How Bailout courses of action should affect your business model This article from the 2001 Nobel laureate in economics is a concise and cogent description of the courses of action re: the bailout.

We're pleased to see that someone is talking about the need for quality due diligence and the potential risks of shoddy or slight investigations into value. We have pushed this message with our M&A acquiror and PE investor clients. They understand pretty readily once the costs are discussed.

Where we still find the most disbelief or unwillingness to accept the facts that diligence leads to estimates of value that support transactions that actually get executed is on the target/portfolio company side of things. Founders and CEOs find it difficult to explain how they will actually achieve the numbers in their projections; we often find that the fundamental business model is unexamined. By business model, we mean not the spreadsheet itself but the concept of the business, in terms of how efficiently a company uses its invested capital to produce revenue, how well it controls product costs as it converts revenue to gross income, how it controls operating expenses as it achieves EBITDA numbers, how it organizes its capital structure as reflected in EBT, and how it manages tax issues as reflected by Net Income, and finally how it balances reinvestment in the business and invested capital as we turn to a pure free cash flow (FCF) number.

We are building new tools and offerings to help companies at the board and senior management level think about their business model in the level of detail required to understand the implications of investor expectations. We focus on simplifying complexity to help direct management attention to the right links in the FCF value chain.

As we start presenting our ideas to the market, we'll announce more here.

Labels: due diligence, expectations, governance, performance

Monday, October 06, 2008 :: posted by Rick Colosimo @ 10:54 AM

Some recent board issues We thought we'd get two short posts out together rather than torture them into longer posts.

Chairman/CEO split. A Breakingviews.com piece published in the WSJ’s May 10-11 Weekend Edition described Wachovia’s recent split of the Chairman and CEO roles. Appparently, they decry the notion that it’s being framed as a punishment of sorts for the CEO Ken Thompson (who is apparently on his way out as of today in any case) and suggest that “the separation makes sense in both good times and bad.” They note that Thompson said that he would "now" be freed up to spend 100% of his time on running the company. It’s unclear to us what would constitute the Chairman’s drain on his time separate from his duties as a director. WaMu just made the same move today, "stripping" the CEO of his chairman title.

In the interest of stirring things up, we did a quick search in some relevant portions of the DGCL (Delaware General Corporation Law) for “Chairman”: it’s conspicuously absent. While the split of these two titles may make sense from an optics perspective, we are neither in favor nor opposed to the concept, and we’re not sure whether the arguments about splitting militate in favor of or against the issues that we see.

People seem to believe that the chairman has special powers. And it’s true, a company’s bylaws may grant some power to a person holding that title. As an example, Dow’s bylaws identify the Chairman of the Board as presiding over meetings of the stockholders. While that may be important, those same bylaws all any vice-president to also serve, which is probably a much larger group.

We think that the chairman issue is a red herring; to state that CEOs have too much power because of the dual titles is to necessarily imply that the other directors are either weak, disinterested, or incompetent. Directors have independent fiduciary obligations. There is no “but the Chairman said” defense, no “I was only following orders” excuse for breaching fiduciary duties. If the board as a whole isn’t operating the way a specific director believes is required, not merely advisable, then the hard right is required over the easy wrong. The director can basically either raise the issue formally, noting disagreement and asking for a resolution at least in terms of additional advice on the issue, whether from outside counsel or even independent counsel for the board or resign. Being a director shouldn’t consign one to a Pyrrhic victory; but we do believe that the withdrawal should be We don’t believe that any thing that confuses directors or shareholders about the responsibility and powers of the board is a good thing.

Say on Pay: We have a similar feeling about say on pay. Getting shareholder input on pay may be useful to the board, as long as the board is cognizant of external factors where a shareholder may have different interests than the board (e.g., union pension funds holding shares, ESOPs, or hedged investors) and that shareholders do not have fiduciary duties generally. However, we oppose the say on pay structure if the board uses it as a reverse rubber stamp to avoid actually engaging in its required analysis of the issues: if shareholders approve a pay structure, that should be almost meaningless to the board technically since it does not mean that the structure is in fact fair or wise, and the board's higher standard of care should not allow them to even use the "approval" as a defense to later complaints or claims.

While it seems at first like a good idea to let shareholders give feedback to the board on compensation (or any other issue), it shouldn’t water down either the board’s efforts or its responsibility. Directors get paid to serve the interests of the shareholders, including developing, implementing, and supervising executive compensation plans.Clouding the issue doesn't help anyone remember whose job is what.

Labels: governance

Monday, June 02, 2008 :: posted by Rick Colosimo @ 2:40 PM

Yahoo board takes fire A few pieces are detailing Carl Icahn's foray into Yahoo and his decision to take up the proxy fight Microsoft appears to have abandoned. This Dealbook article gets my vote today because of this quote from Icahn:

It is unconscionable that you have not allowed your shareholders to choose to accept an offer that represented a 72 percent premium over Yahoo’s closing price of $19.18 on the day before the initial Microsoft offer.

Regular readers will remember that we raised this exact issue recently; the premium was so high that we think it likely that Yahoo's board could not have avoided presenting the opportunity to shareholders, even if it recommended against acceptance. It would have been perfectly acceptable for the board to negotiate a transaction that provided for no breakup fee, a strong fiduciary out, and even limited Microsoft's due diligence before signing up the deal to reduce Yahoo expenses. All of those make sense in terms of protecting Yahoo's value without reducing freedoms or eliminating opportunities for shareholders. Not wanting the company to be acquired or or not wanting to work for Microsoft is woefully insufficient justification for the actions of the board and management. It's not their company; it's the shareholders'.

Labels: deals, governance

Thursday, May 15, 2008 :: posted by Rick Colosimo @ 12:26 PM

Insider deal = Bad, Outsider deal = Okay? The linked Forbes article sets forth an interesting analysis on some factors that might impact the pricing of a Microsoft-Yahoo deal. The basic premise is that since many shareholders of one company are [likely] shareholders of the other, these cross-holdings necessarily lead to an optimization analysis. If MSFT shares fall as a result of an increased deal price and YHOO shares rise, then the return to any shareholder is

((YHOOt2-YHOOt1)*YHOOshares) - ((MSFTt1-MSFTt2)*MSFTshares)

[NB: reformatted equation for clarity.] The next complicating issue is the expectation many of these crossholders will be more exposed to MSFT at least in part due to market cap-weighting in index funds and sector funds. The equation and the assumptions seem to indicate that the bid for Yahoo! is unlikely to rise very much.

If detailed shareholder records were available, then the companies, and the market, could analyze the numbers and make an educated guess about what the outcome was likely to be. However, the number of shares held in street name is huge, and brokers often have difficulty identifying individual holder in an expedient fashion. Couple that with mutual funds, pension funds, and endowments holding vast numbers of shares through multiple entities, and the problem now seems unsolvable but not completely unknowable:

When Hilal ran the numbers, he found that 18 of Yahoo!'s top 25 shareholders own more shares of Microsoft than they do of Yahoo!. This is a powerful block. They own 42% of Yahoo! shares. And, on average, Hilal found members of this group owned 4.4 shares of Microsoft for every 1 of Yahoo! "There clearly are some shareholders that are a bit conflicted," Hilal says.

And there are a few wrinkles left to be explored:

First, we often worry about deals involving insiders because we are unsure whether they are paying a fair price when they are purchasing a company or whether they are exacting extra benefits for themselves. Here, the outsiders, the shareholders, are explicitly and rationally motivated by personal benefit and there is little to counterbalance the threat to non-cross holding shareholders.

Second, the respective boards of the two companies have independent fiduciary duties to their respective shareholders, individually and as a class. How might this play out? YHOO has an obligation to increase the returns of all its shareholders, not just those who are also MSFT holders. If the board believes the price is too low, they have an obligation to recommend against the deal, even if they allow shareholders to vote on the transaction. (As an aside, this is our preferred course of action for strategic transactions -- allowing shareholders to vote their shares as they see fit, assuming the board has adequately investigated a proposed transaction and advised shareholders accordingly, is not shirking the board's duty or allowing the tail to wag the dog. We think differently on say-on-pay, which we'll try to address in a separate post.) The result is similar to a tender offer, where the board makes a recommendation and individual holders are free to choose to accept or reject.

In general, states do not impose similar fiduciary duties on shareholders. In fact, the idea that shareholders can be at cross-purposes in a transaction makes for good reading. (We've got to find a WSJ article, maybe six months old, that described how two hedge funds were fighting over a transaction because one was short the buyer and another long a second acquirer. The true equity hedges and empty voting scenarios were very well explained in the context of an actual deal.) [NB: this post by Larry Ribstein at Ideoblog references the Mylan-King imbroglio in the context of examining empty voting.]

California, it should be noted, is one state where majority and even controlling shareholders can have fiduciary duties imposed on them to the benefit of minority shareholders. While these cases typically revolve around oppression of minority shareholders in closely held small business situations, there is no inherent reason why they may not be expanded to include a "group" of cross-holders working "together" to force a lower bid than might otherwise be presented.

Third, should greater disclosure of private holdings be required? Is it possible that the circumstances that led to holding shares in street name are no longer extant? If one can buy 1000 shares of MSFT in a few minutes online, shouldn't it be equally possible to track those transactions at the end of the day and disclose them to the companies, the exchanges, or the public? The brokers must have this information already since they know who to collect from and who to pay. Certainly it would make sense to track only closing positions, or even just changes as of the close to allow current holdings to remain undisclosed to eliminate any reporting burden. We do not have an opinion on this issue yet; it would require some substantial amount of further study since there are a number of competing interests. What would be most illuminating is figuring out how much of this information is already publicly available and how much is semi-public, meaning available to market participants who are able to employ that information in their trading without violating securities laws.


Finally, we must say that we are continually surprised at the lengths to which management and boards will go to make it harder for shareholders to sell their shares. Poison pills, retention agreements, and option vesting acceleration clauses are tools that serve primarily to keep existing management and boards in place or transfer benefits to non-shareholders rather than provide additional benefits to shareholders. By making an acquisition more expensive, does anyone actually think that a buyer won't adjust the price to compensate? If shareholders have the right to vote their shares, and the SEC's disclosure requirements are followed, what is the harm that these *fiduciaries* are trying to prevent? Shareholders can sell their shares today or tomorrow at any price they wish; why would boards suddenly intervene to restrict that right, particularly at a price that is likely to be far higher than the pre-deal price? In the MSFT-YHOO deal, Microsoft has offered a large premium to Yahoo! shareholders. Yahoo! management seems to think that shareholders should wait several years for management's plans to come to fruition to reap the premium. That's fine, and we fully support their right, and indeed duty, to make cogent good-faith recommendations. But refusing to allow shareholders to make their own ownership decisions pushes past the boundaries of authority that boards and management should exercise.

Labels: governance, hedge, inside information, merger arbitrage

Tuesday, April 08, 2008 :: posted by Rick Colosimo @ 4:09 PM