The benefits and risks of 'medium-merging'

With any market, merger and acquisitions tend to come in cycles.

In the private sector, mergers and acquisitions are often opportunistic, with the price of money, the underperformance of companies, and (increasingly) currency fluctuations all having a role in the cycle. In the housing sector the macro-economic factors that encourage consolidation are often linked to government policy decisions just as much as board aspirations and access to finance.

A combination of the rent reduction and other government policies, such as Universal Credit and benefit cuts, has caused reverberations in the housing sector.

“We are now seeing much more interest in consolidation of smaller organisations.”

The reduced income from these policies has stimulated greater appetite for development and a greater focus on lowering operating overheads in order to ensure the continued financial prosperity of housing associations.

It has been much reported there are efficiency savings that can be unlocked by consolidating providers’ business. In turn we have seen the rise of the mega-merger, with merged organisations focusing on significant cost-efficiency saving targets as well as the expansion of development programmes.

We will have to wait and see whether these often ambitious cost savings and development targets will ultimately be achieved.

What is true is that those same policy reverberations are now having an impact on the under-5,000-unit housing association part of the sector. Just as a few years ago a number of 6,000 to 10,000-unit associations moved to consolidate to form 20,000-plus-home organisations, we are now seeing much more interest in consolidation of smaller organisations.

What are the catalysts for this growth in smaller merger activity? Well, the answer depends on who you talk to.

There are boards which are acutely aware that this lower-income environment is here to stay and that together with rising operating costs it means they are running increasingly harder to effectively stand still.

While things may balance at the moment, in a few years’ time the financial situation will be even worse.

For these boards, closer working alliances with other similar providers offer a way to fast-track overhead reduction. ‘Closer working’ is really a spectrum… It can mean implementing cost-sharing projects through shared service arrangements, joining federated structures or taking part in a true merger through a transfer of engagements or amalgamation.

These financial constraints are compounded by the need to invest for the future. 

“Mergers or joint venture projects offer a way to achieve development ambition quickly.”

The transformation to a digital end-to-end service is an example of where pooling two housing association budgets can produce more. Tenants increasingly expect smooth digital services and housing associations can reduce their employee costs by implementing good customer relationship management and IT systems.

However, the costs of procurement and implementation can be relatively high for a small organisation. Where two or more providers are able to jointly invest their transformation budgets (whether via a merger or otherwise) the joint enterprise can often achieve more than the sum of its parts.

We are also seeing smaller providers now actively seeking to develop much more. While the volume of planned new builds may be very small, the perception is very much that there is a need to use sales income to cross-subsidise core housing services.

However, the lack of skills and lack of experience can act as a barrier to entry or at least a material risk to cost control and success.

Mergers or joint venture projects offer a way to achieve this development ambition quickly and thereby earn valuable additional sales income to subsidise the core social housing business. 

The need to find cost savings, to make IT investment and to increase development do not make any merger inevitable. However, these factors often convince a smaller housing association of the preference to undertake a merger of convenience rather than a merger of necessity.

A merger for convenience allows time to explore different merger partners, to carry out good due diligence, to enable realistic cost saving planning, to make the right IT investment and to carefully plan for development.

A careful merger can also ensure brand survival, ensure local control is retained and that a shared vision is created on equal terms; all important factors for locally based providers.

Conversely, a merger of necessity risks a smaller provider being the more junior partner and not having much, if any, say in the process. Smaller, more symmetrical mergers for convenience are therefore a strategically defensive step to avoid being swallowed up in an asymmetrical merger in a few years’ time.

To conclude, we think the merger cycle has still not peaked. Small mergers may be perceived as far less financially important than mega-mergers, but the risks of smaller mergers are no less real than with the mega-mergers.

Indeed, smaller reserves can mean that the crystallisation of risks can have more dramatic effects.

The typical risks associated with this kind of merger are:

• Financial risks (understanding the numbers and the financial strengths and exposure the merged organisation will face). Smaller associations are perhaps more sensitive to poor due diligence on financials as there is usually a lower level of reserves to fall back on in the event of unforeseen financial problems. Consultancy costs can appear disproportionate for a small merger, but the need for good due diligence cannot be understated.
• Unrealistic expectations around overhead reductions. Over-optimism about the ability to streamline the merged organisation’s headcount and costs can create problems when targets are not achieved. A failure to meet cost-cutting targets can create financial shortfalls and cause services to tenants to start to suffer as employee head counts are reduced further. Merged organisations that fall into the ‘too much, too quickly’ category can cause serious financial and reputational self-harm. 
• Cultural issues. Taking the workforce of each organisation along with the boards is an essential part of a successful merger. The organisation is ultimately the people who work there. Smaller associations will often have very loyal employees who have long associated themselves with that organisation’s brand. Smaller associations can also be more sensitive to key employee departures. It is critical that the new merged organisation’s identity and objectives are sufficiently aligned with the workforce of each merger partner. While at least one merger partner’s identity will be phase out, there needs to be a continuation of the positive aspects of both merger partners.
• Optimism bias as to the skills and abilities of the new merged organisation. If the merger is a precursor to a much bigger development programme, then risks can arise if the new organisation rushes to get started on major development or new non-core activity without carefully working out its strategic approach and whether it actually has the right skills at board level.

Lee Clarke, partner, Capsticks