Friday, October 31, 2014

A Provocative Question That Wasn’t Answered: Dell Computer

A Provocative Question That Wasn’t Answered: Dell Computer

When I checked closing prices for yesterday’s stock market, I was struck by this headline: “Did Michael Dell take his company private on the cheap?[1]  Having written about the Dell buyout on previous occasions, I thought Michael Santoli’s article on Yahoo Finance might have some new information on Michael Dell’s attempt to turn around the company.

Instead, Mr. Santoli suggests that the dissident shareholders – T. Rowe Price and Southeastern Asset Management – might have been right when they claimed that the company was sold too cheaply.  Mr. Santoli cites the 34% rise in PC-related stocks over the past 12 months as evidence for his view.

The fact that the composite of Hewlett Packard, Microsoft, and Lenovo appreciated by an average of 34% in the last year doesn't provide any evidence on the question of whether Michael Dell acquired the company too cheaply or not.  If T. Rowe Price and Southeastern Asset Management reinvested the proceeds of the Dell deal in a composite of those PC-related stocks, they'd be up 34% on that investment.   In other words, they would have enjoyed significant appreciation in the value of their investment.  In order to begin to make the case that Dell was sold too cheaply, Mr. Santoli would have to show some fundamental aspect of Dell’s business improved in the last year over the outlook when the company was sold.  Even if Mr. Santoli included some new fundamental information in his article, it still wouldn’t be clear whether Mr. Dell and his financial partners at Silver Lake Partners were aware of this information at the time of the sale. In other words, the article doesn't provide any data that would give us evidence whether Dell would have performed better or worse than the PC composite or reflects any acumen on Mr. Dell’s part. 

Given the challenges facing Dell when it was sold, I’m not sure we’d be able to reach many long-term conclusions even if we were privy to all the company’s financial information.  Creating a sustainable turnaround in the personal computer or any complex business requires more than 12 months.

Postscript:  For whatever reason Yahoo! would not publish this comment.


Thursday, October 30, 2014

Picking at Nits: SEC Examining Private Equity Fee Calculations

Picking at Nits:  SEC Examining Private Equity Fee Calculations

According to Reuters[1], the SEC is investigating how private equity firms calculate fees.  At issue is the fact that some managers report net returns that include capital contributed by investors who received discounted fees as well as the commitments of the managers themselves, which do not incur fees or carry.  As a result, the performance presented in marketing materials may overstate the performance that the average investor would have received.  Therefore the SEC is likely to insist that these presentations include both net and gross performance figures.

I hope the SEC’s examination is considerably broader than the issue of displaying performance net and gross fees.  Typically managers represent a small percentage of the capital contributed to a fund, and the fee discounts to select clients are usually 0.25% to 0.50%.  Thus, the distortion is likely to be very small and measured in the tenths of a percentage point.

However, there’s a much larger issue when it comes to the accuracy of private equity performance.  Unless a fund is eight or more years old, a great deal of its performance is based on estimates for the unrealized investments in the portfolio.   Estimates are, of course, an inevitable part of valuing illiquid, non-public companies. The various techniques for coming up with those values can lead to widely different results.  The uncertainty surrounding these estimates is far greater than the difference created by different investors paying different levels of fees.

As a PE firm prepares to market a new fund, there’s a temptation to boost valuations in order to create a more compelling marketing pitch. Thus the challenge for investors and the SEC is to uncover biases in the valuation estimates, and that isn’t an easy undertaking.   Tweaking a discount rate, adjusting an earnings model, and/or switching valuation methods can dramatically raise or lower the reported value of a portfolio company.

It will be another good day for the private equity industry if all they have to do to make the SEC happy is to add a couple of exhibits and footnotes to their pitch books.


Wednesday, October 29, 2014

Actuaries: Telling Pension Trustees What They Want to Hear

Actuaries: Telling Pension Trustees What They Want to Hear

Just over a year ago, I wrote a blog post implicating money managers and actuaries in helping to drive up public pension deficits.  My post was prompted by Mary Williams Walsh’s reporting in The New York Times about the unsound decisions made by the trustees of Detroit’s public pension.[1]  Her article had focused entirely on the actions of the board.  Today, Ms. Walsh reports that a retiree in the City of Detroit, municipal police and firefighters, and workers in Wayne County are suing Gabriel Roeder Smith & Company for actuarial malpractice.[2]  The lawsuit contends that the actuary recommended various accounting practices that resulted in the systematic underfunding of the pension plans and repeatedly attested to the soundness of those plans.

The entirety of actuarial mathematics is hard for many trustees (and money managers) to grasp.   Most of us focus on investment returns and benefits, but don’t spend much time making sure that the two are properly connected.  We assume that the actuaries have proposed assumptions that are financially sound.  As I wrote a year ago, we’ve been making a bad assumption about the assumptions that underpin public pensions.

Until I can dig deeper into these lawsuits, it’s hard to say whether they have any merit.  However in reading Ms. Walsh’s article, it appears that many of the assumptions that helped drive up Detroit’s pension deficit were the same ones employed by public pension plans across the country and utilized by most actuaries.  For years, actuaries have been giving trustees the advice needed to maintain or increase benefits, while minimally funding pensions.   There’s nothing unique here.  Like every other governing body, pension trustees prefer to push financial burdens into the future.  In other words, actuaries have been giving trustees exactly what they want.

Ms. Walsh highlights two of the mundane assumptions that have a large impact on the long-term health of public pensions.  In order to properly estimate a pension’s long-term liability, the trustees have to make an assumption about the future growth of the public payroll.  The faster the payroll grows, the larger the future contributions that will flow into the pension to help fund it.  In Detroit, they used a 5% assumption, which turned out to be wrong.  It was only in the last couple of years as Detroit’s government shriveled that the actuary advised the trustees to rethink that assumption.

Since most pensions run some type of current deficit, the trustees have to agree on a time period over which to make the additional contributions needed to bring the plan into balance.  A longer time period dramatically decreases the present requirement to eliminate the deficit and pushes the problem into the distant future.  In Detroit, they were using a thirty-year horizon (North Carolina’s Teachers’ and State Employees’ Retirement System uses a much more reasonable 12-year period). As Ms. Walsh reports, public pension plans reset this amortization period each year in hopes of pushing the problem indefinitely into the future.

The bottom line is that we don’t like to pay for stuff now, whether it’s personal expenditures or public obligations.  As consumers, we’ve run up $3.1 trillion in consumer debt (not including mortgages).  I’m not suggesting that we should totally get rid of credit cards, student loans or automobile leases.  However, we’d be better off and more stable in the long run if we put down a bit more cash upfront.  The same is true of public pensions, which are running a collective deficit of some $2 trillion.  While there’s no reason to eliminate the deficit overnight, here to we need to put more money in upfront.

While the actuaries may escape legal liability, there’s little doubt that they’ve been important enablers in destabilizing the long-term health of our public pensions in Detroit and across the country.  Telling trustees they need to put more money into pension plans or trim benefits isn’t good for an actuary’s business. However, it is the truth. 

Tuesday, October 28, 2014

Put the Brakes on Share Repurchases

Put the Brakes on Share Repurchases

If you are the CEO of public company a sizable portion of your compensation is based on a single decision: how much of your company’s stock should be repurchased.  The financial press is awash in articles describing the debate between Carl Icahn and Apple about the amount of stock that Apple ought to repurchase.   I don’t have a view on this particular battle, but it got me thinking about buybacks and led me to William Lazonick’s article in the Harvard Business Review.[1]  “Profits Without Prosperity” is a scathing attack on the practice.  According to Professor Lazonick, between 2003 and 2012, S&P 500 companies devoted 54% ($2.4 trillion) of their profits to open market stock repurchases.  Another 37% went to dividends, which means that only 9% was plowed back into businesses.  In other words, large public companies invested most of their profits in investors rather than their businesses.

Why is this practice so prevalent?  Professor Lazonick argues that executive compensation is part of the reason:

In 2012 the 500 highest-paid executives named in proxy statements of U.S. public companies received, on average, $30.3 million each; 42% of their compensation came from stock options and 41% from stock awards. By increasing the demand for a company’s shares, open-market buybacks automatically lift its stock price, even if only temporarily, and can enable the company to hit quarterly earnings per share (EPS) targets.

In other words, CEOs and their colleagues have a great deal of short-term incentive to try to control short-term stock prices (in a recent column for the News & Observer,[2] I discussed the role of earnings surprise as a factor in driving short-term volatility).  If a company’s stock were truly undervalued, a share repurchase would make good sense.  However, academic studies show that buyback programs aren’t tied to a company’s valuation and actually decrease during bear markets. 

Rather, share repurchases are a legal form of stock manipulation.  SEC rules allow companies to buy up to 25% of stock’s average volume without providing any notice.  In other words, when you purchase or sell a stock you may be in the market alongside the company, which has a systematic information advantage.  It hardly seems fair and is worthy of attention given the prevalence of the practice.   Perhaps if CEOs spent less time repurchasing shares, they’d focus a bit more on reinvesting in the business.  And if they don’t have any good uses for the company’s profits they should either pay it out as a dividend or resign.

There’s a certain regulatory asymmetry at work.   If a company wishes to sell stock to the public, it has to make a specific filing and give notice of the sale.  If a company wishes to repurchase stock, it only needs to issue a broad statement of intent.  I’m sure you’ve seen these notices, which seem to excite traders.  The announcement goes something like this:

Company A intends to purchase up to x million shares between now and December 31, 2015.  Company A may or may not make such purchases and may terminate the program at any time.

That’s really all there is to it.  If the company has complete discretion over the plan, it will be subject to blackout periods if there’s a pending announcement of material information.  However, if it adopts a non-discretionary plan (Rule 10b5-1), there are no blackout periods.  A company can even use a bit of both techniques to shrink the number of shares and thereby boost earnings per share.

I don’t think there’s any reason for companies to incur the equivalent expenses of an IPO or secondary stock issuance when they repurchase shares.  However, I believe investors ought to know when a company is buying shares, just as they know when it is selling them.  This way those selling the stock will be fully aware that the company itself is a purchaser.  In short, I agree with Professor Lazonick that companies ought to have to make a formal tender offer for shares.  It might not be good for executives or hedge fund managers, but it would be good for long-term investors, if there are any left.