How M&B hedge cost top job

Some are saying the curse of Robert Tchenguiz has struck again. The departure of Mitchells & Butlers chief executive Tim Clarke last week will be seen as pretty much the direct result of allowing Tchenguiz to commandeer the company's strategy back in 2007.

M&B put in place interest rate and inflation swaps to hedge against a proposed property joint venture with Robert Tchenguiz's R20 in the summer of 2007. In the event, the company found itself having to stump up for round after round down at the Hare & Hedge Fund.

The timing of the deal was terrible with the credit crunch tsunami of fear breaking on the shores of the financial sector just as the deal was reaching fruition. M&B's hedges turned out to be a huge bet in entirely the wrong direction. The company thought interest rates would climb whereas they have, as we know, headed south ever since the summer of 2007.

M&B closed 70% of the hedges in February 2008 at a cash loss of £270m or so. Around 30% of the hedges were allowed to ride and were recently closed out at a further cash loss of £69m. Tim Clarke is an honourable man and insisted that M&B accept his resignation last week on the basis that his position had become untenable. He was right to insist on going. The total cash loss to M&B shareholders stands at a mighty £343m in total, a scary £480m or so pre-tax.

As a tax avoidance scheme it's a work of genius; as an overarching strategy for sensible use of M&B cash it's a train crash to beat any in the sector. Don't forget that there is on-going opportunity cost of blowing this kind of money — £343m would buy 170 or so top quality £2m-a-time pubs that, in line with M&B averages, could have produced £40m or so in pre-central overhead earnings per year. Over a number of years, M&B could, potentially, have invested £342m to create an add-on pub estate worth hundreds of millions more.

The fundamental problem for M&B executives, led by Tim Clarke, was the capitulation to those investors, led by Robert Tchenguiz, who held around 60% of the stock in 2007 and pushed hard for the freeholds to be sold to release cash for distribution to them.

The strategic strength of this sector of the shareholder base reached its symbolic zenith when Robert Tchenguiz's key lieutenants, Aaron Brown and Tim Smalley, were given seats on the M&B board last spring. In the event, the Tchenguiz/R20 power base melted away like a late-year covering of snow when the Icelandic banking crisis led Kaupthing to force the sale of the entire Tchenguiz M&B stake to cover debts at the end of last year. It's worth recalling that in October 2006 M&B paid a special dividend of £486m, or £1 a share, because its pubs had increased in value by 40% to £2.8m each over three years thanks to their trading success.

A little more than a year later, as Tchenguiz and other hedgies on the share register held sway, Clarke told me that M&B did not need "the feather bedding of its freeholds because it had the best sites, concepts and personnel". The net result of the new policy came to be a huge special dividend for Black Hole Incorporated. Clarke and other senior executives at M&B could have refused to follow the entreaties of Tchenguiz and co from the start, inviting them to bid for the business or go away.

In years to come, historians of M&B may come to see the £343m cash loss as a symptom of top-of-the-property-bubble madness. They may even decide that this devastating loss of cash, though regrettable, was, in hindsight, a less worse outcome than turning M&B into an multiple leased operating company, given survival rates for these sorts of companies across the sector.

Tragedy​

The real tragedy here is that Clarke is the architect of M&B's largely faultless volume and value strategy, which had consistently driven sizeable market share gains since it demerged from Six Continents in April 2003.

At results last week, acting chief executive Adam Fowle was able to report once again that the company was achieving out-performance as a result of using its scale to deliver ever-greater value to its customers.

There is no doubt what ordinary rank-and-file M&B shareholders want to see happen now. At the annual general meeting of shareholders in January 2008 I heard small shareholder after small shareholder decrying the way M&B had been seduced into behaving like some incompetent Mayfair hedge fund.

Now, no doubt, they must be very keen to see Adam Fowle and his co-directors directing their energies to what they do best from now on in — running pubs rather than gambling on complex derivatives.

One footnote to recent events

concerns Clarke's bonus of £28,000 in 2008, the year that the largest losses on the property transaction hedges were crystallised. Admittedly, the bonus looks small compared to the potential bonus pot for Clarke of £554,000. M&B suggests the bonus was paid in recognition of M&B's on-going operational strength. But you wonder just how much money M&B had to lose before it was felt that bonuses were simply not appropriate.