Making a match for the mortgage melee: Hush hush, whisper who dares, Cheltenham & Gloucester is shifting to shares . . . how Lloyds and C&G played poker in locked rooms

THE DEAL was one of the best-kept business secrets of recent times. From a locked room in the headquarters of Cheltenham & Gloucester Building Society at Barnwood, Gloucester, a tiny band of executives discreetly stitched together a deal that, they claim, will transform the mortgage lending industry.

Last Thursday it all came to fruition when Lloyds Bank announced that it was buying C&G for pounds 1.8bn. Until then, the City had suspected nothing.

Led by Andrew Longhurst, C&G's chief executive, the C&G team consisted of Chris Jones, the company secretary, and David Bennet, the general manager of treasury and investments. They were the only people with access to the secure room where all faxes and phone calls concerning the deal were routed, away from the eyes of other C&G employees who might have talked to the press.

Lloyds also fielded a small team of senior executives, led by Brian Pitman, chief executive, who operated under heavy security out of the bank's strategic planning department in its imposing Lombard Street head office in London. There was no leak of the deal, which Lloyds dubbed 'Operation Paul' after the Pauline conversion on the road to Damascus.

Last October, after a review of its future begun 12 months previously, C&G commissioned JP Morgan, the US investment bank, to send out letters to only four or five shortlisted candidates - including at least one non-bank - asking if they were interested in buying the society. The list was quickly whittled down to one name as C&G decided on Lloyds.

Preliminary meetings had gone well. Mr Pitman and Mr Longhurst, who have known each other for many years, share similar business philosophies - concentrating on profit and quality rather than size. The cultures of the bank and the building society seemed to mesh nicely. In October, JP Morgan asked Lloyds for its best bid. If it was not good enough, they said, the deal was off. There was to be no haggling. Lloyds, however, was given no indication that it was the only bidder.

After weeks of detailed analysis, the bank came up with a bid of around pounds 1.8bn, based on a premium over what it thought the company would get if it floated itself on the stock market. C&G insisted the money had to be paid in cash, effectively forcing Lloyds to take all the risk on a deal that would not be consummated until May 1995.

The aim of Lloyds and C&G is to create a strong mortgage lender - they will have 7 per cent of the market, making it the third largest - that is also more competitive than its rivals. C&G has the lowest cost- to-income ratio of any society - 26 per cent compared with an industry average of about 40 per cent. Allied to Lloyds, it will be even more efficient because it will have access to Lloyds' wholesale money market funds borrowed at finer rates than C&G could borrow on its own.

Lloyds will become by far the largest mortgage lender of the big clearers, but Mr Pitman believes that with his new alliance it will be a profitable area. At present, it is the fastest growing sector of UK lending.

Moreover, Lloyds has bought C&G at a relatively modest price. On a price-to- earnings ratio of 13.6 times, it is cheaper than Abbey National which is now on 15. The City needed little persuading of its merits. Within hours of the deal being unveiled, Lloyds' shares rose 48p to 585p. Nor did C&G's investors. They stand to gain a handsome windfall of at least pounds 500 and at most pounds 10,000, depending on the size of their deposit, from the deal.

But will the deal unleash the wave of cataclysmic change that Lloyds and C&G claim? A triumphant Mr Pitman boasted on Thursday: 'This deal will so upset the competitive equilibrium of the market in our favour that we will win.' He foresees a period of savage competition and upheaval in this sector of the financial services industry, with building societies rapidly linking to form defensive alliances with banks and other building societies. He predicted that other banks were quaking in their boots at Lloyds' purchase of C&G.

Several banks are known to be interested in buying building societies, including Bank of Scotland, Royal Bank of Scotland and TSB. Conglomerates such as BAT Industries (owners of Eagle Star and Allied Dunbar) are also looking, as are large insurance companies such as Standard Life.

According to Robert Villiers, a building society analyst at UBS, two types of society are likely to be seeking a C&G-style link with a bigger brother. There are the ambitious, successful societies looking for a new way ahead, and there are the weak and feeble societies who cannot survive independently in such a competitive climate.

Many in the industry, however, doubt this will lead to an immediate wave of takeovers. The Halifax, easily the largest society, is committed to remaining as a mutual society for the foreseeable future. Peter Robinson, managing director of the Woolwich, said: 'There is no pressing need for us to change our constitutional form on the grounds of financial performance. Mutuals can, and usually do, beat plcs.'

But he conceded that attitudes were changing. 'What will change things is not commercial pressures but the restless pressure inside the industry to try something new.'

Even so, takeovers by banks and others are unlikely to begin until Lloyds has sorted out the regulatory problems of buying C&G. The Building Societies Act says cash cannot be paid direct to society members as Lloyds plans to do. The bank and the Building Society Commission are seeking clarification in the High Court.

If the High Court blocks the bid as it stands, other potential purchasers are likely to have second thoughts. If the bid is cleared, however, other banks and building societies will be encouraged to follow, and Lloyds may indeed have blazed the way in the restructuring of the mortgage industry. In that case, the days of the traditional mutual building society, so long a feature of British high streets, will be numbered.

The deal is likely to cost Lloyds and C&G in the region of pounds 25m to pounds 30m in fees to City advisers, according to Acquisitions Monthly, the leading corporate finance magazine. The costs could be considerably higher, however, if Lloyds's case in the High Court goes to appeal, pushing up the bank's legal fees. This is substantially less than the pounds 80m paid by Abbey National for its flotation.

Lloyds is being advised by Baring Brothers, the merchant bank, and Linklaters & Paines, the law firm.

C&G is advised by JP Morgan, and Slaughter & May, the lawyers. Some success element is likely to be built into the former's fees - because of the risk that the deal might fail because of legal problems.

(Photograph omitted)

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