Venture Capital Prices: Real or Make Believe?

Market efficiency and discounted cash flow analysis are important M&A concepts and tools. Their usefulness is questionable in the sometimes surreal realm of venture capital. Current venture capital valuation based on financing rounds keeps rising with the number of unicorns (private early stage firms with implied $1B+ values) at record levels. Reverse engineering the operating performance needed to justify such lofty values leads to some hard to believe let alone justify sales and margin estimates.

A possible explanation is the prices reflect the value of special downside protection features like liquidation preferences available to venture fund investors. The extra value for those features does not seem large enough to explain the huge current price run up.

This leads to another explanation; namely, the prices and implied values are an illusion. Unlike public shares you cannot short sell private investments if you believe they are overvalued. Absent short sales or some other mechanism prices take on a life of their own. All that is needed for a self fulfilling momentum based pricing cascade are optimistic investors and liquidity. The uptick in prices draws additional investors and the beat goes on. Disbelieving investors are unable to bet against the “excessive” prices. Thus, an apparent arbitrage opportunity goes unanswered.

It appears venture capital markets are inefficient-their prices do not reflect available information and views. Instead, they resemble lotteries-relatively low ticket prices for negative expected value investments with a large positively skewed payoff distribution. Venture funds and other investors are pressured to participate even at higher prices. They fear missing out in getting a winning ticket, and suffering a relative performance drop, which impacts their fund raising efforts. These types of one way markets can remain inefficient for long periods until some event occurs causing a revaluation. Optimistic momentum venture investors with sufficient liquidity will keep bidding up implied finding round valuations.

Interesting to see what values, if any, are realized once surviving start-ups are taken public and begin trading in a market where short sales are possible. I predict IPO investors will be in for a wild ride. Optimists will keep setting venture values until we run out of optimists. Sounds like a game of musical chairs-you do not want to be the last one standing when the music stops.

J

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 Fortune.com

All the best,

Ralph

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.

J

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

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.

J

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,

Ralph

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.

J

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