You remember Ben Stein, don't you? The host of "Win Ben Stein's Money?" No? He's the monotonic economics teacher in "Ferris Bueler's Day Off," you know, "Bueler...? Bueler...? Bueler...?" Ah yes, now you remember. Few things amuse me more than old episodes of "Win Ben Stein's Money." You have to give credit to a game show host who challenges the lead contestant for the final prize (and usually wins). It is not easy to win Ben Stein's money either. Not when you are a contestant on "Win Ben Stein's Money," and not if he's a shareholder of the firm you are trying to take over via a management buyout (as the management of Narragansett Capital apparently discovered when Stein filed objections with the SEC and caused the commission to ask for a full review and kill the deal). I was pleased, therefore, to be pointed by an email from Abnormal Returns to a piece that Ben Stein, intriguingly penned (free but annoying NYT registration avoidable via bugmenot) for this Sunday's New York Times titled "On Buyouts, There Ought to Be a Law." Information Arbitrage and Financial Rounds get in on the game too.
What surprised me is that therein Ben Stein, usually the champion of reason, calls for more regulation, in fact an outright ban, to correct some kind of market imbalance he sees in MBOs. I say "surprised" because his usually deft command of logic and quick wit seems absent here. It also seems out of character for Stein. He was a speech writer for Richard Nixon and appears on Fox News, after all. I even ventured to wonder, at one moment, if someone hadn't pulled a bit of a hoax on the New York Times. (Then again, Stein is a celebrity judge for "Star Search," suggesting at least the early signs of mental defect).
Mr. Stein's main objection to MBOs seems to be a "fairness" one. I've discussed the pitfalls of the "fairness" trap before, I fear this encounter with the concept is no different. Stein quips:
The deals were happening because the market swooned in the mid- and late 1980’s, but asset values remained high, and so there was a major arbitrage to be realized between asset value and stock price. To me, it seems that this arbitrage belonged to us stockholders and not in any way to our trustees, the managers. But the managers wanted that money, and if they wanted it, they usually got it. There was not much of anyone to stop them.
Then the market rallied and stocks came to be worth more than their underlying assets, so the leveraged buyouts came less often. That gap between the value of the assets that managers sold after the buyout and the stock’s value before the buyout had vanished.
Now, the markets have corrected— they have been lackluster for a long time now, in fact— but inflation and immense gains in the price of oil, as well as gas and other commodities, have spawned opportunities for looting us stockholders, and management buyouts are running riot.
Stein's complaint, it seems to me, stems not from "opportunities for looting us stockholders," but rather the "arbitrage to be realized between asset value and stock price." This, his argument implies, is unfair. The fact that the stock price at any particular moment is below asset value is, he seems to suggest, unfair. For a third party to take advantage of this arbitrage is unfair. It is "looting." This argument is just silly.
The arbitrage opportunity, i.e. the difference between the stock price and the asset price, is the result of one of two things:
1. The public market for the securities in question is somehow inefficient. That is, it is "mispricing" the asset (shares of the company) because of liquidity problems, incomplete information, or pure irrationality.
2. The public market for the securities in question is efficient, and is pricing other factors (probably risk) into the stock price. The market's appetite for risk is low, so a small premium and "cash now" sounds much better than patience and maybe cash later.
In either case, Stein's issue is with the markets, not management. One might even suggest that by paying a premium over the current stock price (which they almost certainly will), management is doing the shareholders a favor. Let's also remember, that a management buyout will require board and potentially shareholder approval. If Stein, as a shareholder, wants to involve the SEC, sue, rally shareholder dissent for the deal, or force a proxy fight, he is welcome, as every shareholder is, to do that (as he did with Narragansett Capital). If he cannot convince the rest of the market or the board that the offer is too low, then perhaps it is Stein's pricing of the risk that is off, not the market's. Even this relies on this very flimsy concept that there is some "correct price" for an asset outside of what buyers and sellers will actually agree to pay for it.
Consider this: Two shipwreck victims on a desert island. 4 cans of beats. If the first shipwreck victim offers to sell her 3.5 caret flawless, colorless diamond wedding ring for a can of beats and the second shipwreck victim refuses, what is the diamond "worth?" And this is just the point. Just because it might be worth $80,000 in New York, it is worth less than the salt in her tears on a desert island. They aren't standing in New York. (The fact that the time horizon of the market participants here is measurable in weeks contributes to the low betas, will anyone actually live to actually sell/enjoy the diamond?) Mr. Stein's stock might well be worth more than it is now in an ideal environment. But using that as a price point is about as legitimate as using a parallel universe where the company has a parent for cold-fusion as a price point. It is fantasy. Pricing it accordingly is also fantasy.
Take my scenario and add some mass drama to it, like, say, an oil crisis, and we actually look at market actors who raise prices in the face of dire shortages as criminals. This we call "price gouging." It is illegal because it is unfair. It is unfair that because supplies are low people should have to pay more for a scare product in high demand. (Follow that? Me neither. Seems to depend on the idea that there is some intrinsic right to low prices [or high prices if you are a seller] regardless of market forces. You will see this theme again, I promise).
Calling in the SEC to determine a "fair price" seems absurd to me as well. A "fair price" is what you can get for it. I am constantly suspicious of a small central group (i.e. the SEC) dictating price, particularly when the much larger and more fluid market disagrees and the centralized price is dressed up with the word "fairness." To that point, though Stein seems to imply that Narragansett's management pulled the deal because it was a "looting," I imagine the cost of enduring a full SEC review had more to do with management's decline to pursue the deal than any fear of it being disclosed as some kind of theft or fraud.
Let's also look at Stein's position as a shareholder and the "fairness" of this "arbitrage."
Stein either bought the stock when it was higher (and therefore is underwater on the stock) or he bought it when it was lower, but thinks it should be even higher. If the former, well, it seems to me that Stein timed the market poorly and if he isn't ready to cash out at a premium to the current price then his beta is just different from the majority of the other shareholders. Tough cookies.
If the later, then Stein's return expectation is just higher than the majority of the other shareholders. Tough cookies.
Either way he is swimming against the tide of the market. What really irks Stein, it seems to me, is not that there is an arbitrage opportunity, but that he's on the wrong side of it. The subtle implication here is that Ben Stein is smarter than the rest of the market and if only he could make them act rationally (or his in line with his view of rationality) then he could make the money he expects, nay that he deserves.
Be afraid, be very afraid, I say, of anyone who wants to pass laws to make the market "fair" because they aren't getting the returns they would like. And that's what Stein wants. To wit:
To my mind, these deals should be illegal on their face. That is, they should simply not be allowed at all as a matter of law. Here’s why:
The managers do these deals only to make money. It’s business, after all. They do them to make money off the assets of the stockholders. They could, if they wished, sell off the assets or otherwise manage them for the good of the stockholders. (Again, the assets of public companies do belong to the stockholders as basic law.) Instead, they buy the assets on the cheap and sell them off for their own management benefit, or they manage the company differently for the benefit of themselves and their buyout partners.
But as a matter of basic fiduciary duty law, managers are bound to put the interests of stockholders ahead of their own, in each and every situation. By buying the assets on the cheap and then reaping the benefits, management is breaching that fiduciary duty, or so it seems to me. Likewise, if the managers can run the company more profitably, they owe it to the stockholders to do that for them.
So what is Stein complaining about, exactly? It is not a question of "if the managers can run the company more profitably," it is more a question of whether the shareholders believe management can run the company more profitably, and even if they do, if they are willing to wait that long (and thereby increase their risk to any number of external factors) to cash out rather than take a 20% premium right now. Management gets massive returns because they adopt the risk that the public shareholders willingly sell to them. This is what Stein seems to ignore. As if it is a slam dunk that if we just stay the course he will pocket millions. As if there is no general market risk to running a large public firm.
Stein's timing for this argument stinks as well. If the firm ends up in a management buyout bid this week, it has just put itself in a very liquid and very fluid environment with a ton of competition and a tidal wave of cash floating around, not the least from hedge funds that are spending in a fashion that approximates financial retardation. Hardly a situation where you expect shareholders to get screwed. In fact, you only have to look at the multiples buyouts are paying these days to realize that being a shareholder in the midst of a buyout today is like getting mana from heaven. The Financial Times and the Economist have both quipped in the last quarter that, given the prices of assets, the only beneficiaries of buyouts right now are the shareholders lucky enough to be exited by one. Stein should really look at historical multiples rather than gripe about one or two examples back in the 1980s where no one else wanted to bid on the company he was foolish enough to invest in. In this environment, if you can't even get two bidders then be lucky you have a way to get out of the stock at all.
As for the structural issues, there are ex ante mechanisms in the United States both to guard the shareholder in the form of fiduciary duties of the board and of management, and there are ex post mechanisms for redress if a shareholder feels an executed buyout is unfair despite these protections. Are these somehow ineffective? Is Stein really talking about a corporate governance issue? Let's examine that.
Stein believes there is a conflict of interest here. Classically, there is. What he is pointing out is the classic so-called "agency problem." And what is the conventional solution for the protection of shareholder interests? Anyone...? Anyone...? Anyone...? B...O...A... something...? The board of directors. On paper the board of directors is supposed to safeguard shareholders from management. In buyouts, their role is to review the transaction (often by appointing a special committee) and assess fairness. In many proposed management buyouts, the board will actually fire management, or those of management proposing the buyout, or at least put the parties involved on leave and appoint an interim CEO to deal with the conflict. One public board member I spoke with indicated that if ever approached with an MBO proposal by a CEO he quips back "well if you are serious, give us your letter of resignation and let's get the process moving." Not many take him up on the offer, he says. (Consider the fate of RJR Nabisco's F. Ross Johnson when he tried to mount an MBO).
If these protections are insufficient, and lawsuits challenging the board's objectivity are not sufficient the Stein's problem is with the corporate governance system in the United States, not buyouts. And let's not forget, as a shareholder, Stein had an opportunity to make changes at the board level if he wished. That's what shareholder voting is for. If shareholders believe the board is not objective enough, why did they wait until after a buyout to sue rather than remove them before the problem arose? It doesn't take a genius to see that we are in an era of very powerful shareholders right now. The days of the Imperial CEO are over, for now. Accordingly, I am unsympathetic to these oppression pleas.
Stein goes on to point out:
But in a management buyout, management is seeking to pay the least it can get away with for the assets of the public holders, while the public holders want the most they can get.
How exactly this differs from any buyer-seller transaction in the history of free markets is a mystery to me.
Stein does, however, in a brief flash of the superiority complex I speculated about, finally give us a hint of what drives his call for a new law:
"I want to make sure you know that I am somewhat ahead of the curve. No court has yet put all of this together and banned management buyouts. But it took a long time for courts to bar segregation or for Congress to bar residential housing discrimination."
Ah yes, the great injustices of the world. Segregation. Discrimination. Management buyouts. What WOULD we do without "ahead of the curve" Ben Stein to right these tragic wrongs?