Shareholders, Analysts and Regulators

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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Airgas.

Oh man, there are a lot of timely themes in this Airgas story about how founder-executives should be allowed to ignore their shareholders and run their companies as personal fiefdoms. Airgas was built up by Peter McCausland. In 2010, Air Products made a hostile $5 billion offer to buy it. Airgas shareholders wanted to sell, and McCausland lost a proxy fight, but with the help of a poison pill and an important Delaware Supreme Court decision, he nonetheless was able to fend off Air Products and keep Airgas independent. But then Air Products started circling again, and so this year Airgas ended up selling to Air Liquide, for more than twice what Air Products had offered in 2010. McCausland now raises weird cows on his farm.

The most obvious theme is the one about shareholder short-termism. "The whole system is rigged toward transactions and turnover," says McCausland; silly shareholders jump at any sort of premium offer because they don't have the patience to wait around for management to grow the business. Here the shareholders were wrong and management was right: Management rejected the deal that shareholders wanted, and got a much better deal, at more than twice the price, six years later. (To be fair, the S&P 500 Index was up 87 percent over that same period.) McCausland didn't even really want to sell this time, but shareholder pressures being what they are he didn't have much choice. Without those pesky shareholders, Air Products could be doing even better.

Of course part of the reason that this is a newsworthy story is that it often doesn't work out that way. Every manager has a natural bias for thinking that she can make her company more valuable, and that the company's best bet is to leave her in charge at a high salary rather than sell to a rival. The opposite of "short-termism" is "entrenchment." Often, shareholders and managers disagree about what their companies should do. Sometimes the shareholders are right, and the managers are entrenched (or: just wrong). Other times the managers are right, and the shareholders are short-termist (or: just wrong). There are probably domains in which managers are systematically better, and domains in which shareholders are systematically better, but it seems implausible that either the managers or the shareholders would always be right.

But there is also the theme of "should diversified mutual funds be illegal?" Here's an anecdote about the renewed approach from Air Products Chief Executive Officer Seifi Ghasemi last year:

He ripped out a page showing there was an 86 percent overlap between shareholders of Airgas and Air Products, meaning he could take the offer directly to Airgas investors, who would be inclined to accept (and would not want to pay a rich price because it would be coming out of their pockets).

Hey that's weird. Those companies have basically identical shareholders, except that each has executives who own shares in their own company but not the competitor. Are those executives' incentives really aligned with the interests of their outside shareholders? Should they be? The Delaware Supreme Court allowed Airgas to keep its poison pill in place indefinitely to fend off an Air Products offer with an inadequate premium: Was that actually in the shareholders' interest? The shareholders were mostly going to pay that premium themselves.

I guess one more mini-theme here is McCausland's line about how "the whole system is rigged." We live in a golden age for rich people thinking that the system is rigged against them. You can't go a week without a billionaire fund manager complaining about the Fed rigging the markets. My Bloomberg View colleague Michael Lewis wrote a book about how the stock market is rigged because big hedge fund managers can't buy a lot of shares without moving the price. Donald Trump is running for president. Peter McCausland "netted almost $1 billion" from selling his company, and complained that the system was rigged to force that outcome.  

Research.

In the 1930s, in response to the crash of 1929 and the subsequent depression, the U.S. put together the securities regulatory system that we mostly still live with today. But in the 2010s, in response to the crash of 2008 and the subsequent recession, the U.S. has seen a boom in a sort of financial speculative history, new ideas that basically go back to 1930 and ask: Well, what if we hadn't built the modern system of securities regulation? What would that look like?

Obviously there is bitcoin, and the blockchain generally, which try to exist outside of most normal laws, and which serve to remind us mostly that pre-1930 financial markets had really quite a lot of Ponzi schemes.

But then there are the giant tech start-ups that still trade as private companies, which remind us that there is nothing inevitable about the modern public-company norms of free transferability, shareholders' rights and extensive public financial disclosure. You can go right ahead and invest in Uber, a $62.5 billion company, and it never needs to give you any financial statements. That is probably not quite what people expected when they were writing the Securities Act of 1933. I mean, it's sort of what they thought they were fixing, when they were writing that act. It was pretty easy to buy shares in a big public company without much financial disclosure, before the modern securities laws got going. Now it is again!

I think this is all delightful, in a nostalgic steampunky way. But it is inarguable that the 1930s securities laws were really good for the financial industry, because disclosure and regulation made investors more confident, and confidence begat trading. And now that so many of the biggest and most interesting companies are private, and don't disclose financial information, it is harder to get anyone to trade their shares. And that's where research analysts come in:

In an effort to bring more transparency to big private tech companies such as Uber and Airbnb, a growing number of companies are launching research teams dedicated to analysing private companies and producing reports on them.

Demand for research on start-ups has grown as more investment flows into big late-stage fundraising rounds, which have come to be known as “mini-IPOs”. Investment in venture-backed start-ups reached $60bn last year, double the level of 2013, as new investors such as mutual funds and asset managers have entered the scene.

“This is a new asset class that is emerging,” said Greg Brogger, founder of SharesPost, referring to late-stage tech start-ups. “These are the same companies that would have been public at year six or seven in a previous era. These are not start-ups in the garage.”

It's interesting that the companies leading the charge on private-company research seem to be mostly marketplaces and brokers for private shares (along with PitchBook, a paid research service). There is an old cynical model, left over from the late-'90s dotcom boom, that assumes that banks use research coverage to try to win investment banking business. But the big investment banks that might take Uber and Airbnb public aren't the ones writing startup research reports now. Instead, it's brokerages who have something more immediate to gain by their coverage: If they can give investors some clarity into private tech companies, those investors are more likely to trade their private shares, and that's how the brokerages make money.

Elsewhere: "How Do Venture Capitalists Make Decisions?" And Citigroup's High Yield Energy research team is publishing cake recipes now. 

Revolving doors.

One thing that I like to point out from time to time is that the "revolving door" between regulatory agencies and private industry has a tendency to make regulation stricter. So here is the story of Sean McKessy, the first chief of the Securities and Exchange Commission's Office of the Whistleblower -- he calls the office "the baby that I created" -- who is now joining a law firm that represents whistle-blowers. "There really wasn’t a business space, that I think is now being created by the SEC whistleblower program, that allows for a law firm to participate in a meaningful way, and a way that makes sense economically," he says. "Current and former SEC attorneys now regularly ask me how they can do what I do," says another whistle-blower lawyer (and former SEC official).

There are incentives. If formerly acceptable practices now lead to SEC enforcement actions, if the fines keep getting bigger, if the SEC keeps finding new behaviors to fine, then, in expectation, whistle-blowing will become more lucrative. And so, in expectation, whistle-blower-lawyering will become more lucrative. And so, in expectation, being an SEC enforcement lawyer will become more lucrative. The SEC lawyers get a -- deferred, conditional -- cut of the action they create.

TeslaCity.

I don't know, Elon Musk is not wrong here?

“We will be in a far better position to convince potential investors to bet on us if the headline is not ‘Tesla Loses Money Again,’ but rather ‘Tesla Defies All Expectations and Achieves Profitability,’” Musk wrote. “That would be amazing!"

I love the bold creative thinking in Musk's message to Tesla employees: What if, he asks, instead of losing money, we made money? Don't you think shareholders might like that? 

Elsewhere in Tesla things that shareholders don't like, here are Steven Davidoff Solomon and Ronald Barusch on the Tesla/SolarCity merger proxy filed last week, with particular focus on the math error in Lazard's fairness opinion that we discussed on Thursday. Davidoff Solomon also discusses the awkward fact that "Mr. Musk had discussions in February 2016 with the chief executive of SolarCity about an acquisition," but those "discussions were not disclosed in a subsequent $1.4 billion stock offering" by Tesla. Davidoff Solomon isn't too worried that Tesla broke the law here, but it is not the sort of thing that shareholders would be thrilled with. 

It's so boring.

I mean, let's be fair, the system is rigged against the money managers who are trying to earn their fees:

The difference between various asset classes' returns has been pushed to the lowest in almost two decades, according to one simple measure of so-called performance dispersion.

CreditSights Inc.'s 'total return range' subtracts the total return of the worst-performing asset class of the year from the total return of the best-performer. As of the start of September, that figure comes in at 14.6 percentage points — lower than last year's 22.2 point differential and the 30 point difference recorded in 2014.

Is that the rise of indexing forcing things into narrow historical correlation bands? Is it central banks pushing up asset prices indiscriminately? Sure, why not. Elsewhere: "Could the ECB Start Buying Stocks?" And stocks and bonds now go up and down together: "Share prices and bond yields moved in the same direction in just 11 of the past 30 trading days, close to the lowest since the start of 2007."

1MDB.

Here is a story about "the failure of a host of financial institutions and regulators to detect the alleged fraud" at 1Malaysia Development Bhd. My favorite alleged red flag might be this letter from a Saudi royal about some money that came into the hands of Malaysian Prime Minister Najib Razak, who set up 1MDB:

A letter dated Feb. 1, 2011, which was reviewed by the Journal, said Mr. Najib was being given $100 million as a reward for Malaysia’s “good work to promote Islam around the world.” It said the gift “should not in any event be construed as an act of corruption.”

Imagine having the sort of life where you write letters like that. Obviously if anyone wants to send me $100 million, I'm not going to say no. But please don't write "should not in any event be construed as an act of corruption" in the memo line of the check. That's just the sort of thing they're looking for.

Market structure.

It seems so quaint, here in 2016, to think that the way people once bought houses was that the owner would put a house up for sale, and then someone would offer to buy it, and then they'd negotiate a price. That is such an un-disrupted, non-sharing-economy, pre-blockchain way of doing things. The new thing in Silicon Valley is to buy houses that aren't for sale:

Flushing out people before they are officially ready to sell — by a few weeks or a few years — has obvious benefits for buyers, but sellers say they can profit, too. It streamlines an expensive process that traditionally consumes many months.

Yes it does seem more efficient to skip the step of putting a house up for sale, but surely in the Age of Uber we can do a little better? Even in the current, improved, process, the buyer still has to make a bid, and everyone has to agree on price, and then there is a closing and so forth. Why not just find a house you like and move right in? It is the sharing economy now. Move (in) fast, and break (other people's) things.

Literary criticism.

I expressed a little skepticism on Friday about pleas for "plain English" in financial disclosure, and of course it turns out that there's a literature on the topic. Notre Dame finance professor Tim Loughran sent me this paper in the Journal of Finance, which he co-wrote, finding that standard measures of "readability" (sentence length, complex words, etc.) don't do a good job of measuring the usefulness of financial disclosures. Instead, "10-K document file size provides a simple readability proxy that outperforms the Fog Index, does not require document parsing, facilitates replication, and is correlated with alternative readability constructs." The longer an annual report is, the harder it is to use. Serial commas and notwithstandings don't matter. 

People are worried about unicorns.

Here's a story about a high-tech grilled cheese startup called Melt, backed by Sequoia Capital, that turned out not to be all that high-tech, because, you know, it is a grilled cheese startup. You can modify your grill to use a blockchain or whatever, but the essential process is still unavoidably physical. I guess in a few years you can give people a virtual reality headset and a bucket of Soylent and convince them that they're eating a delicious grilled cheese, but we are not quite there yet. Anyway, the founder and CEO of Melt, "who previously created the innovative Flip camcorder of the mid 2000s," is leaving his job as CEO. In general, I would always like to read more articles about people who left tech or finance to open grilled cheese trucks or cupcake bakeries, going back to tech or finance once they realize that the money is better and their clothes get less greasy. There are examples, but I feel like we are still early in the back-to-tech-and-finance cycle.

On the other hand, we're very much in the sweet spot of the cycle for economists who want to leave academia to work at tech companies, where the data is big and the money is even bigger.

Meanwhile in fintech, "striving to achieve a valuation of $1 billion or more may no longer be in a start-up's best interest":

“What you don’t want to do is get into sort of this half pregnant phase when you're past where you're digestible but not clearly on the trajectory for long term, self sufficiency,” said Sean Park, co-founder of venture capital firm Anthemis Group.

I am not sure that the pregnancy and digestibility metaphors really go together, but then, I am not a professional unicorn wrangler. They seem to have a pretty high tolerance for metaphor. Elsewhere: More on Hyperloop One. "Ve Interactive, the unicorn that hates venture capital." And: "Venture Communism: How China Is Building a Start-Up Boom." 

People are worried about bond market liquidity.

I missed this last week but apparently Goldman Sachs has built a robot that will send out executable markets for odd-lot corporate bond trades. The robot is boringly named "the Goldman Sachs Algorithm," and it's practicing to take over the world:

Prices offered on GSA are dynamic and respond to other trades and market conditions, according to several fund managers.

The GSA offers between $75m and $100m of bonds to trade each day, according to an estimate from one fund manager, in a move that should also free Goldman’s traders and salespeople to concentrate on larger and more profitable trades.

“My guess is that they’re [Goldman] trying to perfect the algorithm,” said Matt Brill, a senior portfolio manager at Invesco.

If you're a human on that desk, I guess you should mostly concentrate on the larger and more profitable trades, but maybe keep an eye on the robot too. You never know when you might find it sneaking up behind you to steal your spot.

Elsewhere, here is a Federal Reserve staff working paper on "Mutual Fund Flows, Monetary Policy and Financial Stability," which is a very people-are-worried-about-bond-market-liquidity-esque topic. ("In an industry that 'mutualizes' redemption costs and where many funds may engage in liquidity transformation, our flow-performance analysis provides evidence of the potential existence of a first-mover advantage in less liquid segments of the market.")

Things happen.

Henkel and Sanofi sell first negative yielding euro corporate bonds. Brazil’s ‘Better Than Goldman’ Bank Slowly Rebounds From Scandal. Bayer Sweetens Takeover Bid Again as Monsanto Mulls Options. G.E. Offers $1.4 Billion for 3-D Printing Technology Companies. There's Been a 'Quiet Riot' in Japanese Government Bonds. Junk Debt Getting Crowded. Toyota, Encana Energy Deal Devolves Into Legal Battle. California Court Case Opens Door for Pension Benefit Reductions. The Downside of Cultural Diversity on Corporate Boards. The Sloppy Battle for the Future of Craft Rye. Revolution against 'rich parasites' at utopian Burning Man Festival as 'hooligans' attack luxury camp. "Doom" with Tim Allen. The Miniature Donkey Therapy Meet-up.

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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