Tags: rates | valuation | extremes | low

Low Rates Push Valuation Engineering to Extremes

Low Rates Push Valuation Engineering to Extremes
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By    |   Wednesday, 11 September 2019 08:30 AM

A decade of experimenting with artificially low interest rates has produced a mixed bag of consequences for the global economic landscape.

The post-crisis measures have undoubtedly seen some short-term success stimulating the world economy. On the other hand, they’ve also produced bubble-like valuations across asset classes. From overvalued equities to expensive real estate, the ability to borrow at near-zero has left its indelible mark.

One recent side effect of this free-for-all mentality is a wave of corporate takeovers that drive valuations sky-high with no discernible reason. Between questionable deal structuring, use of loopholes to bypass shareholders, and fairytale language used to pump company values, there are no shortage of strategies these financial tacticians are willing to deploy to arrive at the perfect number. However, it ultimately benefits executives, owners, and financiers at the expense of common shareholders who often don’t share in the spoils.

The Mystery Behind Magically Multiplying Valuations

The past 10 years are full of corporate takeovers and maneuvering that have tallied billions in value. Recently, however, a deal inked by equity giant Blackstone and the London Stock Exchange (LSE) shone a light on the financial wizardry that has come to give economists and analysts pause. In 2018, Blackstone, which reported $545.48 billion of assets under management as recently as June 30th, acquired a 55% stake in Refinitiv from Thomson Reuters. Blackstone spent $4 billion, with the remainder of the $6.5 billion deal financing coming from other sources within the consortium, valuing Refinitiv at approximately $20 billion inclusive of debt ($13.5 billion).

Although Refinitiv remains behind market leader Bloomberg in the financial markets data arena, a new suitor for the company emerged less than a year after the transaction closed following LSE’s offer to purchase Refinitiv for $27 billion. The major question shareholders are asking is how the valuation grew $7 billion in less than a year with no real motive or catalyst. Apart from shedding some non-core assets and spinning off TradeWeb in an IPO, it’s hard to see how any fundamental changes could translate to an additional $7 billion of value, especially when debt remains at $13.5 billion.

Even so, a willing partner in the LSE and some financial engineering netted Blackstone a whopping $10 billion from an initial $4 billion investment. The structure of the deal, which will see the LSE issue new shares to purchase Refinitiv outright, leaves Blackstone owning 22% of the LSE when the deal closes after regulatory approval. While it isn’t quite obvious how the extra $7 billion materialized, Blackstone’s quickly realized returns cannot match another curious case.

Making Refinitiv’s Valuation Inflation Look Small

If Blackstone engaged in financial wizardry, then the consortium that led the take-private efforts for Qihoo 360 are magicians of the highest order. Qihoo 360, now considered China’s largest cybersecurity company by market capitalization, listed on the New York Stock Exchange in 2011 to much fanfare. After its initial public offering, shares of the company quickly doubled. However, from there, it was a rocky road before the company used its corporate structure in the Cayman Islands to bypass minority shareholders for a “take-private” deal worth $9.3 billion in 2016.

Due to the incorporation laws of the Cayman Islands which allow controlling shareholders to approve delisting proposals, the board of directors quickly rubber stamped the transaction paving the way for the deal to proceed. What happened next though defied all expectations, especially for former Qihoo 360 investors forced to take payouts for their shares based on the less-than-optimistic forecasts the company shared.

Dissenting shareholders refused the company’s offer, landing the matter in the Cayman Grand Court which was tasked with ascertaining the “fair value” of the shares. The subsequent legal action proved embarrassing for the company, but also a headache for shareholders. The dissenting shareholders, including Maso Capital, alleged the company hid material information during the take-private process.

Further, they allege Qihoo 360 has not complied with the discovery process in good faith, especially in relation to disclosing materials pertaining to the valuation model used to justify the transaction. The Court was inclined to agree, remarking, “The Grand Court found the company to have approached its discovery obligations in a cavalier and inconsistent manner.”

However, this was just the first sign of the company’s cavalier attitude. During the discovery process, it came to light that despite a data preservation request, the company gave “Destruction Instructions” to employees pertaining to their devices. More comically, the company declared that the CEO, Zhou Hongyi, had never been issued a company cellphone or computer, and wasn’t able to use these devices due to “eyesight” issues despite evidence to the contrary. Still, the move to delist did have enormous ramifications for investors, who saw their interests devastated by the company’s subsequent actions.

In a move that scorned former investors, Qihoo 360 subsequently relisted on the Shanghai Stock Exchange in 2018 at an eye-popping valuation 550% higher than its take-private valuation. How the company managed to bump its valuation by more than five times in less than 20 months is a mystery, unless Qihoo 360 intentionally misrepresented key company details and metrics.

Double Dealing Doesn’t Always Pay

Cheap financing and a dearth of willing investors has not prevented all companies from bumping up against the limits of reasonable valuations. WeWork’s spiraling IPO is a perfect example, showing the strain of this valuation bubble. The company has yet to record profit, but continued to grow a ”community-adjusted” EBITDA valuation. Down from the $47 billion valuation achieved during its last fundraising round, WeWork is now struggling to find buyers for an IPO valuing the company below $20 billion. Investors are souring on the enormous valuation and CEO Adam Neumann who has repeatedly been caught self-dealing. The embarrassing revelation that he received a $5.9 million payment for the trademark of “We” makes for no shortage of criticism.

Is the era of unjustifiable valuation maneuvering coming to an end? Likely not considering the proliferation of zero interest rate policy which incentivizes extreme financial behavior. Companies that have never been profitable continue to hit public markets at enormous valuations because they can continue to finance themselves cheaply. Meanwhile, investors with few options in a low yield environment continue to hunt for high-yielding opportunities with immense risk which unicorn startups are more than happy to foist upon them.

Magically inflating valuations may seem like a natural way to attract new shareholders, but at what cost? Investors ultimately bear the consequences company management teams should be shouldering but aren’t. However, akin to the ongoing legal challenges facing Qihoo 360, investors are increasingly more inclined to use every tool in the playbook to protect their interests from companies that exhibit starkly different motivations. While a yield starved environment may encourage bad behavior by both companies and investors, valuation inflation works until it doesn’t. Accordingly, companies considering corporate takeovers and take-private deals will be increasingly forced to justify their positions or encounter a market absent bidders for inflated valuations.

Jim Hoffer is founder and managing director at Hoffer Financial Consulting.

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A decade of experimenting with artificially low interest rates has produced a mixed bag of consequences for the global economic landscape.
rates, valuation, extremes, low
Wednesday, 11 September 2019 08:30 AM
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