Monday, April 29, 2013

A Closer Look as Quintiles Makes Final Preparations to Go Public

A Closer Look as Quintiles Makes Final Preparations to Go Public

Within the next two weeks Quintiles should be a public company again. I’ve already written about this company a couple of times.  In my first installment (“Quintiles Files to Go Public:  The Details Matter” [February 20, 2013]), we learned about the many relationships between the company’s founder, Dr. Dennis Gillings, and Quintiles by examining the first iteration of the prospectus.  A few more details were added in a subsequent draft of the prospectus (“Quintiles Update:  Company Will Pay a $25 Million Termination Fee” [April 3, 2012]).  Now the company has filled in a few more tidbits in the latest draft as it drums up interest among stock investors for this offering.
Addressing the Consequences (1996)
Before we delve into the details, I want to make it clear that I don’t think anything I’ve written will matter much to money managers considering a position in the company.  A significant number of the new owners are going to be traders and speculators.  Some investors (they aren’t really investors at all) will own the stock for mere hours as they bet on the strength of Quintiles’ stock on the first day of trading.   Others will be betting on next quarter’s earnings or the size of the next big contract.  Most new investors won’t care about the minutiae unless something goes wrong.  If Quintiles were to fail to deliver the requisite profits and resulting stock appreciation, then the traders and speculators might go back and peruse the details and call their lawyers. Perhaps there are few long-term investors for whom the particulars matter.

In this installment of the prospectus, we learn that the existing investors are selling $225 million worth of stock (or $338 million if the IPO goes well and the underwriters exercise the option to purchase more shares).[1]  This means that existing owners will have pretty much recovered their investment in Quintiles.  Anything they receive from subsequent sales of the stock will largely be profit.   In addition to his share of the $25 million termination fee on the management contract, Dr. Gillings will be selling $54 million in stock.

By the way, Quintiles isn’t going to be getting much money from the IPO.  For one brief moment, the company will receive $490 million in proceeds.  However, $375 million will immediately be used to repay a $300 million loan made in February 2012, a $50 million piece of another loan, and $25 million for the aforementioned termination fee.  

Meanwhile in 2012, the company paid out dividends of $567.9 million to the existing investors after borrowing $481 million.  Apparently, the board of directors pitied the management team because they held stock options, which were not entitled to the dividends. They were paid a special bonus of $11.7 million in lieu of the dividend payouts. 
In summary, almost all the proceeds of this IPO are either directly or indirectly going to Dr. Gillings and the private equity investors. Moreover, a handful of investment banks are earning chunky fees on the short-term loan issued in 2012 ($6 million) and the IPO (an estimated $50 million in discounts and commissions, plus $6.4 million in legal and accounting fees).

Before adding some details on Dr. Gillings financial arrangements with the company, the revised prospectus reminds us that his employment contract was negotiated at “arms length” with the private equity sponsors.  I’m not sure the private equity investors truly represent the interests of the new investors.  As a result, the employment contract may be in the best interest of Bain, TPG and, 3i, but not the public investors. 

We’re also told that the cash bonuses, stock options and $6-$8 million in potential severance payments are seen as necessary in retaining Dr. Gilling’s services.  I would have thought that Dr. Gilling’s 26 million-share position, worth just under $1 billion, would be plenty of incentive for him to continue to serve the company.  It’s hard to understand why he needs to be treated as a highly compensated executive and a major owner.

There are two more items to mention, although they pale in comparison to the figures I’ve been bandying about.  First, Dr. Gillings will be taking a $200,000 pay cut down to $800,000 in base compensation.  You might recall from my previous post, that he’s no longer CEO.  His cash bonus will be limited to 100% of the base.

Second, Dr. Gillings will be receiving another $1.5 million in exchange for agreeing not to seek more than $2.5 million in reimbursement for the business use of his jet.  In other words, if he flies more than 185 hours for business purposes, he’ll absorb the additional expense.  I haven’t seen this type of arrangement before.  The prospectus seeks to assure us that the $1.5 million isn’t coming from proceeds from the IPO.  What difference does that make?  Whether Dr. Gillings gets paid from existing cash or IPO proceeds, it’s money going out the door for a strange reason.

There’s no question, Quintiles is a powerhouse in biopharmaceutical development services and commercial outsourcing services.  It may turn out to be a good investment for its new shareholders.  However, it is carrying a lot of excess baggage that appears to serve the interests of the founder, his family and the private equity sponsors.

[1] I’m using a $38 per share price, which is the estimated midrange for the offering.

Sunday, April 28, 2013

Mass PRIM Does The Right Thing: Salary Increase for Pension Staff

Mass PRIM Does The Right Thing:  Salary Increase for Pension Staff

Kudos to the Massachusetts PRIM Board for authorizing compensation increases for the staff.  Pension & Investment reports that it obtained the letter authorizing a series of increases[1].   In order to operate a public pension plan, especially in a highly competitive market like Boston, you must provide a reasonable level of base and incentive compensation. PRIM is asking its staff to recommend managers earnings millions of dollars of compensation for managing small slices of the pension plan. You would think that Massachusetts State Treasurer Grossman would want to attract and retain competent investment professionals.  I guess not.  He voted against the increases.

In December 2003, P&I graciously offered me the opportunity to explain why I resigned as CIO for the North Carolina Retirement System ("Why I Quit -- We fought the Legislature for more resources — and lost"). I was lucky enough to have our former State Treasurer, Richard Moore as my advocate, but it wasn't enough at the time.  It took hard work and advocacy by both Treasurer Moore and his successor, Janet Cowell, to finally make progress in subsequent years.  While public plans should not replicate the compensation packages found in the private sector, they have to provide enough compensation to bring professional management to their investment assets.

It’s unfortunate that compensation issues remain contentious a decade later.  Meanwhile, money managers continue to get fabulously rich off these plans. It is cheap political theatre for public officials to rail against reasonable compensation for professional staff.    Moreover, it saddens me that P&I still thinks that salary increases are newsworthy. 


Friday, April 26, 2013

Rhode Island is Following South Carolina into Alternative Investment Abyss

Rhode Island is Following South Carolina into Alternative Investment Abyss

Alternative investment managers are continuing to exploit the last great marketing opportunity: public pension plans.[1]   Sadly, Rhode Island has fallen into this trap, and State Treasurer Gina Raimando is vigorously fending off critics.   Edward Siedle, the founder of Benchmark and a contributor to Forbes, has done an excellent job of pointing out the expenses and pitfalls of Rhode Island’s foray into alternatives.[2]  Rather than restating his analysis, I recommend reading his posts for a thorough critique.   Predictably, Treasurer Raimando is attacking Mr. Siedle.  She’d do her pension plan a lot of good by answering his questions.  She might begin to understand that alternatives aren’t the answer to the pension’s woes.  The only clear winners are going to be the money managers.  Treasurer Raimando was, before she was elected to office, the founder of a venture capital firm.
Selling a Discard (1999)
You only have to go to South Carolina to see how this story will end.  South Carolina plowed their pension into alternatives, driving up their fees without improving performance or risk. In South Carolina, a new Treasurer, Curtis Loftis, challenged their Investment Commission’s decisions.  For his efforts, Treasurer Loftis has faced a withering attack from the SC Investment Commission.  Sadly, a future Treasurer in Rhode Island will probably wind up waging the same uphill battle.  Rhode Island could have saved a lot of money by spending just a little time perusing South Carolina’s annual report and the public reports about their foray into alternatives.

Alternative investments can play a positive role in an investment portfolio.  However, when they are applied at a large scale as they are being applied in Rhode Island, South Carolina, and elsewhere, any benefit disappears.  As I mentioned last week (“Lessons from CALPERs: Taking the Long View [April 17, 2012]”), CALPERs is reconsidering its commitment to hedge funds and the size of its exposure to private equity.  Rhode Island is going to find out what CALPERs has learned from long experience; its pension plan will simply be left with a big bill. 

As a reminder, the management fee, which has stirred up debate in Rhode Island, is only a fraction of the cost.  In addition to paying 1.5% to 2% in management fees, the Rhode Island pension plan faces hidden costs (quietly deducted from their investment) in the form of trading costs, carried interest, and various fund expenses.  When it’s all said and done, 35% to 40% of any gains will go to the money managers and Wall Street.  You can guess who loses.

There’s an enormous irony in this saga.  The very alternative managers who are winning assignments with public pension plans are, at the same time, attacking them.  While they are happy to manage a nice chunk of a pension plan and earn a healthy fee, they are attacking defined benefit plans, advocating for defined contribution plans, and otherwise railing against government employees.  Rhode Islanders, and particularly their civil servants, would be well advised to keep a watchful eye on their Treasurer and her relationships with money managers.


Thursday, April 25, 2013

April Drawings

Picking Your Battles: Investors Seek Rule to Require Campaign Disclosure

Picking Your Battles: Investors Seek Rule to Require Campaign Disclosure

A group of investors has petitioned the SEC to issue rules to require public companies to disclose their political contributions to tax-exempt groups and trade associations.[1]  The petition has stirred up a blizzard of favorable comments from public employee and union pension plans as well as individual investors.  Businesses and major lobbying groups, such as the US Chamber of Commerce, are bombarding the SEC with negative comments.  As you might expect, Democrats in Congress are urging the SEC to issue rules requiring corporate disclosure, while Republicans are opposed.  In fact, House Republicans have introduced a bill to prohibit the SEC from considering any such disclosure rule.
Pending Matters (1999)

While I’d to know where public companies are making campaign contributions, I’m not sure this is a battle worth undertaking.  If the SEC decides to propose and eventually enact a rule, we’re going to witness a huge battle before the SEC and then in the courts.

Even if the proponents of disclosure ultimately prevail, it won’t make any difference.  Companies are going to continue donating money to trade organizations and issue groups, whether there is disclosure or not.  Would they prefer to keep their giving secret?  Absolutely.  I doubt they want to have to defend their practices.  However, there’s little evidence that making companies reveal potentially embarrassing information, such as salaries, stock options, or perks, has an effect on corporate behavior.  So why should campaign contributions be any different?  Moreover, any rule would only apply to public companies, as the SEC doesn’t have any jurisdiction of private entities.

In my view, active investors would be better served by focusing their attention on matters of corporate governance.  Rather than opening up another front in their battle with public companies, investors should be pressing to get better access to the proxy process, greater say in the nomination of directors, and more effective policies for curbing executive pay.  Using the SEC to force the disclosure of campaign contributions is a battle that’s just not worth waging.

[1] Under Federal law, donations to PACs and Super PACs are already disclosed, and corporations are not permitted to make direct contributions to candidates.  So this debate is over funds given to various issues oriented organizations that don’t required disclosure of their donors under Federal election laws.

Wednesday, April 24, 2013

Must See Documentary on Retirement Savings

Must See Documentary on Retirement Savings by Frontline

I strongly urge you to watch this documentary produced by Martin Smith for Frontline.  I wish I would have produced "The Retirement Gamble Facing All of Us", because it does such a great job of expressing my views.

The Defense of Puffery at the Expense of Reputation: S&P

The Defense of Puffery at the Expense of Reputation: S&P

Standard & Poor’s is asking a judge to dismiss a lawsuit filed by the Justice Department because the alleged misconduct wasn’t fraud, but rather normal business “puffery.”  S&P also claims that a series of emails cited in the complaint might be embarrassing, but don’t demonstrate the requisite intent for fraud. 

We’ve already seen embarrassing emails figure in many pieces of litigation, including alleged overbilling by lawyers, disingenuous Wall Street Research reports, and cynical comments from investment bankers.  Regulators and plaintiffs claim that these emails are evidence of bad intent.  Meanwhile, defendants always dismiss these missives as the writings of disgruntled or immature employees.  In the case of S&P, the emails seem to confirm other evidence brought out in Congressional hearings and inquiries.  Clearly, S&P was under enormous pressure to provide Wall Street with favorable evaluations of mortgage-backed securities.  Moreover, it is hard to dispute that S&P and the other rating agencies were, and still are, managing an enormous conflict of interest, because issuers of the mortgaged backed securities pay S&P to rate their securities.
Subsidiary Needs (1999)
I’m less interested in the evidentiary debate about emails.  Rather, I’m fascinated by S&P’s assertion that any statements they made about the integrity or objectivity of their ratings were mere “puffery.”   The Justice Department claims that S&P committed fraud when they violated the basic principles espoused on the company’s website, in its marketing materials, and in its internal code of ethics.  For example, the Justice Department complaint alleges that S&P committed fraud because it violated the following statement in one its official documents:

“We are intensely aware that our franchise rests on our reputation for independence and integrity.  Therefore, giving into ‘market capture’ would reduce the very value of the rating, and is not in the interest of the rating agency.”[1]

The defense is basically saying that these claims are mere marketing hyperbole, or “puffery.”  They aren’t to be taken as inviolable statements that, if violated, might constitute fraud.   From what I can tell, the defense may have a valid legal defense.  Most of the representations are, in deed, the kinds of assertions you see in marketing materials, advertising copy, and annual reports.

While the defense’s assertion may help to solve S&P’s legal problems with the US Government, it is an enormous reputational indictment for a business entirely dependent on the integrity of its ratings. Unlike almost any other product or service, S&P’s product – ratings -- is worthless if investors can’t rely on the impartiality and honesty of S&P’s assertions. 

Few would disagree that the credit markets need an objective and truthful evaluator of debt instruments.  The legal system is the place to hold executives or companies responsible for their actions during the credit bubble.  However, it is ill-equipped to address the inherent conflict of interest built into S&P, Moody’s, and Fitch's business model.  Once again, we’re left with regulators and Congressmen who rail against the improper practices of the rating agencies and then do nothing to foster reform.

[1] United States v. McGraw Hill, Inc. and Standard & Poor’s Financial Services, LLC,  Case No. CV 13-00779, Complaint, page 35.

CORRECTION: An earlier version of this post referred to Duff & Phelps  in the last paragraph.  They are no longer in the ratings business, having sold their interest to Fitch.