Letter number 103 of April 2017
- QUESTIONS & COMMENTS
On Friday 17 February, we learnt that Kraft Heinz (market cap of $110bn) had approached Unilever, offering to buy it at a price of $143bn, a premium of 18% on the share price. Kraft Heinz is controlled (49%) by Warren Buffet’s Berkshire Hathaway and the fund 3G which groups together the Brazilian shareholders of AB Inbev.
Two days later, up against opposition from Unilever’s management and the less than positive attitude of the British government, the contemplated offer was withdrawn.
For two reasons, this offer and its subsequent rapid withdrawal made an impression on the market. Firstly, the offer targeted one of the biggest market caps in Europe (€115bn – there are only 17 groups with market caps of over €100bn in Europe), and secondly, it was withdrawn so quickly that the actual offer hadn’t even been filed.
This virtual offer can be used to illustrate several points:
1/ Size provides no protection against long-term underperformance
Since the low point in March 2009 (which corresponds more or less to the arrival of the current manager in January 2009) and the rebound which followed, the Unilever share price has risen naturally (by 152%), but has significantly underperformed compared with its peers: +250% for the STOXX 600 HPC index. When such a situation lasts for a long time, eight years in this case, sooner or later, a group will be held to account and be asked to provide explanations. A takeover bid or the threat of a takeover bid plays a healthy role of disciplinarian, which was highlighted by Michael Jensen. This is not a question of unbridled capitalism, but a matter of ensuring that a precious resource, equity capital, is allocated where it will be the most useful and that the combinations of assets that it finances will be as efficient as possible.
The takeover bid on Unilever reminds us that no group, regardless of its size or reputation, is immune to a takeover bid by a third party. And when size exceeds a certain threshold (say €150bn currently), one or more activist shareholders can, nevertheless, take action, as was shown by David Einhorn and Carl Icahn when they forced the world’s largest market cap, Apple, to stop hoarding its masses of idle and useless cash in 2012 and 2013.
2/ Abundant cash can be used to finance takeover bids with a large cash component
Commentators noted that by valuing Unilever at $143bn, the Kraft Heinz offer would have been the 3rd biggest acquisition of all time. We think that it is more interesting to look at the cash component of this offer ($100bn), putting it in first place for acquisitions with cash components.
Vodafone’s bid for Mannesmann ($181bn in 2001) and AOL’s for Time Warner ($162bn in 2000) were all-share offers, without a single euro in cash. This was in the middle of the TMT (Telecom Media Technology) bubble, where even a dog with dot com attached to it could be worth $1m and a cat dot com $0.5m! The only way to carry out an external growth transaction in such a context was by paying for it in shares and not in cash – a dog was worth two cats. The relative was used to bypass the absolute about which the reasonably minded were starting to have a few doubts, proved by the fact that they weren’t prepared to pay in cash.
With a cash component of 70%, the main shareholders of Kraft Heinz were not sending out a message that they thought that their share was overvalued, on the contrary.
The AB InBev takeover bid of SABMiller in the autumn of 2015 with a cash component of $75bn had already shown the depth of the debt market. At $100bn, the Unilever offer was setting a new record.
3/ A tactic that was successful in the past is not always a tactic that will be successful in the future
The rapid withdrawal of the contemplated offer can be explained, in our view, as a case of tactical error. Given that one of the two partners to the offer, Warren Buffet, had again recently stated that he would not carry out a hostile takeover, the bid on Unilever being called hostile by its management had to be avoided at all costs. A bid that offers a premium of only 18%, compared with a general average of around 25-30%, will not be sufficient to give pause for thought to a management team that is naturally reluctant to relinquish its power and to galvanise major shareholders into demanding that the offer be considered. But the consortium leader, 3G, had a successful experience of starting out by offering a small premium, and then gradually putting on the pressure by increasing its bid and offering bigger and bigger premiums, until all resistance crumbles. This is what it did with SAB Miller: it started out offering £38 for a pre-announcement share price of £29.34 (+30%), then raising it to £40, then £42.15 then £43.50 to finish with a premium of 50% at £44.
In these conditions, it would probably have been better to put a financially irresistible offer on the table, this time putting all of the reserve in price that 3G has set aside into play right from the outset. Always easier to say than to do, especially after the fact.
With the rise in its share price on the Friday after the leak of $11bn, Kraft Heinz would have had the resources to raise its offer substantially, probably without reaching the level of the premium that it paid in 2010 for Cadbury (49%). But between the two, there was room for manoeuvre.
4/ The importance of keeping your word
We believe that this negotiating tip was all the more important to bear in mind given that the British government, since Kraft’s successful takeover bid of Cadbury in 2010, does not seem to be as hands-off as it used to be when it comes to the nationality of the shareholders of large UK groups. We saw this already at the time of Pfizer’s approach of Astra Zeneca in 2014. It is even more the case in this period of preparation for Brexit negotiations so as to avoid giving credence to the idea that, with a bit of help from the post-referendum drop in sterling, UK groups are easy pickings.
But it is also clear that Kraft’s attitude following the acquisition of Cadbury and its reneging on its jobs related promises that facilitated this takeover, did not create very positive sentiments about it in government circles. And that’s the way it should be. Promises are made to be kept by those who make them, and not only in the country where the maxim of the stock exchange is “My word is my bond”.
5/ Two very different styles of corporate governance
The accusation made against 3G of being a hardened cost-cutter and sacrificing the long term for short-term profits, does not seem to tally with the fact that it holds onto the companies that it acquires (AB Inbev, Kraft Heinz, Burger King), unlike a traditional LBO fund for example. So it would be among the first to bear the consequences of any short-term behaviour on its part, which in our view is closer to facile and superficial criticism than a serious analysis.
Its governance of operational entrepreneur shareholders does not spontaneously seem less efficient than that of any other listed group, without a main shareholder, in a context of passive management by tracking the index that continually accounts for a larger share of the capital of groups. That’s a euphemism.
6/ And now?
The Unilever share price did not return to the level it was at before the announcement of the possibility of an offer. It is 21% higher, so higher than the premium offered. Investors are expecting that Unilever, after this narrow escape, will improve its results to avoid the recurrence of such a misadventure in the future.
The management of Unilever has very recently announced cost-cutting measures to increase operating margin from 16.4% to 20% in 2020; disposal or splitting of no-growth assets (margarine); higher dividends, share buybacks and an increase in net debt from 1.3x to 2x EBITDA; and simplification of its two-head structure (two parent companies listed since 1929, one in the United Kingdom and the other in the Netherlands).
If they succeed, its share price will rise which will provide the best protection against a new takeover bid.
If they fail, there will be another takeover bid and it’ll be a lot more difficult to avoid it the second time round without doing a demerger between food and HPC (Home and Personal Care) products.
Food, which accounted for 52% of operating income in 2010, is now only about 40%, and HPC products has increased from 48% to 60% in 2016. Unilever shares were valued on the basis of food multiples up to the proposed offer. Now, it is based on its mix between the food multiples and the HPC multiples which are higher.
From a financial point of view, this coexistence could be justified if the two branches showed synergies between them. But if there were, Unilever would talk about it (completely absent from its latest presentation) and we would measure its impact on the margins (but we do not see them).
Two points can be extracted from this very interesting graph coming from the Credit Suisse Global Investment returns yearbook 2017 by Dimson, Marsh and Staunton:
Over 90 years the difference in returns in the USA between large caps and micro caps has been 3% a year. Could be seen as a liquidity premium.
Over 90 years, a yearly return that is only 3% higher produces a sum that is 11.4 times bigger. And if you were to extrapolate for 10 more years using the same returns, the sum would be 14,9 bigger. Beware of small differences over the long run!
By the way, this should not be seen as an advertisement for investing in micro-caps as the (higher) risk of this investment class is real but not quantified in this graph.
With Simon Gueguen, teacher-researcher at the University of Paris-Dauphine
Like we did last month, we’re taking a look at an article on private equity again this month. This time it concerns the persistence of the performance of fund managers (General Partners, or GPs). The question of performance persistence is crucial in finance. When they are able to boast past super-performances, financial intermediaries leverage this achievement to raise funds. And investors often take these past performances into account when choosing an investment. So it’s interesting from an operational point of view to determine whether past performance is a good predictor of future performance, in other words, whether the performance is persistent over time.
Previous studies have shown that persistence is rare for most asset classes, but significant in as far as private equity is concerned. Compared with existing literature, the article presented is new in two ways. Firstly, it uses a new database, obtained from new information collected from funds of funds. This database has the advantage of allowing performance assessment at the level of the investments made (instead of only focusing on the level of the funds). Effectively, studies that only focus on the level of the funds risk underestimating the real persistence of the manager. For example, it is frequent for an investment in a company to be split between two successive funds (with the same manager). Exposure to similar economic and financial conditions will then give the illusion of persistence. This risk is substantially reduced with the database used in this study. Secondly, the article looks at the development of persistence over the course of time.
The database contains 13 523 investments made by 865 private equity funds managed by 269 GPs, between 1974 and 2010. The first step involved measuring the performance persistence achieved by GPs on investments made. The study confirms persistence that is statistically significant: a performance that is 1% higher on an investment is associated with 10.2 basis points of additional performance for the following investment. The same results are obtained when controls for geographic region and investment period are added, (although as Braun et al note, it’s not all that clear that these controls should be implemented: the ability to make a good choice in terms of both region and period could be a sign of the managers’ competence!).
Seeking to measure the development of this persistence, Braun et al cut the period in two: before 2001, 1% of additional performance 2001, translated into 11.9 more basis points on the following investment. After 2001, the gain was only 4.7 basis points (and even less when control variables were added). So, economically, persistence is becoming weak.
Finally, the article shows that persistence is particularly weak when competition between funds is high. The general increase in competition could then be one of the sources for this reduced persistence. We note that when we look at the GPs with the worst performances, persistence remains strong regardless of the state of the market! Braun et al suggest that there are unsophisticated investors on the market who repeatedly choose managers who perform poorly.
These results are not good news for investors who rely on performance rankings for choosing good managers, nor for managers who publish their good performances in the hope of attracting new investors. Never before has the famous maxim “Past performance is no guarantee of future results” seemed to ring so true.
Finally, these results open up a wide field for research: what are the best criteria for selection?
 R. Braun, T. Jenkinson and I. Stoff (2017), How persistent is private equity performance? Evidence from deal-level data, Journal of Financial Economics, vol.123, pages 273 to 291.
 See for example S. Kaplan and A. Schoar (2005), Private equity performance: returns, persistence, and capital flows, Journal of Finance, vol. 60, pages 1791 to 1823.
 More specifically, LBO funds and Venture Capital (VC) funds were not included in this study.
 Just for a change, the data used were not only US data but international data!
Because each investor has a different tax regime. Let’s take the case of an investor investing in shares. Depending on whether he or she invests in a share savings plan, an employee share ownership plan, a life insurance plan, a holding company, a dedicated mutual fund or directly, you have six different cases; resulting in six different tax rates in some countries. Now let’s take the case of a foreign investor. All will depend on the tax agreement between his or her country and the foreign country for these tax issues.
In short, it’s impossible to determine an average tax rate that will apply to all.
It should be noted that for many investors, there is little or no taxation: investment funds, UCITS, mutual funds and other collective investment undertakings that are tax transparent, companies that benefit from a favourable parent-subsidiary regime, sovereign funds, philanthropic foundations, etc. In fact, the taxation issue mainly concerns private individuals who are rarely directors on a market as in most countries they own less than 20% of the listed shares.
Furthermore, if investors who were taxed more heavily required a higher rate of return (before tax for them) to offset the tax they pay, they would exit the market. Up against other investors who paid less tax, they would always require a lower share price if they were to buy and would thus always be beaten by investors who paid less tax and who could buy this share at a higher price and still get the rate of return that they require.
In an open world, without barriers to investments, investors’ tax is thus borne by the investors and they are unable to pass it on to companies (and that’s a good thing!). It could only be in a closed world, with no foreign investors, where taxation is the same for all that investors could pass on their tax to companies. Let’s just hope that we don’t take this particular step backwards.
Regularly on the Vernimmen.com Facebook page we publish comments on financial news that we deem to be of interest. Here are some of the comments published over the last month.
The managers of Credit Suisse have lost common sense.
While the stock market price of the Swiss bank has lost 45% in two years (and 85% over 10 years), that it has published losses for 2015 and 2016, that it should not earn its cost of capital before 2019 if all goes well; it submits to the shareholders' meeting an increase in the remuneration of 30% of its general manager to CHF11.9m after having increased its variable remuneration package for its employees by 7%.
This illogical, amoral and incomprehensible proposition can only nourish and enliven destructive resentments in society. If the principle of variable remuneration is healthy to reward over-performance, it only makes sense if there is over-performance. Failing this, the variable remuneration must be variable, that is to say, and one should not need to specify it, decrease.
3 proxy agencies have just recommended voting against this remuneration. It is up to the shareholders to take action now, knowing that in a company as well as in society, democracy dies away when those who have the right to vote do not exercise it. And, if necessary, customers should vote with their feet.
Management compensation, continued.
If our previous post could suggest to some that finance is without faith or law, two pieces of information has came since that will reassure our readers (and we at the same time):
Under the pressure of its shareholders, Credit Suisse decided to reduce the bonus of its leaders by 40%. Not only morality is saved (partially), but above all it demonstrates the proper functioning of governance mechanisms.
Gilles Pelisson, managing director of TF1 decided not to receive half of the variable remuneration due to him (in light of the criteria set for the allocation of the variable remuneration). It found that the company's performance was not sufficient to justify such compensation. Let's praise this move (whether moral or self-censored to avoid criticism, whatever).
The mechanisms for controlling and anticipating conflicts do exist. If they could be at work all the time, finance would come out better!