Bank Bailouts and Activist Ideas

Bank bailouts are back.

Earlier this month Banco Popular Espanol SA collapsed very tidily: Europe’s Single Resolution Board stepped in to wind it down, its common stock and additional capital instruments were wiped out, and Banco Santander SA stepped in to buy its remaining assets and liabilities for one euro. Depositors and senior bondholders, who expected their money to be safe at Popular, were safe; shareholders and investors in capital instruments, who knew the risks they were taking, got zeroed. It was as neat a bank rescue as you could ask for, and I praised it in those terms, though I also worried a bit that it was too neat. Two very tidy things happened in that rescue: Senior bondholders didn’t lose any money, and no state aid was required. The question was, which one was the controlling principle: If a future bank bailout had to choose between haircutting senior bonds (which in theory are supposed to be “bail-in-able”) or using state aid, which would the regulators choose?


Italy will commit as much as 17 billion euros ($19 billion) to clean up two failed banks in one of its wealthiest regions, the nation’s biggest rescue on record.

The intervention at Banca Popolare di Vicenza SpA and Veneto Banca SpA includes state support for Intesa Sanpaolo SpA to acquire their good assets for a token amount, Finance Minister Pier Carlo Padoan said Sunday after an emergency cabinet meeting in Rome. Milan-based Intesa can initially tap about 5.2 billion euros to take on some assets without hurting capital ratios, Padoan said. The European Commission approved the plan.

Popolare di Vicenza’s and Veneto Banca’s shareholders and capital instrument holders will be zeroed, but its senior bondholders will be fully preserved, much to their own surprise:

The senior bonds had been trading at steep discounts to face value, reflecting investors’ fears that they could be “bailed-in” – a process whereby losses are imposed on private creditors to lessen the cost to the taxpayer. But over the weekend the EU commission signed off a scheme that will see Intesa Sanpaolo take on the good assets of the two Venetian banks, while also fully protecting senior bondholders.

Vicenza’s €750m 2020 senior note was trading at around 85 cents on the euro on Friday, according to Tradeweb prices, but soared up to 102 cents on Monday morning. Veneto’s €500m 2019 senior bond surged from 88 cents to 103 cents over the same period.

The market sort of half-believed that the bonds might get bailed in (half-believed because, if they had been bailed in, the haircut would probably have been deeper than 15 cents on the euro), but they weren’t. The principle is now clearer: Senior bonds get protected, even at the taxpayers’ expense. That isn’t a principle that anyone wants to say aloud, but here we are, with a revealed preference. “This plan is a dagger in the heart of the euro zone banking union,” writes my Bloomberg View colleague Ferdinando Giugliano. Certainly it is a stick in the eye of the idea that euro-zone regulators would impose bank losses on bondholders rather than taxpayers.

Oh also even the capital instruments won’t quite be zeroed:

For the Veneto banks, around €4bn in shareholder equity and €1.2bn in junior debt will be kept in the liquidated bank and wiped out, as is required under state aid rules. Retail investors missold around €200m of junior bonds are expected to be compensated.

In theory, capital instruments (junior bonds) of banks are risk-sharing instruments, and their buyers knowingly take the risks and should lose money when the banks fail. Except that, once you have a high-yielding capital instrument outstanding, it is just too tempting to sell it to widows and orphans by telling them that it’s just like a bank deposit only better. But this rather defeats the purpose of the capital instrument: Sure you have sold them a loss-absorbing junior claim, but you have also sold them a claim for compensation for mis-selling, which seems to get a more senior status.


Here is Third Point LLC, Dan Loeb’s hedge fund, on what it looks for in a company and found in Nestlé SA:

Third Point invested in Nestlé because we recognized a familiar set of conditions that make it ripe for improvement and change: a conglomerate with unrealized potential for margin improvement and innovation in its core businesses, an unoptimized balance sheet, a number of non-core assets, and a recent history of meaningful under-performance versus peers. 

Nestlé owns about 23 percent of L’Oréal SA, and Loeb wants Nestlé to sell it in a tax-efficient way. (“Current conditions make this the right time to exit the remainder and we believe the stake can be monetized with limited tax or other consequences.”) Nestlé doesn’t have much debt, and Loeb wants it to double its debt and use the extra money for stock buybacks. (“Buybacks offer an attractive alternative to M&A given the high multiples in Nestlé’s sector, offering similar EPS uplift with none of the integration risk.”) And you could even combine the two by using the L’Oréal shares to buy back Nestlé stock:

We also believe that the L’Oréal stake could be divested via an exchange offer for Nestlé shares that would accelerate efforts to optimize its capital return policies, immediately enhance the company’s return on equity, and meaningfully increase its share value in the long run as earnings improve over a reduced share count.

Nestlé is Loeb’s “single largest investment since Third Point was founded in 1995,” and “the biggest company he’s ever targeted to improve shareholder returns”; it also “ranks among the largest in activism history.” Still it is a little bit of a cliché at this point. Activists Love Share Buybacks, as everyone knows, and Third Point’s activism at Yahoo Inc. helped set it off on its still-unfinished quest for a tax-efficient monetization of its Alibaba Group Holding Ltd. stake. This is the standard playbook. If you see a company with capacity for debt-financed stock buybacks, and a noncore stake in another public company, how could you not go do activism at it? And companies know this, too, which is why they divest noncore stakes and lever up to buy back stock, to preemptively ward off activists. There just aren’t a lot of companies left that check the activist boxes so neatly. But I guess once you are big enough, size, rather than activist-optimization, seems like a sufficient defense against activists. Maybe not anymore!

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Elsewhere in activist hedge funds, Joe Biden reportedly got mad at Bill Ackman.

How do mergers work?

I am not sure I believe this but it’s funny:

“There’s a risk you’re buying an empty shell,” overpaying for a target whose patents have been spied on and copycatted, or whose sensitive customer data has been stolen, said Michael Bittan, head of Deloitte’s Cyber Risk Services unit in France. “Cybersecurity is not about getting technical, it’s about business impact, and ultimately valuations. It will become a pillar of M&A decisions.”

The idea here is that you should hire Deloitte LLP, or someone else who offers cybersecurity consulting, to do due diligence in mergers-and-acquisitions deals because otherwise you might sign the merger agreement, wire the money, and then find out too late that your target got hacked and there’s nothing there. I mean, I guess he didn’t mean “empty shell” literally — and, sure, Verizon probably wished it had done more cyber diligence when Yahoo’s hacking problems were revealed — but I like to imagine that Inc. will pay $13.7 billion for Whole Foods Market Inc. and then discover that all of Whole Foods’s stores have disappeared overnight, stolen by hackers. It’s the cyber!

Elsewhere in funny merger problems, Inc. was recently acquired by Wal-Mart Stores Inc., which has really put a damper on the weekly office happy hours:

Last September, a few weeks after the $3.3 billion acquisition, staffers gathered in Jet’s purple-themed headquarters, with sweeping views of Manhattan, to hear the rumors confirmed: Wal-Mart doesn’t allow office drinking.

The lesson here is that like 90 percent of what businesses do is focus on the wrong things. Consultants troop into executive offices and say “hire us to make sure that hackers haven’t stolen the company you are going to buy,” and the executives hire them, and an army of experts prepare an extensive cyber due diligence report, and everyone nods gravely and agrees that there is no cyber impediment to the deal going forward. Meanwhile everyone at the company is like “wait are we going to lose our happy hour?,” and it would be the work of one minute for an M&A lawyer to put into the merger agreement “After the Closing, Acquirer shall not interfere with Target’s workplace drinking policies or lack thereof,” but no one thinks to ask the lawyers to do that, because it is not the sort of Serious Business that consultants market, and so Jet loses its happy hour and everyone is sad and wistful. I should start that consultancy. “Office drinking will become a pillar of M&A decisions,” I will practice saying until I can do it with a straight face, and then I’ll go market my services in office-drinking-culture due diligence.

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Don’t wander in to talk to the FBI without a lawyer.

“Oh but am super charming and believable,” you think, contrary to all evidence, “so when talk to them they will be totally won over and will let me go with a handshake and maybe a medal.” They will not. This isn’t legal advice, because I can’t give you legal advice, but like, have you watched TV? It isn’t a good idea. Anyway, Martin Shkreli, who is full of bad ideas, decided to go brag to the FBI in between bragging on YouTube and Twitter:

Shkreli had requested the January 2015 meeting and walked in without a lawyer because he wanted to find out what the government was up to and make his case that he had done nothing wrong. It didn’t work.

Now, his own words, memorialized in a previously unreported eight-page FBI memo, are part of the case against the man known as the “Pharma Bro” — the brash, unapologetic personification of skyrocketing drug prices. The 34-year-old former biotech executive and hedge-fund manager goes on trial Monday for securities fraud.

The sin bin. 

We talked recently about a reported antitrust investigation into allegations that Barclays Plc and JPMorgan Chase & Co. had some sort of illegal agreement to stop poaching each others’ bankers. The idea is that Barclays hired a lot of senior JPMorgan bankers, and JPMorgan maybe called up Barclays and told them to knock it off, and Barclays maybe did, and that might be a criminal antitrust violation. If you just explicitly tell each other not to hire each others’ bankers, that’s bad. But what is this?

A row over poaching in Asian wealth management helped UBS lose its place in Deutsche Bank’s recent rights issue after the German bank learnt its Swiss rival had been trying to use its financial woes to lure staff.

UBS, which had a lead role in Deutsche’s 2014 capital raising, was conspicuously absent from the eight banks named this year to underwrite the €8bn rights issue that finally drew a line under questions about the German bank’s balance sheet strength.

The story here seems to be that UBS was poaching a lot of Deutsche Bank bankers, and Deutsche Bank, rather than telling UBS to knock it off, just kicked it off the rights offering. “Senior Deutsche executives in Frankfurt were furious when they heard of the hiring tactics and ‘sin-binned’ UBS from the capital raising, two people familiar with the situation said.” That seems perfectly fair to me! But it’s odd that it might be a crime to politely ask your rivals to stop poaching from you, but fine to punish them financially for poaching from you.

Should index-fund voting be illegal?

Here is a paper by Dorothy Shapiro Lund arguing that index funds shouldn’t vote their shares in public companies, since they’re not really set up to know how to vote:

Governance interventions are especially costly for passive funds, which do not generate firm-specific information as a byproduct of investing and thus must expend additional resources to identify underperforming firms and evaluate interventions proposed by other investors. For these reasons, a passive fund lacks both the ability and incentive to invest in thoughtful governance interventions and will instead leave company performance to the invisible hand of the marketplace. If the passive fund does choose to intervene, it will rationally adhere to a low cost, one-size-fits-all approach to governance.

Take the contrast between how, say, Third Point votes its shares, and how, say, BlackRock Inc. votes its index-fund shares. Third Point develops a thesis, buys stock in a company, and votes or agitates for changes as part of its investment thesis. The portfolio manager making the investment decision also makes the voting decision. The governance ideas may be a little one-size-fits-all, sure — optimize the balance sheet! divest non-core assets! — but they are a central part of the investing thesis. 

At BlackRock, there is a centralized team that does voting-and-engagement stuff. If your voting is done by a centralized team that votes on tens of thousands of proposals at thousands of different companies, and that doesn’t make investing decisions, then that team will develop its own expertise. But that expertise won’t be in evaluating companies; it will be in principles of corporate governance. That team will like governance-y things — independent chairs, performance-based compensation — and perhaps environmental-and-social things; it will tend toward governance as a set of principles rather than a practice grounded in specific companies. 

Decades of scholarship has failed to generate consensus about what good governance is, concluding that it is endogenous to the particular firm. And there is reason to believe that one-size-fits-all governance solutions imposed across vastly different firms will make all firms worse off. 

But what do you do about it? Ban index funds from voting? One proposal in the paper is pass-through voting by the ultimate investors in index funds, but that just seems to replicate the problem in a more complicated way: You get smaller more dispersed voters with even less incentive or ability to vote thoughtfully. 

Here is John Cochrane’s proposal:

Companies should issue, and index funds should want to buy, non-voting shares.  Non-voting shares seem to be regarded as a little infamy of internet companies, used to keep control in the hands of founders. But a split between voting and non-voting shares seems ideally suited to a mass of indexing investors, and a few active, information-based traders and active corporate control investors. In this vision, most of those voting shares are in public hands, unlike the internet companies.  In fact, most corporate stock grants and options to insiders should be in the form of non-voting shares.

Cochrane proposes this as a market solution, but the market actually seems to have settled on the internet-company approach: Companies do issue, and index funds do want to buy, non-voting shares, but it’s not like they sell the non-voting shares to index funds and the voting shares to activists. Instead, companies like Snap Inc. are happy to issue non-voting shares to everyone, and everyone is happy enough to buy them (because they know that index funds provide a bid), and so the insiders keep all the voting power. 

Elsewhere in the evils of indexing: “Stock Picking Is Dying Because There Are No More Stocks to Pick.”

Corporate taxes.

Will the U.S. government raise corporate taxes by $1.5 trillion, and upend the business of highly leveraged real-estate investors like President Trump, by getting rid of interest deductibility? No, the answer is no, but here is a story about some of the effects that that change would have, if it happened, which it won’t. Elsewhere: “Corporate Tax Rate at 28% Seen as More Likely Than Historic Cut.”

People are worried about unicorns.

You know, this isn’t scientific or anything, but I don’t think I read a word about Uber Technologies Inc. all weekend. Perhaps their strategy of escaping negative media attention by getting rid of everyone has worked. Maybe they’ve hired an excellent new chief executive officer, and she has already reformed the culture and made Uber profitable, but we just haven’t heard about it.

Things happen.

How the Federal Reserve serves U.S. foreign intelligence. Gold Plunges as 1.8 Million Ounces Traded in a New York Minute. Roiled by Airbag-Recall Crisis, Takata Files for Bankruptcy. After Puerto Rico’s Debt Crisis, Worries Shift to Virgin Islands. Western Union, refugees and immigrants. Why Apple and J.P. Morgan Are Chasing Venmo. Bankers Have Less to Fear From ‘Stress Tests.’ Mozambique Audit Report Asks, Where Is More Than $1 Billion? Stock market closing out the first half of 2017 on an uncommonly smooth ride. “We conclude that the number of charlatans in equilibrium is positively related to the value added of that profession to consumers.” Canada has a shortage of weed. Yorkshire resident calls police on Queen Elizabeth for not wearing seatbelt.

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