Thursday, April 30, 2015

Sex, Lies and Firm Value - The Fortune Story

I've written before about our paper Sex, Lies, and Firm Value.  Personal integrity matters and signals of low integrity in an executive's personal life do indeed signal subsequent corporate misdeeds.  This implication is not lost on the market which lowers firm value immediately.  It is still a working paper and we are pursuing several interesting new results.  The current draft of the paper can be downloaded here.)  It is nice to see that it is getting some attention in the financial press.  See this story in

All the best,


Monday, April 27, 2015

Here We Go Again?

The best of deals are made in the worst of times while the worst deals are made in the best of times. We may be seeing a replay of this mantra in the current M&A market. Coming off a deep post crash low, M&A activity has sharply rebounded. This reflects a recovering economy, booming capital markets and rising managerial and investor optimism. The activity is driven by strategic buyers instead of private equity. The number of large deals over $5B has also increased. Larger deals are froth with danger given the potential to over pay and heightened integration problems associated with larger deals. The buyer’s shareholders usually react negatively to the announcement of such deals-and for good reason. Their track record underlies this reaction; namely, 50% of targets are disposed of within 10 years of the closing.

Yet, such deals are now receiving a largely positive response from the buyer’s shareholders. Some possible explanations for this development include:

1)     Buyers are getting better at making acquisitions (AKA this time is different).I have seen no evidence to support this possibility.
2)     We are early in economic and M&A cycles. Thus as the cycle continues we will see mean reversion.
3)     Shareholders are confusing size and growth with value creation.

My concern is a toxic brew may be developing. This brew includes investor bias towards growth combined with managerial overconfidence. Board selection of CEOs favors over confident CEOs who are viewed as decisive optimists. The process favors the lucky risk taker with a “successful” track record -think of past Hewlett Packard CEOs Carly Fiorina and Leo Apotheker who both engineered disastrous acquisitions.
So what can boards do to prevent future over priced ill conceived acquisition disasters? It is unlikely subordinates will question CEO’s who want to do the deal. What is needed is a strong experienced lead independent director who can challenge-not second guess- large scale transactions by considering the following:

1)     Does due diligence support the deal’s thesis?
2)     Is there a detailed integration plan based on the strategic rationale of the deal?
3)     Have competitor responses been considered?
4)     How will changing economic and industry conditions impact deal economics?
5)     Are CEO incentives tied to the success of the acquisition?

The real key is to run alternative stress case projection scenarios reflecting what could go wrong not just what is expected. A useful approach is to consider what could cause your deal to fail financially in the next few years. If you cannot think of any - then think again - they are out there.


Thursday, April 23, 2015

Offense and Defense in the Drug Industry: Teva and Mylan

A frequent topic in these posts is the fact that certain catalysts set an industry into play with regard to mergers and acquisitions.  It could be regulation, competition, the economy, changes in consumer tastes or something else.  (See Catalysts for Merger).  Our own research has shown that when a firm is an initial target or an initial bidder in an industry, following at least a 12 month minimum dormant period in the industry, the prices of rivals adjust in anticipation.  Moreover, the price adjustments are correlated with the probability of being a subsequent target or  bidder.

The industry consolidation in the drug industry has been going on for some time, and we certainly haven't seen a long dormant period in a while.  What is happening now is that rivals are positioning themselves in anticipation of future industry changes.  Hence, Teva launches a bid for Mylan industries in an attempt to break up Mylan's bid for Perrigo.  This will be a fun one to follow as it illustrates both offensive and defensive techniques of merger strategy.   In this case, the catalyst seems to be slowing growth in the industry and the decision to grow through acquisition to achieve a more dominant role.

(See Joe's related posts on this industry: Build or Buy, Chance Favors the Prepared Mindand The Hammer and Nail).

All the best,


Monday, April 20, 2015

There They Go Again: Shareholder Distributions and Short Term-ism Rant

Blackrock’s Larry Fink is cautioning CEOs about giving in to activists. He suggests that CEOs are influenced by short term activists to increase shareholder distribution-dividends and repurchases. He prefers, and I agree, CEOs should first focus on investing their capital in new growth investments. This assumes of course that firms have positive NPV projects in which they can invest. This becomes more challenging the further we are into an economic recovery.  All too often CEOs feel the pressure to grow and the lure of size when the opportunities just are not there. This results in value destructive growth-both organic and over priced M&A. Not all CEOs are as skillful as Warren Buffett in making investment allocation decisions. Hence, not all CEOs can have Buffett’s zero payout policy.
Some firms simply have more cash than they can profitably reinvest given where they are in their life cycle. Firms should view distributions as a residual capital allocation decision involving the following:

1)     List all projects offering positive NPV
2)     Match opportunities with available internal resources -operating cash flow plus liquid resources
3)     If opportunities exceed internal resources, then raise external capital
4)     If opportunities are less than internal resources, then return the excess to shareholders

Shareholders can search market opportunities to redeploy their capital to higher valued use better than managers trying force the issue.

Next, Fink proposes a protective tax based mechanism to shield CEOs from dividend seeking activists by raising taxes on investments not held for at least 3 years. This would supposedly discourage short term actions. Again, he confuses an investor’s holding period with the market’s investment horizon. Capital markets are like time machines allowing investors to realize cash flows now by liquidating investments. Conversely, they can postpone consumption by increasing investments. The market price for each action is based on the same identical formula independent of the investor’s time horizon; namely the stock price is based on some estimate of future long term cash flow discounted for its risk. Efforts to penalize so called short term investors, however defined, will only reduce market liquidity and entrench management.

Value is created on the asset, left hand, side of the balance sheet by managers skillfully exploiting market opportunities. You cannot, however push on a string when the opportunities just are not there. Returning excess capital under those circumstances is not a sign of weak management, but of good stewardship. It is difficult to create value on the liability, right hand, side of the balance sheet. Nonetheless, you can destroy value by getting the right hand side wrong by being too stingy with dividends.


Thursday, April 16, 2015

Drexel's Corporate Governance Conference

Each year, Drexel's Center for Corporate Governance holds a conference soliciting papers from around the world.  This year over sixty papers we submitted from which five were chosen for presentation.  The audience consists of some of the leading researchers in Corporate Governance from around the world. This year's program honors Jon Karpoff for his outstanding research in Corporate Governance and features an outstanding set of papers.  Patrick McGurn of ISS is the featured dinner speaker.   A copy of the program is shown below.

All the best,


Monday, April 13, 2015

Facts versus Beliefs: Community Banks and Dodd Frank

Community banks have developed an endearing tag-line to flight for exemptions from the deeply flawed and unpopular Dodd Frank Act (DFA). It was passed in 2010 to correct perceived, primarily Too-Big-To-Fail, bank abuses. The regulated never like to be regulated. So the community banking lobbyists have sized on a statistical fact to fight DFA. Since 2010 the number of community banks with assets less than $1B has fallen from just over 2600 to less than 1900. Ergo, the DFA (AKA The Great Satan) is responsible for the decline. Therefore, community banks need an exemption from DFA to prevent their eminent extinction. Everyone who has seen plight of Bailey Building and Loan in Its a Wonderful Life will rush to the defense of such small under dogs.

They almost had me convinced until I looked at the numbers. Small community banks-especially those below $100 million in assets have been in a long-term structural decline since the 1980s. Something other than DFA must be causing the decline. Just so happens that something else is economies of scale. Banks below $100 million in assets simply lack the scale to compete both before and after DFA. Thus, they are forced to exit usually by sale to other larger community banks. In fact, small bank M&A continues to be a bright spot in the industry. Industry consolidation waves are usually driven by underlying structural changes-not evil forces.

Community banking is adjusting to changing industry cost structures. This is a healthy development similar to what has happened in other consolidating industries. Undoubtedly, there will be winners and losers with the losers screaming the loudest. Nonetheless, as former Senator Moynihan noted-you are entitled to your beliefs-but not to your own facts. So stop the screaming and get your facts right.



Thursday, April 9, 2015

Merger Waves in the Oil Industry?

We've talked about merger waves in previous posts, noting that typically some catalyst occurs that makes acquisitions attractive in a particular industry.  Typical catalysts include changes in regulation, consumer tastes, or economic factors within an industry.  Something changes within an industry that makes buying companies desirable.  A major catalyst affecting oil companies is the dramatic drop in the price of oil.

This isn't the first time this has happened.  It occurred most famously in the 1980s as oil dropped from $40 a barrel to $10 and interest rates rose from single to double digits.  Picture how those two changes factor into the present value equation and you will know why drilling for oil became a negative net present value situation.  Anyone who could turn off the let's drill button could create value in a company.  A famous case is the acquisition of Gulf Oil.  It was trading at $38 before the acquisition and overnight the price jumped to $80 as acquisition became imminent.  The source of the $40 plus gain per share can be completely explained by the value created by ending drilling.

Today's situation is a little different, but it looks like we are again set for a wave of oil mergers following the  Royal Dutch Shell's $70 billion acquisition of London's BG Group  announced Wednesday.

As an article in today's news notes, it now appears cheaper to buy oil by buying companies on Wall Street than by drilling for it.  It will be interesting to see what happens.

All the best,


Monday, April 6, 2015

Forgive Them (Not)-They Do Not Know What They Do: Hewlett Packard Again

Hewlett Packard’s (HP) Autonomy acquisition is back in the news again. I previously covered this tale of woe back in 2012. HP was the target of lawsuits following the botched acquisition. The terms of a recently settled suit are pretty interesting. How HP missed “accounting irregularities” so large that they were forced to write-down $8B of the $11B acquisition soon after the close has always puzzled me.

As part of the settlement HP agreed to establish an M&A related risk committee to incorporate the views of the investment, finance and technology committees - now there is a novel thought (get other points of view). Also, they will require their due diligence teams to be better trained - you mean they have to know what they are doing? My God, now they decide to better handle M&A risk and due diligence more than three years after the disastrous Autonomy deal! What were they doing before that deal and since it closed? To be fair this is probably legalese - form over substance.

What I find especially appalling is that the current CEO, Meg Whitman, was one the board members who approved the deal over the objections of HP’s CFO - so much for accountability! You don’t need enhanced risk committees and better due diligence to know that it is a BIG-BIG-BIG red flag if the CFO objects to a deal. Some other less obvious indicators include:

1)     Pressure to grow: looking to cover up weak core operations with a large acquisition is always troublesome as was the case here.
2)     Transformation: big acquisitions away from your core rarely end up well.
3)     Over Priced: the CFO objected, inter alia, that the deal was massively over priced at 11X sales v comparables at 3X.
4)     Dissenting views ignored: like the CFO’s.
5)     Weak Due Diligence: everyone knew the answer the then CEO wanted and no one was going to stand in the way-at least not if they liked their job.

The incident is another example of a board rubber stamping the CEO’s wishes. Of course boards cannot run the firm. This does not excuse boards from exercising some minimum of oversight and basic judgment. This is critical when the board’s CEO selection track record is weak - as it was with HP prior to Autonomy with substantial CEO turnover. CEOs are frequently selected based on luck not skill. A CEO candidate who has a “successful” track record is deemed skillful, when in fact he could have been simply lucky. Such CEO candidates are frequently over confident AKA decisive. Thus, absent a strong board they are prone to behavioral errors in an acquisition setting.


Thursday, April 2, 2015

Listening to Markets and Hearing Government

Readers of this blog know that Joe and I are strong advocates of listening to the market - being aware of current conditions and opportunities.  Certainly, in structuring a deal we must contend with economic reality; a situation suitable under one set of economic conditions may be far from optimal in another.

Many analogies and cliches apply - e.g., play the cards you are dealt.  The best quarterbacks in American football learn to read the defenses and take the best opportunities.  So too should we read the market and find the best solutions.

In the best of situations, markets reflect the economic equilibria of competitive forces.  But alas, they also reflect governmental restraints.  The Wall Street Journal recently published a very interesting article showing the impact of government activity on deal flow.  The article, entitled, "Buyout Firms Feel Pinch From Lending Crackdown" suggests that regulatory guidelines favored by the government are impeding deal activity and deal design.  In particular, the author notes that regulators urged banks to avoid putting debt greater than 6 X EBITDA in most industries.  Further, "So far this year, 21% of U.S. private-equity deals have been financed with leverage at or above levels regulators generally consider risky..." down from 35% last year.  The chart below (from the WSJ article) captures some of these dynamics.

The merits of this regulatory guidance is a subject for another debate, although regular readers can guess where our feelings lie on the subjects of free markets, free choice and the law of unintended consequences.  To be fair, Joe and I have both warned of the dangers of highly leveraged deals and over-excited markets, but we prefer to take things on their merits and consider things in context to all of the other factors that go into structuring the deal.  One size rarely fits all.    But like it or not, the regulators are part of the world we mentioned and hence, their impact must be factored into our decisions.

All the best,