Stubbornness Is Discipline, But Bad
(Bloomberg Opinion) -- How’s David Einhorn doing?
Look, I don’t actually think that famous billionaire hedge-fund managers are just winners of a coin-flipping competition, or that their stock-picking skill is entirely a mirage. I understand that they are brilliant people with smart hard-working employees and well-thought-out strategies and, often, a demonstrable track record of adding alpha that is unlikely to be attributable to chance. I just think that it is fun to read stories about those hedge-fund managers as if markets were efficient and their performance was random. Like if someone flipped a coin 10 times and got 7 heads and everyone hailed them as a genius and they said “our success is due to our independent contrarian streak and our discipline in buying assets that are out of favor,” and then they flipped the coin 10 more times and got only 3 heads and investors started grumbling and they were like “we have had a run of unforeseeable bad luck due to the Fed’s distortion of markets, but we remain committed to our disciplined value strategy and expect to bounce back stronger than ever”—that would be funny. You would laugh at that. What I am saying is, why not keep your mind slightly open to the possibility that that’s what’s actually happening, and laugh at that too?
David Einhorn’s Greenlight Capital is down 5.4 percent for the second quarter and about 19 percent for the year so far, and his investor letter, when read through the lens of market efficiency, is a wondrous thing:
“Right now the market is telling us we are wrong, wrong, wrong about nearly everything,” Einhorn wrote in a letter from Greenlight Capital to clients dated July 31. “And yet, looking forward from today we think this portfolio makes a lot of sense.”
And here is a quote that I deeply loved:
In his letter, Mr. Einhorn said “getting older, changing lifestyles, and an unwillingness to adapt to new market environments” didn’t explain Greenlight troubles.
“We have been accused of being stubborn, but one person’s stubbornness is another person’s discipline,” Mr. Einhorn wrote.
Yes! Correct! Let me make that a bit more explicit: A person who loses money’s stubbornness is a person who makes money’s discipline. If you have a plan, and you do the plan, and it makes money, people are like “good job being disciplined in sticking to your brilliant plan.” If you have a plan, and you do the plan, and it loses money, people are like “bad job being stubborn in sticking to your dumb plan.”
I mean! This is wrong! In fact people regularly distinguish stubbornness from discipline, and evaluate the quality of your plan, without reference to current results; they care about the process by which the plan was arrived at and the quality of your reasoning and the convincingness of your explanation of how the plan will make money in the future. It is not incoherent to say “my strategy is good, and I am right to stick with it, even though so far it has lost money.” It is just kind of funny. And of course, in the long run, how would you distinguish stubbornness from discipline other than by results?
Meanwhile, Einhorn got crushed on both sides of a Tesla Inc. pairs trade in which he was short the stock but long a wonky car:
The billionaire president of Greenlight Capital LLC wrote in a letter to clients dated Tuesday that he was happy the lease on his Tesla had ended, citing worsening problems with its touch screen and power windows. In addition, the carmaker’s shares surged 29 percent last quarter, making Einhorn’s short the second-biggest loser for his fund.
Is appraisal dead?
Schematically, the way mergers and buyouts work is that some company’s stock is trading at $100, and some acquirer offers to buy it for $130, and the board says “that vastly undervalues us,” and there is a flurry of negotiation, and ultimately they agree on a price of $132.50. And then sometimes some shareholders will sue for “appraisal,” asking a Delaware court (most U.S. public companies are incorporated in Delaware) to find that the merger undervalued the company and that really it was worth $150. If they win, then the court can make the acquirer go back and pay them the appraised price, plus interest. But the court can appraise the company at whatever price it thinks is right—based on the standalone value of the company, excluding any synergies and changes that the acquirer plans to make—and if it concludes that actually the company was worth $130 or $120 or $100 or $50, then the holdout shareholders only get that amount, and would have been better off taking the merger consideration instead.
From first principles you might have one of two opposite assumptions about the appraisal price:
- Most of the time, the company should be worth less than the merger price. After all the merger price is at a premium to the previous stock price ($100 in my example), and market efficiency suggests that the stock price is the best estimate of value. The merger price is generally the result of an auction process; if the acquirer gets the company for $132.50 then that means no one else was willing to pay more. And the merger price includes synergies and post-merger efficiencies, which are not supposed to be included in the appraisal price. So in normal circumstances the appraisal price should be $100 or $110 or $120, but not $132.50 and certainly not $150.
- Most of the time, the company should be worth more than the merger price. After all shareholders don’t seek appraisal in every deal; it is risky and time-consuming. If they are seeking appraisal, it is because there was something wrong with the merger process. Maybe the chief executive officer was sandbagging the company, talking it down to try to drive down the price so he could buy it cheap. Maybe the auction process favored one bidder—the one working with the CEO—over others who might have paid a higher price. Maybe the deal value wasn’t driven by synergies but by the possibility of taking it away from public shareholders for cheap.
If you took a random sample of deals, assumption 1 would probably be correct: Of course the average acquirer overpays. But appraisal cases aren’t a random sample, and it’s entirely possible that, among deals where the shareholders seek appraisal, the “actual” value of the company is often higher than the deal price.
Loosely speaking, for most of recent history, appraisals frequently came in higher than the deal price, and “appraisal arbitrage”—buying shares in merger targets and suing for appraisal—was a profitable hedge-fund strategy. But that has changed. In December 2017, the Delaware Supreme Court rejected Vice Chancellor Travis Laster’s valuation in the Dell appraisal case and concluded that, in an imperfect but more-or-less fair-ish looking merger process, the deal price was probably the best indication of fair value. And in February of this year, Vice Chancellor Laster one-upped the Supreme Court by finding, in the Aruba appraisal case, that actually the unaffected stock price—the price at which the stock was trading before the merger was announced—was the best indication of fair value. The entire merger premium, on this reasoning, represented the synergies of the deal and the risks that the buyer was taking on; the best estimate of the company’s standalone fair value is the stock price in the market.
This week a different Delaware Chancery Court judge—Chancellor Andre Bouchard—announced his decision in the appraisal of Solera Holdings Inc., a software company that was acquired by Vista Equity Partners in 2016. It’s another loss for appraisal arbitrage; the chancellor awarded the holdout shareholders a bit less than the deal price ($53.95 instead of $55.85):
Over the past year, our Supreme Court twice has heavily endorsed the application of market efficiency principles in appraisal actions. With that guidance in mind, and after carefully considering all relevant factors, my independent determination is that the fair value of petitioners’ shares is the deal price less estimated synergies …
The sales process delivered for Solera stockholders the value obtainable in a bona fide arm’s-length transaction and provides the most reliable evidence of fair value. Accordingly, I give the deal price, after adjusting for synergies in accordance with longstanding precedent, sole and dispositive weight in determining the fair value of petitioners’ shares as of the date of the merger.
The basic lesson of all these decisions is that, if you can prove that a deal was corrupt and that management did things to keep the price down, then you have a shot at making some money in appraisal; otherwise you don’t. But that is not how people thought it worked. The traditional view was that, if you could prove that a deal was corrupt and that management did things to keep the price down and favor one bidder, then you’d sue in a class-action lawsuit for breach of fiduciary duty. If you could prove you were right, then you’d get damages for every shareholder (not just the ones who held out for appraisal).
Appraisal was something different. In appraisal, you didn’t have to prove that the deal was corrupt. You just had to convince a judge that the company was worth more than the acquirer paid for it. Your evidence wasn’t secret nefarious emails between the buyer and the CEO. Your evidence was discounted cash flow valuations. Your argument wasn’t about fairness, but about value. That might be over. The Delaware courts just don’t want to do valuations anymore; they don’t want to substitute their view of value for the market’s. If you can’t prove that the market failed, that there was some form of corruption that prevented the company from getting a fair price, then don’t bother seeking appraisal just because you think the price is wrong. The courts are no longer interested.
Blockchain blockchain never mind.
A blockchain is, approximately speaking, a secure decentralized ledger that keeps track of a thing, that anyone who uses the thing can access, and that all the people who use the thing can participate in maintaining. This is very useful if the thing is a decentralized currency called Bitcoin and if you want people to be able to transfer that currency to each other without trusting a central intermediary. Good job, blockchain. But in the past couple of years people decided that the blockchain is a magic solution to all of the world’s problems, and an endless string of press releases about the blockchain for, literally, dentistry began arriving in my inbox, and I became very tired.
Bloomberg’s Olga Kharif checks in on how all those blockchain projects are going:
A number of software projects based on the distributed ledger technology will be wound down this year, according to Forrester Research Inc. And some companies pushing ahead with pilot tests are scaling back their ambitions and timelines. In 90 percent of cases, the experiments will never become part of a company’s operations, the firm estimates.
Even Nasdaq Inc., a high-profile champion of blockchain and cryptocurrencies, hasn’t moved as quickly as hoped. The exchange operator, which talked in 2016 about deploying blockchain for voting in shareholder meetings and private-company stock issuance, isn’t using the technology in any widely deployed projects yet.
“The expectation was we’d quickly find use cases,” Magnus Haglind, Nasdaq’s senior vice president and head of product management for market technology, said in an interview. “But introducing new technologies requires broad collaboration with industry participants, and it all takes time.”
It is worth parsing that quote a bit. The U.S. stock market already has a shared ledger system for stock issuance and shareholder voting. It is called the Depository Trust Company. It’s an entity that effectively owns all the stock of every company; banks and brokerages own their shares on the books of DTC. The brokerages participate in the governance of DTC. It is a bit like a private blockchain, in a vague and non-technical sense: The ledger of stock ownership is maintained collectively by all the brokers, except that instead of using cryptographic consensus protocols, they use a centralized administrator to maintain the ledger, and corporate governance mechanisms to make sure that the administrator does its job.
The DTC system has its problems. Reconciling the central ledger with each bank’s ledger takes work, and the brokers also have to keep track of their customers’ share ownership, which is not tracked directly by DTC. Shareholder voting sometimes gets messed up, with this multi-layer manually reconciled system. Weirder stuff—clawing back extra merger consideration from short sellers, for instance—is counterintuitive and messy. You might want to upgrade the system.
You could upgrade the system just by upgrading the system. The DTC structure is from the 1970s and you could imagine just making it a bit smoother and more electronic, giving people better real-time connections to the database and better tools to interact with it automatically, letting them vote their shares through a DTC website, that sort of incremental technological improvement. But instead “blockchain” seized the financial industry’s imagination, and for a while everyone believed that the only way to keep track of who owned which stocks was through a blockchain.
I was not especially convinced by that as a technological matter—the list of stockholders is, at the end of the day, a list, and computer science solved the problem of keeping a list well before the Bitcoin white paper came out—but I frequently wrote that it made sociological sense. No one was all that interested in talking about upgrading and refining back-office processes and technology. CEOs do not get excited about that. But blockchain. For a while, everyone wanted as many blockchains as possible. If you went to a CEO and said “we need to blockchain this,” you could get whatever resources you needed. So perhaps the best way to improve those processes really was to put them on the blockchain, not because the blockchain was technologically superior to say a database, but because if you said the word “blockchain” a lot people would actually do it.
But the upshot is: Nope! “Introducing new technologies requires broad collaboration with industry participants, and it all takes time.” The social issues of getting everyone to agree on a new database architecture or a new way to track shareholder voting actually don’t go away just because you pronounce the word “blockchain.” They might even get worse: If everyone is so excited about blockchain, they will all have their own strong opinions about what sort of blockchain to build and how it should work, and may be less inclined to agree about those issues than they would about some boring non-hyped back-office stuff. Blockchain piqued people’s interest, but perhaps a little too effectively.
One reason behind the delays: Most blockchain vendors don’t offer compatible software. Companies are worried about being beholden to one vendor -- an issue the EEA group hopes to resolve by setting standards. ...
Most blockchains also can’t yet handle a large volume of transactions -- a must-have for major corporations. And they only shine in certain types of use cases, typically where companies collaborate on projects. But because different businesses have to share the same blockchain, it can be a challenge to agree on technology and how to adopt it.
In the endless stream of press releases, I kept seeing announcements that companies were building internal blockchains. Like, they’d keep track of inventory on a blockchain. That does not seem necessary? You are one company. You can keep a list of your inventory. You don’t need a permissionless cryptographic distributed ledger to let your employees keep that list. They can keep it in a Google Doc.
But, fine, you do the internal blockchain as a pilot, and if it works, then you roll it out more broadly. You track your inventory on a blockchain, and if it works you sign up your suppliers and add your transactions with them to the blockchain. Then your competitors get on the blockchain to interact with the suppliers, and then your customers get on it, and pretty soon your entire industry is on one blockchain and reaps massive efficiencies.
Except that every company had this exact thought at the exact same time, which means that every company had its own blockchain pilot that it was going to sign up every other company to. And once you have your own blockchain pilot, why would you sign up to someone else’s?
When I worked at Dealbreaker, I once wrote a post about a guy who allegedly (1) raised money from investors, (2) invested it “based on lunar cycles and gravitational pull between Earth and the moon,” and (3) stole investor funds and Ponzied his returns. I titled this post “Fake Astrology-Based Hedge Fund Threatens To Ruin Things For All The Legit Astrology-Based Hedge Funds Out There.” Because ha ha ha legit astrology-based hedge funds! Anyway here’s a Bloomberg Businessweek article about AFund:
But here’s the thing about AFund: The A stands for “Astrologers.” It’s run by an antic, charming 70-year-old named Henry Weingarten who says he gleans insight from charting the movements of celestial bodies. Today’s event isn’t technically about astrology, but like everything in the universe, it probably is. “Sixty to 70 percent of what I do is in the natural resource space,” Weingarten tells me after lunch at the club, holding a glass of red wine. “I think it’s because I’m a Leo. And effectively, as a Leo, I have an affinity for gold.”
I have questions, but perhaps that’s because I’m a Gemini.
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Matt Levine is a Bloomberg Opinion columnist covering finance. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz, and a clerk for the U.S. Court of Appeals for the 3rd Circuit.
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