Category Archives: Private equity

LinkedIn IPO: sign of a second internet bubble? three reasons I don’t think so

May 22, 2011 By in Current Market Thoughts, Industry Analysis, internet, Private equity, Recent Market Action Tags: , , , , , , , 2 Comments

the LinkedIn IPO

Class A shares offered

Social networking company LinkedIn (LNKD) went public last Thursday, offering 7.8 million Class A shares.  According to the preliminary prospectus, 4.8 million of them were new shares sold by the company;  the rest were secondary shares sold by existing stockholders.

LinkedIn also has Class B shares, which differ from Class A mostly in that each has 10 votes while Class As have one apiece. This is a standard device used by family-owned or other closely held firms to raise public money and have a listed stock, while retaining complete control over operations.  News Corp., Hershey and Google are other US examples.  In the case of LNKD, the insiders who own Class Bs still muster 99.1% of the corporate votes, making the class As, in my mind, more like preferred shares than common.  For Thursday and Friday, though, no one cared.

pricing and initial trading

Underwriters initially talked of an offering price in the low thirty-dollar range–maybe $32.  But as they saw the strength of investor demand for the issue, the number gradually rose to $45.

The opening trade for LNKD was $83.  The day’s low was $80, the high $122.70.  The stock closed at $94.25, on volume of 30+ million shares–meaning each share changed hands 4x on average during the day.

I was in PA

I was driving to Pennsylvania while this was going on, listening to the Bloomberg Surveillance program on satellite radio.  The reporters on the broadcast commented a number of times that this felt to them like Internet-Bubble activity of late 1999-early 2000.  When I got home, I read similar comments in the Wall Street Journal and the Financial Times.

How quickly they forget!

Yes, there are some similarities.  Both then and now are periods of very easy money policy, and extra money sloshing around the system invariably gets into speculative mischief.

But the late-1999 Fed had the money taps wide open in spite of economic strength, not like today when the central bank is fighting to reduce sky-high unemployment (how effective today’s Fed policy can be is another question).

Y2K

If you recall, the Fed’s big worry back in 1999 was Y2K–the possibility that every computer in the world would shut down at midnight on 12/31/99, stopping commerce everywhere dead in its tracks (kind of like the Lehman failure did in 2008, only worse).  That would supposedly have left us with blue screens, warm refrigerators, stuck elevators, dead machine tools and ATMs that refused to give out cash.  All our financial information might be wiped out.

In 1999, Amish farmers couldn’t replace worn out horse-drawn plows, because survivalists preparing for this potential Armadeggon bought them all up.  Silver coins were trading at 10x face value, on the idea that paper money would be worthless as developed economies fought to avoid sinking back into pre-industrial chaos.

The Fed injected a lot of extra money into the system to help ease any Y2K damage–none of which occurred.

three big stock market differences:

1.  cult of the internet back then

In late 1999-early 2000, the US stock market was flooded with internet-related IPOs.  Many of these firms had no actual businesses and little more than business plans (sometimes, not even that).  In normal circumstances, they would be looking for venture capital financing.  At investor meetings, which had a cult-like quality to them, company executives focused on concept, not near-term business prospects.

Even a survivor of the subsequent dot.com meltdown like Amazon didn’t make money back then.  The company wouldn’t turn profitable until 2003, and had negative net worth until two years later.  In my opinion, Amazon only made it because it had large follow-on offerings of stock and bonds.  But very many more, like eToys or Boo.com, went out of business as soon as they burned through their IPO proceeds.

It wasn’t just crazy IPOs, either.  At the peak of the frenzy, media conglomerate Time Warner traded half its assets for a near-worthless AOL.

In contrast to the hundreds and hundreds of highly speculative transactions in 1999-2000, in 2011 there have only been two questionable ones that I see:  the first-day price of the LinkedIn IPO, and Microsoft’s purchase of Skype.

2.  wild overvaluation in 2000…

…in the TMT sector…  internet-related stocks as a group were known as Technology-Media-Telecom (TMT) stocks.  They made up a significant chunk of the overall US stock market, even before the buying frenzy began.

As I mentioned above, many e-commerce stocks had no earnings at al–and therefore no meaningful PEs.  More mature companies did have earnings, though.  And they were priced through the roof.  At the peak, Qualcomm was trading at 177x its 2000 profits; smaller chipmakers traded at even higher multiples.  Staid, slow-growing, highly cyclical communications equipment providers, like Ericsson and Alcatel traded at 137x and 110x respectively.  Similar “hot” names like Nortel no longer exist.

Brokerage house analysts like Henry Blodget (since barred from the securities industry and now a blogger) and Mary Meeker (now in vc) whose horribly inaccurate forecasts helped justify the mania, acted like–and were treated like–rock stars.

…and in the stock market as a whole

In March 2000, the S&P 500 peaked at about 28x earnings for 2000.  This compares with a ten-year Treasury yield at that time of about 6%, which would justify a stock market PE of 17.  Relative to bonds, then, stocks were 65% overvalued.

In contrast, the S&P is trading today at under 14x the consensus estimate of 2011 profits.  The ten-year Treasury is trading at a 3% yield, implying a stock market multiple of 33x.  So stocks are 60% below the level implied by bond yields.  Put another way, if stocks are fairly valued, bonds are trading at well more than twice the price history would say they should be.

3.  real rocketship IPOs back then

Yes, LNKD did double from the IPO price on its first day.  So what.  Renren (social networking in China), a first-day star a couple of weeks ago, is now trading $1 below its initial offering price of $14.

If you want to see real IPO action, take a look at UTStarcom (which still exists today).  It debuted in March 2000 at an IPO price of $18.  It closed that day at $68, up 277%, after having reached an intra-day high of $73.  It then proceeded to run up to its all-time high of $93.50–5x the IPO price–before the end of that month.  (It closed last Friday at $2.09–but, hey, it survived, which is more than you can say about most of the dot-com names.)

my thoughts

Yes, there may be overvaluation in today’s financial markets, but I don’t think it’s in publicly traded stocks.  Maybe  privately-traded equities are too expensive.  But that’s a relatively small market whose failure wouldn’t have severe negative consequences for the US economy.  For my money, if you want to see expensive, look at bonds and commodities.


initial thoughts on Microsoft/Skype

May 11, 2011 By in Current Market Thoughts, Industry Analysis, internet, Private equity, Recent Market Action, Stock ideas, Technology Tags: , , , , , , Leave a comment

the purchase

Yesterday, May 10th, MSFT announced it had agreed to buy Skype from its private equity owners for $8.5 billion in cash.

a little history

If you recall, e-Bay bought Skype from its founders–who opened up for business in 2003–for a total of $3.1 billion ($2.6 billion up front, an additional $500 million in incentive payments) in 2005.  The idea was that free phone calls between seller and bidder would somehow boost e-Bay’s online auction business.  That didn’t work.  In 2009, after Meg Whitman was ushered out of the company and new management began to clean up, e-Bay tried to sell Skype.  Only then did it learn that Ms. Whitman had neglected to secure the basic intellectual property behind the internet phone service (whoops!).   But e-Bay eventually managed to sell roughly 70% to Silver Lake for a price that valued the whole company at $2.8 billion (Silver Lake did manage to acquire the IP from Skype’s founders).

After freeing itself from the “bureaucratic mess” of e-Bay, as the New York Times reported, quoting a Skype blogger, the company dusted itself off, filed for an IPO about eight months later and simultaneously began exploring the possibility of a private sale.

Enter MSFT, which intends to link Skype to its e-mail, X-Box and office collaboration offerings on the idea that this will make them all more attractive.

This will be the largest purchase for MSFT ever, though not its highest-ever offer.  Remember, MSFT made an unsuccessful $44+ billion bid for YHOO in 2008.  In that instance, the YHOO board (strangely, given the firm’s operational difficulties) rejected the $31 a share offer, which was at about a 60% premium to the pre-bid price.  The S&P 500 is about flat since that time.  YHOO has  new CEO and is now trading at just under $19.

why Skype?

Skype is probably not the purchase you or I would make if we had a loose $8.5 billion lying around.  I don’t think it’s one that GOOG would make  …or AAPL   …or WMT.  In addition, as far as I can see, MSFT had no interest in Skype when it was in the process of being sold for less than $3 billion a year and a half ago–which for me is the most troubling part of the deal.

But the acquisition may not be as bad as it looks on the surface.  It also gives you insight, I think, into what MSFT sees as its best viable investment options.  To elaborate:

foreign earnings

1.  Like many US-based international companies, MSFT has a ton of profits it has earned overseas that are lying around in low-yielding offshore bank accounts.  There are two reasons for this:

—economically, repatriating these earnings to the US would subject them to federal income tax at a rate of 35% minus any foreign tax paid.  Since the funds are presumably in low- or no-tax jurisdictions, a company returning the funds to the US would have to fork over a third of the money to Uncle Sam. Why do it without a clear domestic need for the money?  Suppose you repatriated a large amount, paid tax and then figured out you wanted to use it for an acquisition abroad?  Better to keep your options open.

—financially, unrepatriated funds can’t be used to pay dividends to US shareholders.  So in some sense, this money is not worth 100 cents on the dollar to US shareholders.  A generation ago Wall Street would have worried about this and applied a discount PE multiple to low-tax foreign earnings.  No more.  Today’s investors seem to me to be indifferent to the tax rate a company pays.  They capitalize all after-tax earnings at the same rate.  So in today’s world, repatriating funds, which lowers reported eps, lowers the stock price as well.   …another reason not to do it.

If we assume MSFT will pay for Skype with money marooned in a zero tax rate jurisdiction, then paying $8.5 billion for Skype in Luxumburg is like paying $5.5 billion in the US.

a quick-and-dirty payback analysis

2.  In an interview with Forbes, Silver Lake says that if MSFT manages Skype well, it could eventually be worth $25 billion-$30 billion.  (Huh?  If this is the case, why in the world are they selling 100% of what they own?)

Let’s assume, just for the sake of argument, that Skype, which is around breakeven in its seventh year of operation and has only 8 million paid users, somehow grows profits in a linear fashion to $500 million five years from now and $1 billion in ten years, before earnings flatten out but continue at the $1 billion a year level.  Let’s also assume that MSFT doesn’t spend a penny integrating Skype into its software offerings.  How long does it take MSFT to recover its $8.5 billion?

The answer is 13.5 years.

That’s a looong time, especially in the fast-changing world of the internet.  In fact, if we were calculating a present value and not just a simple payback, or if we were assuming the MSFT has to spend money to integrate Skype (which it will have to, I think), recovery would be even loooooonger.

What makes Skype an attractive investment for MSFT, then?  The simple answer is that this is the highest-return investment the company can find that’s within its core competence.  Yes, it could buy something in an unrelated field, like a department store or a circus or a mining company, as Big Oil did when it was flush with cash in the mid-Seventies.  But ideas like those are always disasters.  In other words, the Skype deal underlines how mature a company MSFT is.

the Flatotel and the Alex Hotel: a cautionary tale for investors

April 6, 2011 By in distressed assets, growth vs value, Investment firms, Private equity, Property/housing Tags: , , , , 1 Comment

a free Wall Street Journal

I’m not a particular fan of News Corp, even though I will admit I was one of the first US-based holders of the stock–and a large one at that–in the mid-Eighties.  The Wall Street Journal is being delivered to my door every day this week as part of a campaign to gain new subscribers, however.  Yes, there’s a lot of fluff and it’s very US-centric.  But the paper is better than I remember.  To my surprise, I may end up subscribing.

That’s not my point today, though.

the underbelly of finance

The “Greater New York” section of yesterday’s paper has an interesting article in it that gives a glimpse at a part of the usually-hidden underbelly of finance.  It also shows some of the obstacles that investors in “deep value” or “distressed” assets routinely face.

Titled “Hotel Developer Must Check Out,” the article describes a recent foreclosure action in which a New York judge put two Manhattan hotels, the Flatotel and the Alex, into receivership.

Alexico

The back story is about a former gold trader and a hotel developer who met in the gym and formed a hotel management company, Alexico.  Borrowing heavily from Anglo Irish Bank (the institution, incidentally, that played the pivotal role in crashing the entire Irish economy), the two started a number of high-end hotel and condominium projects. Then the great recession came.

Anglo Irish has since been nationalized.  As part of its restructuring, it sold the loans it made Flatotel and Alex–a face value of $258 million–to a consortium of US real estate management groups for maybe half that.  They went to court to force Alexico to turn over control of the two hotels.

That’s not the interesting part.

the interesting part

This is:

–the two hotels are losing money   They haven’t made payments on their debt, nor have they paid real estate taxes, for two years.  But they did manage to pay Alexico $570,000 in management fees during that period.

–in addition, the ailing hotels scraped together enough cash to lend $5.3 million to other parts of the (now crumbling) Alexico empire.

–why didn’t Alexico extract even more money from the two failing hotels, you may ask?  A cynic, meaning someone who’s seen this movie before, would say that what Alexico took was all the cash the hotels were generating.

–besides this, the plaintiffs in the case say the hotels’ financial records are a mess (what a surprise!). No elaboration, but I don’t think the issue is that the accountants spilled coffee on the books or that the entries are all mixed up and in the wrong places.  I interpret this as meaning there’s no way of knowing how much money came in the hotels’ doors or tracing where it went.  If so, there may be more money missing than the loans.

All of this is pretty standard fare.  But there’s typically more:

–were the hotels larger, we’d probably also be talking about their employee pension plan–who manages it?  did it too lend money to other parts of Alexico?

–if Alexico built the hotels instead of buying them, we’d likely also be asking about whether the structures are up to code, or if the construction company used lower-quality materials than specified in the contracts.

when the burden of proof shifts…

As a general rule, it’s a mistake in a situation like this to think either  1) that this is the first time the people involved have done something like this, or 2) that what you’ve discovered to date is everything they’ve done to the asset in question.

This is why it takes a certain mindset to navigate through the potential minefield of a distressed asset.  All in all, I’m happier being a growth stock investor and leaving this sort of analysis to someone else.

pension consultants and placement agents: the CalPERS report

March 17, 2011 By in Getting financial advice, hedge funds, Investment firms, Private equity Tags: , , , , , Leave a comment

the situation

Imagine you’re a global equity portfolio manager.  You have a top quartile record over virtually any period during the prior ten years.  In fact, there’s no one in the US, and only one in the EU, who can equal or better your numbers.  You have presentation skills polished by intense preparation by experts both inside and outside your firm, as well as your many hours of practice.

You visit a pension consultant in Connecticut.  You show him your numbers, make your presentation, and await his comments.

He has only two:

–your presentation skills are terrible.  Before he can recommend you to any clients, you must take a remedial course from his firm.  It costs $25,000.

–he’s not sure you know enough about foreign markets.  The only way he can gain the confidence he needs is if you subscribe to his firm’s international information service.  He shows you the latest copy.  It’s a worthless collection of news clippings–superficial, and weeks behind what your own information network provides.  It costs $50,000 a year.

Summary:  despite the fact your record is better than that of anyone he is currently recommending to clients (who are, incidentally, paying him large amounts of money to do manager searches for them), those clients will only hear your name if you agree to make an upfront payment (read: bribe) of $75,000 and agree to continuing payments of $50,000 a year.

We decline.

Welcome to the Realpolitik of pension consulting.

the CalPERS report

The consultant I’ve described lacks finesse.  It would be more common for a pension manager to agree buy analytic services from a consultant, who would examine the manager’s product offerings for their potential attractiveness to customers.  Paying the consultant to come to your offices and spend time digging through your products will not only give the consultant the knowledge of your products that might otherwise take five years of you visiting him to impart.  But it might engender a feeling of obligation as well.

The biggest weapon in the consultant’s arsenal, however, is his control over the types of products he will recommend that his client buy.  They will be all highly specialized, offering the maximum potential for the consultant to “add value” by applying asset allocation services to the individual pieces a given asset manager sells, thereby customizing a portfolio.

CalPERS wouldn’t see the sometimes seamy interaction between manager and pension consultant.  But that’s small potatoes compared with what the consultant earns by selling manager selection and asset allocation services.

None of this is mentioned in the just-released CalPERS investigative report on placement agents and consultant services.  In fact, the part about consultants is much like the amuse bouche in a five-course meal.  What the report says is this:

1.  Somehow, while it continued to pay pension consultants as neutral third-parties to find managers and monitor performance, CalPERS ended up hiring the same organizations as money managers, as well.  Talk about the fox guarding the chicken coop.

CalPERS has finally worked out that, in addition to not being a sound action from a fiduciary standpoint, this is a no-win situation for it.  If the performance is outstanding (and my casual reading suggests it isn’t), there’s still the blatant conflict of interest.  If it’s poor, there isn’t even a pragmatic justification for the breach of prudent behavior.

2.  The big issue in the report, though, is placement agents.  These are well-connected individuals who sold their privileged access to CalPERS management for tens of millions of dollars in fees paid by third-party money managers, some of whom gained CalPERS as a client.  This appears to have happened predominantly in CalPERS alternative investment and real estate areas.

The report of the investigation, lead by law firm Steptoe and Johnson, LLP, is a carefully crafted document.

The authors point out that they received “universal and unlimited cooperation”  only from CalPERS and its current employees, less than that from others.   Some relevant people, notably former CalPERS CEO Fred Vuenrostro and former board member Alfred Villalobos, refused to cooperate entirely (understandably, perhaps, in the case of the named individuals because the report notes both are defending themselves against charges brought by the California Attorney General).

As I read it, the report makes several, not entirely consistent, points about the attempts of several of CalPERS key alternative investment managers to buy influence through Villalobos and Vuenrostro:

a.  CalPERS lost no money (not relevant from an economic point of view, but likely a key point under state securities laws)

b.  the main operational failure was on the part of the board of directors in not reining Villalobos and Vuenrostro in, and in some cases, aiding their influence-peddling efforts; the staff of CalPERS consistently resisted unwarranted pressure from Vuenrostro to select certain managers or not negotiate fees diligently

c.  nevertheless, the report also cites the case of the former head of CalPERS’ alternative asset arm, who appears to have accepted inappropriate favors from Apollo Global Management, while CalPERS was negotiating to buy a stake in Apollo

d.  in addition, many of the third-party managers who paid a total of $180 million to placement agents, Apollo Global Management, in particular, remain among CalPERS’ “most trusted external managers.”

e.  again, despite the contention that the staff of CalPERS acted entirely appropriately, the report also says that four alternative asset managers, Apollo, relational, Ares and CIM, “agreed to a total of $215 million in fee reductions for CalPERS.”

my thoughts

At least this behavior is out in the open.

To me, the conclusions in the placement agent part of the report don’t add up.  It may be, however, that CalPERS is so deeply entwined with the alternative asset managers who paid placement agents all that money and who overcharged the agency by close to a quarter billion dollars that it isn’t able to extricate itself.  So it has decided to make the best of a bad situation.  We’ll probably find out more as pending lawsuits wend their way through the legal system.

JP Morgan’s forex + IBM’s Watson = problems for Wal-Mart?

February 25, 2011 By in Current Market Thoughts, economics, Private equity, Strategy, Uncategorized Tags: , , , , , , 2 Comments

is the high unemployment rate cyclical or structural?

One of the more opaque, but nonetheless (I think) important, aspects of the US economy at present is the current long-term unemployment.  Is it cyclical–meaning the issue will gradually go away as the economy gains strength–or is it structural–meaning the recession prompted/accelerated a change in the way business is done, and that many of the jobs lost aren’t coming back?

For what it’s worth, I’m in the structural camp.

The Fed thinks that the unemployment is structural, too, if last year’s remarks by Minnesota Fed President Kocherlakota that monetary policy can’t change construction workers into manufacturing workers are any indication.  Despite this, the Fed continues to pump extra money into the economy through its “QE II” operations (dubbed that by some economics professor who lives near where the original Queen Elizabeth ships were built), as if the issue were mostly cyclical.

Why?  It feels an obligation to do something–on political and social grounds, I think, not economic–to help reduce unemployment, and this is the only tool it can wield.  I worry that, however well-intentioned, this will do more harm than good.  I’m by no means alone in this.

The orthodox remedy for structural unemployment is to retrain workers, something the country’s community colleges do admirably.  These institutions are particularly effective in getting women ready for better jobs.  Men, on the other hand, appear to come back to college having fewer learning skills.  They quickly fall behind in class, become embarrassed and tend to drop out.

recent evidence

(More than) enough preamble–What evidence is there for structural vs. cyclical?  Three recent items:

JP Morgan Chase

1.  At its investor day on February 15th, JP Morgan Chase talked about its $500 million plan to consolidate its global trading systems.  One result will be savings of at least $300 million a year.  Another is the elimination of the jobs of 3,000 people who manually type trade information into the firm’s computers–likely taking output from one computer and inputting it into a second because the firm’s disparate systems can’t “talk” to one another.  1,300 of the jobs are already gone.  To date, this effort has cut the cost to JP Morgan of making a foreign exchange trade from $.75 to $.10.  $.05 is the final goal.

I realize that Jamie Dimon hasn’t been at JP Morgan Chase that long and that some of the computer incompatibility has doubtless come from acquisitions made during the financial meltdown.  Still, this is a project that will yield at least a 60% annual return on investment and it’s only being done now.

It’s also 3,000 jobs as typists being eliminated.  If we figure that most of the savings are in compensation, that’s 3,000 typist jobs paying around $100,000 each!  Talk about low-hanging fruit.

Many of these jobs may be outside the US.  But not all of them.  And I think they illustrate a part of the employment situation that isn’t noticed or discussed much.  My experience is that every corporation has, say, 5%, of the workforce that adds absolutely no value, that’s “dead wood.”  Imagine the floor you work on.  There’s probably, even today, one person you’d nominate for membership in this club.  But these employees have enmeshed themselves so deeply in the company that it’s either legally too difficult or it’s just too unpleasant to eliminate the positions or to replace the employees with productive workers.

Deep recession both provided the occasion and the motivation to fix these problems.  When MSFT, which has money coming out of its ears, has layoffs, you know that’s what’s going on.  The downturn also taught managers that they could operate productively with less labor.

Having just unloaded the burden of “dead wood,” what would ever prompt you to hire it back?

Watson

2.  Watson is the IBM computer that recently soundly defeated two human champions on the game show Jeopardy. Watson can understand slang- and pun-filled speech, is chock full of mounds of trivia facts and can trigger a buzzer faster than most (at least, faster than the two human champs).  Long-term, this is not good news for librarians, tour guides or people manning information booths at the railroad station.  More generally, it suggests that having lots of local lore at your fingertips is eventually going to become little more valuable than having fingertips that can touch the correct keyboard keys.

In other words, the replacement of man by machine is nowhere close to being played out as a fact of modern life.

Wal-Mart

3.  WMT’s sales in the US continue to stagnate.  There appear to me to be two reasons for this:

–more affluent customers, who traded down to WMT during the recession, are migrating back up to the more upscale venues they frequent in better times.

–less affluent customers are trading down from WMT, to stores that are normally off Wall Street’s radar screen.  In particular, the “dollar stores,” whose target market was once single heads of household who have incomes of $20,000 or less and who typically live within walking distance of the stores, have expanded their lines of merchandise to woo WMT shoppers looking for cheaper prices.

What I find telling about the WMT example is that the retail giant’s customer base is moving in two directions, one with the economic cycle and one against it.  Private equity investors are falling all over themselves trying to participate in the dollar store phenomenon.  They might not be the brightest crayons in the financial industry box, but they see a clear opportunity.  They’re placing their bets squarely on the idea that this counter-cyclical consumer movement will be with us for a long time.

my conclusions

Nothing really concrete in what I’ve written, just a few straws in the wind.  But they’re all evidence that support the belief that the US is facing is a structural employment issue–one that can only be fixed through retraining–rather than a cyclical one that will eventually be remedied by keeping fiscal and monetary taps wide open. 

Being right or wrong on this issue won’t make much difference to stock market action this year or next.  But there are long-term consequences to what policy makers believe.  For example, if unemployment is structural, it won’t make much difference if we tighten money and fiscal policy to put our government finances on a sounder footing.  Our efforts should go into retraining, particularly for men who left high school with few learning skills.  This is the opposite of the current Washington position that we have little to lose from running super-accommodative policy.  It also puts the risk of weakness in the US$ or Treasury bond markets in a different light.