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- 08/10/18--09:47: The Privatization of Tesla:
- 08/15/18--13:46: Deja Vu In Turkey: Currency Crisis and Corporate Insanity!
After my last two posts in Tesla, I was planning to take a break from the company, since I had said everything that I had to say about the company. In short, I argued that Tesla, notwithstanding its growth potential, was over valued and that to deliver on this potential, it would need to raise significant amounts of capital in the next few years. In an even earlier post, I described Tesla as the ultimate story stock, both blessed and cursed by having Elon Musk as a CEO, a visionary with a self destructive streak. Even by Musk's own standards, his tweet on August 7 that Tesla would be going private, adding both a price ($420) and a postscript (that funding had been secured), was a blockbuster, pushung the stock price up more than 10% for the day. The questions that have followed have been wide ranging, from whether Tesla is a good candidate for "going private" to the mechanics of how it will do so (about funding and structure) to the legality of conveying a market-moving news story in a tweet. 1. Public to Private - The WhyWhen we talk about transitions between private and public market places, we generally tend to focus on private companies going public. That is because it is natural and common for a small, privately owned business, as it grows larger, to move to public markets, with an initial public offering. That said, there are publicly traded companies that seem to move in reverse and go back to being privately run businesses, as Tesla may be proposing to do. The Trade OffTo understand both transitions, the more-common private to public and the less-frequent pubic to private, let us consider the trade off between being a private business and a publicly traded company, from the perspective of the business:Private versus Public: Business PerspectiveThe simple summary is that as a private company's need to access capital increases, it will accept more information disclosure and a more outsider-driven corporate governance structure, and make the transition to being a public company. In recent years, the market for private equity has broadened and become deeper, allowing companies to stay private for far longer; Uber, for instance, is worth tens of billions of dollars and is still a private company. To fully understand the transitions, though, we also have to look at the choice from the perspective of investors:Private versus Public: Investor PerspectiveIn the classic structure of going public, private firms raise money from venture capitalists who accept less liquidity, but structure their equity investments to often get more protection and a bigger say in how the company is run. It is the desire for liquidity that makes venture capitalists push private companies to go public, so that they can cash out their investments. To be able to negotiate better disclosure and control, private company investors have to be investing larger amounts, and it is one reason that regulatory authorities have been wary of allowing small investors to invest in private companies, since they may end up with the worst of all worlds: illiquid investments in businesses, where they have no say in how the company is run, and no information about how well or badly it is doing.The Public to Private TransitionWith this trade off in mind, why would a public company choose to go back to being a private business? This transition makes sense if a company feels that the easier access to capital and a continuously set market price (which delivers liquidity), two features of public markets, no longer provide it with sufficient benefits, and/or the costs of disclosure and outsider intervention (from activist investors), that also come with being a public company, increase. In short, it has to be a company:that does not need access to large amounts of new capital to continue operating,where the market is under pricing the company, relative to its intrinsic value ,that feels the actions that it needs to take in its best long term interests will either create public backlash (layoffs and plant closures) or adverse market reactions (because of the effect that they will have on metrics that investors are focused upon).It should come as no surprise that most companies that have gone through the public-to-private transition have been aging companies (no growth, no capital needed), trading at prices that are below their peer group (lower multiples of earnings or cash flows) and that need to shrink or slim down to keep operating.The Tesla CaseAs I look at the list of criteria for a good buyout company, I see nothing that would bring Tesla onto my radar as a potential candidate:It is a growing company and it needs new capital to not only deliver on its growth promise but to survive for the next few years. If you are more optimistic than I am about Tesla, you may disagree with how much cash the company will have to raise to keep going, but I challenge even the most hardened optimist to tell me how the company will be able to increase production to a million cars or more without investing mind blowing amounts in new capacity.If markets are punishing Tesla by under pricing the company, they are doing so in a very strange manner, giving it a higher market capitalization than much larger, more profitable automobile companies, ignoring large losses and generally tolerant of Elon Musk's errant behavior. In fact, if the critique of markets is that they are short term and focused on profits, Tesla would be the perfect counter example.It is true that there was substantial drama and market volatility around the 5000 cars/week production target, and there may be some in the company who have the drawn the lesson that since there will be more production targets to come in the future, the company needs to operate out of market scrutiny. That would be the wrong lesson, since almost all of the drama in this episode, from setting the target (5000 cars/week) to the constant tweets about whether the targets would be met, was generated by Elon Musk, not the market. In fact, a cynic would argue that by focusing the market's attention on this short term target, Tesla has been able to avoid answering much bigger questions about its operations.There are, of course, the short sellers in Tesla and Musk's frustration with them was clearly a driver of his "going private" tweet. His argument, which many of his supporters buy into, is that short sellers in public markets make money from seeing stock prices go down, and that some of them may do real damage to companies, because of this incentive. I will not dismiss this complaint, but I will come back to it later in this post, since I do think it is playing an outsized role in this process.Public to Private - The FundingWhen you decide to take a publicly traded company into the privately owned space, you have to replace the public capital (public equity and debt) with new capital that can be either private equity or new debt. The key questions then become what mix of debt and equity to use, how to raise the private equity needed to get the deal done and what the ultimate end game is in the transaction. Specifically, you may take a company private, because you want to control its destiny fully, and keep tit a private business in perpetuity. More often, though, the end game is to make the changes that you think will make the company more attractive to investors, and either take it back public or sell it to another public company.The AnalysisIf the company in question fits the buyout mold, i.e., it is an aging company with a lower market capitalization, relative to earnings and cash flows, than its peers, the going private transaction can be funded with a high proportion of debt, explaining why so many buyouts have leverage attached to them, making them leveraged buyouts. Given that the equity investors in the transactions have to give up public market governance tools, it should come as no surprise that in many of these deals, the private equity comes from a single firm, like KKR or Blackstone, with top managers holding some of the private equity, to align interests, after the deal goes through. Success in these deals comes from taking the reconfigured company public again, at a much higher value, leaving equity investors with outsized gains.The Tesla CaseTesla is a money-losing company, burning through significant amounts of cash. Not only is the company in no position to borrow more, I have argued before that it should not even carry the debt that it does. If this deal is to make sense, it has to be predominantly equity funded, but that does create some challenges. 1. The No-pain solution: Musk, in his Tuesday tweets, seems to offer a solution, which, if feasible, would be relatively painless. In his set up, existing shareholders will be allowed to exchange their shares in Tesla, the public company, for shares in Tesla, the private business, and those shareholders who are unwilling to take this offer will sell their shares back to the company at $420/share. In the extreme case, where every existing shareholder takes this offer and if existing debt holders are willing to continue to lend to the new private enterprise, Tesla will need no new funding:This would be magical, if you can pull it off, but there are two significant impediments. The first is that the deal may not pass legal muster, since the SEC restricts private companies to having less than 2000 shareholders, and Tesla has far more than that number. It is true that you might be able to create a fund that has individual shareholders, which then holds equity in the private company, like Uber has, but that fund is restricted to very wealthy, big investors, and the SEC may be unwilling to go along with a structure where there are thousands of small stockholders in the fund. The second is that even if Tesla manages to get regulatory approval for this unconventional set up, many shareholders may choose to cash out at $420, if the company goes private, even if they think that the shares are worth more, because they value liquidity.2. A Deep-pocketed Outsider: The announcement that the Saudi Sovereign fund had invested $2 billion in Tesla shares came just before Musk's "going private" tweet, setting up a second possibility, which is the a large private equity investor (or several) would step in to fund the deal. Here, Tesla's large market capitalization and cash burning status work against it, reducing the number of potential players in the game. At the limit, if all existing shareholders, other than Musk, cash out at $420/share, you would need about $55-$60 billion in funding. No sovereign fund or passive investment vehicle can afford to have that much money tied up in one company, and especially one that is illiquid and will need more capital infusions in the future. Even the biggest private equity and venture capital investors, generally more willing to hold concentrated positions, will be hard pressed to put this much capital, for the same reasons. In fact, the only name that you can come up with that has even the possibility of pulling this off is Softbank, for three reasons:They may be big enough to make the investment. As a publicly traded company with a market capitalization of $103 billion, making a $55-60 billion additional investment in Tesla would be a reach, but Softbank is capable of drawing other investors of its ilk into the funding.They have and are invested in young, growth companies: Unlike traditional PE investors whose focus has been on doing leveraged deals of cash-rich companies, Softbank has invested successfully in growth companies, many of whom continue to burn through cash.They have a history with Tesla: There were rumors last year that Tesla and Softbank had talked about taking the company private, but control disagreements caused negotiations to break down.That said, I am not sure that Elon Musk and Masayoshi Son (Softbank's CEO) can co-exist in the same company. Both value control, and both are unpredictable, and I have to confess that watching the two tango would make for great entertainment. 3. A Corporate Investor: There is one final possibility that I considered and it is that a corporation with deep pockets would provide the money needed to take Tesla private. Given how much money is needed, the list of potential buyers is small and perhaps restricted to the large tech companies - Apple and Google. While they have the cash and perhaps may even have the interest, Musk's follow up that he would continue to run the company and hold on to his ownership stake strikes me as a poison pill that no corporation will want to swallow.It is at this point that the "secured funding" claim that Musk made in his initial tweet comes into question. If the statement is true, he has either found an inept bank that will lend tens of billions to a money losing company with an undisciplined CEO, or a private equity investor who is willing to make the largest PE investment in history, while allowing Musk to continue running the company, with no checks and balances. If the statement is false, we will be seeing lawyers debating the meaning of the words "secured" and "funding" for a while.Occam's Razor: A simpler explanationThis entire post has been premised on the notion that Elon Musk had done his homework and that he intended to send a serious signal to markets about a future buyout. Given Musk's history of impetuous and personal tweets, that premise might be completely wrong, in which case the explanation for this episode may be far simpler and rooted in the war with short sellers that Musk has been fighting for a while. Musk is convinced, rightly or wrongly, that short sellers in Tesla are conspiring to bring not just the stock price, but the entire company, down. While there are short sellers in every publicly traded company, including the most successful in market capitalization (Apple, Facebook, Google, Amazon), Tesla is an outlier in terms of the short selling on two fronts:It has a CEO who is obsessed with short selling and spends a disproportionate amount of his time and attention on bringing them down. So, it is true that short sellers are a distraction to the company, but only because Elon Musk has made it so. On the other side, many of the short sellers in Tesla seem to be just as obsessed with Musk and are convinced that he is a scam artist. I have a sneaking feeling that for many of them, winning will mean not just making money on their Tesla positions, but seeing the company cease to exist (and taking Musk down with it). On my Tesla valuation from a few weeks ago, it is telling that the most heated responses that I got were not from Tesla bulls, accusing me of being too pessimistic, but from Tesla short sellers, arguing that I was being over valuing the company, even though my assessed value per share was half the prevailing price.Investing is a difficult game, to begin with, but it becomes doubly so, when it becomes personal. Just as it is dangerous to fall in love with a company that you have invested in, it is just as dangerous to bet against a company because you hate its management and want it to fail. I think both sides of the Tesla short selling game are so infected with personal bias that they may do or say things that are not in their best long term investing interests. That is why I hope, for Tesla's sake, that Musk's personal dislike of short sellers did not lead him to tweet out that Tesla would go private. with both the price ($420) and the "secured funding" being spur of the moment inventions. In his zeal to make short sellers pay, he may have handed them the weapon they need to bring him down. I know that Tesla's board has backed Musk, saying that he had opened a discussion about going private with the board, but since no mention is made of a price or funding, and given how ineffective and craven this board has been over the last few years, I cannot attach much weight to this backing.Bottom LineThere are publicly traded companies where going private is not only an option, but a value-increasing one, but Tesla is not one of them. As with so much else that the company has done over its history, from its acquisition of Solar City to borrowing billions of dollars to this talk of going private, it is not the action per se that is inexplicable, it is that Tesla is not the company that should be taking the action. The drama will undoubtedly continue, and in a world where we get much our entertainment from reality shows, the Elon Musk show is on top of my list of must-watch shows.YouTube VideoBlog Posts on TeslaTwists and Turns in the Tesla Story: A Boring, Boneheaded UpdateShare Count Confusion: Dilution, Employee Options and Multiple Share ClassesPaper on Going PrivateAnatomy of a Leveraged Buyout: Leverage, Control and Value
This has been a year of rolling crises, some originating in developed markets and some in emerging markets, and the market has been remarkably resilient through all of them. It is now Turkey's turn to be in the limelight, though not in a way it hoped to be, as the Turkish Lira enters what seems like a death spiral, that threatens to spill over into other emerging markets. There is plenty that can be said about the macro origins of this crisis, with Turkey's leaders and central bank bearing a lion's share of the blame, but that is not going to be the focus of this post. Instead, I would like to examine how Turkish business practices, and the willful ignorance of basic financial first principles, are making the effects of this crisis worse, and perhaps even catastrophic. The Turkish Crisis: So far!The Turkish problem became a full fledged crisis towards the end of last week, but this is a crisis that has been brewing for months, if not years. It has its roots in both Turkish politics and dysfunctional practices on the part of Turkish regulators, banks and businesses, and has been aided and abetted by investors who have been too willing to look the other way. The most visible symbol of this crisis has been the collapse of the Turkish Lira, which has been losing value, relative to other currencies, for a while, capped off by a drop of almost 15% last Friday (August 10):Yahoo! FinanceWhile it is undoubtedly true that the weaker Lira will lead to more problems, currency collapses are symptoms of fundamental problems and for Turkey, those problems are two fold. One is a surge in inflation in the Turkish economy, which can be seen in graph below:While it easy to blame the Turkish central bank for dereliction of duty, it has been handicapped by Turkey's political leadership, which seems intent on making its own central bank toothless. Rather than allow the central bank to use the classic counter to a currency collapse of raising central bank-set interest rates, the government has put pressure on the bank to lower rates, with predictable (and disastrous) consequences.Corporate Finance: First PrinciplesI teach both corporate finance and valuation, and while both are built on the same first principles, corporate finance is both wider and deeper than valuation since it looks at businesses from the inside out. i.e., how decisions made a firm's founders/managers play out in value. In my introductory corporate finance class, I list out the three common sense principles that govern all businesses and how they drive value:The financing principle operates at the nexus of investing and dividend principles and choices you make on financing can affect both investment and dividend policy. It is true that when most analysts look at the financing principle, they zero in on the financing mix part, looking at the right mix of debt and equity for a firm. I have posted on that question many times, including the start of this year as part of my examination of global debt ratios, and have used the tools to assess whether a company should borrow money or use equity (See my posts on Tesla and Valeant). There is another part to the financing principle, though, that is often ignored, and it is that the right debt for a company should mirror its asset characteristics. Put simply, long term projects should be funded with long term debt, convertible debt is a better choice than fixed rate debt for growth companies and assets with cash flows in dollars (euros) should be funded with dollar (euro) debt. The intuition behind matching does not require elaborate mathematical reasoning but is built on common sense. When you mismatch debt (in terms of maturity, type or currency) with assets, you increase your likelihood of default, and holding debt ratios constant, your cost of debt and capital.In effect, your perfect debt will provide you with all of the tax benefits of debt while behaving like equity, with cash flows that adapt to your cash flows from operations.There are two ways that you can match debt up to assets. The first is to issue debt that is reflective of your projects and assets and the second is to use derivatives and swaps to fix the mismatch. Thus, a company that gets its cash flows in rupees, but has dollar debt, can use currency futures and options to protect itself, at least partially, against currency movements. While access to derivatives and swap markets has increased over time, a company that knows its long term project characteristics should issue debt that matches that long term exposure, and then use derivatives & swaps to protect itself against short term variations in exposure.Turkey: A Debt Mismatch Outlier?The argument for matching debt structure (maturity, currency, convertibility) to asset characteristics is not rocket-science but corporations around the world seem to revel in mismatching debt and assets, using short term debt to fund long term assets (or vice versa) and sometimes debt in one currency to fund projects that generate cashflows in another. In numerous studies, done over the decades, looking across countries, Turkish companies rank among the very worst, when it comes to mismatching currencies on debt, using foreign currency debt (Euros and dollars primarily) to fund domestic investments. Lest I be accused of using foreign data services that are biased against Turkey, I decided to stick with the data provided by the Turkish Central Bank on the currency breakdown of borrowings by Turkish firms. In the chart below, I trace the foreign exchange (FX) assets and liabilities, for non-financial Turkish companies, from 2008 and 2018:Central Bank of TurkeyThe numbers are staggeringly out of sync with Turkish non-financial service companies owing $217 billion more in foreign currency terms than they own on foreign currency assets, and this imbalance (between foreign exchange assets and liabilities) has widened over time, tripling since 2008.I am sure that there will be some in the Turkish business establishment who will blame the mismatching on external forces, with banks in other European countries playing the role of villains, but the numbers tell a different story. Much of the FX debt has come from Turkish banks, not German or French banks, as can be seen in the chart below:Central Bank of TurkeyIn 2018, 59% of all FX liabilities at Turkish non-financial service firms came from Turkish banks and financial service firms, up from 39% in 2008. The mismatch is not just on currencies, though. Looking at the breakdown, by maturity, of FX assets and liabilities for Turkish non-financial service firms, here is what we see:Central Bank of TurkeyIn May 2018, while about 80% of FX assets are Turkish non-financial firms are short term, only 27% of the FX debt is short term, a large temporal imbalance.It is possible that the Turkish government may be able to put pressure on domestic banks to prevent them from forcing debt payments, in the face of the collapse of the lira, but looking at when the debt owed foreign borrowers comes due (for both Turkish financial and non-financial firms), here is what we see.Central Bank of TurkeyFrom a default risk perspective, though, the debt maturity schedule carries a message. About 50% of debt owed by Turkish banks and 40% of the debt owed by Turkish non-financial service companies will be coming due by 2020, and if the precipitous drop in the Lira is not reversed, there is a whole lot of pain in store for these firms.Rationalizing the Mismatch: The Good, The Dangerous and the DeadlyTurkish firms clearly have a debt mismatch problem, and the institutions (government, bank regulators, banks) that should have been keeping the problem in check seem to have played an active role in making it worse. Worse, this is not the first time that Turkish firms and banks will be working through a debt mismatch crisis. It has happened before, in 1994, 2001 and 2008, just looking at recent decades. If insanity is doing the same thing over and over, expecting a different outcome, there is a good case to be made that Turkish institutions, from top to bottom, are insane, at least when it comes to dealing with currency in financing. So, why do Turkish companies seem willing to repeat this mistake over and over again? In fact, since this mismatching seems to occur in many emerging markets, though to a lesser scale, why do companies go for currency mismatches? Having heard the rationalizations from dozens of CFOs on every continent, I would classify the reasons on a spectrum from acceptable to absurd.Acceptable ReasonsThere are three scenarios where a company may choose to mismatch debt, borrowing in a currency other than the one in which it gets its cash flows.The mismatched debt is subsidized: If the mismatched debt is being offered to you (the borrower) at rates that are well below what you should be paying, given your default risk, you should accept that mismatched debt. That is sometimes the case when companies get funding from organizations like the IFC that offer the subsidies in the interests of meeting other objectives (such as increasing investment in under developed countries). It can also happen when lenders and bondholders become overly optimistic about an emerging market's prospects, and lend money on the assumption that high growth will continue without hiccups.Domestic debt markets are moribund: There are emerging markets where the only option for borrowing money is local banks, and during periods of uncertainty or crisis, these banks can pull back from lending. If you are a company in one of these markets and have the option of borrowing elsewhere in the world to fund what you believe are good investments, you may push forward with your borrowing, even though it is currency mismatched.Domestic debt markets are too rigid: As you can see from the debt design section, the perfect debt for your firm will often require tweaks that include not only conversion and floating rate options, but more unusual tweaks (such as commodity-linked interest rates). If domestic debt markets are unwilling or unable to offer these customized debt offerings, a company that can access bond markets overseas may do so, even if it means borrowing in a mismatched currency.In all three cases, though, once the money has been borrowed, the company that has mismatched its debt should turn to the derivatives and swap markets to reduce or eliminate this mismatch.Dangerous ReasonsThere are two reasons that are offered by some companies that mismatch debt that may make sense, on the surface, but are inherently dangerous:Speculate on currency: Mismatching currencies, when you borrow money, can be a profitable exercise, if the currency moves in the right direction. A Turkish company that borrows in US dollars, a lower-inflation currency with lower interest rates, to fund projects that deliver cashflows in Turkish Lira, a higher-inflation currency, will book profits if the Lira strengthens against the US dollar. Since emerging market currencies can go through extended periods of deviation from purchasing power parity, i.e., the higher inflation emerging market currency strengthens (rather than weakening) against the lower inflation developed market currency, mismatching currencies can be profitable for extended periods. There will be a moment of reckoning, in the longer term, though, when exchange rates will correct, and unless the company can see this moment coming and correct its mismatch, it will not only lose all of the easy profits from prior periods, but find its survival threatened. Currency forecasting is a pointless exercise, even when practiced by professional currency traders, and I think that companies should steer away from the practice.Everyone does it: I have argued that many corporate finance practices are driven by inertia and me-tooism rather than good sense, and in many countries where currency mismatches are common, the standard defense is that everyone does it. Many of these companies argue that the government cannot let the entire corporate sector slide into default and will step in to bail them out, and true to form, governments deliver those bailouts. In effect, the taxpayers become the backstop for bad corporate behavior.Bad ReasonsI am surprised by some of the arguments that I have heard for mismatching debt, since they suggest fundamental gaps in basic financial and economic knowledge.The mismatched debt has a lower interest rate: I have heard CFOs of companies in emerging markets, where domestic debt carries high interest rates, argue that it is cheaper to borrow in US dollars or Euros, because interest rates are lower on loans denominated in those currencies. After all, it is cheaper to borrow at 5% than at 15%, right? Not necessarily, if the 5% rate is on a US dollar debt and the 15% debt is in Turkish Lira, and here is why. If the expected inflation rate in US dollars is 2% and in Turkish Lira is 14%, it is the Turkish Lira debt that is cheaper.Risk/Reward: There are some companies that fall back on the proposition that mismatching debt is like any other financial choice, a trade off between higher risk and higher reward. In other words, their belief is that they will earn higher profits, on average and over time, with mismatched debt than with matched debt, but with more variability in those profits. This argument stems from the misplaced belief that markets reward all risk taking, when the truth is that senseless risk taking just delivers more risk, with no reward, and mismatching debt is senseless.The FixIt is too late for Turkish companies to fix their debt problem for this crisis, but given that this crisis too shall pass, albeit after substantial damage has been done, there are actions that we can take to keep it from repeating, though it will require everyone involved to change their ways:Governments should stop enabling debt mismatching, by not stepping in repeatedly to save corporates that have mismatched debt. That will increase the short term pain of the next crisis, but reduce the likelihood of repeating that crisis. Bank Regulators should measure how much the banks that they regulate have lent out to corporates, in mismatched debt, and require them to set aside more capital to cover the inevitable losses. That, in turn, will reduce the profitability of lending out money to companies that mismatch.Banks have to incorporate whether the debt being taken by a business is mismatched in deciding how much to lend and on what terms. The interest rates on mismatched debt should be higher than on matched debt.Companies and businesses have to consider what currency a loan or bond is in, when evaluating interest rates, and in their own best interests, try to match up debt to assets, either directly (in debt design) or using derivatives.Investors in companies should start breaking down the profitability of firms with mismatched debt, especially in good periods, into profits from debt mismatch and profits from operations, and ignore or at least discount the former, when pricing these companies.I don't think any of these changes will happen overnight but unless we change our behavior, we are designed to replay this crisis in other emerging markets repeatedly. YouTube VideoDataFX Assets & Liabilities of Turkish non-financial corporations (from Turkish Central Bank)Loans from Abroad to Turkish Private SectorPapersFinancing Innovations and Capital Structure Choices