The news last week that the Boards of Nationwide Building Society (Nationwide) and Virgin Money UK (Virgin Money) had reached a preliminary agreement on the terms of a potential cash acquisition of Virgin Money by Nationwide for £2.9bn had not been on our bingo card. Nationwide’s relatively new CEO used to work at Virgin Money so will know the bank well but we were left scratching our heads to think of another example of a mutual buying a listed bank. In the 1990s, it was UK building societies either listing or being bought by larger banks.

It is not news that listed UK companies have arguably been trading at large discounts to their inherent value, which explains the recent raft of bids. However, that the Board of Virgin Money, which we assume are not a distressed seller, to have agreed to potentially sell the bank at over a 40% discount to book value, which is below the £3.9bn the bank was valued at when it was created by the combination of CYBG and Virgin Money in 2018, is a further surprise. A bank whose management and Board believed could achieve a double-digit return on equity would justify a much higher price, we believe, and requires explanation.

What does it mean for investors?

We would not be surprised if Nationwide has to sweeten the deal but, with the share price trading below the offer price, it would suggest the market does not believe this. The combination makes financial logic and would result in the combined group having £366bn of assets and a mortgage market share of over 15%, second only to Lloyds. That aside, the impact for Virgin Money equity and bond holders is good, with the price of its shares jumping around 35% on the day and its AT1 bonds also seeing a decent, albeit much more modest, rally.

Another interesting aspect of this is Nationwide’s capital structure. It includes Capital Core Deferred Shares (CCDS) which are, by definition, equity being subordinated to the building society’s AT1 securities but which are treated as bonds by most investors due to the fixed coupon they pay - effectively treated as interest. It is an oddity that, Nationwide’s listed security which most resembles equity, trades at over a 30% premium to par value while not a single UK bank's equity gets close to that valuation. 

Heightened competition ahead?

Nationwide’s CCDS have performed well, due mostly to the high coupon it had to agree to pay when first issued in 2013, but also as the building society has been buying them back. We sold the majority of our holding at the beginning of March in the Polar Capital Financial Credit Fund, as we thought they were overvalued, and the balance following the news, as we see a risk they could weaken as buybacks fall away. We also own one of Nationwide’s AT1 bonds in the Polar Capital Global Financials Trust but see little risk to its price, albeit the combined group will likely need to issue some more debt over the medium term. Finally, this should be good for customers but will likely lead to greater competition in the mortgage market, which is less good news for other UK banks.

Note: Nationwide Building Society is the UK’s largest building society. It was founded in 1884 as the Southern Co-operative Permanent Building Society. It changed its name in 1970 to Nationwide. CYBG, which owned Clydesdale Bank and Yorkshire Bank, acquired Virgin Money Bank, which itself was largely created by the purchase of Northern Rock in 2011 from the UK government, before rebranding the whole bank as Virgin Money.