“Board Walk or Parked Place? Acquiring Firms and the Director Labor Market”

A lot of attention has been given to the composition of a firm's board of directors.  Much less attention has been directed to changes in the board of directors, particularly around major events.  An important literature does address changes around mergers, but concentrates on target firms.  What about acquiring firms?  After all, mergers can represent dramatic shifts in the evolution of a firm.  It makes sense that monitoring and advising needs of boards should evolve as well.  The only evidence we do have on acquiring board changes around mergers suggests relative stability with few changes.  This evidence comes from the examination of target firms which finds that target directors are not often retained by the acquiring firm.  If these are the only changes, general stability of the acquiring board is implied.

In recent research with my colleagues David Becher and Jared Wilson, we find that stability is far from common with acquiring firm boards.  There are significant and substantial changes of boards over time and the changes are significantly different around mergers.  As just one indication the post-merger board typically consists of 7% target directors, but 11% of new directors unaffiliated with either target or bidder before the deal.  In addition, board size often changes either increasing or decreasing

“Board Walk or Parked Place?

Acquiring Firms and theDirector Labor Market”

Abstract

"This paper examines the stability and composition of acquirer boards around mergers.  Contrary to perceived wisdom, composition of the post-merger board changes substantially and these variations are significantly different from both non-merger years and non-merging firms.  These adjustments reflect firms upgrading skills associated with executive and deal experience.  Board changes also reflect bargaining between targets and acquirers rather than CEOs seeking a more friendly board.  Conversely, director selection in non-merger years is driven by general skills and diversity.  Overall, our analyses provide insight into the dynamic nature of board structure around mergers and characteristics valued in the director labor market."

All the best,

Ralph

DuPont, Trian and Shareholder Votes

Yesterdays Wall Street Journal had a very interesting article related to Dupont's impending election, noting the importance of small shareholders in the voting process.  The vote will be to elect DuPont's 12 directors.  Trian has nominated an alternative slate containing eight of DuPonts nominees and four of their own, including Trian boss Nelson Peltz.  A decade or so ago, institutions typically sided with management.  Today's institutions appear to take a more nuanced look at the issues and directors upon which they vote.  Still, the typical shareholder is likely to be apathetic with regard to voting, assuming that their small holdings do not count.  

To understand the typical voting distribution, take a look at the chart below from our Journal of Finance paper, Electing Directors.  The typical director gets well over 90% support.

The chart is derived from an analysis of about 2500 director elections (for more detail, see Electing Directors).   However, only four of those were contested.  In the DuPont case, the 12 directors receiving the largest number of votes will be elected.  It will be interesting to see how this one turns out and if Trian is successful, what changes in DuPont's structure and what changes in share value follow.

All the best,

Ralph

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 Mind, and The Hammer and Nail).

All the best,

Ralph

Offense and Defense - The Evolution of Takeover Strategy and Defense

One of the hot topics of today's acquisition climate is the role of activists.  While activism has been a hot topic before the situation today is a  bit different, with many boards actively listening to activists.  It is another step in the give and take of corporate acquisitions between bidders and targets.  In fact, the recent history of acquisitions reveals the continually evolving offensive and defensive strategies.   Consider just a bit of the historical give and take (not in exact order but close):

• Hostile takeovers were big in the 80's.  
• Poison Pills are invented by Marty Lipton (Enstar 1982)
• Acquiring firms started using junk bonds to finance deals.  Even large companies were vulnerable
• States enacted anti-takeover statutes to slow down hostile deals.  
• Courts strike down many of these statutes.
• States revise anti-takeover statutes to be in conformity with the law 
• Poison pills become a bit more popular
• Poison pills are challenged in the courts (Household International)
• Courts uphold poison pills (November 1985)
• Poison Pills become widespread. 
• Hostile deals decline
• Shareholder activism picks up but doesn't capture great momentum (Mid - 90's)
• Governance Scandals rock the corporate world (Enron, Worldcom)
• Sarbanes Oxley is passed
• Boards become independent in response to the law
• Shareholder advisory services gain influence (Institutional Shareholder Services)
• The financial crisis occurs
• Dodd Frank is passed
• Shareholder activism picks up speed - boards start to work with activists

Stay tuned.  It's a rapidly changing world.

All the best,

Ralph

Investing in Young and Start-up Firms: Using the Fermi Estimate

Early stage venture capital investment is more strategic and legal than financial analysis-the reverse of traditional investments. This reflects the lack of not only firm but also market history. What is needed is structure to help improve our estimates from a wild ass to reasoned guess. A modified Fermi Estimate provides such a structure. It involves starting with some defendable assumptions, updating the assumptions with observations, forming revised assumptions and repeating the process. This requires learning from facts as the investment unfolds using a Bayesian Inference approach. A key is to take small (baby) steps as the start-up evolves beyond the idea stage (no revenue) to stage one growth (revenue validation) and finally to stage two growth (profit validation). A lack of hard data does not mean anything goes. Instead, substitute reasonable assumptions which are updated as the process unfolds.

A useful framework is as follows:

1)     Industry: Porter 5 Forces

a)     Customer: who are the customers and how much bargaining power do they have?

b)     Suppliers: who are the suppliers and how much bargaining power do they have?

c)     Competitors: existing competitors and their relative positions.

d)     Substitutes: what substitutes exist?

e)     Entrants: what entry barriers exist?

2)     Strategy: what is our strategy regarding the 4 Ps

a)     Pricing

b)     Place-market segments and geography

c)     Promotion

d)     Products

3)     What is our business model for revenues and ultimately profits? Can we identify any sustainable competitive advantages? Is there enough built-in flexibility to allow for mid course corrections?

4)     Value realization plan

a)     Liquidity event: IPO;M&A

b)     Timing of liquidity event

c)     Realistic pricing expectations

Now we can turn to a DAR (Decisions at Risk) analysis:

1)     Asymmetric information

a)     Adverse selection-selecting the wrong firm, team or idea

b)     Moral hazard-failing to monitor the investment

2)     Bias: either the VC firm or the team suffers from over confidence, excessive optimism, the illusion of control, confirmation bias

3)     Control Mechanism: get a good lawyer and conduct appropriate due diligence to make sure you get the deal you thought you were getting. Consider:

a)     Monitoring: Board representation

b)     Incentives: Alignment of interests; make sure the founders are financially committed

c)     Governance: VC investor veto rights over compensation, management, vesting rights, redemptions and strategy.

d)     Investment Allocation and Timing: Stage investments based on milestones being obtained. Purse string control over the burn rate is needed to avoid incremental over committing. Balance against any first mover advantages requiring a fast rollout.

e)     Control: tight control over cash flow, assets, voting rights and dilution. Reflected in complex capital structures involving multiple instruments with different features.

The above helps avoid undue reliance on comps which can wildly overvalue start-ups when firms in the same industry are overvalued during bull markets.

J

The Power of Focus and A Sustainable Comparative Advantage

The concepts of focus and diversification are diametrically opposed, but both are crucial concepts in finance.  As investors, we are wise to diversify, to not put all of our eggs in one basket.  As one extreme, employees of Enron who also invested their personal assets in the fast rising company lost both their wealth and their income when the firm collapsed.

For companies (and for individuals considering career options), the opposite is true, and much research has found that those companies that focus on their core competencies are those that prosper.  Companies, like people, have distinct advantages at certain things - but not at everything.  Effective strategic leadership requires defining and honing a sustainable comparative (competitive) advantage.  Let's consider that phrase more fully:

• Comparative (competitive) Advantage means that you can deliver a service or product more effectively, or with higher quality or more inexpensively than your competition.  Now whether you focus on quality or cost is another major decision that we leave for later discussion, but the choice comes down to knowing your marketplace, to understanding customer wants and needs. But as my colleague Joe Rizzi points out, make sure your advantage is comparative: "Having smart people doesn’t mean anything if all your competitors have smart people as well."

• Sustainable - means you will continue to enjoy this advantage for at least the next several years.  This is why Warren Buffett and other great investors talk of finding companies with moats protecting them from competition.  The moat may be in the form of a superior product that cannot be duplicated -  perhaps due to technological knowledge, but more likely due to patents.  It could be from regulatory advantages or political alliances. It could also be from brand capital - the reputation of your firm in the marketplace.  A moat could also exist because of natural barriers to entry like regulation or other legal structures or because the business requires intense capital or other requirements, not easily copied.  There are many more ways to build a 'moat' but the concept is the same, find a way to stay ahead of the competition - a way that is not easily duplicated.

Note that managements can have moats built around themselves as well - a highly undesirable characteristic.  Moreover, management can be so enamored with the size of their empire that they forget the need to focus.  When this happens, external forces - takeovers or activists - step in to correct the situation.  Indeed, the need to focus, to find the sustainable competitive advantage is at the heart of much recent activist activity.  See Joe's recent post discussing Yahoo, Darden, Ebay, Hewlett Packard and DuPont (Royalists Vs. Governistas).  

You can think of sustainable comparative advantage as overlapping circles.  One circle contains the set of all things a company is good at - another partially overlapping circle contains the set of things the market will reward.  The intersection of these circles is the sweet spot where businesses (and people) can prosper.  For businesses and individuals with a sustainable competitive advantage, the sweet spot exists for a longer period of time, but even here the circles are continually moving as technology, consumer tastes, regulation, political climates and other catalysts shift the circles.  It is essential to stay ahead of the shifts.  

Note: for individuals considering career choice, I'd add a third circle consisting of things you enjoy doing.  If you find the intersection of those three circles in your life you are indeed fortunate, doing something you like, that you are good at, that the market values. 

All the best,

Ralph

Allergan and Valeant - Lessons from the Market for Corporate Control

The current Allergan Inc. case illustrates many points we have made in these posts.  As we start to think about our upcoming Amsterdam class on Structuring the Deal, it is useful to review.  The Allergan situation is an important illustration of the importance of corporate governance and the fact that when internal governance mechanisms (e.g., management and the board) overlook value creating strategies, external governance mechanisms (e.g., hostile bidders, arbitrageurs and the stock market itself) will force that change upon the firm.  It is better to be proactive.

On April 22, 2014 Valeant announced a hostile bid for Allergan, explicitly noting its value creating strategy, with an estimated $80 billion in synergies to be achieved in the first six months.   Allergan rejected the acquisition offer by Valeant but is now implementing many of the same strategies Valeant has proposed.  Specifically, Allergan has focused heavily on research and development while Valeant has focused more on sales.  Valeant said it would cut up to 20% of Allergan employees, primarily in R&D.  Allergan rejected these initiatives but is now following a similar strategy in an attempt to pacify its shareholders.  It has announced that it will lay off about 13% of its workers.  Here are just a few of the lessons from past posts.

The Best Takeover Defense: Don't leave Money on the Table.  Anticipate value creating activities and implement them, however painful.  Continuously evaluate your firm's strategy, particularly in light of a changing environment.  Consider Are You a Takeover Target? Take the corresponding action before external markets force change upon you. Don't wait for a hostile bidder to force you into action.  Indeed, Do Unto Thyself.

Once your firm is in play, the ownership quickly shifts to arbitrageurs.  The Speculation Spread between the offered bid price and the post announcement market price reveals the market's anticipated outcome for the deal (e.g., successful or unsuccessful acquisition and whether the bid will be revised).  Once arbitrageurs are the major owners, a deal is much more likely to happen as their interest coincide with deal completion.  As we noted in April, "The market is predicting a higher, successful bid as the Allergan's stock price on Monday closed well above the $153. value offered by Valeant." Allergan's shares closed at $171.14 on Monday.

This deal is reminiscent of the numerous oil takeovers in the 1980s.  During the late 1970s, many companies began an extensive drilling program searching for more oil.  By the 1980's two factors made that strategy hugely unprofitable.  First, the price of oil fell from $40. a barrel to around $10. a barrel. Second interest rates rose from single to double digits.  Thus, in terms of the present value equation, the numerator declined while the denominator rose.  Not a good combination.  Firms that failed to adjust were subsequently taken over.  

To repeat, it is necessary to always consider if your current strategic course is the best one for maximizing value.  If you get this wrong, you are likely to find out the hard way.

All the best,

Ralph