Takeover bids are generally thoroughly benign economic events; they are after all the principal process by which Joseph Schumpeter’s process of “creative destruction” takes place. Without them, with corporate governance currently weak as in Britain and the United States there would be no power to compel entrenched management to downsize itself, even when it was obvious that the company’s technology was no longer dominant. Nevertheless, at the top of a bull market one may reach a point at which the dangers of future destruction in a takeover outweigh any possible creativity. In the recent frenzy of takeovers backed by private equity and hedge funds, we appear to have reached that point.
There are certainly companies which could do with a good management shake-up. However the companies which get taken over are not necessarily those which need the shake-up. In the tech sector, for example, the two titans, Microsoft and Google, may be losing their way. In Google’s case, the company’s insouciance about copyright, attempting to seize the print and video contents of the world’s libraries cost-free and turn them into a Google advertising platform, is clearly running into a brick wall in the case of its expensive acquisition of YouTube. It may well be, in spite of the company’s current market capitalization of $147 billion, that its business will degenerate eventually to its origin in a clever search engine that sells advertising, in which case it will undoubtedly be commoditized out of any exceptional profitability.
In Microsoft’s case, it is rapidly becoming clear that the company’s major new products, the Xbox 360 and Vista, are inadequate to the job they’ve been sent into the market to do. In the Xbox 360’s case, Microsoft benefited considerably in 2006 from having its product in the market a year before its two competitors, Nintendo’s Wii and Sony’s Playstation 3, but is now beginning to suffer as its product is significantly technologically behind its two competitors. At least, it is becoming clear that Microsoft is nowhere near establishing the position of dominance it had hoped for.
As for Vista, it’s a disaster. Microsoft’s decision to construct Vista by add-on, without removing the redundancies and bugs that had bedeviled its previous software, is reminiscent of the Detroit of the late 1960s, which gave the world such triumphs as the Ford Pinto, of the exploding gas-tank. Vista, which is exceptionally sluggish to load and causes all sorts of backward-compatibility problems with its predecessor operating systems is an excess of costs, with few benefits, imposed on consumers who may now have an alternative available in the modernized and strengthened Linux. Further, Microsoft’s announcement that it will no longer wait five years to launch a new operating system, but will in the future impose the huge harassments of system transfer on its customers every two years is likely to make its operating systems history within the next half-decade. Vista will not even be remembered with the faint nostalgia of the Ford Edsel, which was at least attractive.
Were it a conventional manufacturing company, Microsoft would be ripe for takeover, or even descent into bankruptcy. However with $34 billion in cash, a market capitalization of $280 billion and a strong friendly shareholder in Bill Gates and his family foundation, Microsoft is not remotely vulnerable to such a takeover. Blackstone, Carlyle and KKR can reluctantly put away their spreadsheets.
At the end of a long bull market with an excess of liquidity, such as we have enjoyed or in some cases suffered for the last 12 years, two factors prevent takeovers from fulfilling their creative function and maximize the likelihood of their causing destruction. First, fashionable shares have been bid up to astronomical prices. Thus even when as in the case of Google and Microsoft they have major operating weaknesses, they are priced not on the basis of their weaknesses but on the memory of their previous strengths – or in Google’s case, their previous hype – thus making any health-giving asset-stripping or break-up exercise impossibly expensive. That’s why dead technology companies such as Polaroid and Xerox frequently linger decades beyond their last real success, earning below average returns but always priced on memory, so never vulnerable to the Schumpeteran process.
Conversely, twelve years of liquidity leads to an accumulation of money in the wrong places, whether in dozy conglomerates in the late 1960s, in semi-fraudulent investment trusts in the 1920s or in hedge funds and private equity funds today. This “silly money” has to find something to do; its shareholders won’t stand for inaction. Since badly run tech companies are off the table because of their overvaluation, and all the badly run non-tech companies have been snapped up long ago, the only remaining victims are well run non-tech companies.
“Silly money” conglomerates or private equity funds buy these, often assisted by promising to overpay existing management, giving it a huge conflict of interest in the takeover process. They then load up the companies’ balance sheets with unwarranted leverage, and discover that since the companies were well run in the first place and has management that (other than those overpaid by the acquirer) is eminently employable elsewhere, interference by the acquirers inevitably causes operations and financial results to deteriorate alarmingly. Since late in the market cycle the next recession is at most a couple of years away, most of these deals go wrong, resulting in bankruptcy and emergency break-up of previously well run companies, destroying immense value in the economy and creating nothing.
There are innumerable examples of this. Nelson Peltz, for example, has a 30 year record in acquisition that is wholly undistinguished by any example of operating improvements he has made. It is thus unimaginable that Cadbury-Schweppes, a company that has been formidably well run since the two companies Cadbury and Schweppes merged in 1969 – or indeed since they were founded, in 1824 and 1783 – has anything to learn from Peltz. Instead of creating value, Peltz has merely forced an entirely unnecessary de-merger of the confectionary and beverages businesses, which cannot be justified on the spurious basis of unlocking stock market value, but will simply destroy synergies built up over 40 years, cost hundreds of millions in legal, accountancy and IT fees and enrich the undeserving.
The rumored attempt by KKR on the Canadian telecommunications conglomerate BCE is another example. BCE is the largest quoted company in Canada; its tentacles stretch throughout the Canadian economy and there is no reason to imagine it to be badly run. Again, if KKR were to buy it there would be little they could improve on the operating side; they would simply leave the company overleveraged and vulnerable going into the next recession. Tens of thousands of Canadians would then lose their jobs and Canadian capabilities in various high-tech areas would also be lost. Such a takeover would have little chance of creating value and every chance of destroying it. Fortunately the Canadian government appears to have means whereby a takeover can be blocked, so the rumors have died down.
TXU Energy, the former Texas Utilities, also seems to have achieved a reprieve through delay. Its buyout by a group led by KKR had been favored by environmental groups because it would prevent construction of several coal fired power plants needed for future energy development in Texas. However the announcement March 28 by the Texas Utilities Commission of a 6-month review of all power company buyouts has delayed the acquisition, and if Texas utility customers are lucky will have done so beyond the collapse of the KKR Group’s capability to finance it. Any such buyout would inevitably run into difficulty in a downturn, with KKR incapable of generating improvements in a well run utility company, a business in which they have little experience, and would load Texas electricity customers with long term brownouts, excessive charges or most probably both.
Finally there’s Boots, subject to a $20 billion buyout by KKR with neither side alleging any ineptitude in a well run British drugstore chain that has been in business since 1849. KKR has no special expertise in running British drug stores; it will simply load the company with debt and force the closure of hundreds of Boots stores that have served their local communities well for a century or more. Rationalization is frequently necessary and even desirable, but in this case the profits of rationalization if any will go entirely to fly-by-night Americans and the costs of Boots corporate failure will fall on its British customers and employees. As with BCE and TXU, the host government should figure out a way to force a long enough moratorium to tie up the buyer’s financing sources and compel it to retreat.
Franz Muenterfering, Vice Chancellor of Germany, described private equity companies as “swarms of locusts, which pounce on companies, strip them bare and move on." He produced a “locust list” of twelve prime offenders and recommended that private equity managers should be forced to wear a yellow locust-shaped patch on their suits.
In normal markets, one would dismiss Muenterfering’s remarks as the ravings of a deranged socialist fruitcake. In today’s markets, where private equity firms have indeed proliferated like an insect infestation and no solid well-established company outside the tech sector is safe from being destroyed by them, there is no question that he has a point. Governments should react by finding ways to block private equity transactions, not forever but for a moratorium of six months or a year until the bubble has burst and financing for disreputable short-term operators is no longer available. Maybe even the EU could make itself useful for once and pass a twelve month cool-off directive mandatory on its members. A great deal of job loss, value destruction and human misery would thereby be avoided.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)