Monday, July 15, 2013

Robbing Peter to Pay Paul

They are at it again. There is another muddled attack on shareholder value Shareholder Primacy. Ordinarily, I ignore these, but this one sounded so smug that I could not let it pass. The separation of ownership from management in large public firms makes having a clear measurable managerial objective critical to govern a firm. That objective should be to maximize shareholder value, which is the value of the firm less debt claims. A firm’s value is the present value of its long-term cash flows discounted for their risk. Capital goes where it is welcome and stays where it is treated well. The shareholder value objective satisfies both requirements.

Shareholder value is especially important in M&A. For example, target management frequently alleges in a hostile takeover that the offer price does not reflect the target’s long term value (e.g. Jerry Yang resisting Microsoft’s offer for Yahoo). Another example is an acquirer’s management trying to justify an over-priced empire building acquisition as not being fully appreciated by the market (e.g. First Niagara’s HSBC branch purchase).

Shareholder value is usually attacked by management and their lawyers (e.g. M. Lipton) on the following grounds:

1)     Shareholder value is short term orientated. They mistakenly characterize shareholder value as myopically focusing on increasing current earnings - in particular earnings per share(EPS). It is true that some managers have twisted shareholder value towards such short term measures to maximize their bonuses ( e.g. Robert Nardelli at Home Depot). This more a governance - incentive compensation lapse by an ill informed board than a problem with shareholder value. Evidence clearly shows that capital markets reward firms that invest for the long term (e.g. Amazon), and penalize short term accounting-EPS orientated firms like the old Home Depot. Managers may be myopic, but markets are not.

2)     Capital markets cannot properly value strategies and managerial vision. Strategies and visions have financial implications and results, which sometimes differ from what was anticipated or promised. Ignoring stock market responses is like flying blind - it leads to crashes. Clearly share price does not always equal value. Rather, it represents investor consensus of value, not value itself. When the consensus differs from management’s value belief it reflects either an investor relations communication problem or that investors do not share management’s beliefs. Either way, management should react rather than ignore financial market responses just as they would react to product market customer input. This is required to protect against managerial visions becoming delusional.

3)     Shareholder value does not properly reflect the interests of other stakeholders. While shareholder value can be measured, I know of no way to meaningful measure stakeholder value. Furthermore, it is difficult to increase shareholder value if you are exploiting other stakeholders. Usually, when stakeholders are mentioned, management is trying to justify robbing Peter(shareholders) to pay Paul (themselves). In such circumstances you can always count on the support of the Paul’s and their lawyers. Allowing stakeholders coequal control over capital supplied by other is equivalent to letting one group risk another’s capital. This will impair future capital formation and depress share prices and shareholder wealth.

Bottom line, shareholder value attacks are really efforts to weaken governance by deflecting criticism of underperformance. Understandably, managers do not like having their actions questioned, but that is precisely the meaning of governance. In M&A, governance is critical to offset the impact of the winner’s curse, unless, of course, you are Paul.


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