The Implications of Dodd Frank for Private Equity

In this very thoughtful video, Richard Jaffe (partner at Duane Morris) discusses the implications of Dodd Frank for Private Equity.  While the law applies in the US, Richard also discusses the European and US models related to management fees, current trends,  and the pressure on the industry in general.  

Incidentally, Richard has chaired the advisory board of Drexel's Governance Center since 2007.  While this video is unrelated to the Center, it is consistent with our mission of advocating excellence in Corporate Governance, which certainly includes a thoughtful consideration of the impacts and unintended consequences of regulation.

The video and transcript are available here.

All the best,

Ralph

Yahoo-Tumblr : Here We Go Again?

Yahoo recently announced a $1.1B acquisition of Tumblr.  Marissa Mayer, their new CEO, is seeking a transformational acquisition of a young, fast growing social blogging network to energize her slow growth media firm whose business model is under question.

As mentioned in my April 14, 2013 post “May the Odds Be withYou” large transformational acquisitions by new CEOs seeking to make a reputation for themselves are dangerous. (Mayer joined Yahoo in July 2012 from Google). They usually succeed in making their reputation. Unfortunately for their shareholders, it is not the one they intended. Leo Apotheker stands out as the poster boy of such follies with his disastrous HP-Autonomy acquisition. CEOs in general, and especially new CEOs, would be better served addressing core business model issues before trying to cover them up by embarking on risky acquisitions. Mayer may be hoping to replicate Google’s successful YouTube acquisition. Nonetheless, hope is never a good strategy. Additionally, there are some significant Tumblr questions which need to be addressed.

The first is the price question. Tumblr burned through $25MM of cash last year on just $13MM of revenues. Analysts estimate Tumblr needs to grow quickly to $1B in revenues with 10%+ profit margins just for Yahoo to breakeven. That is very aggressive. Keep in mind Tumblr experienced difficulty in its latest round of venture capital funding. Also, allegedly, Tumblr tried unsuccessful to sell itself to Microsoft, Facebook and Google. So I think part of the Yahoo bet is to gain access to Tumblr’s “unduplicated audience of users” that can be integrated with Yahoo i.e. 1+1=1000.

Both the growth and integration synergies require flawless execution. Yahoo’s acquisition record, however, suggests this may be a challenge. Its 1999 $3B Geocities acquisition ceased operations in 2009. Other acquisitions like Overture and Flickr have yet to pan out. Also, Tumblr users have expressed concerns over the transaction and threatened to leave the site.

Recognizing these issues, Yahoo has promised not to screw it up-their words not mine!  You know you are in trouble when you have to make statements like this.  Yahoo plans to keep Tumblr separate from Yahoo to retain Tumblr users. The problem is, if Tumblr is kept separate, how can you achieve the required integration synergies needed to justify the acquisition premium? This raises the question of whether Yahoo is the best owner of Tumblr - defined as being able to extract the highest value from Tumblr.

It usually takes two years before you can judge the success of an acquisition. Nonetheless, it looks like Yahoo massively overpaid for a company that will be difficult to integrate by an eager new CEO. Yahoo’s board approval of the transaction raises additional governance concerns. This suggests a bumpy road ahead for Yahoo.

J

p.s. Yahoo is also reportedly a bidder for Hulu, which has already received a formal $500MM News Corp. offer. If true, Yahoo would be entering an auction for another major transformational acquisition. This increases both the odds for over paying and greatly complicates execution and integration concerns should Yahoo’s bid succeed. What is the board thinking in supporting this action? Start shorting Yahoo’s stock. They look like they are trying to replace HP as the new serial acquisition value killer.

J

The Influence of ISS: The Case of JP Morgan

Merger decisions are dramatically impacted by acquiring and targeted boards.  Boards are elected by shareholders, many of whom lack the time or other resources to carefully scrutinize directors or issues to be voted upon at an annual meeting.  Enter the Proxy Advisory Firms who make a business of issuing recommendations (and, pardon the conflict of interest, selling advisory services - but that is a point for another time). Today, I just want to talk about the influence of advisory firms.  

The influence of Proxy Advisory Firms is receiving renewed attention with the recent vote to separate the CEO and Chairman roles at JP Morgan.  Jamie Dimon 'won' that vote in spite of negative recommendations from Institutional Shareholder Services and Glass Lewis.

Let's examine the 'win' a bit closer and also examine an article in the Wall Street Journal today that suggests the influence of proxy advisory firms is on the decline.  I'm not so sure that Dimon's results suggest any loss of influence of ISS or Glass Lewis.  True, the proposal to split the roles received 33% support this year, down from 40% last year.  But that is in the face of a massive campaign by JP Morgan to influence investors.  In spite of the "London Whale" incident, Dimon is widely regarded as one of the most competent executives on Wall Street and it is clear that Morgan has benefitted under his leadership.  I wouldn't expect firms or executives with lessor records to be able to sway votes.  

The chart below, taken from the WSJ article, suggests that an ISS recommendation is associated with a change in votes by about 15%.  This simple chart doesn't indicate that the ISS recommendation swings votes by that much as factors that influence ISS also influence shareholders themselves.  However, it is interesting to note that the 15% level is quite similar to our own analysis of over 2400 director elections.  In that analysis we found that a negative recommendation by ISS moved votes by over 18% - after controlling for all of the other logical factors (firm performance, director performance, etc.).  We'll discuss those results in a subsequent post.  Here we also note that the three directors from the risk committee of JP Morgan received a negative recommendation from ISS and garnered less than 60% shareholder support.  Those are very low numbers for directors.  They typically receive over 90% support.

The WSJ article can be downloaded here.  More detail on our analysis of Board Elections will be found in a subsequent post.

All the best,

Ralph

Risk Based Capital: The Good, Bad and Mostly Ugly

The Basel capital framework categorizes assets by risk level. Safer assets receive lower risk weights than higher risk assets. The sum of the weighted or adjusted assets is then compared to existing capital to determine capital adequacy. Supporters believe risk based capital (RBC) is a superior measure of bank strength compared to non risk adjusted accounting based measures like the leverage ratio. Unfortunately, the facts do not support this belief Hogan,etal.

The flaws plaguing RBC are well known Hoenig and Admati and Hellwig Chapter 11. The weights are far from scientific. They are heavily influenced by politics and tradition. The more serious problem, however, is their mechanical attachment to history based on the use of flawed Value at Risk methodology, which confuses history with science. If the future deviates from history, then the resulting risk weights are incorrect. For example, using 25 years of pre crisis data from the “Great Moderation” presents a misleadingly low level of mortgage risk. It is like meteorologists without knowledge of storms trying to forecast long term weather.

Next, RBC fails to recognize that banks do not passively accept regulation-they react to it by adapting their behavior. They will engage in regulatory arbitrage to shrink their capital requirements without trimming actual risk by inappropriately risk weighting assets. This is made easy by RBC reliance on bank internal risk models to set lower risk weights. This flexibility allows banks to have vastly different risk weights for the same assets. The gaming of results leads to risk weighted assets (RWA) to total asset ratios of less than 60% at many large banks. Furthermore, the ratio is falling as total assets continue to grow faster than RWA. This opacity underlies investor mistrust of big bank balance sheets. No wonder many of them trade at discounts to their breakup values.

The problem will worsen under Basel III’s new higher nominal capital requirements for RWA. The higher capital standards increase the incentive to manipulate models to reduce RWA. The lower RWA only appears to make risk disappear while actually creating stealth leverage. The London Whale situation in which the models and inputs were changed to fit the desired low risk weights may be just the start of this development.

Risk standards should be objective, forward looking and do no harm. RBC fails on all accounts. Worse than ineffectual, RBC serves to increase systemic risk. It causes herding into portfolio concentrations of incorrectly classified low weighted assets. Next, it breeds over- confidence and a false sense of security by substituting models for judgment. The biggest risks faced are those believed to be mistakenly under control. Finally, RBC is pro cyclical. Thus, banks appear well capitalized in calm periods. Consequently, they are encouraged to return capital via dividends and share repurchases just as they did in 2007 and 2008 leaving them undercapitalized during the crisis.

The conceit of RBC is it assumes regulators relying on bank models and inputs can predict risk. In reality, the future is uncertain. Substituting a probability distribution for uncertainty does not make us safer. Instead it can cause a risk misdiagnosis leading to the acceptance of low probability high impact adverse events-black swans-which become evident during a crisis. Probabilities are of limited use when dealing with black swans. A 1% chance of failure does not mean that 99% of the bank survives if it occurs. Prudence trumps prediction when dealing with black swans. RBC models capture only particular risks. Consequently, they are inferior to less elegant, but more practical simple measures like the leverage test that can serve as an early warning indicator. Thus, the preferred approach is to abandon an over reliance on RBC. Instead, use RBC only as a supplement to a meaningful leverage test, not the inadequate 3% leverage ratio proposed by Basel III. These actions combined with traditional judgment based safety and soundness supervision would present a more accurate measure of capital adequacy.

RBC has a weak empirical foundation which was exposed by the financial crisis. Its supporters need to keep an open mind and address this ugly fact, recognizing that no map is better than a wrong map. Only then can we prevent RWA from standing for Really Wrong Answers.

J

Jamie Dimon and JP Morgan, continued: CEO and Chairman of the Board; One Job or Two?

Joe's post on Monday (Great Men + Weak Governance = Bad Decisions)
did an excellent job of discussing the CEO/Chairman controversy at JP Morgan.  The issue is certain to get additional press as shareholders vote on the split.  Joe and I don't always  agree on particular issues, but in this case we are fairly well aligned.  There are just a few things I'd like to emphasize about the situation and the vote.

First, the empirical evidence on splitting the two roles is mixed.  There is not clear evidence that it matters either way.  The theory, however, is more one sided.  The board's most important job is to hire (and know when to fire) the CEO.  It is tougher to do this unless the two jobs are split.  

My personal view is that the empirical evidence is split simply because both models have some merit and some personalities work better under one structure than the other.  When things go wrong, however, one looks for reasons and companies not splitting the roles face tough questions. 

There is a popular insurance ad being used today that depicts a crocodile creeping up on an unsuspecting golfer.  The ad reads, 'who you insure with doesn't matter - until it does'.  The same is true of some governance structures.  They may not appear to matter - until some catastrophic event occurs.

This is certainly what happened with the 'London Whale' situation.  This is not to say that would have been prevented by splitting the roles.  We don't know.  But as Joe points out, Great Men + Weak Governance = Bad Decisions.  Certainly, Catastrophic Errors = The Need to reexamine potential causes and combining the two roles was certain to be questioned.

It is interesting to note that in the UK about 95% of the largest companies split the roles. But again, this doesn't mean it is the right thing for a particular company.  One doesn't necessarily think of UK firms as being better governed or having dramatically better performance than their US counterparts.  

Which brings us to the upcoming vote.  Remember that, like Say on Pay, the vote to split the two roles is only advisory to the board.  Boards need not follow the recommendation suggested by the vote. But like the evidence on Say on Pay, many boards do make changes in the face of shareholder pressure.  For JP Morgan, this would be a difficult decision in face of Dimon's generally outstanding performance.  Dimon has threatened to quit if the roles are split.

Moreover, in this election, the board itself is facing challenges.  Our evidence shows that a negative recommendation by ISS is the single most powerful determinant of votes in shareholder elections, swinging votes by an average exceeding 18%.   While this level of vote reduction might not cause a director to resign or be forced to resign, our evidence on director votes (discussed in a subsequent post) also suggests that even a very small reduction in votes leads boards to make changes to CEO compensation or corporate governance mechanisms.  Nevertheless, when particular directors receive less than 50% of the vote, boards have historically found excuses to retain the directors.   So changes are made, but turnover is generally not one of them.

Time for a prediction: the vote goes against retaining the two roles or is just narrowly defeated, but Dimon stays as the boards make other changes that they hope will placate shareholders.  In addition, several directors earn substantially lower support (75% or less).  At the end of the day, however, shareholders will recognize Dimon's overall performance.  

All the best,

Ralph

  

Great Men + Weak Governance = Bad Decisions

The on-going JP Morgan Chase, London Whale drama about striping Jamie Dimon of his joint CEO-Board Chairman title, along with the replacement of some directors, raises interesting governance lessons. These lessons are not just limited to JP, Dimon and banking. They apply to most major decisions, good and bad, including M&A.

Dimon is a strong willed, successful, confident leader, some would say over confidant, AKA a great man. He runs a large complex organization operating in a challenging industry undergoing rapid change. As the Whale incident demonstrates, he operates with limited board oversight. JP’s board is large, has a long tenure, and was handpicked by Dimon, who controls the selection and nominating process.  The board has limited industry technical experience in key areas like risk management. Hence, it is deferential to the CEO/Chairman’s wishes and decisions. This is reinforced by his relatively successful navigation of his bank thru the financial crisis.

As Douglas Hubband notes, never attribute to malice or stupidity that which can be explained by moderately rational individuals following incentives in a complex system of interactions. The purpose of board governance is to protect the institution from being driven by the narrow interest of an individual, the great man. Absent this governance check, Warren Buffett’s Institutional Imperative takes hold.

Institutional Imperative involves (1) resisting change, (2) staff support of leadership desires and actions regardless of merit using all means available including complex financial models and detailed strategic plans prepared by expensive and high profile advisors and (3) slavishly following peer behavior. It is very difficult to challenge great men decisions and desires. This is probably best summed up by former MGM head Louis B. Mayer’s comment that “….he admired men who were unafraid to speak their mind even if it cost them their jobs.”

Some possible control mechanisms include:

1)     Spliting the CEO and Board Chairman roles

2)     Obtaining a strong lead director capable of challenging the great man

3)     Smaller boards

4)     Independent experienced directors - no more museum directors on the bank board!

5)     Proper incentives for both management and the board

Perhaps most importantly, a culture which encourages professional challenge of senior management decisions is needed. JP’s management discussion in their 2012 annual report in which they discuss the London Whale problem provides some interesting points - albeit learned the hard way after a $6B loss.  Some of the more important points are as follows:

1)     Fight complacency: do not assume tomorrow will look like today. Question others and let others question you-especially after a long period of when thing have gone well.

2)     Overcome conflict avoidance: ask hard questions.

3)     Controls must match the activity being conducted. This means for big ‘bet your company type’, major acquisitions use a rigorous independent review process.

4)     Trust but verify: the board should not micro manage executives. Neither, should it blindly assume they are correct. Make them verify their plans.

5)     Do not shoot the messenger: encourage everyone to quickly surface problems so they can be fixed before they become fatal.

Even great men have bad days and make bad decisions. Good governance can help minimize the damages of those bad decisions on their organizations.

J

Industry Merger Waves

In February, we talked about Motives for Mergers.  We followed up on this theme in March writing about Catalysts for Merger, discussing shocks that lead to merger waves within an industry:

"So what are these shocks, these catalysts?  Common catalysts include: shifts in regulation, shifts in consumer tastes, competition from unexpected sources, changes in the factors of production and changes in technology."

As a result of these shocks mergers occur in waves, both in the aggregate economy and within industries.  We'll leave the aggregate waves for another discussion and today talk about waves within an industry.   Current examples include old technology firms, banking, pharmaceuticals, and energy.

An interesting research piece on industry merger waves is by Jarrad Harford of the University of Washington.  Harford uses a novel measure of merger waves and extends our knowledge about the necessary conditions for a wave.   

Harford calculates merger waves in a statistical fashion, defining a merger wave within an industry as a twenty-four month period with a statistically unusual level of activity.  He identifies 35 merger waves in 28 industries over the 1981-2000 period. A list of these industry waves is contained in the article.  

While Harford notes that shocks do indeed precipitate merger waves, he also notes that shocks are not enough.  In particular, Harford notes that "There must be sufficient capital liquidity to accompany the asset reallocation.  The increase in capital liquidity and reduction in financing constraints that is correlated with high asset values must be present for the shock to propagate a wave..." (p. 1)

The abstract of the article entitled, "What Drives Merger Waves" is below.

Abstract: What Drives Merger Waves, by Jarrad Harford     

"Aggregate merger waves could be due to market timing or to clustering of industry shocks for which mergers facilitate change to the new environment. This study finds that economic, regulatory or technological shocks drive industry merger waves. However, the degree of capital liquidity determines whether a shock initiates a merger wave. This macro-level liquidity component causes industry merger waves to cluster in time even if industry shocks do not. Market-timing variables have little explanatory power relative to an economic model including this liquidity component. The contemporaneous peak in divisional acquisitions for cash also suggests an economic motivation for the merger activity."

The complete article can be downloaded here.

All the best,

Ralph

  

A Tale of Two Capital Structures

Investment, not financing, decisions are the primary source of value creation. This does not mean, however, that capital structure choices are unimportant. The wrong capital structure can destroy or trap shareholder value. This fact was illustrated this week by a pair of different decisions by two very different types of firms.

Apple reluctantly agreed to address investor concern over its growing cash hoard with a $100B three year shareholder distribution program involving share repurchases and dividends. This concern was one of the many issues over hanging its declining share price. The others being reduced growth and a maturing product line. Once announced, the program was very favorably received reflected in about a 10% raise in the stock. Part of the increase resulted from the decline in investor concern over the possible misuse of the excess cash in value destroying over priced acquisitions like those incurred by HP and other maturing tech firms.

Apple initiated the program with a $17B debt financed share repurchase program. They used varied instruments including fixed and floating with maturities ranging up to 30 years. They received AA1/AA+ ratings from Moody’s and S&P respectively. The debt was widely over- subscribed despite being priced very aggressively.

The tax benefits to shareholders were particularly interesting. First, using debt instead of repatriating some of their $145B in foreign cash avoided about $9B of taxes. Second, the use of debt created a tax benefit of $6B representing the capitalized value of the interest tax shield. This illustrates the scope of the problem with their previous highly inefficient ‘no debt’ capital structure.

Also announced this week, but smaller and less well covered was Deutsche Bank’s (DB) Euro 2.9B (approximately $4B) equity offering. This represented almost 10% of their preannouncement market capitalization. DB is a large German based global bank with a depleted capital structure due to crisis related losses and scandals. Like Apple, it reluctantly agreed to a capital structure change only after substantial regulator and investor pressure. Investors were especially concerned that DB’s weak balance sheet would reduce financial flexibility, hamper their on-going restructuring program and increase the risk of being forced to issue equity in a difficult market at depressed prices. Ordinarily, when equity is issued, the firm’s share price drops around 2-3% or about 20% of the equity raised. Except for growth firms with strong investment prospects, equity issuances are seen as negative signals.

Surprisingly for DB, their share price actually increased by double digits on the announcement. Investors seemed relieved that DB was raising capital when it could, at an identified priced instead of being forced to issue at a potentially lower price. Thus, the financial uncertainty surrounding DB was reduced. The new equity also puts DB at the top of its peer group regarding capital strength. This increases their financial flexibility and the possibility of successfully completing their restructuring program in a difficult European economic environment. These benefits more than offset potential dilution concerns.

The lesson is correcting inefficient capital structures, under leveraged at Apple, and under capitalized at DB, can unlocked formerly trapped shareholder value. Another lesson is sometimes management needs to listen to pesky shareholders.

J

Mergers and CEO Retirement Age

In a previous post I  discussed my research on Golden Parachutes, describing the delicate balance boards face in developing an appropriate package.  Today I link to a related article on mergers by Dirk Jenter of Stanford and Katharina Lewellen of Dartmouth.  The article, entitled CEO Preferences and Acquisitions, describes an interesting phenomena, the dramatic increase in firms acquired when their CEO reaches age 65.  I had the pleasure of discussing this interesting article at a conference in Seattle last summer.  The complete abstract is below:

CEO Preferences and Acquisitions

Abstract:       "This paper explores the impact of target CEOs’ retirement preferences on the incidence, the pricing, and the outcomes of takeover bids. Mergers frequently force target CEOs to retire early, and CEOs’ private merger costs are the forgone benefits of staying employed until the planned retirement date. Using retirement age as an instrument for CEOs’ private merger costs, we find strong evidence that target CEO preferences affect merger patterns. The likelihood of receiving a takeover bid increases sharply when target CEOs reach age 65. The probability of a bid is close to 4% per year for target CEOs below age 65 but increases to 6% for the retirement-age group, a 50% increase in the odds of receiving a bid. This increase in takeover activity appears discretely at the age-65 threshold, with no gradual increase as CEOs approach retirement age. Moreover, observed takeover premiums and target announcement returns are significantly lower when target CEOs are older than 65, reinforcing the conclusion that retirement-age CEOs are more willing to accept takeover offers. These results suggest that the preferences of target CEOs have first-order effects on both bidder and target behavior."



The article can be downloaded here.

All the best,

Ralph