Aviva plc; market cap (as of 27/11/2014 ): £14.96bn

Friends Life Group; market cap (as of 27/11/2014): £5.21bn

Introduction

On November 24, Aviva plc, a multinational insurance company headquartered in London, reached a preliminary agreement to acquire its British rival Friends Life Group, the 5th largest life and pensions company in the UK by market capitalization. The two insurers have agreed terms for an all-share deal worth about £5.6bn, in which Aviva would offer a 15% premium to Friends Life’s share price – the valuation reaches 398.9 pence per share. Aviva said it is willing to pay 0.74 shares of its own for each share of Friends Life. Friends Life shareholders would also receive an amount in cash equal to any Friends Life final dividend for the 2014 fiscal year. At closing, Friends Life’s shareholders would own about 26% of the combined company. If the deal goes through, it would create a combined life insurance and asset management business worth about £20.7bn with more than £300bn in assets under management and 16m customers as well as the biggest provider of corporate pensions in the UK. Under British takeover rules, Aviva has to decide until December 19 whether to make a firm offer or walk away from any such transaction for up to six months.

Rationale

The deal aims to accelerate the transformation of Aviva’s balance sheet, including reducing leverage and strengthening capital and liquidity, helped by Friends Life’s strong cash generation. In addition, the company would benefit from a boost in assets under management and substantial cut in costs. Potential savings could also come from rationalizing management and staffing and closing Friends Life’s head office. In fact, Nomura analysts estimate that the potential takeover could generate cost savings of £188m at the end of 2015 and £255m by the end of 2016. Moreover, the deal would allow Aviva Investors to take on Friends’ funds. It would also give Aviva bigger scale in handling corporate pension mandates, a corner of the industry that is growing given separate reforms that require employers to enroll workers automatically. This will not only enable Aviva to accelerate the growth of its dividends but will also put Aviva in a better position to make more fulfilling overseas acquisitions.

However, the execution of the merger still remains with a big question mark since paying £5.6bn is close to Friends’ embedded value – a way of valuing life assurance companies’ future cash flows – which is hardly a bargain by industry standards since putting together insurance staff and systems has never been an easy task. Guaranteed synergies are management fees and headquarter costs. It is hardly enough to justify the price announced, so Aviva needs to strive hard to fulfill all the promises regarding deal’s benefits it made to its shareholders.

However, according to the Financial Times, insiders at Aviva say that the main rationale is financial and not strategic. They say the tie-up with Friends would improve cash generation and reduce leverage, which Mr. Wilson, Aviva’s CEO, has made a priority. Indeed, Friends Life, formerly known as Resolution, is expected to generate £370m of cash this year, largely from a multibillion-pound pool of closed life assurance funds. While the Friends deal itself might provide only limited growth opportunities outside the corporate pensions business, backers believe it will give Aviva more financial firepower to pursue growth elsewhere or to reinvest into Aviva products. It should also give Aviva greater scope to boost the dividend, which Mr. Wilson slashed by 44% just few weeks after he was appointed.

Stocks Performance

On Monday, Friends Life’s shares in London were up 5.3% to £3.66, whereas Aviva’s shares declined 4.7% to £5.13 reflecting uncertainty about the potential benefits of the company’s £5.6bn merger plan as well as the risk of a potential dilution of the value of the acquiring company’s stock as a result of the all-share transaction.

Financial Advisors

Aviva is being advised by JP Morgan Cazenove, Morgan Stanley and Robey Warshaw, while Friends Life Group is being advised by Goldman Sachs, Barclays and the Royal Bank of Canada.

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