIS.
But rightly or wrongly, the real ire of the fund managers involved in the computer company float is reserved for Barings, which they say failed to find out what was really happening at MDIS. "I was amazed at how they were taking everything the company said for granted and not doing any cross-checking," said one shareholder. A source close to the flotation admited privately that this may have been the case, although it was never raised as an issue at the time. "I saw no sign of any undue influence," he said. In the City, you just do not challenge a bank, with the reputation Barings then had, for failing to do its due diligence diligently. In the light of the bank's collapse and subsequent rescue this year as a result of lax controls on its futures trading in Singapore, that attitude might have been a trifle too innocent. Barings was unable to comment last week, saying all the people involved were away on holiday.
The bank's position would be far stronger if it had not so obviously had something to gain by getting the issue away at a strong price. Baring Capital Investors and associates made about pounds 48m on the sale.
Barings was under no obligation to pass up the opportunity to advise MDIS. Many other banks in recent years have found themselves in similar situations and have gone ahead without criticism, because the offerings were successful. But the collapse of MDIS has thrown into stark relief one of the weaknesses of the system of Chinese walls set up during Big Bang - the deregulation of the City in 1986.
The rules were designed to keep one department of a bank, say corporate finance, from telling another, such as its trading section, about confidential information - a possible takeover offer, for example. What works reasonably well when there is price-sensitive insider information to be kept secret becomes suspect when the gains to be made are obvious to all. "The possibility for conflict of interest is clearly apparent to the institutional investors," said one such. Barings corporate finance experts could have been in no doubt about what their colleagues in venture capital would make from a flotation: the prospectus lists their shareholding.
Yet the Stock Exchange, the Bank of England, and the Securities and Futures Authority remain convinced that their existing controls work.
Meanwhile, MDIS is clawing its way back. Mr Causley's departure paves the way for a new chief executive, who is likely to focus on the core business in the UK and possibly seek an alliance with a larger company. Analysts now see MDIS as a potential recovery stock - though that is scant comfort for fund managers left with a deep red ink stain over their books.
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