2019's mega-mergers: What is really driving shareholder wealth creation?

“Finally, knowledge of the source of takeover gains still eludes us.” (Jensen & Ruback, 1983)

It is a known fact that global economic development is a driving force for international mergers and acquisitions (M&A) activity. For the 4^th quarter of 2019, Bloomberg estimated a 19% GDP and a

Figure 1. Global dealmaking numbers. Reprinted
from Financial Times, by E. Platt, J. Fontanella-Khan, L. Noonan
& A. Massoudi, 2019, https://www.ft.com

12.5% policy interest rate depreciation compared to the 3^rd quarter. Taking this data, the further ongoing global political uncertainty due to Brexit and several market events like the cancelled multi-billion tobacco merger between Altria and Philip Morris into consideration, it does not seem surprising that the global M&A activity has fallen 11 per cent by the 3^rd quarter 2019 in comparison to the previous year, presenting a 2 year low in terms of deal value (FT). Although those numbers may not directly imply prosperous business activities, 2019 was still characterized by several US publicly listed mega-mergers: The $89.5bn purchase of the pharma company Celgene by its direct competitor Bristol-Myers Squibb, the $88.9bn armaments concern merger between United Technologies and Raytheon and lastly, the $86.3bn fusion between the pharma giants AbbVie and Allergan. It seems obvious that one could believe the former mentioned economic and business developments have put pressure on the performance of the executed multi-billion-dollar mergers. In the following, I want to explore the actual short-term historic performance of 2019’s two biggest deals, taking into consideration major deal characteristics and furthermore, discussing possible alternative managerial firm-specific value drivers.

First of all, it is important to examine the research on historic M&A performance. The 1983 conducted meta-study by Jensen & Ruback delivered statistically significant evidence on shareholder gains or losses after takeovers, concluding that acquiring company shareholders make regular short and long-term losses while target company shareholders make significant gains in value. Moreover, empirical studies suggest that when it comes to M&A financing methods, share-based takeovers underperform compared to cash-based acquisitions (Fischer, 2017). Reasons for this may be due to deal value preciseness or acquiring shareholders’ retainment of company control. When looking at 2019’s two biggest deals now, the numbers paint a surprisingly different picture:

Figure 2. United Technologies (UTX) share price development.
Reprinted from Bloomberg, 2019.

The 5 months after each merger-announcement daily price data (Bloomberg) of each acquiring company suggest periodical positive geometric returns of 3.61% and 16.30%, respectively for Bristol-Myers Squibb and United Technologies. Taking into consideration the companies’ required capital return of the same 5 monthly period, calculated by the use of CAPM (See blog post from 03.11.19) with an overridden periodical beta, the 2 companies generate excess returns of 0.59% and 13.7%. Therefore, especially the United Technologies and Raytheon fusion created substantial short-term shareholder value, although the global economic state and conducted research might have implied different results. Additionally, the strong performance of both acquirers can not be explained in the context of M&A financing research as Bristol-Myers Squibb purchased with a well-balanced 53% to 47% Stock-Cash mix while United Technologies even financed its merger with a 100% stock payment.

Without doubt, my short analyses of those 2 recent mega-events in the M&A industry are due to its way too small number of observations not statistically representable at all. Although, they do symbolically represent a recent development in M&A research. While the study of specific deal characteristics like the aforementioned financing methods or political and regulatory effects have been researched for decades, more and more academics use a different approach, considering mainly firm-specific managerial characteristics for explaining shareholder wealth creation in M&A. “Extraordinary acquirers”, a paper published by Golubov, Yawson & Zhang in 2015, is one interesting example of this new school of thought. The three academics conclude that firm-specific fixed effects match, partially even overshadow, the explanatory power of important deal-characteristics. Going more into detail, they deduce that positive and negative acquirer returns are firm-specifically persistent over time and that they are also persistent under new managerial influences due to changes of the CEO. Golubov et al. explain those findings mainly by firm-specific organizational knowledge in form of M&A development teams and expertise in post-merger integration, by “bidder-specific synergies, […], derived from the nature of the firm’s assets or its business model that are particularly well-suited for acquisitions” and lastly, by prior success in acquisitions that may facilitate future M&A activities.

Unfortunately, qualitative analyses always bring the same problem with them: They allow academics to retrospectively understand events by the use of econometric methods, but they do not allow regular investors to form a quantifiable opinion on future events that may influence their actual wealth. Although, my small research on state-of-the-art developments on this topic implies the same results as my valuation-blog post from 01.12.2019: Even though the real-life application of many academic papers seems too complex, we should still learn from research and integrate major findings in our daily investment strategies. Looking at the present case of this blog again, acquirer performances of recent deals within the last 20 years or company characteristics like the availability of in-house M&A development teams are publicly available and it should be a matter of course for every shareholder to be in knowledge of such information when it comes to the question of investing or an approval of a possible future merger. 

Bibliography

Fischer, M. (2017). The source of financing in mergers and acquisitions. The Quarterly Review of Economics and Finance, 65, 227-239.

Golubov , A., Yawson, A., & Zhang, H. (2015). Extraordinary acquirers. Journal of Financial Economics, 116(2), 314-330.

Jensen, M. C., & Ruback, R. S. (1983). The market for corporate control: The scientific evidence. Journal of Financial economics, 11(1-4), 5-50.

The Greatest Money Maker: A critical exploration of his investment philosophy

“You look at Berkshire and you think of things like the furniture company or Dairy Queen, but when you look at where the massive profits and the cash generation is coming from, it’s really from the insurance business, it’s really from derivatives, it’s really from the investments that he is making on Wall Street […] there is a divide between what you see on one side, which looks very simple, and what’s actually happening behind the curtain” (Sorkin, 2009, 00:52:20).

Since its founding in 1955, there have been enough books, newspaper articles or blogs written about Berkshire Hathaway and its founder Warren Buffett, to keep a person busy for the rest of his life reading. Therefore, it seems unnecessary to summarize Buffett’s way of becoming the most popular investor of all time. Rather, I want to directly start analysing excerpts of what the 2009 published documentary titled “The World’s Greatest Money Maker: Evan Davis meets Warren Buffett” identified as Berkshire Hathaway’s investment principles and discuss them by taking into consideration academic research.

1. "Invest, don't speculate"

In the investment manager’s opinion, a clear distinction between speculating and investing in financial markets can be drawn. While the former describes simplified the act of “betting” on prices going up or down, the latter expresses the way of looking at the underlying asset itself and its future return. However, research suggests that there is a difference between the commonly shared definition of investing and speculating but it is a blurred line as speculation is neither defined in terms of time frame, risk level and expected return, nor in terms economic utility (Arthur, Williams & Delfabbro, 2016). Furthermore, it would be simply false to think of fundamentally analysed investments as purely rational decision with determined outcomes and even Benjamin Graham, Buffett’s mentor and source of wisdom, wrote: “some speculation is necessary and unavoidable, for in many common-stock situations, there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone." (Graham, 2009, Chapter 1).

2. "You don't have to diversify"

Figure 1. Berkshire Hathaway's public holdings. Reprinted from
Yahoo Finance, https://finance.yahoo.com/

I want to remind again that this list of investment principles was created by the producers of the BBC documentary and the reason this fact is worth being highlighted again is simple: It is truly questionable if Warren Buffett would ever make this statement as it is scientifically proven that diversification has major advantages concerning the elimination of unsystematic risk (Markowitz, 1952; Statman, 1987). Moreover, the latest data of Berkshire’s current portfolio allocation shows that the holding invested in 20 publicly listed companies in addition to their private investments, clearly taking advantage of diversification effects (Yahoo Finance). There is a reason behind the saying that “Diversification is the only free lunch” and it is important to remind oneself that even the possibly greatest of all investors does not do everything different than the regular shareholder.

3. "Don't get into debt"

When it comes to the question of optimal capital structure, there is still disagreement among academics. Classical theories like  Modigliani & Miller (1958) state the irrelevance of capital structure concerning the cost of capital while more recent approaches like Kraus & Litzenberger (1973) manage taking into consideration observable market imperfections like taxes and behavioural aspects in form of asymmetric information to create a model that states an optimal debt to equity level for every individual company. Although the latter approach has drawbacks like, for example, the quantification of debt disadvantages through financial distress and therefore the actual determination of an optimal debt to equity level, it is still the more realistic and applicable approach. Hence, it seems quite ignorant to make such a bold statement like “Don’t get into debt” in the factual presence of tax advantages of debt. For the benefit of the shareholders, there is happening something different behind the curtains of Berkshire Hathaway: Recent research on Buffett's investment strategy revealed average leverage of 1.7 to 1, significantly increasing Berkshire’s investment return (Frazzini, Kabiller, & Pedersen, 2018). In conclusion, the documentary’s findings and the actual reality fall significantly apart again.

After only having criticised the documentary in this blog, I want to highlight that Warren Buffett is in my opinion unquestionably the greatest investment mogul on this planet and his portfolio performance and constant success over decades speak for itself. Therefore, it remains a mystery for me how he can provide investment principles like the “Don’t diversify” one, that surely worked for himself in the past but that are highly dangerous for regular investors who are no financial geniuses. If I am being honest, I have not read any books written by Buffett himself, hence, it is possible that the BBC production team came up with the presented principles on their own. In any case, it is this ubiquitous discrepancy between Buffett’s success and the way he presents himself, what he does and how he does it, that my opening quote and the whole documentary highlight so well: There is happening more behind Berkshire Hathaway’s curtains than outsiders believe and maybe they even have a reason to make people believe it is that easy. The truth is: It is not. 

Bibliography

Arthur, J. N., Williams, R. J., & Delfabbro, P. H. (2016). The conceptual and empirical relationship between gambling, investing, and speculation. Journal of behavioral addictions, 5(4), 580-591.

Frazzini, A., Kabiller, D., & Pedersen, L. H. (2018). Buffett's alpha. Financial Analysts Journal, 74(4), 35-55.

Graham, B. (2009). The Intelligent Investor, Rev. Ed. London: HarperCollins.

Kraus, A., & Litzenberger, R. H. (1973). A state‐preference model of optimal financial leverage. The Journal of Finance, 28(4), 911-922.

Markowitz, H. (1952). Portfolio Selection. The Journal of Finance, 7(1), 77-91.

Miller, C., Crossley-Holland, D. (Producers), & Sorkin, A. R. (Journalist). (2009). The World’s Greatest Money Maker: Evan Davis meets Warren Buffett [Motion Picture]. Retrieved from https://learningonscreen.ac.uk/ 

Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review, 261-297.

Statman, M. (1987). How Many Stocks Make a Diversified Portfolio? The Journal of Financial and Quantitative Analysis, 22(3), 353-363.

The limits of DCF models and the need for alternative valuation methods

Figure 1. WeWork valuations. Reprinted from CNBC,
by A. Sherman, 2019, https://www.cnbc.com/

As the year 2019 is ending soon, it may be worth to take a look back on major events that happened on the international financial markets in the recent past. If I would ask investors what first came to their mind when recapping the incidents, surely many would come up with the WeWork case. In a summary, the telecommunication company SoftBank invested up to $10.65 billion (CNBC) in the loss-making office space renter start-up, leading to excessive value inflation that ended up with a $47 billion valuation in their most recent private funding round (FT). WeWork’s following IPO plans lastly collapsed under the scrutiny of the public markets, revealing the over-valuation and the tremendous misjudgement of financial analysts. But when it comes to incorrect valuations, WeWork’s case was not the only one in 2019. While the fitness equipment producer Peloton failed to convince it’s investors of their $8.2 billion (FT) valuation, trading at almost 15% below their offer price (FT) on the first trading day, the question that investors ask themselves at the latest since the crash of the Dotcom-Bubble, namely if there is any truth in financial valuations, is still a recent one.

Logically, if one doubts the correctness of financial valuations, one must doubt the commonly used valuation techniques which are mainly the discounted cash flow method (DCF) and the multiple analysis approach (Mukherjee, Kiymaz, & Baker, 2004). In the following, I want to shortly discuss uncommon points of critique on DCF models and give an overview of a strategic framework that can even be used by regular investors, in addition to traditional financial valuation.

First of all, when people criticise the use of discounted cash flow methods, they mostly see issues in the assumptions of static discount rates, inappropriate discount rates or the imprecise prediction of future cash flows, but never in the use of free cash flows itself. As there are no “perfect” markets in which companies only invest in positive NPV projects and return excess profit to their shareholders like Modigliani & Miller (1961) state in their residual dividend policy theory, it is questionable if the usage of free cash flow itself is an appropriate measuring unit. For example, 2 comparable companies that both have the same predicted future cash flows and discount rates should have the same valuation, even if one of both only spends its cash on increasing executive salaries and negative NPV projects while the other one is acquiring strategically suitable and highly efficient competitors. Taking this argument into consideration, the Dividend Discount Model would be a way more appropriate method of valuation as Dividends paid back to the shareholders can not be embezzled anymore, could one argue cynically.

Figure 2. Impact of WACC on Terminal Value. Reprinted from Financial Times,
by D. Keohane, 2016, https://www.ft.com/

A second DCF criticism that I want to highlight here is a highly topical one. Only a few years ago, not many people may have imagined that the base interest rate of several economically stable countries could be more or less zero, somehow even negative. This significant macroeconomically shift has a major impact on basic financial models like the capital asset pricing model and therefore also on DCFs. When the risk-free rate is approximately zero, WACC falls due to falling costs of equity. In this case, the anyhow hard to predict terminal value gets accountable for a higher proportion of the total NPV and therefore, a possible misjudgement has a greater impact on the total valuation. This issue is surely a commonly known one, although, investors and analysts should be aware of it as the impact of the terminal value and its faultiness is way greater than one could think.

Referring back to the recently unsuccessful valuations of WeWork and Peloton, it is not a secret that start-up valuations present the most complicated cases in practice. The simple reason for this is the lack of accounting information. Therefore, the state of the art academic research suggests shifting the focus from solely carrying out a financial valuation to taking into consideration modern frameworks of strategy theory. As Miloud, Aspelund & Cabrol (2012) suggest, modern start-up valuation should take place in the context of the structure of its market, stress out the firm’s valuable assets and inputs instead of possible future cash flows and examine the network and external relationships of the company. More precisely, statistically significant factors that correlate positively with the start-up valuation are I] Industry product differentiation, II] Industry growth, III] Founder with industrial experience, IV] Founder with managerial experience, V] Founder with start-up experience, VI] Team of founders, VII] Managerial key positions are filled, VIII] Number of alliance partners. The weak spot of the strategic framework is obvious: It always needs the so often and with justification criticised financial valuation. However, it provides an excellent benchmark for valuation if compared to peers that share general characteristics with your target and recently went public. Lastly, it has the same major benefit as discounted cash flow models: The investors or acquirer has to scrutinize the target as carefully as possible, has to be familiar with the business model and not only with the financials and therefore, he or she gets more and more of a personal feeling if the company may be the next unicorn or if it disappears within the next few years.

Professionals all over the world love the saying that “Valuation is an art, not a science” and, understandably, they repeat it as often as possible as it allows them to justify their mistakes. However, I think the saying is nonsense because art can never be judged as right or wrong while there definitely exists an unambiguous value for each existing company, we just often can’t tell what it is. I do not want to question the difficulty or complexity of business valuation but once again, I want to emphasize the importance of research on daily business as both should learn from each other instead of working in different worlds.

Bibliography
Miller, M. H., & Modigliani , F. (1961). Dividend policy, growth, and the valuation of shares. The Journal of Business, 34(4), 411-433.

Miloud, T., Aspelund, A., & Cabrol, M. (2012). Startup valuation by venture capitalists: an empirical study. Venture Capital, 14(2-3), 151-174.

Mukherjee, T. K., Kiymaz, H., & Baker, H. K. (2004). Merger motives and target valuation: A survey of evidence from CFOs. Journal of Applied Finance, 14(2).

Margin Call: Historic recurrence of financial crises

“It's just money; it's made up. Pieces of paper with pictures on it so we don't have to kill each other just to get something to eat. It's not wrong. And it's certainly no different today than it’s ever been. 1637, 1797, 1819, 37, 57, 84, 1901, 07, 29, 1937, 1974, 1987, […], 92, 97, 2000 and whatever we want to call this. It's all just the same thing over and over; we can't help ourselves. And you and I can't control it or stop it, or even slow it, or even ever-so-slightly alter it.” (Irons, 2011, 01:36:50)

Back in 2011, roughly 4 years after the outbreak of the great recession, director J. C. Chandor and his team released one of the most interesting movies about the financial crisis by taking a different perspective on the crash. Margin Call, as the movie is titled, shows the happenings inside a fictional investment bank during the last 24 hours before the financial collapse. In summary, everything starts with the junior risk management analyst Peter Sullivan (Zachary Quinto) whose financial models show that the firm’s mortgage-backed securities, financial instruments that pool securitized mortgages, were valued incorrectly. He predicts that a 25% depreciation of those products would be enough to force the bank into insolvency whereupon the executive staff meets immediately to discuss how to handle the situation.

This is the point where Margin Call manages to stick out of the list of historical examinations of the 2007 financial crisis: It tries to focus on the personal reasons, thoughts and fears of the people behind the desks instead of analysing technical details like who really could be blamed for the existence of collateralized debt obligations. It is indisputable that many personal mistakes in form of unethical behaviour were made on sides of the bankers in the years before the crash and the list of unscrupulous activities reaches from excessive greed to misleading investors. Although, it is a fact that great parts of the emotionalized public debate on the topic failed to take into consideration that bankers are not part of a vicious sect that plans on how to rob the society’s wealth but just human beings that got the same fears and burdens like everyone else. However, one of the major differences between those 2 groups is the circumstance that senior bankers work in positions where any kind of action can have severe systemic impact on the globalized world and whenever at the same time, regulations fail to keep bad incentives in check, people tend to exploit the system if they have no other motives to not do so.

Therefore, one could argue that the solution is simple: Regulate the financial markets! But taking into consideration the quote at the beginning of this blog, why were people in history not been able to control the markets if regulation was the answer? Proponents of regulation will state that the regulative measures and activities that have been used in the past were not efficient enough, so they call for higher influence and funding of regulative authorities. On the contrary, opponents will highlight the failures of regulative activities in the past and point to idealistic liberal theories of self-regulation due to market efficiency.

Looking at those controversies from a non-institutional shareholder point of view, investors have no other choice than to admit that they just can not know if politicians and regulators can keep our financial ecosystem stable. This is surely not an academical approach at all, but it might make sense on a personal level as regulatory jurisdiction is also often way too complex for regular investors to understand and analyse. However, as soon as they admit that the system we live in is not perfect and vulnerable to crises, shareholders can start taking measures to prepare and protect themselves. Examples would be portfolio diversification in form of buying stocks that historically performed above average in recessions like utility, energy or pharma companies, investments in stocks that pay historically stable and constant dividends or insurances that grant the investor safe income in times of crisis.

Finally, I think that academic research in the field of regulation leads us to efficient markets closer every day. Although, it would be naive to think that we are even close to a “perfect” and infallible market system. Margin Call shows us certain reasons for this fallibility on a human and psychological level and as an investor, I should learn the lessons of this and integrate them into my investment strategy every day.

Bibliography

Barnum, A. O., Benaroya, M., Quinto, Z., Dodson, N., Moosa, C., Jenckes, J. (Producers), Chandor, J. C. (Director), & Irons, J. J. (Performer). (2011). Margin Call [Movie]. United States: Before the Door Pictures. Retrieved from https://learningonscreen.ac.uk/

Share buybacks: The other side of the medal

Figure 1. Buybacks are the new dividend. Reprinted from 
Financial Times, by R. Henderson, 2019, https://www.ft.com

Following the trend of the last 10 years, share buybacks remain on track to be the highest ever as companies are spending an incredible amount of over $200 billion per quarter on the corporate pay-out programs in 2019 (FT). Even though the massive payments appear to be a sign of a prosperous economy, at first sight, there seems to be another side of the medal. On 30^th July, CNN Business publishes an article called “Stock buybacks are reaching dangerous levels”, on 10^th September 2019, the Forbes magazine titles: “The Stock Buyback Disaster (And 3 Exceptions)”. This list of articles could be continued way further, and Investors ask themselves why certain academics and experts are so concerned about share repurchases which were always believed to be a positive market signal.

In order to evaluate and understand the recent media coverage, investors must understand the basics of stock buybacks. Companies have 3 ways to deal with earning profits namely reinvesting them into the firm in the form of buying new assets or paying higher wages, paying dividends to shareholders or lastly, buying shares back. Latter implies that the bought back stocks are taken from the market, decreasing the outstanding number of shares and therefore increasing the Earnings per Share as the denominator falls while the numerator stays constant. Further benefits are the already mentioned signalling because markets interpret the repurchases as believes of undervaluation, as well as observable short-term share price appreciations due to supply shocks.

In 2014, William Lazonick publishes a controversial paper stating that not tendered share buybacks are one of the major reasons why the cumulative change in per hour productivity rose significantly faster than the cumulative annual change in real per hour wages since the 1970s. The economist provides several points of critique on share buybacks which I will discuss in the following.

Figure 2. Where did the money from productivity increases go? Reprinted
from "Profits without Prosperity" by W. Lazonick, 2014, Harvard Business
Review, 92(9),  46-55

Firstly, the academic highlights that stock repurchases are positively correlated with stock prices (See Figure 2) when looking at historical data. Therefore, executives do not buy shares when they are undervalued because this would imply that buybacks are the highest in recessions. This argument doubts one common justification of buybacks but as long as markets interpret them factually as positive signals and companies are not forced to offer low price stocks in recession, the implications of this data proven refutation are not apparent to me.

Secondly, the article emphasizes that repurchases do not have any tax advantages in the US. Due to the Bush tax cuts in 2003, so-called “Qualified Dividends”, which are dividends paid by a US corporation if the stocks are owned longer than 60 days (90 for preferred stocks), are taxed at the capital gains tax rate. Therefore, one of the main arguments of buyback proponents is completely invalid and even a major conclusion of Grullon’s & Michaely’s (2002) paper, namely that taxes do matter when comparing dividends with repurchases, must be reconsidered. Surely, one could argue that the concept of qualified dividends is not universally applicable as it only exists in certain countries (for example in Germany where dividends are taxed at the same rate as capital gains), nevertheless, it has to be considered as economies like those two have a significant impact on global markets. Taking this knowledge into consideration, I further ask myself why companies are not taking advantage of the tax implications of qualified dividends as they create a strong incentive to hold the shares for a longer period.

Lastly, Lazonick gives an alternative explanation for the excessive amounts of buybacks in recent years: The fact that most of the modern-day CEOs receive a significant amount of their salary in the form of stock-based pay. Simplified, this means that they receive higher bonuses if the company succeeds to reach the threshold of certain ratios like Earning per Share. As we know that share repurchases artificially increase EPS through the decrease of the outstanding shares, this method would help the executives to reach their required targets and increase their salary without having any impact on the financial stability of their companies. The data supports his theory as the CEOs of the 10 largest repurchasers between 2003 and 2012 received an average of $168 million each in compensation during the same period while stock-based payments accounted for over 50% of those salaries. Interestingly, only 3 of those 10 companies have outperformed the S&P 500 during this period. Basically, Lazonick severely accuses all executives who participated in the enormous buyback programs of the last years of corruption if they intentionally put their own monetary interest before the company’s and shareholder’s one. This whole line of reasoning may present the strongest argument for dividends over repurchases as both may be substitutable in forms of pay-outs to the shareholders, but the latter creates strong incentives for excessive underinvestment as managers may favour short-term salary appreciations over long-term corporate growth.

In summary, there are several points provided that strongly question the amounts of share buybacks during the last decades. By his taxation argument, the economist scrutinizes the often-stated advantage of buybacks over dividends, but he is never directly criticising the usage of buybacks over dividends, rather the massive underinvestment of firms in their assets. Although, his claims indirectly state an advantage of dividends over buybacks in terms of preventing underinvestment as the latter create undesirable incentives.

Having discussed several aspects of modern shareholder pay-out policy, I now realise once again how easy it is to form and take over commonly shared opinions without questioning them. Especially when your university provides you papers and PowerPoint slides with accepted theories, I tend to forget that there are still many prestigious academics who share a completely different point of view on the same controversial topic. Although I am not overwhelmed by Lazonick’s paper as he only criticises share repurchases but does not give any data or evidence on the effect of dividends on underinvestment in pre-buy back times and how it got worse or not, it is still a recommendable paper more than worth a read for every finance interested student, academic or investor.

Bibliography

Grullon, G., & Michaely, R. (2002). Dividends, Share Repurchases, and the Substitution Hypothesis. The Journal of Finance, 57(4), 1649-1684.

Lazonick, W. (2014). Profits without Prosperity. Harvard Business Review, 92(9), 46-55.

Leveraged buyouts and the effect of capital structure on the shareholder value

Only 5 days ago, on 5^th November 2019, the Financial Times reported about meetings between the $55 billion market valued global drugstore Walgreen Boots Alliance and several private equity groups. According to the magazine, both parties evaluate a possible $70 billion leveraged buyout (LBO), constituting the largest take-private deal ever in history. Immediately after Bloomberg’s and Reuters’ media coverage of the rumours, Walgreen’s share price rose 4 percent on the New York Stock Exchange implying that investors would support the potential takeover strongly.

Figure 1. Walgreen Boots Alliance's share price development.
Reprinted from Yahoo Finance, https://finance.yahoo.com/

How is this instant value appreciation explainable in the context that Walgreen’s share price fell almost 25 percent (Bloomberg) since last year? And even more striking, why do markets have no concerns about bankruptcy due to the arising debt obligations when modern capital structure theories suggest the disadvantages of such capital restructuring?

Before going deeper into detail, I want to shortly summarize and explain the basics of Private Equity (PE) firms and their way of investing and operating. Generally, PE companies can be viewed as the fund managers, so-called General Partners, of private equity funds which are financed by institutional investors and high net-worth individuals, the so-called Limited Partners. The main goal of the private equity managers is to acquire controlling positions by engaging in buyouts of publicly listed companies in order to take on operational roles in the firms and maximize their value. By listing, merging or selling the restructured companies afterwards, the fund managers and their limited partners receive their return if they were successful. Going deeper into detail, one way to achieve the aim of delisting the public equity of the targets are the already mentioned leveraged buyouts. LBO’s are highly geared company acquisitions characterized by the fact that the raised debt is not backed by the PE firm but only by the target’s future cash flows. The purpose of this way of structured financing is the high return on equity that can be achieved according to our understanding of the capital structure and the impact of high debt on the equity cost of capital.

With that kind of knowledge, we can partly explain the share appreciation of Walgreen. Firstly, the rumours about the buyout directly imply that the target should be currently undervalued, that it can be restructured to be more profitable in the long-term and that it should be financially stable enough in terms of future free cash flow to repay all occurring debt obligations. Furthermore, there is strong academic evidence for the positive impact of leveraged buyouts on shareholder value and future financial performance. Exemplars in favour of this kind of view are Bull (1989), giving proof for superior post-buyout performance in comparison to pre-buyout performance and Torabzadeh & Bertin (1987), stating that companies acquired in LBO’s from 1982 to 1985 made statistically significant economic gains posterior the corporate restructuring. We see that PE firms are taking advantage of the implications of capital structure theory by buying strategically suitable targets in combination with the increased return on equity in order to increase shareholder value.

Although all the mentioned benefits, there is also justifiable criticism when it comes to highly indebted company acquisitions, especially such oversized mega deals like the Walgreen one. Concerning the biggest risk namely the rising probability of bankruptcy due to the high gearing, we should look at the current largest LBO ever. In 2007, a syndicate of 3 PE firms took control over the Texan power company TXU corp. for $31.8 billion (Reuters) at a point of depressed valuation with the expectation of rising of gas prices. 7 years later in 2014, TXU declared insolvency, collapsing under the obligations of more than $40 billion (Bloomberg) in debt. This is exemplary demonstrating the risk that comes along with higher return on equity demands and is in accordance with modern capital structure trade-off theory that suggests not to lever up to such excessive levels (Kraus & Litzenberger, 1973).

In conclusion, it might seem like investors are too enthusiastically focused on the upsides of the potential takeover. Since the pharma giant is going through tough times as newly digital businesses in the healthcare sector like online prescription companies are flooding the market, the shareholders might have desperately waited for a managerial turnover without critically questioning the full background of the deal. Furthermore, subjective criticism could also be the arguable managerial abilities of a few non-specialist private equity bankers to fix Walgreen’s weakened business model.

Having discussed the possible takeover, I realized how present and important modern financial capital structure theories are in daily business. One the one hand, the theories can be used to elucidate the cornerstone of investment strategies like leveraged buyouts, on the other hand, models like the trade-off theory are furthermore able to give explanations for the limitations and risks that come along with certain capital structures (Kraus & Litzenberger, 1973).

Bibliography

Bull, I. (1989). Financial Performance of Leveraged Buyouts: An Empirical Analysis. Journal of Business Venturing, 4(4), 263-279.

Fontanella-Khan, J., Vandevelde, M., Kuchler, H., & Massoudi, A. (2019). Walgreens Boots Alliance Explores $70bn Buyout. Financial Times. Retrieved from https://www.ft.com/

Kraus, A., & Litzenberger, R. H. (1973). A state‐preference model of optimal financial leverage. The Journal of Finance, 28(4), 911-922.

Torabzadeh, K. M., & Bertin, W. J. (1987). Leveraged Buyouts and Shareholder Returns. The Journal of Financial Research, 10(4), 313-319.

The story of LTCM: Can we blame financial models for market crashes?

“If you are out to describe the truth, leave elegance to the tailor.” – Albert Einstein

Since hundreds of years, academics in the field of the philosophy of science among the globe discuss on the trade-off between simplicity and detailedness of theoretical models and mathematical equations. Theories on this question date back to middle ages like the famous law of parsimony, also called Occam’s razor, stating that the most obvious and simplest solution is mostly the correct one and therefore, theoretical models should be kept as straightforward as possible. On the other hand, many scientists, like Einstein in my entrance quote, oppose this kind of view and are convinced that the truth is way too complex and therefore mostly not possible to be described in efficient and simple formulas (Ironically this is coming from the man who delivered the mathematical proof for “e=mc²”, maybe the most known and elegant equation in the world).

Especially relating to modern financial theory, commonly used and accepted models among academics and professionals like the capital asset pricing model (CAPM) that build the cornerstone of finance as an econometric exercise (Dempsey, 2013) are under severe critique of being oversimplified and not applicable at all. Arguments that underpin this critique highlight false CAPM assumptions like observable market inefficiencies.  Besides CAPM, one of the most popular but also heavily criticised and furthermore Nobel Prize winning financial theories is known as the Black-Scholes Model (BS). Published in 1973 by Fischer Black, Myron Scholes and Robert Merton, the three economists claimed to have found a way to value option prices correctly and therefore creating the possibility to eliminate risk completely by using dynamical hedging strategies. Nonetheless, also Black and Scholes elegant equation was constrained by several key assumptions creating the same trade-off problem between parsimony and detailedness.

I asked myself several times during my studies of quantitative finance and economics: Are there any real-life consequences of the application of models with insufficient assumptions? Or is it enough that the people and the markets unitary believe in them, creating self-fulfilling prophecies. One case in history might indicate where the boundaries of financial modelling are and how these insufficiencies could affect everyone, being way worse than CAPM and poorly calculated benchmarks for managers or inappropriate discount factors (Dempsey, 2013).

The instance refers to the already mentioned Myron Scholes and Robert Merton. In 1994, years after their publication of the Black-Scholes Model, the 2 academics and a Hedge Fund manager named John Meriwether decided to operate on the global markets on their own and founded Long-Term Capital Management (LTCM). Within a few months, the team raised 3 billion dollars (Barbu, 1999) as investors were almost proud to give their money to 3 of the most popular luminaries in finance. The fund managers invested mainly in options in the field of Fixed-Income Arbitrage by applying the same dynamical hedging approach they used in their model.  In the following 3 years, LTCM generated an exorbitant return after costs between 30% and 40% per year (Barbu, 1999) and it seemed like the impossible had happened namely that science had cracked the code of the financial markets by using mathematics.  

Figure 1. $1000 investment in LTCM . Reprinted from
Wikipedia, by R. Lowenstein, 2000, https://en.wikipedia.org/

Although, it came different as the Russian financial crisis of 1998 hit the global markets completely unexpected. Investors all over the world reallocated their capital in the safest way possible, mainly in securities like US Treasury Bills. The consequences were an increase in the spread between interest rate swap derivatives and their underlying Treasury Bonds – the exact opposite way to LTCM’s investments. The hedge fund began to lose hundreds of millions every day till their liabilities reached an unimaginable amount of $1.25 (Barbu, 1999) trillion causing the possibility of a collapse of the global financial markets.

Lastly, the markets did not crash as the USA organised the biggest bail out of history prior to the 2007 financial crisis, nonetheless, the story of LTCM raised many questions concerning the reasons how one single company could create a systemic risk of this scale and what role the financial models like Black-Scholes played in this context.

A main implication of the simplicity of models like BS and CAPM is the common usage among finance professionals. One could say that this is a good thing because not applicable models are worthless in real life. On the other hand, models that are followed by everyone and finally turn out to be wrong lead to much greater downturns as everyone is betting on the wrong horse. The major problem that occurs when people criticise the utilisation of financial and econometrical models is in my opinion the lack of alternatives. I doubt if it would be truly socially desirable if we could force traders to stop listening to academics and let them invest only because of their gut feelings and instincts. Moreover, the dystopian idea of stopping academics research in order to prevent investors from using their ideas would be even worse, leading to a complete standstill of human and social development. Whereas what we need instead of thoughtless criticism of mathematics is the efficient regulation of markets through legislation to prevent excessive risk-taking, illegal exploitation of asymmetric information distributions and all the other cases where markets fail to regulate on their own.

Having analysed the downfall of Long-Term Capital Management, a company that could not even be managed by 2 of the greatest minds in modern economics, makes me even look more critical on financial theories like CAPM and their assumptions. Professors all over the world teach about the models’ limitations, but the excessive usage of them makes the students, me included, often forget about the obvious imperfections. Although, I am in the opinion that academic models are an important cornerstone for modern investment management, as long as they are not applied thoughtless and get steadily falsified and improved as academics gain more and more knowledge every day.

Bibliography

Barbu, G. (Director). (1999). Horizon – The Midas Formula [Motion Picture]. United Kindom: BBC. Retrieved from https://learningonscreen.ac.uk/

Dempsey, M. (2013). The Capital Asset Pricing Model (CAPM): The History of a Failed Revolutionary Idea in Finance? Abacus, 49, 7-23. Retrieved from https://onlinelibrary.wiley.com