Thursday, February 26, 2015

Doing a (Large) Deal? Expect to Get Sued

A year ago we posted  "Doing a (Large) Deal? Expect to Get Sued" which discussed research by Matthew D. Cain  and Steven M. Davidoff.  They've updated their sample to include 2013 and we've updated the original post accordingly.   The numbers are even more striking today.  The updated, original post is below. 

 A recent working paper by Matthew D. Cain  and Steven M. Davidoff entitled Takeover Litigation in 2013 provides some interesting statistics about the rise in merger related litigation.  Their Table A, reproduced below reveals a dramatic increase in litigation over the past eight years.  In particular, about 39% of deals involved litigation in 2005, while close to 97% involved litigation in 2013.

Litigation rates over time
Year Deals Litigation % with Litigation
2005 183 72 39.30%
2006 232 99 42.70%
2007 249 97 39.00%
2008 104 50 48.10%
2009 73 62 84.90%
2010 150 131 87.30%
2011 128 117 91.40%
2012 121 111 91.70%
2013 80 78 97.50%
Total 1,320 816 61.80%

Thus, the probability of being sued in a merger today is over 90%.  Keep in mind, however, that the size limitation on their sample is deals over 100 million.  The percentage would undoubtedly be smaller for smaller deals.  Also, as my friend Jan Jindra notes: "The result is, perhaps, not surprising, when private plaintiff attorneys are allowed to initiate class action lawsuits in names of nominal shareholder plaintiffs and finding a willing shareholder plaintiff is made easy and cost-efficient through the use of law firm internet websites. Rational economic agents, attorneys, find that filing a class action lawsuit circumvents the constraints imposed on derivative suits which are designed to limit opportunistic “strike” suits. Furthermore, ready availability of websites by law firms actively recruiting shareholders who have been involved in a merger helps in finding a shareholder plaintiff." See for example the website linked here. "These two ingredients make an increase in merger lawsuits likely."

Certainly there are adequate reasons to have concerns about certain mergers and we've enumerated many in these posts.  Concern over the 'kneejerk' reaction of filing a lawsuit, however, is revealed in "Cash for lawyers - zero for you".  The article reports that over 70% of lawsuits resulted in no payment to shareholders. 

Regardless of the merit of the litigations, the actions definitely increase the costs of mergers. They also increase the need for best practices in corporate governance and in planning and executing the deal.  We'll continue to explore these issues in this blog.


Monday, February 23, 2015

Venture Capital Discount Rates: Precisely Wrong or Roughly Right?

The standard  Discounted Cash Flow valuation approach discounts an investment’s expected cash flows at their risk adjusted cost of capital. This rate is usually estimated using a Portfolio Theory based approach like CAPM. These models concentrate on Systematic Risk not total risk. Idiosyncratic Risk can be diversified away. Hence investors can expect no compensation for holding it. An example is a resort island which has two firms-one selling suntan lotion and the other umbrellas. Holding shares in just one firm exposes you to weather risk (idiosyncratic).If you hold shares in both you are no longer exposed-you have diversified the risk. Nonetheless, you remain exposed to systematic risk of a tsunami.

Some take this to mean idiosyncratic risk can be ignored. For passive minority investments in larger more stable going concern firms this is a good enough approximation. For VC type startups idiosyncratic –total risk cannot be ignored. These firms are not and may never be going concerns due to their failure to execute their business plans. This risk is unique not systematic. In fact failure rates for startups is very high-greater than 50% in the first five years of existence. The firm never realizes on it growth potential, which represents the majority of startup firms’ value, if it fails. Furthermore, liquidation values for VC investments are usually low. This is because the assets are primarily intangible meaning they have limited value if the firm ceases to exist. Thus, the key to value creation is management’s ability to exploit the firm’s idiosyncratic opportunities. Successful venture capitalists can identify these unique undiversified winners.

The standard DCF approach utilizing portfolio theory understates the discount rate and over states value. This is why many venture capitalists use arbitrarily high discounts rates of 25%+ instead of the lower academically determined rates. The rates VC’s use vary depending on the stage of the investment with earlier stage investments having higher rates than later stage follow-on investments.
Another measure of failure risk is the Cash Burn Rate. This is the cash raised and remaining from the prior funding round divided by cash operating losses. Firms with high burn rates need access to get additional funding to fund continued losses. This access can be difficult to measure. It depends largely on VC market condition which can turn on a dime. One possible reason for the current buoyant VC valuations is inexperienced investors may be using low discount rates ignoring failure and refinancing risks.

Academics dismiss the venture capitalists’ ad hoc approach. They argue that instead of raising the discount rate you should adjust the cash flows downward to reflect their uncertainty. The problem with startups is how to make such adjustments when you lack historical operating history. Instead of the false precision from cash flow adjustment the rough approach of increasing the discount rates may not be so bad after all. As Keynes noted-it is better to be roughly right than precisely wrong.


Thursday, February 19, 2015

The Empire Strikes Back: DuPont's Response to Trian

As readers of this blog know, contested offers, proxy fights, and activist campaigns produce heated exchanges between the parties involved.  The latest round in the DuPont/Trian exchange is from DuPont, filed with the SEC yesterday.   This is management's defense of its record and counter claims against Trian and occurs in a letter to shareholders.  See DuPont's response.

As the letter indicates, DuPont has outperformed the market in the last one, three and five year periods.  What remains unclear, however, is what additional value can be obtained through the actions Trian proposes, namely splitting up the company.  It is difficult to defend against projected 'what ifs' and admittedly, the track record of activists in general, is positive in terms of creating value. In many cases where activists attack, however, the target has been underperforming.  That certainly isn't the case with DuPont.  In Star Wars, the Empire represented the villains.  That's not clear here.  Stay tuned.

All the best,


Monday, February 16, 2015

Shareholder Activism and Political Correctness

Dealbook issued a novel politically correct gender bias attack on shareholder activists. It noted that six of the 23 S&P 500 firms headed by women have been targeted by activists. This limited sample over a short time period is alleged to constitute circumstantial evidence of gender bias. Putting aside the statistical issues consider the following:

1)     Activists are probably the most equal opportunity group of investors in existence. All they care about is perceived value gaps which they can exploit. This is usually represented by ROE< cost of equity or market values<breakup value. Race, color, creed, nationality, or gender are not screens they use to identify targets. This is not because they are nice guys. Rather it is because they must make profit to attract investor funds. If you underperform you pop up on their list and they will be calling you regardless of whether you are male, female, transgender, or a eunuch.

2)     The specific  harassed female lead firms identified in Dealbook  all have stories and performance issues which would justify inclusion on any activists list:

a) Pepsi: suffering from a profit decline related to sagging soda revenues-the same problem impacting Coca Cola. Activists raised concerns regarding the continued operation of the drinks and snacks businesses at Pepsi. This represents a legitimate view that shareholder value can be increased by spinning off the snack division.

b) Yahoo: Starboard raised issues concerning the tax efficient disposal of the Alibaba shares and the continued operation of Yahoo as an independent entity. Given Yahoo’s past performance problems these seem like appropriate questions to ask.

c) DuPont: Peltz wants to spinoff DuPont’s business units to improve efficiency. The CEO’s vigorous defense has been questioned by her recent surprise disposal of a large block of stock.

d) Mondelez: also suffered profit declines. The CEO’s judgment when CEO of Kraft (Mondelez was spun-off from Kraft) was questioned by Warren Buffett regarding the use of undervalued stock to fund an acquisition. Does Dealbook think Buffett is gender biased as well?

e)Hewlett-Packard: Meg Whitman has a difficult job turning around accident prone HP.  Any wonder why investors are concerned?

Thus, more than one conclusion, gender bias, can be drawn from the companies cited. Dealbook seems to be suggesting that female CEOs are immune to scrutiny and should be granted extra leeway. Is this political correctness or a disguised attack on shareholder activists?

My money is on the activists. Their self interested focus on profit ensures their gender blindness.

Before thinking I am a male chauvinist pig-keep in mind I have two daughters and especially frown upon anyone using gender to discriminate against them or anyone else.


Thursday, February 12, 2015

Shared Auditors in Mergers and Acquisitions

What happens when a target and bidding firm share the same auditor?  According to an interesting study by Dhaliwal, Lamoreaux, Litov, and Neyland, targets lose.  Of course, this is a characteristic of the sample and not true for every observation, but certainly something that deserves thinking about.  The abstract is below:

Shared Auditors in Mergers and Acquisitions


We examine the impact of shared auditors, defined as audit firms that provide audit services to a target and its acquirer firm prior to an acquisition, on transaction outcomes. We find shared auditors are observed in nearly a quarter of all public acquisitions and targets are more likely to receive a bid from a firm that has the same auditor. Moreover, these shared auditor deals are associated with significantly lower deal premiums, lower target event returns, higher bidder event returns, and higher deal completion rates. These results are driven by bids in which targets and acquirers share the same practice office of an audit firm and in which the target is small. Overall, our evidence suggests that bidders benefit from sharing an auditor with the target, and that these results are robust to controls for alternative explanations and for selection bias in the shared-auditor effect.

The complete paper, can be downloaded here.

All the best,


Monday, February 9, 2015

Venture Capital Pricing: Bubble or Something Else?

Trying to make sense of current VC pricing is a daunting task. The increased pricing is reflected in VC IRRs for the past year which exceeded 25% according to Prequin-exceeding those of PE for the first time this century. Consequently, fund raising is accelerating as investors chase yield. This is producing ever higher pricing multiples. Is it a bubble, a recovery or something different?

My thoughts, which focus primarily on the ecommerce segment, are as follows:

1)     There are only three ways to profit from ecommerce. Either you sell devices like Apple, sell goods or services such as EBay or Angie’s Page, or sell advertising –Facebook.
2)     The implicit assumption for investors is competition is weak due to something like network effects-hence the need to raise lots of money, invest it quickly and get big quick. Investors flock to the industry and its participants creating a momentum pricing effect lifting pricing multiples-a virtuous circle.
3)     Wild changes in pricing occur once evidence accumulates that the competitive advantage period is unrealistic. Investors are reintroduced to Porter's  five forces which eventually impact industry profitability.
4)     Investors recognize they misread market signals and have misallocated capital, and begin to curtail investments. This triggers a reverse momentum or vicious circle.

Investor errors are understandable given the lack of operating history or clear business model for these firms. The impact of seemingly small changes in investor estimates can have a major valuation effect:

1)     Simple earnings calculation model: P=E/(r-g) were E is a horizon value earnings estimate, r is the risk factor and g is estimated growth.
2)     P/E ratio is then equal to 1/(r-g). If we assume (r-g) =2 at the beginning of the investment then the P/E ratio is 50. If (r-g) increases to 4 due to a combination of changes in r and g then the P/E ratio falls to 25 resulting in a massive value change.
3)     The change in estimated growth, g, is probably the greatest wildcard. Over estimating growth (AKA under estimating competition) results in investors over paying for growth and reduces their margin of safety when something causes a reassessment.
4)     VC markets, especially early stage, are by no means as efficient as established markets. Thus, the price is not always right. Even in efficient markets the price is not always right. Rather, it means it is difficult to exploit any perceived errors.

The above volatility is characteristic of investors “shooting in the dark” given the lack of operating histories and clear business models for many of these new firms-leap of faith investing. Warren Buffet calls this speculation and not investing-different strokes for different folks I guess.  Until new information arrives, investors are left following technical demand factors (e.g. momentum which is heavily dependent on the amount of new capital raised) and guesswork. Momentum and guessing are prone to error and wild corrections as the mean reversion impact of the Five Forces kick-in.

So, keep your safety belts fastened and do not bet the ranch. The path for now is up, but how long this lasts is unknown. When it changes things will get bumpy as is characteristic of the creative destructive process of economic progress.


Thursday, February 5, 2015

Staples, Office Depot and the New Competitive Landscape

Nearly 20 years ago, Staples tried to acquire Office Depot to find the deal rejected by regulators.  Fast forward to today and we see the two largest office supply stores again seeking to combine.  What has changed and will the deal still be anti-competitive in the eyes of regulators?   How does the market see the prospects of the deal? What are the lessons to be learned?

To answer the last question first, there are many elements that make this an interesting story.  First is the role of activists (hedge fund Starboard Value).  Second, we have noted that a wave of consolidation in an industry is often sparked by some catalyst.  Note the Office Depot and Office Max combination of two years ago reduced the number of main stream office suppliers to two.  This merger would reduce that number to one.  Ironically, although the catalysts here are multifaceted, they led by a string of new competitors with competition for Staples and Office Depot ranging from the big box stores (Walmart and Target) to online behemoth Amazon. 

So will the deal be seen as anti-competitive?  That depends on how regulators view the market for Staples and Office Depot.  To be sure, there is considerable overlap in the geographic location of stores and the closing of duplicate stores is undoubtedly a central factor in any synergies from the deal.  But the question of market is much more complex.  For example a sizable component of the sales of the two firms comes from large quantity orders from businesses.  In addition, we have the big box and online competitors to consider.

Regulators measure anti-competitive behavior by a number of factors, including the 4-firm concentration ratio and the Hirfindahl index.  As we have noted before, the key to determining concentration is defining the market and in today's landscape, that market is widespread but the jury is out on how the regulators will view the world.

As for the market, it seems to be expressing skepticism over completion of the deal.  Office Depot closed yesterday at $9.49 a significant gap below the deal value of $10.91.  That is a quite sizable speculation spread.

(See also Comcast, Time Warner and the Myth of the Cable IndustryConcentration Ratios, the Case of Anheuser Busch and Modelo, and Speculation Spreads and the Market Pricing of Proposed Acquisitions)

All the best,


Monday, February 2, 2015

The Swiss Franc (SwF) Surprise and Private Equity Risk

The Swiss National Bank unexpectedly removed its cap/peg limiting the value of SwF on January 15, 2015. The SwF soared and traders who had relied on the peg since its 2011 creation to bet against the rise suffered huge losses. For example, Citi Bank, Deutsche Bank and Barclays lost a combined $300mln. Smaller trading houses like FMCX had to be rescued or failed. The losing parties claimed the situation was an unforeseen BLACK SWAN or 20 standard deviation event (AKA not their fault).

What happened is a classic example of Peso Risk. It reflects exposure-not experience-to a risk event not reflected in the sample period used to gauge risk. The termed was coined by Milton Friedman in the 1970s to describe what happened to traders engaging in a carry trade between the Mexican Peso and USD. The official Peso exchange rate to the USD had been fixed by the Mexican government since the early 1950s. Mexico had higher inflation and interest rates than the United States. Traders were borrowing USD at relatively low rates to spot into Pesos which were then invested in higher yielding  Mexican bonds and pocketing the difference. It looked like a free lunch except for one thing; namely devaluation risk. Sure enough in the early 70s, the Mexican government could no longer the support the Peso, which was promptly devalued. The losses wiped out years of “profits” – the profits were of course illusory. Traders, just as in the SwF case, blamed it on unforeseen events.

Private Equity is sometimes based on the carried trade model involving Peso Risk, and it too suffers from periodic blowups like the one experienced during the recent Financial Crisis. As debt markets overheat PE firms borrow heavily (FD/EBITDA > 6X), cheaply (low debt spreads and at relatively low absolute rates) and with favorable terms (Cov-Lite, back ended amortization and PIK) to acquire firms and achieve a positive carry (i.e. with positive debt service coverage of EBITDA/I >1). Eventually an event occurs and the carry turns negative leading to losses.

Bottom line, make your risk assessments based on exposures and fundamental analysis and not just on recent experience. Past performance is not indicative of future results because the past sample period may be biased by not including a major bad event. Assume a worst case and ask if you are prepared to accept the consequences - if not then walk. Be skeptical of claims that a worst case will never happen -they do.