Index Funds and Merger Mistakes

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Index funds.

Index funds have been a great friend to me over the years, and yesterday was their 40th birthday, and I didn't do anything to mark the occasion. I just forgot. Sorry, index funds! Here are articles from Bloomberg and the Wall Street Journal celebrating John Bogle's $11.3 million launch of what is now the Vanguard 500 Index Fund, 40 years ago yesterday. 

We talked last week about the (tenuous) connection between index funds and Marxism, but Hamilton Nolan at Deadspin identifies another link:

John Bogle has done more than any crusading socialist (in America) to take money out of the pockets of Wall Street con artists and keep money in the pockets of regular people. John Bogle founded a multi-trillion dollar investment firm and did not use it to make himself into a multi-billionaire, but instead used it to produce a good product at a fair price that saves money for everyone who uses it.

Is that true, do you think? I mean, the second sentence is clearly true; index funds are great. But Henry Ford produced a good product at a fair price that saved money for everyone who used it, and one doesn't usually think of him as having impoverished car manufacturers. There is a broad sense -- certainly including on Wall Street -- that the rise of index funds has hurt the revenues of investment firms, and there is evidence for that. But the share of U.S. national income that goes to the financial industry has risen significantly in the 40 years since Vanguard's founding. Financial wages are up, and the cost of financial intermediation does not seem to have gone down much. The financialization of the U.S. economy seems to date, in the popular telling, from right around the time that index funds got going.

I'm sure this is all mostly coincidence. But the index-funds-are-anti-competitive crowd would have something to say here: The rise of diversified passive investing, on my reading of their view, has created a cozy managerial-shareholder alignment that is bad for workers and consumers, but good for executives and financial capital. (And for investors, in their capacity as investors, but investors are workers and consumers too.)

I also wonder if it is in part just the same simple story you see in other industries: Making a product more efficiently can grow the market for it. I think of Bogle as the great embodiment of the efficient markets hypothesis, and reassuring people that the stock market is rational will tend to draw them to that market. Defined-contribution pensions, 401(k)'s, the general linking of the fortunes of normal Americans to the stock market -- those things are easier if you can just buy the stock market in a cheap, simple, efficient way. If everyone can deal easily with Wall Street, it's easier to enact policies that end up requiring everyone to deal with Wall Street. And if everyone has to deal with Wall Street, then Wall Street will tend to make more money. Index funds could be the industry's loss leader. 

This is all pretty speculative, but if you look around at the financial industry as a whole, the evidence that it has suffered from Vanguard is maybe just a bit thin. (Disclosure: I am a Vanguard investor.)

Math is hard: Lazard.

The way you figure out how much a company is worth is, you figure out the discounted present value of its future cash flows, you subtract the amount of its debt, and what's left is the value of its equity. Then you divide by the number of shares of stock outstanding, and that is your price per share. This is not an exact science. When, for instance, a bank gives a fairness opinion in a merger or acquisition, opining that the price paid is fair to the target, it will put a pretty wide range around its valuation analysis, and will conclude that any price within that range is fair. The range is understandable, because this stuff is hard. Obviously projecting the future cash flows is hard! Figuring out the number of shares is complicated too, though, what with options and such, and bankers have been known to get it wrong. Subtracting the debt can also be a problem:

On August 18, 2016, Lazard became aware of a computational error, which double-counted certain amounts of SolarCity’s projected outstanding indebtedness, in certain SolarCity spreadsheets setting forth SolarCity’s financial information that Lazard used in its discounted cash flow valuation analyses.

Oops! That's from a revised proxy statement for Tesla's proposed deal to buy SolarCity. Lazard is advising the special committee of SolarCity's board that is negotiating the transaction. Its numbers were off by $400 million, or about $3.87 per share. (There are handy, embarrassing tables on pages 91-92 of the proxy.) Tesla and its adviser had the correct numbers, which made SolarCity look like it was worth more; SolarCity and its adviser had the wrong numbers, which made SolarCity look like it was worth $400 million less. And they negotiated a deal that both sides thought appropriately valued SolarCity. 

And then Lazard caught its mistake and gave a revised opinion to SolarCity's board, with the new, lower, numbers. And it told the board that "the recalculated discounted cash flow analyses would not have changed the conclusion set forth in Lazard’s opinion," that the deal was fair to SolarCity. Even though SolarCity turned out to be worth $400 million more than Lazard thought it was, when it gave its opinion the first time.

That is not particularly a surprise, as fairness opinions go. Look at those tables on pages 91-92: They calculate values per share of SolarCity as low as $5.04 and as high as $40.61 (total equity value of $522 million to $4.2 billion), before the error was discovered; after correcting the error, the range is $8.91 to $44.48 ($922 million to $4.6 billion). The price paid in the deal was about $24.16 worth of Tesla stock, near the middle of that very wide range. A $3.87 error moves the endpoints of the range, but the purchase price is still well within it, and still "fair" in Lazard's opinion.

But there are lots of prices that Lazard would consider "fair"; the bigger question is what price SolarCity's special committee would agree to sell at. The special committee, based on its knowledge of how much SolarCity was worth, negotiated for and agreed to a $24.16 price. Now it turns out that SolarCity was worth $3.87 more than the committee thought. That is an awkward fact! On the other hand, Tesla, based on its knowledge of how much SolarCity was worth, also negotiated for and agreed to that $24.16 price, and it was operating with correct information.

Also, you know, what else was SolarCity going to do? Related: "Elon Musk Faces Cash Squeeze at Tesla, SolarCity."

Math is hard: RBC.

Here is a strange Securities and Exchange Commission settlement with RBC Capital Markets, part of the Royal Bank of Canada, over a fairness opinion that it gave to Rural/Metro Corporation when Rural/Metro was bought by Warburg Pincus in 2011. You might remember Rural/Metro from the bombshell Delaware court ruling holding RBC liable for $76 million in damages to Rural/Metro shareholders, in part because the court concluded that RBC had lowered some of the numbers in its fairness opinion to make Warburg's offer look more better than it actually was, due to various conflicts of interest. That's bad! You're not supposed to do that! 

It is also, though, a bit of a solved problem. There is an industry of plaintiffs' lawyers who sue after almost every announced public merger transaction, and those lawyers specialize in finding evidence of bankers' conflicts of interest and misleading fairness opinions. There is a court, the Delaware Court of Chancery, that specializes in evaluating those cases. It's kind of an ugly system sometimes, but it is very effective at keeping an eye on mergers-and-acquisitions bankers. Mostly it just keeps them honest, so most fairness opinions are pretty good, occasional math errors notwithstanding. Sometimes the fairness opinions are bad, though, and then the plaintiffs' lawyers are skilled at extracting money for shareholders (and themselves).

You mostly don't see the SEC get involved. Yesterday's $2.5 million settlement is for RBC "causing materially false and misleading disclosures about its valuation analysis in a proxy statement." The false statements are a little boring: According to the SEC's order, RBC's fairness opinion, and the proxy statement's description of the fairness opinion, referred to "consensus projections based on Wall Street research" for Rural/Metro's 2010 earnings, but in fact used Rural/Metro's actual 2010 earnings rather than analyst projections. (This was in March 2011, so 2010 was, you know, over.) First of all it is weird to refer to the results of a completed year as "consensus projections," but the bigger issue is that the actual research-analyst consensus was that some of the charges in Rural/Metro's 2010 earnings were non-recurring, so the "consensus projections" (for the completed year!) were higher than the number RBC used. It's probably not worth thinking too hard about any of this.

It is weirdly nit-picky stuff. But you can see why the SEC wanted to get involved here. The Rural/Metro decision was a big deal in the M&A world, finding in essence that RBC misled the company's board and shareholders about the value of Rural/Metro, and about its own motivations. Valuation mistakes, merger conflicts of interest and poor governance aren't really issues for the SEC, but misleading shareholders is. And if the SEC is going to claim jurisdiction over merger disclosures that mislead shareholders, it really ought to collect a fine for an M&A case as high-profile as this one.

Elsewhere in Delaware Chancery Court news, a "story of love and business gone bad is at the center of an unlikely debate: whether Delaware’s mighty business court -- which has legal authority over half of all U.S. public companies -- has grown too powerful."

Deutsche Bank.

Oh man, things are rough:

Deutsche Bank’s market value is around $20 billion, a bit bigger than Buffalo, N.Y.-based M&T Bank Corp. Its profit in the second quarter fell 98%, to €20 million ($22.3 million), or around $200 per employee.

That's from a general catalogue of misery at Deutsche Bank, whose senior executives are meeting this weekend to figure out what to do about it. One possibility -- merging with Commerzbank -- seems to be off the table; "the two banks in August held preliminary discussions about a tie-up, before concluding last week it wasn’t viable." No one loves the other possibilities either:

As part of a continuing review of strategic options, the bank in recent weeks has analyzed possibilities including selling all or part of its asset-management business, people close to the matter said. Deutsche Bank executives want to keep most of the business, the people say. They see the steady returns as ballast against volatile profits from the bigger trading and investment-banking businesses.

A big universal bank is a collection of risky businesses that diversify each other, which makes it very hard to shrink. You can't just reduce your risk by selling off a risky business; that might actually make you riskier overall. 

ISDS.

BuzzFeed has been running a series of articles about the investor-state dispute settlement mechanism called for in many international trade treaties, and yesterday's article is about the use of ISDS for financial transactions, including sovereign-debt enforcement and derivatives disputes.

Countries often must give its rulings the same deference as those from their own highest courts, and there is effectively no means of appeal. The system was meant to be available only to those companies that had invested the time and money to create something of broad economic value.

But over the past two decades, corporate attorneys have stretched the parameters of ISDS, allowing banks, hedge funds, and private equity firms to shatter the careful bargain that participating nations thought they had made. Indeed, financiers and ISDS lawyers have created a whole new business: prowling for ways to sue nations in ISDS and make their taxpayers fork over huge sums, sometimes in retribution for enforcing basic laws or regulations.

On the one hand, I have some sympathy with, say, Deutsche Bank, which sold Sri Lanka some oil hedges, and then didn't get paid because the country's central bank decided to walk away from the deal when the hedges moved against Sri Lanka. The central bank decided that the agreements were invalid, but as both debtor and decision-maker, Sri Lanka seems a bit conflicted. There really ought to be a competent neutral court to adjudicate disputes like that -- which is why so many sovereign bond disputes are resolved in New York or London courts. New York courts aren't quite the same thing as international-trade arbitration tribunals, though.

Elsewhere, "the White House said it had chosen seven experts in finance and the law to supervise Puerto Rico’s fiscal affairs in the coming months under a law enacted this summer intended to help the island restructure its $72 billion debt."

Hyperlinks.

Makes sense!

The Securities and Exchange Commission today proposed rule and form amendments that would require registrants to include a hyperlink to exhibits in their filings.

“The proposed changes should make it significantly easier to locate documents attached to company filings,” said SEC Chair Mary Jo White.

I enjoy wild predictions of how the blockchain will revolutionize finance and move us to a seamless future of automated efficiency, but it is good to remember that there is a lot of low-hanging fruit out there, computer-wise. 

Elsewhere: "Tracking tuna on the blockchain."

Economic possibilities for our grandcomputers.

Here is an article titled "Quant Fund Gives Robots 364 Days Off to Best Currency Rivals," and while the well-rested robots apparently do a great job of currency trading, doesn't the division of labor seem ... not quite ideal? Like, wouldn't you want the robots to do all the work and give the humans lots of vacation, rather than the reverse? I hope the robots go somewhere fun during their time off. 

Elsewhere: "Quant Empire Forged Through Netflix Ascends the Hedge Fund Heap."

People are worried about unicorns.

Here is Katie Benner on controversies at a startup called WrkRiot, and aren't startup employees adorable?

Penny Kim, the former head of marketing at WrkRiot who wrote about her experience at the company, including the forgery allegations, said, “I’d heard stories about late paychecks or start-ups failing, but who expects fraud in Silicon Valley?”

Now, I have no idea if Kim's claims about WrkRiot are true, but the general point about Silicon Valley is: It's a giant center of commercial and financial activity! It would be weird to expect no fraud at all. You don't hear anyone say "I'd heard stories about risky trades and banks failing, but who expects fraud on Wall Street?" The enchantments on the Enchanted Forest are strong, but they can't keep out fraud. 

Speaking of vulnerable enchantments on the Enchanted Forest, did you know that downtown Palo Alto has "an all-but-forgotten zoning regulation that bans companies whose primary business is research and development, including software coding"?

Elsewhere, venture-capital firm Andreessen Horowitz has done pretty well, but not as well as Sequoia Capital, Benchmark or Founders Fund. Oh, and while we're listing VC firms: In Money Stuff yesterday I mentioned the Central Intelligence Agency's venture capital fund, In-Q-Tel, and made fun of the name. "I honestly can't think of a worse VC fund name," I said, "though I am looking forward to your nominees." No one sent me a worse name. But I did learn this, from a 2013 paper about In-Q-Tel by John T. Reinert:

The CIA wanted to play up the mystique of James Bond—the “Q” in the firm’s name, placed between “Intel” (shorthand for “Intelligence”), refers to James Bond’s fictional inventor of high-tech spy gear and other gadgets.

That might be the most embarrassing thing I've ever heard.

People are worried about swap spreads.

This is my favorite recurring section because it almost never recurs, but here is Bloomberg Gadfly's Lisa Abramowicz worrying a little about swap spreads, as well as Libor, leverage ratios, the yield curve and other signs of impending doom.

People are worried about bond market liquidity.

They're not really. "Treasury Liquidity Beats August Heat as Market Shows More Depth." "America’s Corporate Bond Party Goes on as Sales Near $1 Trillion." We're living in a golden age of bond market liquidity, this week. 

Me yesterday.

I wrote about speed bumps.

Things happen.

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net