Industry: Financial services
If you own a stock that you think is worth $10 a share, and I also own that stock and I think it’s worth $20 a share, I can try to convince you that I’m right. I can make predictions about the company’s future prospects and earnings, and build a discounted cash flow model to prove that the stock really is worth $20. And you can make different assumptions about the future, and build different models, and try to convince me that $10 is the right number. But this is all kind of dumb. I should just pay you $12 for your shares. Then you get paid more than you think the stock is worth, and I get stock that I think is worth more than I paid, and we never have to discuss it. This is called the efficient markets hypothesis.
This is such a good and pleasant way of avoiding discussion that it isthe principal way that people in finance make arguments. Every once in a while a famous investor will rent out a ballroom and give a three-hour presentation about why a stock is going to go up (or down). But these presentations are actually relatively rare. Mostly when investors think a stock is going to go up, they buy the stock. The buying is the argument. You don’t even need a ballroom.
One argument that you hear a lot is that public stock markets are too focused on the short term, giving too much weight to quarterly results and not enough to long-term visions. Structurally, this argument tends to be expressed by the people with the long-term visions, who feel that they’re being undervalued. They make the argument in words, in shareholder letters and television appearances, but they also sometimes make it with money. Companies sometimes buy back their stock because their managers think the market undervalues it. And companies that aren’t already public perhaps put off going public to avoid all the short-termism, or, if they do go public, do it in ways that insulate the managers from the markets’ short-term focus.
One person who thought his company’s stock was undervalued by a short-term public market is Michael Dell, the founder and chief executive officer of Dell Inc., which in his long-term vision was moving from being a personal-computer manufacturer into an enterprise software company. He made this argument in boring verbal ways:
Mr. Dell lamented that the market just “didn’t get” the Company. He thought that in spite of the Company‘s transformation, “Dell [was] still seen as a PC business.” Mr. Dell conferred with his management team and hired consultants to devise strategies to help the market view the Company as “a sum of the parts.” Mr. Dell regularly communicated his views to analysts.
Unsurprisingly this didn’t work. So he made the argument in a more persuasive way: In 2012, with the market not getting Dell and valuing it at just $9.35 a share, he rounded up some financing sources and offered to pay about $12 or so for it.
That argument worked, eventually. Michael Dell and his private-equity backers at Silver Lake ended up paying about $13.75 a share ($13.96 counting some dividends) in a $25 billion deal that they signed in February 2013 and closed in October of that year. There were twists and turns along the way; in particular, Carl Icahn held up the deal for a while by arguing that Dell was actually worth much more than $13.75 a share. But Icahn’s arguments were not ultimately persuasive, because they consisted mostly of words and numbers and not money. (They were somewhat persuasive because they involvedsome money — Icahn made a couple of leveraged recapitalization proposals for Dell that would pay some cash to shareholders that might have sort of looked like a higher price than $13.75 — but that isn’t quite the same as bidding $14 a share for all the shares in ready cash.)
And then some shareholders sued in an appraisal lawsuit, arguing that the $13.75 was too low and that a Delaware court should award them more money. And then most of those shareholders were thrown out of court for hilarious legalistic reasons that don’t concern us here, though they have concerned us previously. But on Tuesday Delaware Vice Chancellor Travis Laster ruled on the remaining appraisal claims and found, in a 114-page opinion, that Dell was really worth $17.62 a share, so everyone who successfully sued — and managed to jump through the correct hoops — is entitled to an extra $3.87 a share, with interest.
Appraisal is a weird bit of corporate law, because it undermines the usual nice clean process of deciding how much a stock is worth by just seeing what someone will pay for it. The market said Dell was worth $9.35, or whatever, and Silver Lake said it was worth $13.75 and paid that, and then some shareholders said it was worth even more. The normal form of financial-markets argumentation would be for them to offer more. But instead they get to sue, and make arguments to the court, and then Michael Dell and Silver Lake have to make arguments about why it’s worth less. Their heart is unlikely to be in those arguments since, you know, they paid the $13.75, which implies that they think it’s worth more than that. But their best argument will always be: If this company was worth more than $13.75 a share, why did no one offer more?
And that is a pretty good argument! The best reply, especially in a conflicted management buyout where the buyer is also the CEO, is often along the lines of “because management deliberately undermined the sales process to prevent other bidders from seeing the company’s true value, so they could take it for themselves on the cheap.” But that’s not really what happened here; the court found that, while there were some inherent conflicts of interest, Dell’s independent directors basically did a bang-up job of running the sales process, and even Michael Dell himself — despite being both the CEO and the prospective buyer of the company — behaved like a prince.Actually, reading the opinion, you almost get the sense that Michael Dell didn’t do this leveraged buyout for the money. It was just an intellectual engagement, a point of principle. He thought the stock was undervalued, and he wanted to argue his case, and the way you argue that is by buying all the stock.
But the court nonetheless disagreed with the price, and decided that the fair price was $17.62. To get there, first of all, Vice Chancellor Laster had to disregard the market price for the stock, which was $9.35 when the deal was first proposed, $13.42 when it was officially signed, and never closed above $14.51 afterward. These lower prices are not too hard to explain away:
A second factor that undermined the persuasiveness of the Original Merger Consideration as evidence of fair value was the widespread and compelling evidence of a valuation gap between the market‘s perception and the Company‘s operative reality. The gap was driven by (i) analysts’ focus on short-term, quarter-by-quarter results and (ii) the Company‘s nearly $14 billion investment in its transformation, which had not yet begun to generate the anticipated results. A transaction which eliminates stockholders may take advantage of a trough in a company‘s performance or excessive investor pessimism about the Company’s prospects (a so-called anti-bubble). Indeed, the optimal time to take a company private is after it has made significant long-term investments, but before those investments have started to pay off and market participants have begun to incorporate those benefits into the price of the Company‘s stock.
That is: The market price didn’t reflect fair value, not because the market didn’t have the relevant information, but because it weighted it incorrectly. Analysts had a myopic “focus on short-term, quarter-by-quarter results,” and couldn’t understand the long-term value of the company’s plan. This is true even though Dell’s management explained its long-term plan and “tried to convince the market that the Company was worth more.” The stock market, in Vice Chancellor Laster’s view, was just incorrigibly short-termist, and couldn’t take the long view and value Dell properly.
After all, that’s why Michael Dell wanted to take the company private in the first place:
Mr. Dell identified the opportunity to take the Company private after the stock market failed to reflect the Company‘s going concern value over a prolonged period. He managed the Company for the long-term and understood that his strategic decisions would drive the stock price down in the short-term.
So he went to private-equity firms to fix his short-termism problem. This makes sense! If you have a public market that doesn’t properly value a company because it is too short-term focused, you can ask a private-equity firm to buy the company and run it for the long term, without the pressure of quarterly earnings calls and microsecond stock-price moves. That was Michael Dell’s thinking, and Silver Lake’s, and it’s a pretty standard move. And the next standard move would be to have an auction among private-equity firms to figure out how much they think the company is worth. That more or less happened here; the auction was imperfect, but ultimately three private-equity firms put a lot of effort into Dell, with KKR and Blackstone putting in bids at various points before dropping out of the running. The highest price that private equity was willing to pay for Dell was $13.75, give or take, significantly above the pre-announcement market price.
Meanwhile no strategic buyer — no other company that might want to acquire Dell’s business — put in a bid. So the best bid that anyone with a long-term perspective put in was $13.75.
So why wasn’t that the right price? The opinion on this is interesting, and it turns on the difference between an “LBO model” and a “DCF model.” Here is the oversimplified difference:
- A discounted cash flow model makes some assumptions about the company’s future cash flows, assumes a reasonable capital structure, discounts those cash flows back to the present based on the company’s cost of debt and a market-based cost of equity capital, and comes up with a value per share reflecting the present value of those cash flows.
- A leveraged buyout model does the same thing, except that the capital structure is more leveraged and, instead of a reasonable cost of equity capital, it assumes a 20 percent to 30 percent cost of equity capital.
Again, this is super oversimplified; please don’t use this description to prepare for your investment banking interviews. But the basic idea is: Private-equity firms like to buy companies for less than they’re worth, so that they can make 20-plus percent returns on their equity investments, so that their own investors will be happy with them and pay them their big fees. Public investors are satisfied with market-rate returns. Vice Chancellor Laster’s DCF calculation used an 11.3 percent expected return for Dell’s equity. If you expect an 11.3 percent return, you will be willing to pay more for a company than you will if you expect a 30 percent return. That is just math.
So you see the problem. Private-equity firms will only buy companies for cheap and lever them up, so they can get the 20-plus percent returns that their investors demand. So any price that a private-equity firm will pay for a public company is inherently suspect, since private-equity firms expect such high returns. So Vice Chancellor Laster ignored the price that Silver Lake actually paid, after a quasi-auction among private-equity firms. He chose his own DCF model, with lower expected returns, and calculated a higher price for Dell.And then he declared that that was the fair value.
I realize that this all sounds pretty naive when I put it like that, but it is kind of … exactly what Vice Chancellor Laster says? This paragraph, near the end of the opinion, is deeply weird:
The fair value generated by the DCF methodology comports with the evidence regarding the outcome of the sale process. The sale process functioned imperfectly as a price discovery tool, both during the pre-signing and post-signing phases. Its structure and result are sufficiently credible to exclude an outlier valuation for the Company like the one the petitioners advanced, but sufficient pricing anomalies and dis-incentives to bid existed to create the possibility that the sale process permitted an undervaluation of several dollars per share. Financial sponsors using an LBO model could not have bid close to $18 per share because of their IRR requirements and the Company’s inability to support the necessary levels of leverage. Assuming the $17.62 figure is right, then a strategic acquirer that perceived the Company‘s value could have gotten the Company for what was approximately a 25% discount. Given the massive integration risk inherent in such a deal, it is not entirely surprising that HP did not engage and that no one else came forward.
That is, Vice Chancellor Laster checked his work — and his price of $17.62 — by looking at the actual results of Dell’s sales process, which got a price of $13.75. If Dell was worth $17.62, then no strategic buyer would be willing to bid more than $13.75, because at only a 25 percent discount to fair value “the massive integration risk” would make Dell unappetizing. And if Dell was worth $17.62, then no private-equity buyers would be willing to bid more than $13.75, “because of their IRR requirements and the Company‘s inability to support the necessary levels of leverage.” The proof that $17.62 was the fair price is that no one was willing to pay it:
- Public shareholders won’t pay fair value for Dell, because they are obsessed with the short term and can’t understand the long-term strategic vision.
- No strategic buyer would pay fair value to buy Dell, because that would be risky.
- No private-equity buyer would pay fair value to buy Dell, because private-equity firms only buy companies at a discount.
So how could any merger deliver fair value to shareholders? This opinion creates its own weird valuation gap. Public-equity markets, let us assume, focus too much on the short term, and undervalue companies whose immediate results don’t match their long-term prospects. The solution to that short-term-ism might be to go private so you can focus on the long term. But private-equity firms undervalue companies because, let us also assume, they demand an above-market rate of return and so will only buy companies at a discount. The only buyer willing to pay fair price for a company, apparently, would be a buyer with the relatively long-term focus of private-equity firms and the relatively low-return expectations of public-equity investors. Perhaps such a buyer exists. But it would be a little weird. After all, the higher returns are the compensation private equity gets for taking the longer view (and longer-term risks). And ample short-term liquidity is what allows public markets to afford the lower-return expectations.
Why should there be mergers? Sometimes there are synergies: Company A and Company B will be better off together, because they can sell each others’ products or cut back-office costs or whatever. Sometimes there are governance benefits: Company A’s current managers don’t know what they’re doing, and an acquirer could install better managers with better ideas that make it worth more money. Either way, the merger creates value by making the business better. That’s not what happened in Dell:
This was not a case in which the Buyout Group intended to make changes in the Company‘s business, either organically or through acquisitions. The Buyout Group intended to achieve its returns simply by executing the Company‘s existing business strategy and meeting its forecasted projections. Mr. Dell identified for the Committee the strategies that he would pursue once the Company was private, and the record establishes that all of them could have been accomplished in a public company setting. BCG recognized and advised the Committee that the only benefits Mr. Dell could realize by taking the Company private that were not otherwise available as a public company were (i) accessing offshore cash with less tax leakage (to pay down the acquisition debt) and (ii) arbitraging the value of the Company itself by buying low and selling high.
I suppose that sounds derogatory, but there are those who think that “arbitraging the value of the company itself by buying low and selling high” is … I don’t want to say a noble purpose, but let’s say, the most noble possible purpose. When Michael Dell proposed a buyout, the company’s price was wrong. Everyone involved in this case agrees on that. Michael Dell thought — and said — that Dell was undervalued. The Dell board said that it was undervalued. Its financial advisers said it was undervalued. Silver Lake thought it was undervalued. When the deal was announced, Carl Icahn said it was undervalued. When the deal closed, the appraisal plaintiffs sued, saying it was undervalued. And now a judge has decided it was undervalued.
But Michael Dell and Silver Lake are the ones who did something about it. Everyone says Dell’s market price was too low; they skipped the talk and just offered to pay more. This buyout didn’t create value by changing Dell’s business model; it created value by changing Dell’s ownership — by moving the shares from people who mostly didn’t value them that highly (public markets) to people who did (private-equity buyers). It didn’t create synergies or improve Dell’s sales, sure, but it did correct an error. There are those who would say that’s a worthwhile thing to do. The court, though, suggests that it isn’t.