The Venture Capital Lottery

Venture capital investing has never been for the faint of heart. It seems to be getting even less so with a new type of deal risk entering the market. The current VC environment is characterized as follows:

1)     Profitable exits 2012-2014 and LP distributions have increased the demand for VC investments.

2)     VC industry has responded to LP’s forgetting that past success does not guarantee future success by raising new VC funds to satisfy LP demand.

3)     VC funds are having trouble investing the funds raised in high quality investments and are engaging in higher risk transactions.

4)     The number of hyper risk lottery ticket investments is increasing i.e. investments in pioneer-idea only type firms (no sales) at high valuations.

Usually in such investments founders remain fully invested until later financing rounds i.e. they have skin-in-the-game and are committed. Now, VC are allowing founders to withdraw liquidity in the first financing round. This should send a negative signal to investors. If founders, usually an optimistic lot, are willing to share their upside, it suggests they are unsure about that upside. If founders have questions, then so should investors. Founder liquidity should depend on the firm’s success not the VC fund raising cycle. Remember, these firms must at least pass the revenue test, and hopefully the cash flow positive test before the end of the current up cycle in VC fund raising; otherwise they will fail.

This newest development is being rationalized as removing financial distractions from founders. May be I am cruel, but I want the founders to be paranoid committed to their firm’s success. If they want me to take the plunge, then I want them jumping alongside me for the entire journey. This development is another froth indicator in the VC industry along with nose bled valuations.

VC is moving into the lottery phase. In lotteries, the size of the prize, regardless of its likelihood increases the demand to participate. Everyone becomes fixated on the multibillion payouts of firms like Whatsapp. They are focusing on the greatest maximum return or variance, while ignoring the negative expected return. This is not investing-it is gambling.

I hope everyone had a Great Holiday Season.  I wish all a Happy New Year!

J

The Siren Song of Public-to-Private (PTP) Buyouts

A BC Partners consortium announced an $8.7B PTP buyout of PetSmart out bidding Apollo and KKR. The deal is the largest buyout of 2014 and one of the rare PTP transactions since the Great Recession. The purchase price is 9.1X railing EBITDA and represents a 40% premium to the pre bidding price. Its capitalization includes 20% equity and 7.2X trailing EBITDA in debt facilities underwritten by Citi, Jefferies, Nomura, Barclays, and Deutsche. The aggressive capitalization runs afoul of U.S. regulatory guidance. Perhaps that is why the bank group includes 2 non banks, Nomura and Jefferies, and 2 foreign banks, Barclays and Deutsche. PetSmart had been under activist pressure to improve its lagging stock price, which had only increased by 3% in the past year. The activist identified pricing, ecommerce and cost issues as factors underlying PetSmart’s performance problems.

More interesting than the deal is the possible return of higher risk-lower quality PTP transactions. PTP deals involve a PE firm taking a public firm private. The grand daddy of PTP was the disastrous RJR deal lead by KKR in the 1980s. PTP transactions are the poster boys of boom period deals. They reached almost 50% of the dollar amount of all LBOs before the financial crisis. The performance of PTP deals like TXU and Caesars, among others, caused PE firms and their investors to swear off PTP. Through 3Q14 the volume of PTP fell to less than 15% of LBOs-the lowest level in a decade. 

The issues with PTP include the following:

1)   Size: they involve large companies which entailed significant capital commitments.

2)   Fully Priced: public firms usually involve auctions which increases the risk of the winner’s curse. While PetSmart’s PPX seemed modest in the current market with PPX exceeding 10X-it still is over 15% higher than the median retail PPX over the past 5 years.

3)   Aggressive Financed: needed to offset the rich price.

4)   Limited Improvement Potential: most public firms have picked the low hanging fruit. Thus, the ability to achieve improvements needed to offset a 40% premium plus achieve a 20% IRR is questionable.

So why might PTP deals like PetSmart be returning? The answer is PE needs to deploy its substantial dry powder. LBO volume remains depressed at 2009 levels. A rising stock market and strategic buyers have simply out priced PE firms. Many recent LBOs have been Sponsor-to-Sponsor (STS) or pass the parcel deals. These involve one PE firm buying another PE firm’s portfolio company. Trouble is STS deals tend to smaller in size, and most the upside has been squeezed out by the original LBO buyer. As boilerplate PE documents highlights-GP carried interest depends on performance which means GP’s are motivated to approve more speculative investments than would ordinarily be the case. Yes, GPs are pirates, but at least they are honest pirates and state upfront what they are going to do to LPs.

PE restraint lasts only so long. When pressured by the need to invest GPs can no longer resist. PTP deals represent another sign, along with high leverage, that the LBO market is entering into a more speculative state. 

j

MergerProf will not publish this Thursday due to the Holiday.  Best wishes of the season to all our readers.

SEC and Stanford vs. Harvard - Staggered Boards and the Shareholder Rights Project

Our friends at Harvard run an excellent blog on corporate governance featuring agreements and disagreements on various issues.  Lucian Bebchuk of Harvard has been quite successful in launching the shareholder rights project, an effort to get boards of directors to "de-stagger" or unclassify.

A classified board (also known as a staggered board) typically elects just 1/3 of its directors each year.  Thus, it takes 3 years to remove a board by election.  In separate research, Bebchuk and co-authors has shown that the combination of a staggered board and a poison pill can entrench management making it very difficult to remove them.  Hence, he suggests forcing boards to become unclassified and have all directors elected each year.

Opponents are primarily lawyers and corporate boards who make a counter argument - classified boards enable stability, continuity of leadership in the board room.  Opponents also argue that rather than entrenching management, staggered boards slow down hostile raiders and enable a target firm to better bargain for their shareholders.

Much of the empirical evidence supports Bebchuk's view, but now a new paper by SEC commissioner Gallagher and Stanford Law Professor Joseph Grundfest  suggests that Harvard violated security law.  Rule 14a-8 used by Bebchuk's group requires " proposals not be materially false or misleading" and they argue his use of empirical evidence doesn't give opposing views adequate attention.  

The back and forth between Harvard and Stanford is reminiscent of the takeover field in general.  More on that in another blog.  For now, let's keep an eye on the evolution of this web fight.  You can find the latest blog post here.

All the best,

Ralph

Shareholder Activists: The Empire Strikes Back

Activists have become victims of their own success. The number of activist campaigns is near 300 this year-the highest level in years. Furthermore, their success rate is increasing as is the funds under management by such investors. These facts have an out-sized fear factor impact on corporate America. Consequently, they and their shills, Harvard Business Review, New York Times and corporate law firms inter alia, have attacked activists as being responsible for income inequality, slow growth, under investment, and reduced competitiveness. I think they will also be blamed for global warming. Let’s look at some of the charges.

The first attack is activists are not long term shareholders and thus do not seek to advance the firm’s long term interests. Consider the following:

1)     There is no evidence activists are short term investors.

2)     Even if they are-so what? Firms are valued based on the market investment horizon-T- and not on the investor holding period. Does the value of your home depend on whether you own it for 1 year or 5 years?

3)     Long term is used as an excuse for lagging short term performance. Remember, the longer you must wait for value, the more value you must receive.  It is as if the steepness on your treadmill increases. Look at what happened in Japan with their massive over investment in the 1980s, and what may be happening in China now. The size of the investment should be proportional to the expected long-term risk adjusted cash flows. Companies not following this rule like Nokia and Blackberries end up destroying wealth unless stopped in time by activists or the board.

4)     The short termism frequently seen at under- performing firms concerns the perversion of incentive compensation schemes by management and a compliant board toward short terms measures like EPS and earnings growth.

The next attack states that returning funds to shareholders via dividends or stock repurchases instead of reinvesting the funds in the firm is harmful to the firm and the economy. This is related to #3 above. The argument is more investment, regardless of its risk adjusted return, is better. This mistaken approach neglects, or should I say mistrusts, the role of capital markets. If a firm cannot earn enough to cover its cost of capital, then the excess funds it has should be returned to shareholders. Over investing in under-performing projects helps no one-the economy, the employees or the firm. The funds returns do not sit idle. They are reinvested and recycled into new more productive endeavors as part of the creative destructive process.

The last attack is that firms should not be managed solely for the benefit of its shareholder owners, but more broadly for all stakeholders. The problems with the stakeholder theory are as follows:

1)     Faulty premise: long term wealth creation is not based upon the exploitation of stakeholders. Communism is dead. Stakeholders, whether they are employees or suppliers have alternatives.

2)     Which stakeholders and who chooses what they get?  This is a political issue best left to the political process and not CEOs.

3)     Capital goes where it is welcome and stays where it is treated well. Taking from shareholders will always be supported by the “takees”. The result will be a higher cost of capital and less wealth for all.

4)     A simple clear objective is needed to hold management accountable. It is no wonder managers like stakeholder theory. If you are accountable to everyone, then you are accountable to no one.

Bottom line, activists may be rough around the edges, and you may not want them going out with your daughters. Nonetheless, they provide a valuable check on managerial excesses. The problem is not with the activists, but with the breakdown of the internal control system i.e. the board, which typical gets captured by management.

Sorry for rant, but these attacks are totally baseless. The empire should just be honest and say ”let them eat cake”.

J

First Mover Advantages and Disadvantages

In Joe's last post The Price is Right he questioned the pricing of Uber, noting:

"Uber’s price is being justified on a winner- take- all, first mover, basis. I wonder, however, about the economic validity of this agreement. The industry entry barriers seem porous, switching costs for both users and drivers are low and international competition exists. "

Indeed, in a paper two colleagues and I published in the Review of Financial Studies, we do  find that the first acquiring firm in an industry after a long dormant period without acquisition activity earns abnormally positive returns.  We are quite skeptical of the first mover - or low hanging fruit argument, however, noting:

"Cottrell and Sick (2001), and Schnaars (1994) examine first-mover advantages and disadvantages, noting numerous cases in which the imitator ultimately gains the advantage over the first mover. Examples from the software industry include the success of the VHS tape format over Betamax, IBM following Apple, and Excel following VisiCalc. Cottrell and Sick (2001) also note the phenomena in the motorcycle industry with Yamaha, Kawasaki, and Suzuki successfully following Harley Davidson, and the Indian and European models."

The question is whether Uber can maintain a sustainable comparative advantage.  It's an open question, but my instincts align with Joes.  

All the best,

Ralph


References

Cottrell, T., and G. Sick. 2001. First-Mover (Dis)advantage and Real Options. Journal of Applied Corporate Finance 14: 41-51.
Schnaars, S. 1994. Managing Imitation Strategies: How Later Entrants Seize Markets From Pioneers. The Free Press, New York.

The Price is Right or Is It?

The latest financing round values Uber at more than $40B. Uber’s transaction volume is around $2B of which their take is 20% or $500MM. Yes its revenues are doubling each year over its short existence. Still this seems richly priced. How long and fast can they grow, and when do they start earning a return? Keep in mind Uber’s value exceeds that of Aetna, CBS and KKR among others. Uber’s price is being justified on a winner- take- all, first mover, basis. I wonder, however, about the economic validity of this agreement. The industry entry barriers seem porous, switching costs for both users and drivers are low and international competition exists. Furthermore, as the Wall Street Journal notes, some smaller tech firm valuations have recently fallen prior to their planned IPOs. So, is Uber immune to such a reversal?

Some VC observers like Play Bigger Advisors have tried to explain away a possible bubble by inventing a new metric- Time to Market Cap (TTMC). They believe special firms like Uber represent mythical Unicorns endowed with unique market characteristic justifying what at first glance appear to be nose-bleed valuations. Past Unicorns included Apple, Microsoft and Google who capture a disproportionate share of their market categories. They cite the TTMC of $1B for Unicorns has fallen from 8.5 years in 2000/2003 to now just under 3 years. VC are focusing on a few winner Unicorns with big investments and driving up their values. Conversely, they are pulling back from losers referred to in the Wall Street Journal article just as quickly. Therefore, they conclude there is no bubble.

This sounds like another version of the “This Time Is Different” justification. How do you operationalize the invest in winners (Unicorn) strategy? Is it like buy low and sell high? Can TTMC slow down and mean revert? The problem with these types of relative value approaches is they lack an intrinsic value anchor. They can quickly degenerate into a herding or momentum investment strategy. Over optimistic investors ignoring the base case who have excess liquidity and are eager to invest will keep pushing prices higher until there is no one left who believes and the process corrects. The price is right, but which one-the price going up or the price coming down? Finding mythical Unicorns may be more difficult than thought. Even if you do, at what price does investing in Unicorns cease making sense?

j