Tuesday, January 19, 2010

Cadbury's deal puts M&A on notice for return of long-termism

Cadbury’s resistance to Kraft finally melted away today when the price rose to 850p including dividend. Like so many “bear hugs” before it, this was an entirely predictable ending, with price being the only barrier to a deal.

But something stands out. In the small print of its announcement, Kraft said it will drop its acceptance condition from 90 to 50%. For a large public deal with so much bank debt, this is not normal behaviour. It means refinancing in the bond market could be messy and expensive. It will weigh on Kraft’s credit rating and place huge pressure to cut costs, an area where Kraft is already feeling some heat. So why do it?

The answer is that Irene Rosenfeld’s advisors had no choice. This was the first big deal since the bank reform lobby started gunning for M&A. There is really a possibility that, despite Roger Carr’s recommendation, a tenth or more of Cadbury’s shareholders will show Kraft a big fat chocolate finger.

Since Lord Mandelson first spoke in Cadbury’s defence, more and more commentators (and chocolate eaters) have joined the chorus, including City grandees, industrialists and the BBC’s Robert Peston.

As a chocolate maker, Cadbury touches an unusually raw nerve. Comments on Peston’s blog today offer a tasty pick’n’mix of public anger. There is fury for the bankers: “We kiss goodbye to another significant chunk of British industry becoming ever more reliant on banking”. There is resentment for the institutional shareholders: “We're turning ourselves into a nation of slaves by those who run our pensions”. And there is dread of American chocolate making: “One would hope there is no dumbing down of the chocolate to the awful US candy type!!”

While the chocolate point is quite understandable (no one make chocolate like the British, not even the Swiss), these comments miss the point that in a free market the market must be, well, free. I doubt many of those complaining about Cadbury’s complained when the unsexy BOC, maker of industrial gases, disappeared, although they probably enjoyed their UK mutual funds climbing a notch as a result.

Market failures

Accepting the free market approach means believing the market works as it should, and it is here that critics may be on to something. First is the accusation that Kraft will sack UK workers before its own. This is quite believable since Kraft’s board will be more susceptible to political economy in its home market, but it's not easy for a share price to reflect externalities such as local job losses. It is the government's job to price that in by throwing grit in the wheels.

Another fear is that the deal signals that shareholder value is more important than stakeholder value, leaving benefits undefended by the market, such as the brand’s contribution to the nation's feeling of warm, fuzzy chocolate-induced wellbeing, or the company’s example to corporate responsibility.

It also confirms that today’s shareholder value is more important than tomorrow’s, so that selling out now is fine if the price reaches today’s market metrics, even if it strips the British index of a dividend stock that serves many a British pensioner. The culprit here is the fund management industry, which lacks incentives to protect the long-term interests of its customers.

The price itself is also in question. In this case it was 13 times Cadbury’s profit from last year. Why not 12, or 15? The number depends on the opinion of analysts in banks and funds and the multiples in previous deals agreed by other bankers. It is therefore set entirely by financial intermediaries rather than savers. Most of the bankers will benefit in some way if the deal goes through but we will never know if the cost of pensioner’s losing another dividend stock was priced into the deal.

A lot of recent commentary has quoted academic findings that takeovers destroy more value than they create. That’s been the case for a long time (it was even a set text in my economics A level in 1989, ouch) and is undoubtedly true for many landmark deals. What the research does not show, because it is unmeasurable, is how much the economy benefits from management being kept on their toes by the threat of takeover.

Philip Green’s failed approach for M&S in 2004 led to new management and the reinvigoration of the national underwear-provider under Lord Myners and Stuart Rose. It transformed M&S and there wasn’t even a deal to complain about.

So rather than banning such bids, perhaps the best way to preserve the value of companies such as Cadbury would be to make it easier for them to defend against predators with long-term arguments.

Back to long-termism?

One idea to put the long-term back into investment would be to restrict voting rights to shareholders with more than one year on the register. However, this wouldn’t help in a bid, since shareholders can still exercise their most powerful “vote” when they tender their shares.

An idea common in France and Belgium is to double voting rights after a period of ownership, usually one or two years. In theory, this rewards long term investors. In practice, it makes ownership opaque and unstable and enables creeping takeovers from strategic minority shareholders.

Economist Roger Bootle’s version of this idea is to restrict dividend rights to long-term holders, but this would have similar limited effect and likely spawn a cottage industry of merger dividend arbitrage to get around it.

Perhaps the only practical way is through a universal and variable transaction tax designed to make longer term positions much cheaper than short term ones. It could be based on stamp duty and apply to derivatives and contracts for difference to minimise avoidance. It could also be variable, increased during takeover periods or bubbles and decreased when fresh capital is needed, for example when vulnerable industries (like banks) are recapitalising.

That might curtail hedge funds, but they rarely have the casting vote in takeovers. Institutional fund managers are the real key and their quarterly performance incentives make them suckers for a good cash offer, regardless of the bigger picture.

One fund manager told me of her huge relief when QIA’s approach for Sainsbury’s failed, as she did not have a position at the time of the approach. If the bid had succeeded, her competitors would have leapfrogged her in the performance tables and her fund and bonus would have suffered. Her investors are mostly long-term pension savers, many of whom rely on Sainsbury’s for their income almost as much as their shopping. They might agree with her position on that deal, but you could hardly say they share the same interests.

Unless institutional fund managers are rewarded on the same timeline as their investors’ average investment horizon, institutions will manage the nations's equity for their immediate gain, as would anyone else in their shoes. Their interests need to be better aligned by lowering fund manager salaries, insisting that bonuses are paid into the fund they manage and locking them up for at least 10-15 years.

There’s little sign of any of these happening now, but the election is putting such topics on the agenda in a way that never would have been possible before the crisis. If George Osbourne becomes serious about long-termism, future deals will have to learn from Kraft’s 50% tactic and not expect such a soft centre next time round.

UPDATE 15 June 2010 just stumbled across this statement from think thank Aspen Institute on Overcoming Short-Termism. The statement calls for the encouragement of more patient capital, including through capital gains tax measures; for better alignment of interests of intermediaries and their investors, including longer term compensation structures and disclosure thereof; and more transparency of holdings from short-term investors to help management assess their motivations. The signatories include Warren Buffet, Vanguard founder John Bogle, James Wolfensohn and many former CEOs and chairmen of big corproations.

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