Revisiting Jensen’s Agency Costs of Overvalued Equity
After the dot com bust, Michael C. Jensen wrote a paper comparing overvalued equity to managerial heroin:
When a firm’s equity becomes substantially overvalued it sets in motion a set of organizational forces that are extremely difficult to manage — forces that almost inevitably lead to destruction of part or all of the core value of the firm. (Jensen, M.C., 2005. Agency costs of overvalued equity. Financial management, 34(1), pp.5-19.)
What is amazing about the equity overvaluation created by meme-based investing (the reddit and Robinhood retail investors) is that far from destroying companies, it is resuscitating companies that were earlier presumed to be beyond salvation. On Tuesday, AMC Entertainment Holdings, Inc. raised $230 million by selling 1.7% of its equity to a hedge fund, Mudrick Capital, which promptly turned around and sold the shares into the market at a profit. AMC which claims to be “the largest movie exhibition company in the United States, the largest in Europe and the largest throughout the world with approximately 950 theatres and 10,500 screens across the globe” was struggling because of the pandemic and had plenty of uses for the money: it stated that:
The cash proceeds from this share sale primarily will be used for the pursuit of value creating acquisitions of additional theatre leases, as well as investments to enhance the consumer appeal of AMC’s existing theatres. In addition, with these funds in hand, AMC intends to continue exploring deleveraging opportunities.
With our increased liquidity, an increasingly vaccinated population and the imminent release of blockbuster new movie titles, it is time for AMC to go on the offense again.
The prospectus related to this sale described the risks very clearly:
it is very difficult to predict when theatre attendance levels will normalize, which we expect will depend on the widespread availability and use of effective vaccines for the coronavirus. However, our current cash burn rates are not sustainable.
during 2021 to date, the market price of our Class A common stock has fluctuated from an intra-day low of $1.91 per share on January 5, 2021 to an intra-day high on the NYSE of $36.72 on May 28, 2021 and the last reported sale price of our Class A common stock on the NYSE on May 28, 2021, was $26.12 per share.
the market price of our Class A common stock has experienced and may continue to experience rapid and substantial increases or decreases unrelated to our operating performance or prospects, or macro or industry fundamentals, and substantial increases may be significantly inconsistent with the risks and uncertainties that we continue to face; our market capitalization, as implied by various trading prices, currently reflects valuations that diverge significantly from those seen prior to recent volatility and that are significantly higher than our market capitalization immediately prior to the COVID-19 pandemic, and to the extent these valuations reflect trading dynamics unrelated to our financial performance or prospects, purchasers of our Class A common stock could incur substantial losses if there are declines in market prices driven by a return to earlier valuations;
AMC shares rose after this capital raise, and AMC followed up on Thursday with a at-the-market offering of an additional 2.3% of its shares that raised $587 million at a price of $50.85 per share. The prospectus came with an even more blunt disclosure:
We believe that the recent volatility and our current market prices reflect market and trading dynamics unrelated to our underlying business, or macro or industry fundamentals, and we do not know how long these dynamics will last. Under the circumstances, we caution you against investing in our Class A common stock, unless you are prepared to incur the risk of losing all or a substantial portion of your investment.
Michael Jensen considered the possibility that capital raising could eliminate overvaluation, but ruled it out:
Some suggest that one solution to the problem of overvalued equity is for the firm to issue overpriced equity and pay out the proceeds to current shareholders. I have grave doubts that this is a sensible or even workable solution for several reasons.
AMC has shown that Jensen’s fears about regulatory obstacles and disclosure requirements were totally misplaced. But Jensen also raised an ethical issue which goes to the very foundations of corporate finance:
I believe it is impossible to create a system with integrity that is based on the proposition that it is ok to exploit future shareholders to benefit current shareholders. I realize this is not a generally accepted proposition in today’s finance profession, not even among scholars, but it would take us too far from my topic today to discuss it thoroughly.
I am not however impressed by this ethical argument because capitalism depends on allowing trades between two parties with differing beliefs and expectations without worrying that one party is mistaken and is therefore being exploited by the other. I see the AMC capital raises as capitalism working nicely to harmonize heterogeneous beliefs and expectations through the mechanism of mutually beneficial trades.
Posted at 4:07 pm IST on Fri, 4 Jun 2021 permanent link
Categories: bubbles, corporate governance
Lessons from the Hertz Bankruptcy for Indian Bankruptcy Law
The pandemic induced Hertz bankruptcy in the US has upended a whole lot of what we thought we knew about how to run a bankruptcy proceeding.
What we used to think
It is optimal to complete the bankruptcy as quickly as possible. An insolvent business is like a melting ice cube that would lose all value if the bankruptcy were not sorted out very quickly. The gold standard of this approach was the Lehman bankruptcy in which the judge approved a sale agreement (filled with handwritten corrections) after midnight at the end of a chaotic day-long hearing. In India, the law mandates tight deadlines for the whole process, but it has not proved possible to adhere to them.
The big players know best and everybody else is basically a nuisance. In India, this is written into the law where a bunch of supposedly omniscient and incorruptible “financial creditors” have complete control over the proceedings and everybody else is left to their mercy (I have blogged about this here, here, and here). In the US, this is thankfully only an unwritten law, but there is little doubt that the big distressed debt investors are in charge.
The Absolute Priority Rule (APR) is the ideal way to distribute value: the sale proceeds or liquidation value should be distributed to creditors in the order of their seniority. This implies that the junior creditors as well as the shareholders often get wiped out. Bankruptcy courts do find ways to bypass the APR, but, to a first approximation, it more or less determines the allocation of value. In India, the APR is twisted to prioritize financial creditors over operational creditors, but in that modified form, it holds sway.
What Hertz taught us
Hertz reminds us that there are many exceptions to the received wisdom that guides our thinking and statutes about bankruptcy.
Hertz is likely to realize substantial value only because the bankruptcy court has run the proceedings at a leisurely pace allowing a sequence of ever higher bids to emerge as the pandemic abated. In some ways, this was an accident caused by the unplanned bankruptcy filing that was not accompanied by a Debtor in Possession (DIP) financing package, but it is at least partly due to the incessant prodding by the shareholders’ committee.
The retail shareholders who bought Hertz stock after it filed for bankruptcy were ridiculed at the time, but they now seem to have been at least partly right. The latest bids show that the shareholders will get some payout in bankruptcy after all. Some commentators have even compared the retail shareholders’ optimism to Bill Ackman’s legendary exploits during the General Growth Properties (GGP) bankruptcy.
Some scholars are now arguing that the Hertz bankruptcy exposes problems with the Absolute Priority Rule and that a Relative Priority Rule makes more sense. Casey and Macey argue that the option value of junior creditors and shareholders should not be extinguished as in the APR, but they should be allowed to recover that value as a payout in the bankruptcy proceeding, a stake in the reorganized firm, or a warrant that allows them to buy shares of the reorganized firm at a predetermined exercise price at a future date (see Casey, A.J. and Macey, J.C., 2020. The Hertz Maneuver (and the Limits of Bankruptcy Law). U. Chi. L. Rev. Online, p.1. available at https://lawreviewblog.uchicago.edu/2020/10/07/casey-macey-hertz/). In fact, I must acknowledge that Casey and Macey as well as Best Interest Blog inspired many of the ideas in this post.
Posted at 1:20 pm IST on Mon, 3 May 2021 permanent link
Categories: bankruptcy, investment
Archegos and marking academic literature to reality
Last week, Bill Hwang’s family office, Archegos, imploded as it was unable to meet the margin calls emanating from steep declines in the prices of stocks that Hwang had bought with huge leverage. Mark to market is a very powerful discipline that spares nobody however rich or powerful. This ruthless discipline makes financial markets self-correcting unlike many other social institutions.
Academic literature in particular is much more insulated from the discipline of mark to reality. Old papers discredited by subsequent developments or even subsequent research continue to be cited and quoted (this is the replication crisis in economics and finance). To borrow accounting terminology, the academic community tends to carry the old literature at historical cost without sufficiently stringent periodic impairment tests.
There is a large stream of finance and accounting literature which is probably badly impaired by last week’s developments. I refer to the literature that uses percentage of institutional shareholding in a company as a proxy for various things including corporate governance. What we are learning now is that Archegos used over the counter derivatives like swaps and contracts for differences to invest in a range of companies with very high leverage. The banks who sold these derivatives to Archegos bought shares in the companies to hedge the derivatives that they had sold. The shareholding pattern of these companies would then show the Archegos counterparties (banks) as the principal shareholders of these companies though in economic terms, the real owner of the shares was Archegos. Media reports suggest that this includes companies which were targeted by short sellers (and presumably had corporate governance concerns).
In the case of these companies with possibly dubious corporate governance, academics and investors might have been reassured on observing that say two-thirds of the shares were owned by institutions without realizing that much of the holding was the family office of a person who had committed insider trading. I think this is another illustration of Goodhart’s law: “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” The lesson that the academic literature must learn from that law is that the longer established a proxy measure is, the more ruthlessly one must apply an impairment test and mark it to reality.
Posted at 9:02 pm IST on Wed, 31 Mar 2021 permanent link
Categories: arbitrage, banks, failure, regulation
Stock Exchange Outages
A month ago, the National Stock Exchange (NSE), India’s largest stock exchange, suffered a software glitch and suspended trading about four hours prior to the scheduled end of the trading session. As the clock ticked close to the scheduled end of the trading day, there was no news about resumption of trading, and stock brokers decided to close out the outstanding positions of their clients on the other exchange (BSE) to avoid exposure to overnight price risk. About 13 minutes before scheduled close of the trading session, the NSE announced that normal market trading would resume 15 minutes after the scheduled close and would continue for 75 minutes thereafter. Yesterday, the NSE put out a self congratulatory press release providing some details of what happened on February 24, 2021. This is a vast improvement on the very limited information that they released a month ago (24th morning, 24th afternoon and 25th).
It appears that the regulators are also investigating the matter and, perhaps, much effort will be expended on apportioning blame between NSE and its various technology vendors. I wish to take a different approach here and argue that the regulators should simply lay down an downtime target. The computing industry works with Four Nines (99.99%) availability (less than an hour of downtime a year) and Five Nines (99.999%) availability (about five minutes of downtime a year). Let us assume that Five Nines is out of reach for stock exchanges and settle for Four Nines. There would then be no penalty for the first hour of downtime permitted under Four Nines and the penalty per hour thereafter would be calibrated so that the entire profits of the stock exchange are wiped out if the availability drops below Three Nines (99.9%) corresponding to a downtime of about nine hours per year.
Based on the most recent financial statements of the NSE, the penalty for that exchange would be about Rs 2.2 billion (around $30 million) per hour beyond the first hour. The penalty is designed to be large enough to ensure that the shareholders of the exchange weep when the exchange suffers an outage. They would then force the management to invest in technology, and also design management bonuses in such a way that they all get zeroed out when there is a large outage. The exchange would then negotiate large penalty clauses with their vendors so that if a telecom link fails, the telecom company pays a large penalty to the exchange. That provides the incentives to the telecom company to build redundancies. The regulators do not have to do any root cause analysis or apportion blame; they just have to collect the penalty, and use that to compensate the investors.
The other thing that the regulators need to do is to provide greater predictability about resumption of trading after a glitch. I would propose a simple set of rules here:
- If an exchange has suffered an outage and has not resumed trading one hour before the scheduled end of the trading session, all other exchanges (which have not suffered an outage) would extend their trading session by two hours automatically.
- If the exchange suffering the outage is able to resume trading not later than half an hour after the regular closing time, its trading session will also extend two hours beyond the regular closing time.
- If an exchange does not resume trading even half an hour after the scheduled closing time, it is not permitted to resume trading that day.
Stock exchange software glitches have been a favourite topic on this blog as long back as fifteen years ago and I suspect that they will continue to provide material for this blog for many, many years to come.
Posted at 5:07 pm IST on Tue, 23 Mar 2021 permanent link
Categories: exchanges, regulation, technology
Does Gamestop have a negative beta?
TL;DR: No!
The internet is a wonderful place: it knows that I have posted on Zoom’s negative beta and it also knows that I have posted on Gamestop and r/wallstreetbets. So it quite correctly concludes that I would have some interest in whether Gamestop has a negative beta. Yesterday, I received a number of comments on my blog on this question and my blog post also got referenced at r/GME. According to r/GME, several commercial sources (Bloomberg, Financial Times, Nasdaq) that provide beta estimates are reporting negative betas for Gamestop (GME).
I began by running an ordinary least squares (OLS) regression of GME returns on the S&P 500 returns. Using data from the beginning of the year till March 16, I obtained a large negative beta which is statistically significant at the 1% level. (If you wish to replicate the following results, you can download the data and the R code from my website).
Estimate Std. Error t value Pr(>|t|)
beta -10.54182 3.84200 -2.744 0.00851
The next step is to look at the scatter plot below which shows points all over the space, but does give a visual impression of a negative slope. But if one looks more closely, it is apparent that the visual impression is due to the two extreme points: one point at the top left corner showing that GME’s biggest positive return this year came on a day that the market was down, and the other point towards the bottom right showing that GME’s biggest negative return came on a day that the market was up. These two extreme points stand out in the plot and the human eye joins them to get a negative slope. If you block these two dots with your fingers and look at the plot again, you will see a flat line.
Like the human eye, least squares regression is also quite sensitive to extreme observations, and that might contaminate the OLS estimate. So, I ran the regression again after dropping these two dates (January 27, 2021 and February 2, 2021). The beta is no longer statistically significant at even the 10% level. While the point estimate is hugely negative (-5), its standard error is of the same order.
Estimate Std. Error t value Pr(>|t|)
beta -4.97122 3.62363 -1.372 0.177
However, dropping two observations arbitrarily is not a proper way to answer the question. So I ran the regression again on the full data (without dropping any observations), but using statistical methods that are less sensitive to outliers. The simplest and perhaps best way is to use least absolute deviation (LAD) estimation which minimizes the absolute values of the errors instead of minimizing the squared errors (squaring emphasizes large values and therefore gives undue influence to the outliers). The beta is now even less statistically significant: the point estimate has come down and the standard error has gone up.
Estimate Std.Error Z value p-value
beta -2.7999 5.0462 -0.5548 0.5790
Another alternative is to retain least squares but use a robust regression that limits the influence of outliers. Using the bisquare weighting method of robust regression, provides an even smaller estimate of beta that is again not statistically significant.
Value Std. Error t value
beta -1.5378 2.3029 -0.6678
Commercial beta providers use a standard statistical procedure on thousands of stocks and have neither the incentive nor the resources to think carefully about the specifics of any situation. Fortunately, each of us now has the resources to adopt a DIY approach when something appears amiss. Data is freely available on the internet, and R is a fantastic open source programming language with packages for almost any statistical procedure that we might want to use.
Posted at 2:47 pm IST on Wed, 17 Mar 2021 permanent link
Categories: CAPM, investment, market efficiency
The rationality of r/wallstreetbets
Much has been written about how a group of investors participating in the sub-reddit r/wallstreetbets has caused a surge in the prices of stocks like GameStop that are not justified by fundamentals. I spent a fair amount of time reading the material that is posted on that forum and am convinced that most of these Redditors are perfectly rational and disciplined investors, and have no delusions about the fundamentals of the company.
Rationality in economics requires utility maximization, but does not constrain the nature of that utility function. It does not demand that the goals be rational as perceived by somebody else. Rationality of goals is the province of religion and philosophy: for example, Plato’s Form of the Good, Aristotle’s Highest Good, Hinduism’s four proper goals (puruṣārthas), and Buddhism’s right aspiration (sammā-saṅkappa). Economics concerns itself only with the efficient attainment of whatever goals the individual has. Even the Stigler-Becker maximalist view of economics (Stigler, G.J. and Becker, G.S., 1977. De gustibus non est disputandum. The American Economic Review, 67(2), pp.76-90) does not seek to impose our goals on anybody else, and does not require that the goals be pecuniary in nature (consider, for example, the Stigler-Becker discussion about music appreciation).
It is perfectly consistent with economic rationality for a person to buy a Tesla car as a status symbol and not as a means of going from A to B. Equally, it is perfectly consistent with economic rationality for a person to buy a Tesla share as a status symbol and not as a means of earning dividends or capital gains. Buddha and Aristotle might take a dim view of such status symbols, but the economist has no quarrel with them.
It is in this light that I find the Redditors at r/wallstreetbets to be highly rational. There is a clear understanding and Stoic acceptance of the consequences of their investment decisions. In this sense, there is greater awareness and understanding than in much of mainstream finance. When Redditors knowingly pay prices far beyond what is justified by fundamentals in the pursuit of non pecuniary goals, they are only indulging in a more extreme form of the behaviour of an environment conscious investor who knowingly buys a green bond at a low yield.
There is overwhelming evidence throughout r/wallstreetbets that these Redditors are focused on non pecuniary goals:
/r/wallstreetbets is a community for making money and being amused while doing it. Or, realistically, a place to come and upvote memes when your portfolio is down.
Yo, health check time: Get proper sleep, Eat proper food, Stretch occasionally, HYDRATE. I’m sure we’ve all been glued to our screens all week, but please make sure you take care of yourselves.
There is a crystal clear understanding that most trades will lose money:
Buy High Sell low - what you do as a newcomer.
First one is free - A phenomena where you are so retarded and don’t know what the [expletive deleted] your doing you somehow make money on your first trade.
… if you don’t know any of this there is really no reason for you to be throwing 10k at weeklies you’ll lose 99% of the time.
We don’t have billionaires to bail us out when we mess up our portfolio risk and a position goes against us. We can’t go on TV and make attempts to manipulate millions to take our side of the trade. If we mess up as bad as they did, we’re wiped out, have to start from scratch and are back to giving handjobs behind the dumpster at Wendy’s.
… and also for the most part, they’re playing with their own money that they can actually afford to lose even if it hurts for a year or two.
Options are like lottery tickets in that you can pay a flat price for a defined bet that will expire at some point.
Indeed mainstream regulators could borrow some ideas from r/wallstreetbets on how to disclose risk factors in an offer document. When a risky company does an IPO, a prominent disclosure on the front page “This IPO was created for you to lose money” would be far better than the pages and pages of unintelligible risk factors that nobody reads.
Posted at 8:19 pm IST on Sun, 31 Jan 2021 permanent link
Categories: investment, market efficiency
SPACs and Capital Structure Arbitrage
Special Purpose Acquisition Companies (SPACs) have become quite popular recently as an attractive alternative to Initial Public Offerings (IPOs) for many startups trying to go public. Instead of going through the tortuous process of an IPO, the startup just merges into a SPAC which is already listed. The SPAC itself would of course have done an IPO, but at that time it would not have had any business of its own, and would have gone public with only the intention of finding a target to take public through the merger. Both seasoned investors and researchers take a dim view of this vehicle. Last year, Michael Klausner and Michael Ohlrogge wrote a comprehensive paper (A Sober Look at SPACs) documenting how bad SPACs were for investors that choose to stay invested at the time of the merger. Smart investors avoid losses by bailing out before the merger, and the biggest and smartest investors make money by sponsoring SPACs and collecting various fees for their effort.
As I kept thinking about the SPAC structure, it occurred to me that at the heart of it is a capital structure arbitrage by smart investors at the cost of naive investors. The capital structure of the SPAC prior to its merger consists of shares and warrants. However, in economic terms, the share is actually a bond because at the time of the merger, the shareholders are allowed to redeem and get back their investment with interest. It is the warrant that is the true equity. If the share were treated as equity, it would have a lot of option value arising from the possibility that the SPAC might find a good merger candidate, and the greater the volatility, the greater the option value. A part of the upside (option value) would rest with the warrants. But if the shares are really bonds, then all the option value resides in the warrants which are the true equity. Naive investors are perhaps misled by the terminology, and think of the share as equity rather than a bond; hence, they ascribe a significant part of the option value to the shares. Based on this perception, they perhaps sell the detachable warrants too cheap, and hold on to the equity.
From the perspective of capital structure arbitrage, this is a simple mispricing of volatility between the two instruments. Volatility is underpriced in the warrants because only a part of the asset volatility is ascribed to it. At the same time, volatility is overpriced in the shares since a lot of volatility (that rightfully belongs to the warrant) is wrongly ascribed to the share. One way for smart investors in SPACs to exploit this disconnect is to sell (or redeem) the share and hold onto the warrant, while naive investors hold on to the share and possibly sell the warrant.
Capital structure arbitrage suggests a different (smarter?) way to do this trade. If at bottom, the SPAC conundrum is a mispricing of the same asset volatility in two markets, then capital structure arbitrage would seek to buy volatility where it is cheap and sell it where it is expensive. In other words, buy warrants (cheap volatility) and sell straddles on the share (expensive volatility). At least some smart investors seem to be doing this. A recent post on Seeking Alpha mentions all three elements of the capital structure arbitrage trade: (a) sell puts on the share, (b) write calls on the share and (c) buy warrants. But because the post treats each as a standalone trade (possibly applied to different SPACs), it does not see them as a single capital structure arbitrage. Or perhaps, finance professors like me tend to see capital structure arbitrage everywhere.
Posted at 4:51 pm IST on Thu, 14 Jan 2021 permanent link
Categories: leverage