IPOs: The Unicorns Moment of Truth

It has been said that in finance things take longer to happen than you would expect, but then unfold faster than you would have thought. This fact seems to be occurring in the mythical land of unicorns. I am fascinated with unicorns because their purported valuations seem to violate basic economic logic. Values not dependent on cash flow, risk and time would upset how we approach mergers and acquisitions. Rest easy as it appears unicorns do not violate the first principles of finance. Rather, their financing round based implied valuations are worse than theoretical (the usual compliant against discounted cash flow models)-they are just fanciful.

Some many unicorns are getting long in the tooth at 5-7 years of age (tech firms age in dog years). Investors are pressing for liquidity AKA an IPO. The IPO process or test is exposing some of the inconvenient facts I have previously highlighted about unicorn implied valuations. A stark example is provided by the pricing range assigned to the pending Square IPO. Last year Square was valued at over $6B based on its last financing round. Fast forward to the present and the IPO values Square in the $4B range. So what the!@#$ happened?

Something could have dimmed the prospects for Square such as the loss of Startbucks next year and continued large operating losses. Also, IPO market conditions have softened somewhat following the August correction. Worse yet is the possibly that Square was never was worth $6B. It seems that investors in the 2014 financing round did not receive ordinary shares. Rather, they received “super shares” providing them with protection against an IPO priced below their financing round value. Basically, they get more shares at bargain prices to make them whole if the IPO is priced at less than their investment. Thus, unicorn values may be inflated and exposed during the IPO process. No wonder many unicorns are trying to postpone going public for as long as they can. It will get even more interesting after they are public when they face scrutiny of real market disciple. Perhaps, things may not be so different for unicorn valuation after all.

J

Acquisition Finance: Structuring the Deal

Joe and I are gearing up for our Acquisition Finance Class in Amsterdam.  With the year set to be the biggest yet in M&A there is much to discuss.  I'll be sharing this year's outline later, but material on last year's program and a place to sign up can be found here.

For those with an interest in this subject, I recommend the text we use in the class:  Investment Banking, by Rosenbaum and Pearl.  It provides nice background reading for the course with rich institutional detail and applied models.

Material in the course, however, draws on both the rich and recent academic material on this subject and on detailed practical analysis and case examples.  Joe's 25 years plus in the field is an ideal compliment to the empirical research I do on M&A.  If it fits into your plans, we hope to see you in Amsterdam.

All the best,

Ralph

Venture Capital and Rational Bubbles

This post continues my journey to explain the seemingly over priced, high risk and difficult to value venture capital market. It is well known that the empirical security market line is too flat compared to theory. This means higher risk-higher beta stocks have lower than predicted returns. Conversely, lower risk-lower beta stocks (just like the ones Warren Buffett favors) have higher than expected returns. This phenomenon is called betting against beta (BAB). Two possible reasons exist for its existence.

The first is based on leverage constraints facing institutional investors like pension and endowment funds. These investors are forced to reach for asset risk to satisfy their higher risk appetites. Furthermore, leverage constraints may impede margin and short sales ordinarily used to correct over pricing. Leverage constraints and aversion probably tightened following the great recession given the failures and near failures on many undercapitalized institutions like Lehman.

A second complementary explanation is provided by behavioral economics. The argument is as follows:

1)     Investors over weight low probability high payoff events-even those with negative expected values. A simple example is the lotto. The number of players spikes as the grand prize increases even though the winning odds fall even lower. The large unlikely payoff dominates the negative expected value. A technical explanation is players (investors?) prefer positive skew. This is especially true when the wager (investment?) is relatively small compared to investor’s overall wealth. Thus, as investor wealth tends to be pro-cyclical-so is the demand for lottery type investments like venture capital (IPOs and Private Equity as well).

2)     Two additional behavioral effects reinforce the above.

a)     Representativeness-investors focus on winners like Uber and hope their investments will be winners. They are ignoring the higher base rate failure of such investments.

b)     Overconfidence-even if investors realize “home runs” like Uber are rare they believe they possess special skill enabling them to spot “Ubers”.

Add to the above the difficult to value nature of venture investment and it is easy to see how investors can get carried away in a rational bubble.

A third more traditional factor underlying the current market is low interest rates. The Federal Reserve has keep rates artificially low following the great recessions hoping to stimulate the economy. This means projected cash flows are discounted at lower rates leading to higher values. Additionally, on the demand side, low rates forcec investors to search for higher nominal (non risk adjusted) yields by going further out on the risk curve.

Thus, the venture capital market may be experiencing a rational, albeit still dangerous, bubble.

J

Pfizer and Allergan: Viagra Meets Boxtox

I can't wait to hear the late night talk show hosts talk about a merger between the makers of Viagra and Botox!  But we'll confine ourselves here to the more technical aspects of this deal.  There are many interesting aspects to this one including the size of the deal, the continuation of industry trends, the creation of a giant in Pharmaceuticals, the current price movements of the bidder, target and competitors, the possibility of an inversion, and the social terms of the deal.

First, this deal could be the largest deal of the year as Allergan has a market cap of $112.5 Billion and Pfizer has a market cap of $219 Billion - this year is on pace to be the biggest year yet in M&A.  Second, it continues the consolidation trends we have seen in the pharmaceuticals industry.  Third, it creates the world's largest drugmaker.  The combination would surpass Johnson and Johnson (currently valued at $278 Billion).

The deal would be an inversion, as Allergan is headquartered in Ireland with a far lower tax rate than Pfizer faces in the US.  Expect the US government to seek to impose restrictions on the move putting the tax benefits of an inversion in question.  See our posts about inversions (here, here and here) and the folly of governmental attempts to restrict inversions rather than addressing the root issue and making domicile in the US more attractive.

The price movements at the announcement were typical for the bidder and somewhat abnormal for the target.  The bidder lost a few percent while the target shares rose only 8%. Typical price jumps for the target would be in the 20% - 40% range.   

We've noted many times in these pages about the impact of mergers on rivals.  In particular, our research has shown how the rivals of bidders and targets react to deals involving a competitor.  In today's case, the Guardian reports that the prices of two competitors (GlaxoSmithKline and Shire) declined in value as there was some anticipation that they would be Pfizer's target instead of Allergan.  This illustrates both the anticipation effects embedded in a firm's stock price and the reaction when those anticipated effects are put into question.  Many social terms of the deal remain to be determined, including what happens to Allergan's CEO and how many layoffs might occur as part of the deal.  

One senses that in this market, there is more to come.  There will be a lot to talk about during our December course in Amsterdam.

All the best,

Ralph 

Fear the Walking (Dead) Unicorn

I posted several notes here, here and here trying to make sense of inflated late round technology valuations. My conclusion was the valuations were illusory rationalizations used to justify inflated prices. The private market valuation of these firms suffered from being unregulated, questionable accounting, lack of comparability due to differing provisions (e.g. liquidation preferences), and lack of short selling. The result is momentum based pricing driven by the optimism of the last investor. The number of previously rare unicorns (private firms with values exceeding $1B) increased to 124 in July of this year. Eventually, however, you run out of optimism when an event occurs causing investors to re-examine their assumptions and reduce their risk appetite leading to lower pricing. That something was the August correction.

You only really accurately value a private firm when you make the initial investment, and then when you exit. Exits had been delayed for many later stage tech firms. Only 14% of 2015 IPOs were tech related. The reasons (excuses?) given for the lack of tech IPOs was twofold. First, the founders did not want the hassle of public market scrutiny. Second, they did not need an IPO liquidity event because they could always do a “private IPO” (oxymoron?) by accessing private investor cash in subsequent financing rounds (at assumed higher valuation levels). Both reasons are nonsense.

In reality they wanted to avoid the evaluation of numerous hard-nosed investors both at the time of the IPO and the on-going trading-including short selling. You need a public market to get liquid; it is hard to access public markets at sky high prices.

Many tech founders and investors who confused bull market valuations for liquidity are now discovering the difference between paper and real liquidity. Over 40% of 2015 tech IPOs like Novo Cure are being priced near or below their last private financing round valuation. This fact has not gone unnoticed by private investors. They are balking at high implied valuations in later financing rounds forcing firms to accept lower values. For example, Blackrock which lead a prior $350M financing round for Dropbox has marked down its investment by 24%.

Pricing represents a short term belief in expected operating performance. Investors should gauge the gap between expectations and reality. This means not falling in love with stories about market growth and technology without considering how those factors translate into revenues and ultimately cash. 

This involves understanding the following:

1)     Market Characteristics: some markets have difficult characteristics making it difficult to yield superior returns. Use Porter's 5 forces framework as a starting point.

2)     Business Model: who will the firm achieve and maintain market share and pricing power when facing competitors, new entrants and substitutes?

3)     Execution: inept managers can negate attractive markets and credible business models.

If you claim this is hard because of profound uncertainty then recognize you are not investing. Rather you are speculating based on what you hope someone else will pay for the firm. This someone else can and does change his mind leading to wild price swings like those experienced this August. This in turn can turn your hoped for unicorns into unicorpses.

J

A Few Working Papers on Mergers (and Finance)

I just attended the Financial Management Association International meetings in Orlando, Florida.  The FMA also holds European, Asian and other meetings, but the one in North America is the annual one and draws a large crowd.  The FMA itself consists of over 7000 academics and practitioners interested in best practices in finance.  The way we find 'best practices' is typically through analyzing empirical data - often samples of thousands of observations to find out what is increasing value and what is not increasing value.  Topics analyzed range from all the aspects of mergers one can imagine to capital structure, dividend policy, agency theory, option pricing, investments, banking, regulation, working capital and much more.

 The working papers presented at this conference are just that - works in progress that will improve from the careful criticism of peers.  Ultimately, academics hope their working papers are published in leading academic journal and influence theory and practice.  Indeed, what we teach in the business schools is designed to be cutting edge practice and is (or should be) heavily influenced by current research and conditions.  Textbooks are three to five years out of date by the time they are published.

Rather than comment on individual papers, I am adding the link to the complete program which itself has links to individual papers.  This way readers can note the breadth of topics covered and choose those of interest.  Of course, you can find papers on any specific topic (i.e, mergers) with the search function (control + f on my computer).  Not all of these papers are at the stage where they are informative of 'best practices'.  Some of them are.  I sift through research carefully before presenting in executive education sessions but our next session in Amsterdam is in early December and my Drexel EMBAs in early January.  Many of my practitioner colleagues find scanning even the topics to be a way to stay current and get new ideas and in the best scenarios, get ahead of the competition.

All the best,

Ralph

Dell EMC Merger: Return of the Master

Michael Dell’s deal skills are second to none-including the Great Donald (Trump that is-the current presidential contender and author of “The Art of the Deal”). Michael took Dell PC (Dell) private at a very attractive price in 2013 utilizing clever vendor financing and high yield bonds. Now he is capitalizing on an activist motivated seller to make a beautifully structured acquisition of EMC, which will be the subject of numerous cases studies.

Both EMC and Dell are suffering serious business risk issues reflected in their declining revenues. EMC’s data storage business is moving towards the cloud, while PCs face a shift to alternative devices. Also, putting together the firms to create a technology conglomerate runs counter to others in the industry like Hewlett Packard that are spinning off divisions to achieve more focus.

Let’s consider the following:

1)     Deal Type: the deal is structured more like a LBO than a corporate acquisition with its high leverage, break-up fees and go shop clauses especially given the rumored shopping of the PC business for sale post close. The possible sale would also lower integration risk.

2)     Purchase Price: the purchase price multiple is around 11X EMC’s EBITDA-more in line with LBO multiples than higher priced corporate deals. The premium over the pre bid stock price is 20%. This is probably inflated given the use question value of the tracking stock being offer as partial payment. Adjusting for the post announcement fall in EMC’s price means the actual premium is closer to 13%. Dell appears to be getting a fair firm at a great price. EMC’s management is under attack by activist Elliott Management, and appears to be a very willing seller not necessarily acting in the best interests of EMC shareholders. Interestingly, Elliot sought the partial break-up of EMC by spinning off a majority owned subsidiary (VMware). Lawsuits will surely follow. The $2.5B break-up fee due Dell if EMC walks may mean EMC’s shareholders are stuck. Dell receives a substantial break-up fee should a competing bid arise during the go-shop period.

3)     Funding: this is where it gets really interesting. Dell, Silver Lake (partner in the original Dell LBO), et al are contributing around $4B in equity (not all cash?). The hard to value tracking stock representing a currently majority owned EMC subsidiary (VMware) supposedly represents $13B of the “equity” consideration. My take is the tracking stock is actually seller financing to close the funding gap facing Dell. The balance is $10B committed bank debt (plus a $3B revolver) and $40B in bonds. $5.5B of EMC’s existing formerly investment grade bonds do not need to be re-financed because they lacked covenant protection. Based on the combined EBITDA the funded debt multiple is around 5.5X EBITDA-modest by LBO standards and within banking regulator guidelines; hence the ability to secure the up-front bank group commitment. The bond financing portion is huge and market conditions remain unsettled. Nonetheless, Dell must feel comfortable based on the advice of his advisors because he is offering EMC $4B if he fails to obtain the financing.

Bottom line, Dell gets a modestly priced $67B firm with only $4B in equity and regains public market access. Hats off to Michael Dell if he can pull this off. It becomes even better if he can quickly reduce the debt thru the unloading of the PC business. The deal is not without risks, but my money is on Michael Dell.

J