Why I don’t like Cash Shells

A cash shell is a company formed to make an unspecified acquisition. It raises money by listing on a stock market, with the stated intention of making an acquisition once it has achieved that listing. The eventual acquisition is then financed using the cash raised and, often, newly-issued shares.

I’d known about cash shells for years – I got interested when the ill-fated Knutsford Group plc[1] came and went in 1999 – and I’d never understood why people would put their money into such a vague proposition. When The Today Programme asked me to speak about Bumi, I started to research it further.

The original prospectus for Bumi (or rather, Vallar plc, the name of the company before it made its acquisition) referred to incentives for the Founders, Nat Rothschild and James Campbell. Now, executive incentives is my research subject, so I got interested and followed this up. It said – once you cut through the legalese - that the Founders would get Founder Shares and Founder Securities in order to, “incentivise them to achieve the Company’s objectives. The Founder Shares reward such members of the Vallar Team for their initial capital commitment to the Company and for completing the Acquisition… The Founder Securities encourage the Vallar Team to grow the Company following the Acquisition and to maximise value for holders of Ordinary Shares by entitling the Vallar Team to a share of the upside in the Company’s value once the Performance Condition is satisfied …”


Hmm – I’m sorry, but why exactly do they need this incentive? Surely growth and value are what they are founding the company to do? And as they are putting their own money into it, isn’t the prospect of that capital growth incentive enough? Apparently not.

Now, Founder Shares are a very commonly-used device in venture capital deals, where the founder of a business puts in a lot of effort to develop an idea/product before the financiers invest. In order to compensate them for this, they receive ‘sweat equity’ in the form of Founder shares that will convert into Ordinary shares on favourable terms if the enterprise is successful. This is a very useful device in structuring the finance for a venture capital-backed business. But in this listed shell company, I’m at a loss to see how much ‘sweat’ has been put into the enterprise at this stage.

I mean, it’s not as if they are doing the work for free. As well as being directors of the company, for which they, quite properly, receive a fee, they are also its Adviser. Well, technically they are not the Adviser, the Adviser is a newly-formed Jersey-based Limited Partnership. But the Founders appear to be the main owners of that partnership. And the partnership is going to do quite nicely out of the company. The prospectus says:

“…the Adviser will receive an annual fee of £5,000,000 or 0.5 per cent. of the average Monthly Market Capitalisation of the Company for the year in question (whichever is higher), subject to a maximum of £10,000,000”

So, £5m a year. Plus, the Adviser will be reimbursed all reasonable transaction-related costs when an acquisition is being considered. They are not doing too badly so far.

Now, back to those Founder Shares and Securities. Founder Shares always imply that the founders are getting a sweet deal – as I said earlier, that is the reason for them. How sweet is this deal?

Well, it’s not too easy to understand. So let me translate it as I see it, and explain a bit about venture capital deals as we go along.

In venture capital, you aim to make your money on an eventual sale of the business. So, the aim is to grow the enterprise, and sell out for a high share price. Let’s say that a company is started with £100,000, of which the Founders put in £10,000 and external investors £90,000. What might happen is that the Founders receive 10,000 Founder shares and the other investors receive 90,000 Ordinary shares. A few years later, the company is about to be sold, for say £1m. Just before sale, the Founder shares will convert into Ordinary shares. If they converted at par, i.e. one Founder share became one Ordinary share, then there would at the point of sale be 100,000 shares in issue, and the Founders would get £100,000 of the £1m proceeds.

Still with me? Okay, let’s make it a bit more complicated. We want to give the Founders an incentive to work really, really hard, and we want to reward them for what they brought to the business before the investors came in. So instead of converting the shares at par, we’ll convert such that for every one Founder share you get two Ordinary shares. That means 110,000 shares in issue on sale, with the Founders getting £181,818 of the £1m proceeds. A conversion of 3:1 would give the Founders £250,000. And so on. The Founders get more as the conversion ratio increases; and the investors agree to this because they know that without the Founders there wouldn’t be a business.

Right, now that we’ve had a venture capital lesson, back to the Vallar prospectus. There are Founder Shares and Founder Securities, so let’s deal with each in turn.

The Founder Shares convert into Ordinaries using a formula that is slightly different to the one I demonstrated above, and rather more complex. It means that if the Founders put in £20m and another £680m was raised from external investors, the Founders’ investment of 2.85% of the whole would give them 6.67% of the company. Using the terms from above, that is a conversion ratio of about 2.4:1.

Then there’s the Founder Securities. The terms again are quite complex, but broadly, these give the Founders 15% of the increase in the value of the company over and above its value at the flotation.

Okay, let’s summarise. If you put your money into this shell company you would be buying shares in an unidentified business, in the hope that its promoters (a) found a target to buy, (b) could buy it at a not-too-excessive price, and (c) could run it successfully in order to make it worth more than it was worth to its previous owners. (They need to create some sort of synergy – a grossly-misused word in corporate finance – in order for them to justify paying the vendor a premium over what it’s currently worth. Because presumably, the vendor is not going to sell out for less than it’s currently worth…) That’s quite a big ask. And in exchange for you giving them your investment funds on trust, they will take out salary, advisory fees and a rather significant share incentive.

Please don’t think I’m getting at Messrs. Rothschild and Campbell for this. I’m not. Well, not really. I happen to have looked at Bumi because I was on the Today Programme talking about it. But what they are doing, although very aggressive, is above-board. I pulled all of this information out of the prospectus, which is a public document. Any potential investor could read it.

Do other shell companies do similar things? Well, I had a quick look at a shell company that was floated about the same time as Vallar/Bumi – Horizon Acquisition Company. This company, led by entrepreneur Hugh Osborne, raised about £400m floating as a shell early in 2010 with the aim of buying over-leveraged businesses hit by the financial crisis. On a very quick look-through, its remuneration structure is less aggressive that Vallar’s. It doesn’t have Founder Shares but it does have Founder Securities, which convert to the same 15% of capital gain as did Vallar’s. What is interesting to me about Horizon is what it did with the money. Here is an extract from the RNS Announcement [2] (I couldn’t find the prospectus online):

“Horizon intends to acquire and restructure a single major business or company, significantly reducing its debt (the "Acquisition"). The business is likely to have significant operations in the UK, to have an enterprise value of between £1 billion and £3 billion ( although a business with a larger enterprise value may be considered ) and to be constrained by its capital or ownership structure. … Horizon intends to use the net proceeds of the Placing primarily to reduce the leverage of the acquired company or business.”

The RNS announcement  just gave a couple of line so information about the directors, but press comment at the time [3], presumably based on the prospectus, emphasised the skills and background of Hugh Osborne and Alan McIntosh, the executives behind the venture.

In June 2011 Horizon acquired APR Energy, a US energy company! Hugh Osmond and Alan McIntosh then stepped down from the Board – presumably because there was little that their experience could bring to a US energy business. I have not checked, so I have no idea if this acquisition brought value to the original shareholders in Horizon. I merely point out that a US energy company isn’t exactly what they signed up for.

So, what is being done about this? Well, it’s tricky to regulate. A few days ago the Financial Services Authority issued the catchily-titled Enhancing the effectiveness of the Listing Regime and feedback on CP12/2. In a short section on ‘externally managed companies’ (apparently the new technical name for cash shells) they introduce rules to stop such shells taking a premium listing, and they tighten some regulations for the companies’ advisors. This doesn’t do much, although it does prevent such companies from becoming a component of the FTSE 100, which will mean that your index-tracker pension fund is no longer exposed to them. The problem the FSA has is that this is a legitimate business activity, and difficult to regulate.

The new regulation will limit ‘accidental’ investment in cash shells. But one really would hope that common sense would limit deliberate investment: buying shares in an unknown quantity on the strength of its (probable) management will always be risky.

Around the time of the South Sea Bubble there was a company that raised money “for carrying on an undertaking of great advantage, but no-one to know what it is”. Nobody would fall for that these days. Would they?

[1]  Knutsford raised about £600m to buy a struggling retailer, partly on the strength of the track record of Archie Norman, who had been successful at Asda.  He then left, for a political career. As far as I’m aware, Knutsford never bought a retailer, but it did acquire a small internet company.

[2] Regulatory News Service.  A London Stock Exchange service to ensure market news is released in an orderly manner.

[3] See for example The Telegraph, 12^th December 2009, 20^th January 2010

Posted 11 Oct 2012.  Typos corrected & minor textual changes 12 Oct 2012

Something Must be Done - but not a public inquiry

In the last fortnight we have seen the banks making the news for all the wrong reasons: excessive pay, tax avoidance schemes, manipulation of interest rates, mis-selling of complex financial products to people and firms who couldn’t possibly understand them, and massive failure of computer systems.  That last was an unfortunate matter, the others all appear to be indicators of a pervasive culture of casual corruption.

We are all agreed that something needs to be done.  Indeed, pretty much everyone says that the culture in banking needs fundamentally to change.  There is a call for a public inquiry. This, I think, is a mistake.

It’s not that I think the banks are right, or that nothing needs to change.  I just don’t think that a public inquiry will get to the bottom of things and facilitate the changes needed. [1]

We already know what happened.  On LIBOR, the FSA report is clear, and horrifyingly explicit about the arrogance and lack of conscience of the Barclays bankers involved in rigging LIBOR.  Various other reports have come out about the mis-selling and the tax avoidance.  And we have a lot of information about the huge levels of pay, and the bonuses that appear to be paid regardless of performance.

It’s not only Barclays at fault.  Nor just the UK banking system.  The LIBOR scandal involves other banks, and is also being investigated elsewhere.  The Financial Times yesterday mentioned: the FSA report, the Treasury Select Committee, regulatory inquiries in ten countries over three continents, an inquiry by the EU Competition authorities, and the work being done by the US Department of Justice and the FBI.  It’s not that we are going to be short of information on this.

A public inquiry will not provide any further benefit.  Indeed, it is likely to delay any reform of the system, as nothing would be put into place until it had finished.  It would cost a lot of money.  And it would not last the ‘one year’ that Ed Miliband is suggesting – banking is too complex for that.  Indeed, in my view banking is too complex for a public inquiry.  Leveson has been brilliant in exposing hacking and the rotten culture surrounding tabloid journalism.  But hacking is easy to understand; banking isn’t.  It will serve the public interest better if we let the various experts and regulators investigate these matters, and then make a full public report, with recommendations that are implemented quickly and in full.

We need a culture change in the banks, to return trust to the system.  This must start at the top, as an organisation’s culture and attitudes are driven by the signals sent from the boardroom and the top executives.  Bob Diamond’s letter to the Chairman of the Treasury Committee explained away the bank’s two efforts at rigging LIBOR (firstly to raise it and then to lower it) as being “wholly unrelated”.  This is a deliberately naïve statement that misses the point.  Any rigging of the system reflects the underlying values pertaining in the bank that he heads, in the department that he ran for many years.  An aggressive, results-driven organisation is prone to veering close to the edges of acceptability – and in this case, way beyond those limits – unless a clear steer is given as to where the line should be drawn and what is morally acceptable.

As Bob Diamond himself said, “culture is how people behave when no-one is watching”.  Well, we now know how they were behaving, and we hate it.

I spoke to a colleague of mine who works in change leadership, and asked him how this could be effected.  He gave me several points to consider.  Fundamentally, change  only happens if those within the organisation see the need for change.  If they don’t see it as urgent, it won't take place.  If the organisation has been successful (which in this case means profitable) through undertaking the flawed behaviour, then they won’t want to change. Likewise, if individuals are being rewarded for the results they are achieving, they will keep on doing what they have always done.  And finally, in this case fundamental culture change is likely to necessitate change at the top – a new CEO - both as a symbol that things will be different in the future, and in order to set the new path.

Action needs to be taken, quickly, to restore trust in a system that many now perceive as morally bankrupt.  Bob Diamond in his lecture last year said we should, “judge the success of … banks on the basis of broader measures and values”.  In that, he was right.

[1] Late addendum.  I wrote this entry after having been asked specifically if a Leveson-type inquiry was appropriate, and that was the focus of my comments.  But as I said above, the Treasury Select Committee is already involved.  I'm not suggesting that that is unnecessary - just that we don't need yet another body to look at it as well.

Bankers' Bonuses - some more considered thoughts

A few months ago I recorded a video for Cranfield, aiming to set out both sides of the ‘Bankers’ Bonus’ debate – why they should get bonuses, and why they shouldn’t.  I tried to be even-handed, but most people reckoned that I was far less convincing when arguing that they deserved them, than I was when I was explaining just why they should not be awarded. 

Having tried on Thursday night to defend Stephen Hester’s bonus at RBS – which resulted in a bit of a minor media storm[1] about my ‘pro-bonus’ views, I thought I’d like to restate the position, using more words that I was able on air.

There are two issues here.  One is the level of bankers’ bonuses in general, and one is the particular bonus for Mr Hester. 

As regards bankers’ bonuses in general, indeed, the whole top echelon of executive pay packages, it is difficult to argue that they are justifiable.  The arguments in their favour are weak, and mostly boil down to ‘custom and practice’.  We pay bankers a lot of money because we have always paid them a lot of money.  But being a banker is not riskier than being a soldier; it is not more stressful than being a nurse; it is not more physically demanding than … well, than most things, really.  Society has arranged itself in such a way that it values some jobs more than others; there is no logic behind it.

There is another argument against these bonuses: they don’t work.  Research indicates that bonuses can be very successful to motivate people to do better in low-level tasks that involve physical work .  They are much less successful in motivating performance in complex cognitive tasks.  Worse, the research suggests that giving a bonus for such tasks actually has detrimental effects on performance: the exact opposite of what we want.

So, logic suggests that we should change things.  But logic has only a small role in this.   Society does not change easily.  Governance experts (myself included) have endlessly discussed what might be needed to restore trust in our boards, and how the pace of executive pay acceleration might be slowed.  If it were easy, an answer would already have been found.  Back in 1995, the Greenbury Study Group thought additional disclosure would be the answer: ‘name and shame’ the highly-paid directors, and they would be humiliated into receiving less.  As we know, that didn’t happen.  The Government’s new proposals, set out by Vince Cable earlier this week, may chip away a bit at the edges of the issue, but on their own are unlikely to achieve the result desired by politicians and by a public which is being hit hard in a recession caused, by and large, by many of these highly-paid individuals.

The debate is not helped by a distortion of the facts.  A 2011 survey by IDS has been widely reported as saying that directors’ pay had risen by 49% in the year.  That is an egregious figure which, not surprisingly caused a great deal of outrage and distress.  However, Manifest, taking a closer look at the numbers has suggested that the calculations behind that 49% are misleading, and a better indication of the rise in executive pay would be around 12%.  That in itself may be too high - it's a lot higher than the rest of us are getting - but it would probably not have attracted the level of opprobrium of widely-publicised numbers.

Similarly, we hear the phrase ‘crony capitalism’ used to describe how directors sit on each others’ boards and vote each other high pay.  Now, I can refer you to several academic theories that show how this might happen: how people at a certain level tend to mix with others at that pay rate, and so this anchors their views of what is reasonable.  But if this is happening – and I suspect to some extent it is – it’s happening at a more subconscious level: there are very few cross-directorships within UK PLC, and people just don’t get to vote on each others’ pay in that way. 

I could say more about the pay debate – and no doubt at some point I will.  But I want now to return to Stephen Hester, whose bonus I was defending in the media.

First some facts.  Mr Hester was not responsible for the mess that RBS got itself into.  Indeed, he was not even a banker at the time it happened – he was the well-respected CEO of a large property company.  But, his track record as a banker in earlier years, coupled with being untainted by the so- called ‘credit crunch’ meant that he was invited to become a non-executive board member of Northern Rock and the RBS, and then, a few months later, invited to take over the top job at RBS.

Not many people would want that job.  Company turnarounds are not easy at the best of times.  The job Mr Hester was brought in to do – de-risk the bank, restore it to eventual profitability, sell off parts of it – is a complex one, made more difficult by the fact that we, the public, own it, and so politicians and the media take a close interest in every move.  As I said, not many people would want the job; and probably only a few of those who wanted it would be capable of doing it.

In recent days it has been argued, quite reasonably, that because we own RBS, Stephen Hester is a public servant and as such should be on a salary much lower than his £1.2 million, and with no bonus.  Public sector employees all over the country have faced huge pain: so should he.  Whilst I appreciate the emotional appeal of this argument, I think it’s a bit disingenuous.  He wasn’t employed as a public sector worker; he was employed as a banker.  He agreed a contact at a certain level of salary, and with the possibility of a bonus.  And whereas we wage-slaves might gasp at the size of the numbers being discussed, in the world of bankers it is, I’m afraid, relatively low.  Set in the context of an industry where the CEO of Barclays got a bonus of over £6m last year (with more rumoured for this year), and where the CEO of Lloyds would have been in line for bonuses of about £2m (ill-health and a leave of absence meant that he waived all right to that bonus), the RBS bonus (which was undoubtedly kept below £1m for political reasons) is not extraordinary.

There has been much call for Mr Hester to waive the bonus or to give it to charity.  Well, he chose to waive his 2009 bonus, which would have been in excess of £1 million.  That was a generous gesture: we may argue that the bonus was too high, but most of us, given the chance, would have taken the money.  As to giving it to charity – what he does with the money is his business, not mine.  For all I know, he could give most of his pay to worthy causes, but that is between him and his conscience; it is not for me to judge.

Two final points on that bonus.  Everyone is speaking of £963,000 bonus as if it will be piled up on his desk in crisp fivers.  That’s not the case.  He has been awarded 1.6 million shares which, at that day’s price, were worth about £963,000.  But those shares are in a ‘bonus bank’.  What that means is that he can’t touch them until 2014.  If between now and then the bank’s performance get worse, the shares will be ‘clawed back’.  In the same way that he was awarded them for what the board saw as ‘good’ performance, he will lose them for bad performance.  Oh, and even if he keeps all 1.6 million of them, he won’t get £963,000 – what he actually gets will depend on the share price in 2014.

Personally, I hope that by 2014 Mr Hester’s bonus is worth several million pounds.  If that’s the case, it means that the share price will have recovered enough to repay the taxpayer what we invested in it.  And that can only be a good thing.

---

[1] 11 interviews in 24 hours is probably normal if you are a public figure, but quite a big day if you’re just a finance lecturer.

It’s not market failure; it’s not a market

The debate on executive pay became more intense in the UK last weekend, with politicians of all hues arguing that it is too high and needs to be contained.  In an interview, Prime Minister David Cameron told the BBC that there had been a "market failure", with some bosses getting huge rises despite firms not improving their performance.

I won’t argue with the comment that many executives receive too much pay.  I won’t argue with the statement that the pay is apparently increasing regardless of performance (although I would refer you to Manifest’s blog which gives some numbers on this).  My position in this article is that it’s not a market failure, because there is no real ‘market’ in top executives.

I’ve been saying this for a while. I first pointed it out in my PhD, in which I interviewed members of remuneration committees, executives and advisors.  I went on to write it in academic articles such as The Platonic Remuneration Committee.  But on the basis that few people will have the time or inclination to read any of that, I set out some thoughts below.

1.      The UK Corporate Governance Code does not require that pay be benchmarked against a market.  It says, more subtly, that committees should “judge where to position their company relative to other companies”. The word ‘market’ is not mentioned, and so the debate really centres around defining appropriate comparators.

Each company selects its own comparators (generally, research suggests, from companies where pay is high).  Therefore, each company sees a different ‘market’.  It could be argued that what is being benchmarked is not a market but instead a sampling population: companies define their market as a limited population of elite salaries, sampled 100%.  (Not surprisingly, nobody ever says that – the term ‘market’ carries a lot more legitimacy than ‘sample of elites’!)

2.      Even if companies attempt to define their market, data become anomalous because companies cannot benchmark like against like.  In my ‘Platonic’ paper I give the example of a utility that unintentionally ended up benchmarking against high tech companies through a hidden chain of comparators.

3.      Individual executives are not fungible.  They have different qualifications, talents, backgrounds and reputations. These human capital attributes mean that any ‘market-determined’ price may need to be tailored to individual circumstances.  Companies too vary widely - two organisations are not similar just because they have the same turnover or market capitalisation.  Simple benchmarks ignore pay that has been awarded for individual skills or circumstances. 

4.      Executive pay will increase for three reasons:  pay inflation, new entrants to jobs; and merit awards for individuals progressing in their roles.  Lumping all pay rises together without differentiating their cause gives a distorted view of the ‘market’ rise, which should just be that inflationary element.

In summary, executive pay is not a market in the generally-accepted sense. When economists speak of markets they assume a competitive market in which prices settle at the intersect of supply and demand curves to arrive at a market-clearing price. The goods being traded are identical, or at least closely similar. If a merchant sets his prices at a premium to the market-clearing price he will find that there are few buyers; likewise, setting below-equilibrium prices should increase the demand for his goods.  That isn’t in any way what we have in executive pay.

Putting it another way, the ‘market’ surveys on which we rely do not themselves represent a price at which individuals could, to put it crudely, be acquired. They represent the prices currently being paid to other elite individuals. They are not an ‘offer for sale’ and will never be tested as such. The market data reflect what others are reporting as earnings, not what a market-clearing price would be. For example, if the median rate for CEOs in a certain sector were £300,000 one could probably find a qualified individual who would take the job for, say, his reserve price of £200,000. Paying the median gives that individual a surplus of £100,000. Put in terms of the UK Governance Code, the money is certainly sufficient to “attract and retain”, but it fails on the criterion of “not excessive”. Indeed, taking this analysis a stage further, we can see that individuals who see their worth as being higher than the median get paid as such, but others get paid at the median, rarely below it. Thus, the median is an inadequate proxy for the true market-clearing rate.

Does it matter that we refer to executive pay as a ‘market’?  Yes, I think it does.  We should not say that the market has failed, because it conveys the wrong impression - the market does not exist.  Trying to correct that ‘market’ is perhaps a waste of time, and other approaches may be more useful.  We need a radical approach to executive pay, and re-defining and clarifying our terms might help us to start to achieve this.

---

Why Jack Welch was Wrong - Some thoughts on Shareholder Value

This is a copy of my comments on a LinkedIn thread.  I felt so strongly about it I thought I'd do it again...

Jack Welch was wrong. Twice.

He was wrong when he ran GE for quarterly profits, and he was wrong again when he called Shareholder Value ‘the dumbest idea’.  What he should have said was that running a company for quarterly profits is a silly idea; running a company for quarterly stock prices is a silly idea; but, running a company for shareholder value is actually pretty smart.

Go back to what Rappaport said, in the early days of the shareholder value ‘movement’.  In his book, Creating Shareholder Value, Alfred Rappaport defines Shareholder value in terms of Value.  He sets out seven drivers of value:

1. Sales growth (increase it)
2. Operating profit margin (increase it)
3. Cash tax rate (decrease it)
4. Capex % of sales (decrease it)
5. Working capital % of sales (decrease it)
6. Cost of capital (decrease it)
7. Timescale of competitive advantage (increase it).

#7 is fundamental to value – Shareholder Value is not about the next quarter’s stock price, it’s about building an enduring, profitable business.  And running any organisation in line with these value drivers can be beneficial – I’ve used the model to work with not-for-profits as well as commercial companies.  It’s not used as a strategy in itself, but as a way to evaluate potential strategies, and for that it is very powerful.

In my own book, Corporate Financial Strategy, I address head-on the issue of different stakeholders, and point out the problems inherent in running an organisation to prioritise all of their different needs.  I conclude chapter 1 as follows:

● Stakeholder management is an important part of long-term shareholder value

creation.

● Although accounting results are not necessarily an indicator of shareholder

value, companies spend much time and effort on ensuring that the accounting

results look good, sometimes to the detriment of value.

I don’t disagree with the Martin ideas and the Forbes article.  But it’s lazy thinking to misapply a perfectly useful concept and then damn it for  being wrong.