Unincorporating Corporations: The Problem with Large Public Corporate Governance

Large public corporations and their managers have come under increased scrutiny since the great recession. They have taken the easy steps of reducing costs and returning cash to shareholders. Unfortunately, they still face revenue growth problems, excess capacity, changing technology and regulation, and lagging performance. These problems have depressed relative share prices and attracted the interest of third parties. Hostile takeovers bids from strategic acquirers have increased to pre crisis 2007 levels of 20%+ of M&A. Activists like Daniel Loeb’s Third Point have raised record amounts to fund new campaigns to instigate strategic change. Understandably, managers are concerned about this increasingly active market for corporate control. They are reluctant to change formerly successful business models even though conditions have changed due to organizational inertia.

These managers are seeking political support to protect their positions. They allege hostiles and activists with their alleged short term focus harm the long-term value of their firms and ultimately the country. Thus, they evoke stakeholder and long-term holding requirements arguments to slow the process; they just need more time to prove that everything will alright. As Ralph highlighted, allowing alternative stakeholders control over capital supplied by shareholders allows one group to risk the capital supplied by someone else-never a good idea.

Equally unwise is to discriminate against investors based on their holding period. Examples include granting long-term shareholder enhanced voting rights as in France or taxing short term investors at higher rates as proposed by Hillary. When it comes to bearing risk the length of ownership is not a factor. There is no grace period during which new shareholders are shielded from management miscues. The real problem with so-called “short-termism” is poor governance and weak board oversight regarding short term orientated incentive compensation plans. Many public boards have been “captured” by management.

The agency cost problem with large slow growth public firms was pointed out over 25 years ago by Michael Jensen in his seminal article. The eclipse is a work in process. Attempts to inhibit the market for corporate control will retard reform efforts. It is puzzling that we do not see more going private transactions for large public low growth firms (like Buffett-3G Heinz and Kraft acquisitions) if markets are so short term. This is especially compelling since they no longer need public capital market access to fund their limited growth opportunities

An interesting legal development is taking place which may offer some new solutions to the agency cost-governance breakdown. The development is outlined in a recent book. Business form matters because it impacts governance and agency costs. The statutory based corporate form may be inefficient for mature public firms. Contract based limited life alternatives like limited liability companies (LLC), REITS and limited partnership do away with permanent capital and encourage the disgorgement of cash. They require investors to “re-up” in new vehicles if they believe in management.

The problem of failed attempts to adjust to a volatile business environment (Schumpeter's Ghosts) is highlighted in a provocative new BCG report. The life expectancy of domestic public firms has declined by almost 50% over the past 30 years due to bankruptcy, liquidation, M&A, LBO, or other causes.  The 5 year morality rate or exit risk for for U.S. public firms is now over 30% compared to just 5% on the 1960s.

There is no escaping change. Not everyone can or will adjust. The agency problem in public firms complicates the problem. The market for corporate control and evolving legal structures are some market solutions addressing the problem. They are preferred over political “solutions”, which merely try to hold back change.

J

Similar Deals, Different Tax Effects: Aetna\Humana and ACE\Chubb

We spend a considerable amount of time in our Acquisition Finance course analyzing form of payment and form of combination.  Deal terms are vital for many reasons, not the least of which is the tax consequence to selling shareholders.  Nearly identical deals can produce substantially different tax consequences.

This point is driven home by an interesting article appearing in the Wall Street Journal recently.  (See Same Deals, Different Taxes, by Laura Saunders.)  Ms. Saunders describes three deals: Cigna's purchase by Anthem, the combination of Aetna Inc. and Humana Inc., and the merger of ACE Ltd. and Chubb.

The form of payment is similar in all three deals - about half cash and half stock but Cigna and Humana shareholders won't owe taxes on the share portion of the deal because of the way the combination is facilitated.

The details are a bit complicated, but are provided  in a report  by Robert Willens who publishes The WillensReport.  (Ms. Saunders drew on Mr. Willens for her article.)  With Mr. Willen's permission I quote from his report:  The basic idea is that "an acquisition of stock ...... followed by an 'upstream merger' .... will be treated as an 'integrated asset acquisition' in a single statutory merger if the transaction, so viewed, qualifies as a reorganization in which the acquiring corporation takes a carryover basis in the target's assets."

To be clear, Cigna and Humana shareholders will  ultimately pay taxes but only when shares are sold - thus deferring payment and hence gaining the time value of money.

As I mentioned, the details are more complicated, but the point is that how you merge matters.  Competent legal and tax advice is essential.

Here are some concluding thoughts:

1) Depending on the parties often conflicting objectives, you can often find a way to make a deal 'tax free'

2) The ultimate deal reflects the following:

                a) bargaining power

                b) buyer objectives

                                1) taxes: a tax free deal means carryover basis(no step up). Thus, lower future depreciation and higher taxes on a subsequent sale.

                                2) price: the above may be reflected in the price

                c) seller objectives

                                1) taxes: deferred taxes are preferred

                                2) price: the price may be lower for tax free deal

3) Bottom line: the parties will focus on net after tax returns which involves comparing NPV of asset write-ups for buyer less increased price needed to compensate seller for taxes paid.

All the best,

Joe and Ralph

Curb Your Enthusiasm: The Valuation Impact of Interest Rate Increases

Banks are suffering from low net interest margins (NIM) and net income growth since the 2008 Great Recession. Some believe the Federal Reserve’s low interest rate policy is responsible for this situation. In fact, the two favorite excuses provided by banks for performance issues are regulation and low rates. This post focuses on the bogus interest rate excuse. Bankers are awaiting the long expected Fed rate hike now hoped for this fall. They believe NIM, net income and hopefully stock prices will benefit from the hike. NIM and net income may initially and temporarily improve but bank stock prices are unlikely to improve.

All intrinsic valuation models capitalize expected future earnings or cash flows and their timing at a discount rate. The rate reflects two factors. The first is the time value of money (i.e. present value factor) usually represented by the risk free (Rf) rate of return. The second factor is the riskiness of the cash flows. Keeping risk, earnings and the timing of the earnings constant, rate increases will impact the time value of money thru changes in Rf. Simply stated expected earnings discounted at a higher rate have a lower (present) value.

It gets a little more complicated for banks because there may be an initial temporary increase in bank earnings when rates rise. This depends on the shape of the yield curve and how the bank’s balance sheet is positioned (asset sensitivity). Over time, the liabilities will re price and the benefit disappears.

All other things equal, rate increase are not good for stocks, banks included. Simple valuation fundamentals may be forgotten, but do not disappear.

J

Shareholder Centric vs. Stakeholder Centric - Mylan and Teva

So let me ask you a question?  As a person or institution about to invest in common stock, what do you expect of the board and management?  I'll give you my own answer: I expect them to maximize the value of my shares.  If I didn't have that expectation, I'd never invest.

My response reveals a shareholder centric attitude - that management works first and foremost for shareholders.  While such a view is overwhelmingly favored by independent experts in  corporate governance, it is by no means without some legal, management and even some academic dissent.  The alternative view is stakeholder centric - that management must consider the well being of all of its stakeholders when making decisions.  Stakeholders other than shareholders include employees, bondholders, customers, and even the community in which a firm operates.

Stakeholder centric requirements in the United States vary with State Law and Corporate Charters.  Different countries around the world take different viewpoints with some (Ireland) being more shareholder friendly and others (The Netherlands) being more stakeholder centric.

This was borne out with Mylan's recent rejection of a $40 billion takeover by Teva.  (For interesting details, see Mylan). Mylan, formerly a Pennsylvania corporation became dutch based in February as part of an inversion - where companies merge with other companies to change the location of their headquarters.  Typically this is done for more favorable tax treatments but it also has other repercussions for shareholders - in this case enabling management to espouse a stakeholder approach to the takeover and find support under Dutch law.  What are the repercussions of a stakeholder centric view?  I'll mention three:

First, companies that could be run more efficiently under new management are protected under existing management.  It can be cost advantageous - and beneficial to society as a whole to have the company acquired.  In some cases it is beneficial to society as a whole to lay off employees and focus the company in more efficient ways.  Companies protecting employees may resist such change.

To be sure, communities can be harmed when companies close plants, lay off employees and perhaps move their location.  But community or state or country protectionism is harmful in the long run.  Subsidizing inefficient operations may prolong the inevitable, but it avoids the obvious - uncompetitive companies will ultimately die and shareholders and ultimately all stakeholders will suffer.  Protectionism and cross-subsidization will ultimately fail.  The employees,  companies and communities that thrive are those that embrace change and continually adapt - keeping themselves competitive in a global marketplace.

Second, situations that can benefit shareholders - the residual claimants in a company can be rejected.  Not only is this unfair to the owners of a company, it is again ultimately destructive.  Few investors would invest in a company that doesn't look out for their own best interests.

To be clear, stakeholders are important and they deserve every consideration by management.  Even under a shareholder centric view, the best companies are conscious of the needs and obligations of their stakeholders and fulfill these claims in consideration of the competitive marketplace.  Usually the claims of stakeholders are also defended by other means including contracts, union, and laws.  Shareholders are not provided the same contractual certainties that stakeholders enjoy.  They are the residual claimant of a firm's profits.  They are entitled to everything that is left after all other expenses and claims have been paid - if there is anything left.  Shareholders are not guaranteed a profit, but have the benefit of knowing management and the board are looking out for their best interests.

Third, boards that take a stakeholder centric approach are answering to more than one master - not an optimal situation.  It is never clear whose interests should be pursued or which direction to follow.  The typical result is stagnation.

To be sure, laws that permit boards to reject takeovers based on stakeholder theory can also insulate management from needed change.

Thus, Mylan's shareholders have lost the opportunity to sell their shares at a substantial premium.  Share prices fell 14%.

All the best,

Ralph

Mature Tech: Valuation and Pricing Lessons

Apple’s large price drop and the Google’s large price jump occurred within days of each other. They highlight how challenging tech valuation and pricing can be in a normal trading context let alone in an M&A setting. I find it useful to distinguish the different stages of tech firms to understand the economic dynamics. My scheme is as follows:

1)     Seed: idea stage with no established business model or revenues; private market valuation set by handful of optimists of questionable reliability.

2)     Early: established business model and revenues -profits hopefully to follow e.g. Square; price based on relative value compared to “peers”.

3)     Mature: great returns/profits but growth leveling off e.g. Apple and Google; key drivers are growth and returns.

4)     Old: declining returns with limited if any growth e.g. Hewlett Packard and IBM; focus on shareholder distributions and breakup asset values.

Recently, Apple and Google experienced large stock price swings. GOOGLE increased by 16%+ or $65B on July 17 while Apple fell 7% or $60B four days later. Ralph correctly notes stock prices are based on expectations not actual results.

Expectations are frequently based on extrapolations-sometimes sophisticated, but still extrapolations based on beliefs not facts. Once a new signal (which could be information or noise) is received, investors revise their prior beliefs regarding future operating performance-Bayesian updating or learning. Tech firms are inherently volatile given short product life cycles and their uncertain operating environment. Relatively small changes in expected growth rates can have a huge valuation impact.

Apple, although it had a great quarter, gave revenue guidance that shook investor growth expectations. Specifically, concerns over iPhone, iPad, iWatch and the next “big thing” caused investors to markdown growth estimates. It is still a great firm but was priced too high based on new growth estimates. This raises another issue-will Apple’s management try regain its growth “mojo” through expensive unfocused new product R&D and acquisitions? Remember they have a huge $200B+ cash pile and could do lots of damage. Hopefully activists like Icahn will keep pressuring them to return more cash to shareholders. Interesting to see how their management reacts. The record of aging tech firms refusing to age gracefully like HP is not a happy one.

Google benefited from a “twofer”. They had a better than expected second quarter. They also provided information on improving growth prospects for mobile ads. Equally important, their new CFO provided comforting words on expense and capital discipline. The problem with maturing tech is the discipline to manage the transition from high growth to more modest growth. Managing the transition has an important impact on expectations. Whether Google’s management can deliver on these raised expectations remains to be seen. If they disappoint then expect a subsequent large downward pricing adjustment.

My take is mature tech firms are fraught with agency cost issues which make them difficult to value. They will try to fight the transition to slower growth and try to manufacture growth through undisciplined capital allocation at the expense of returns and value. New management teams unburdened by legacy culture will be needed to avoid Microsoft-Nokia type M&A misadventures.

J                                                                                                

Apple Profits Surge 38%; Price Drops 7%

The headline above, paraphrasing results in today's WSJ drives home a reality of the market.  It is not enough to outperform your past, you must outperform expectations. In an efficient market, past performance and future expectations are already discounted (i.e., reflected in price).  What matters is how you perform relative to those future expectations.  Indeed, in the case of Apple, sales of iphones were 35% higher than the same quarter a year before.  And sales more than doubled in China.  Not enough.  The market expected more.

A firm's stock price will always be forward looking, reflecting future expectations.  Deviations from those expectations, either up or down, will move the stock price.  Thus, prices move based on new not historic information.

So how does this relate to mergers.  In pricing a deal bidders (should) establish a walk away price based on their expectation about the present value of future cash flows once a target is under their control.  That walk away price represents the maximum the acquiring firm should pay.  But what is the minimum price the bidder can get away paying?

For a publicly traded firm, this minimum is generally above the prevailing stock price.  But here is where expectations come to play.  What if the prevailing stock price anticipates acquisition.  In this case the market price of the target is already inflated.  It doesn't represent the value of the target's assets in place but the value of those assets under new management.  Bidders need to be aware of this when setting bid premia.  Flatly paying a fixed premia over an inflated market price raises bidder cost, giving a bonus over values already incorporated in target prices due to the bidder's subsequent actions.  

Yet this is precisely what one influential analysis of bid premia implies.  Bill Schwert, in his paper Mark Up Pricing in Mergers and Acquisitions finds little correlation between previous run-ups and subsequent premia, implying that the runup (anticipation) is an added cost to the bidder.  Note that this does not necessarily imply that this is optimal or sub-optimal practice as we don't know the lowest price at which the bidder actually could have purchased the target.

It does imply, at least to me, the importance of keeping deals quiet before a bid is made.  It also suggests a psychological element to target shareholder behavior.

All the best,

Ralph

Leveraged Lending Envy: Banks and Non Banks

Bankers and their supporters continue to object to regulatory leveraged loan leverage limits. The limits raise concern whenever transaction related Funded Debt to EBITDA ratios exceeds 6X. The usual complaints include:

1)     The Market and Bankers know what is best-not regulators

2)     Regulators are keeping banks from lucrative lending opportunities

3)     The lucrative opportunities will be picked up by less regulated non banks like business development companies (BDC)

4)     The restrictions are inhibiting the LBO market development and growth

Let’s take a look at these complaints:

1)     Market knows best: The tragedy of commons shows that some market equilibrium can lead to suboptimal results. Look at the concentrations(leveraged loan commitments YE 2007):

Merrill: $97B

Citigroup: $97B

JPMorgan: $95B

Goldman: $95B

2)     Loss of lucrative loans: lucrative loans usually have more risk than acknowledged. Consider leveraged loan 1Q08 provisions and charges for some of the major players:

Merrill Lynch: $1B; contributor in its forced sale to BofA

Citigroup: $2.6B; contributor in its subsequent failure and rescue

BofA: $700Mln; contributor to its need to be rescued

JPMorgan Chase: $1.4B

Wachovia: $500MLn; contributor to forced sale to Wells

3)     As I previously discussed-this is really a work in process whose outcome remains to be seen. Nonetheless, just because someone else is doing something stupid doesn’t mean tax payer guaranteed banks should follow them off the cliff. Private capital not subsidized by tax payers should be free to invest at whatever leverage levels they chose. Furthermore, bankers seeking BDC lending flexibility should keep in mind it comes with BDC capitalization levels which have substantially less leverage than banks. Sorry boys, you cannot pick and chose the good BDC features without taking the bad.

4)     Restricting the LBO Market: PE may complain that the restrictions reduce the availability of under priced bank loans. The response- is that so bad? Also, remember the restrictions focus on leverage greater than 6X. If you need more than 6X to make the deal work, then maybe the deal is overpriced.

The leveraged loan market, like other deal markets, such as real estate, is prone to boom and bust cycles. Lenders fixate on nominal not risk adjusted return as they are driven by incentive compensation to maximize their bonuses. Regulators trying to stop them face the same plight as someone trying to stop an individual from playing Russian Roulette who is on a winning streak. When that individual is subsidized by tax payers, as banks are, then it does not seem too much to ask to place some restrictions on leverage levels. The banks should be thanking the regulators for stopping them from hurting themselves.

J