Last month we engaged in some wild speculation about how index funds and other big diversified institutional investors would cure Covid-19. Sort of what we wrote is that those big investors, who own every public company, are less interested in the relative performance of any one company, and more interested in the performance of companies—and the economy—in general. They do not particularly care which company wins in cutthroat competition with other companies; they care about all of the companies doing okay.
All of the companies, right now, are not doing okay. If one company could find a way to fix that—if a drug company found a cure for Covid-19, say—that company could, theoretically, make a lot of money for itself. If you had a cure you could charge a lot of money for it; if you were the first drug company to make the cure there would be glory and patents and market share in it for you. During Covid-19 could be a high-stakes competitive endeavor, for a drug company, just like solving any big societal problem is generally a high-stakes competitive endeavor for the for-profit companies looking to do it. From a societal perspective this might not always be good: It might be better if the drug companies all shared information and worked together to find a cure as fast as possible; once they found it, it might be better if they gave it away for free. But from an individual company’s perspective there are other incentives.
Except that all the individual companies are owned by the same big shareholders, and those shareholders don’t care about who wins, they care about getting the economy working again. So we wrote:
We will say that if we ran one of the big index-fund companies, and a pharmaceutical company in my portfolio developed a patented fully effective cure for Covid-19 that it could manufacture cheaply and planned to sell to anyone who could pay $50,000 a dose, we would call that company right up and say “no, you give that pill away for free, because the value to me of Covid-19 going away quickly and the economy recovering—the value to me as an owner of airlines and hotels and chain restaurants and retailers and every other company—is vastly, vastly greater than the value to me of your profits on that pill.” Strictly as a financial matter we mean, strictly as a matter of my fiduciary duty to my investors. We would call my index-fund-manager friends and tell them to do the same thing, and between us we might own enough shares of the company’s stock to make it do what we want. Later the antitrust authorities would ask us some uncomfortable questions about our conversations, but in these extreme circumstances that is a risk we’d live with.
Badly we are not there yet, in that no one has found a cure. But the rest of that paragraph—about index funds calling drug companies, and each other, to coordinate—is totally happening. From the Financial Times:
The world’s biggest investors are urging drugmakers to collaborate on developing a coronavirus vaccine to end a crisis that has unleashed market turmoil and hammered returns for pension funds across the world.
BlackRock, the world’s largest asset manager, Fidelity Investments and sister company Fidelity International, Aviva Investors, Janus Henderson and Amundi, Europe’s largest asset manager, all told the Financial Times that they want drug companies to put aside any qualms about collaborating with rivals. …
BlackRock has recently held talks with pharma companies about ways of developing and deploying medicines and equipment, including working with industry competitors and regulators.
A separate group of more than 50 investors, managing more $2.5tn in assets, will next week step up the pressure by writing to more than a dozen global pharmaceutical companies. The letter will ask the groups to share any relevant findings on a vaccine and other treatments as well as to drop any enforcement of relevant patents.
Rogier Krens, chief investment officer of Achmea, the Dutch asset manager that is organising the letter, said it was vital that a vaccine was developed and made available as quickly as possible.
Pension fund returns had been “very hard hit by the economic crisis”, said Mr Krens.
“It is very important for us and for our clients to recover as quickly as possible,” he added. “One of the means to that end is to get the health industry and pharma companies in particular to collaborate.”
We wrote last week:
We talk all the time about how weird it is that the big shareholders of every big company are also big shareholders of all of the other big companies. Typically we talk about it in the antitrust context—“won’t they want the big companies to compete with each other less aggressively?”—but in the current crisis that seems a little trivial. In the current crisis it seems like an interesting opportunity that all the companies have the same shareholders.
That seems right. It is good, right now, that big drug companies are getting phone calls from their owners, and the owners are saying “look, don’t worry too much about competition or profits or shareholder value right now; we’re your shareholders, and what we value most is a cure for this disease and a path to reopening the economy.”
It is good, but also strange. Usually when we talk about this stuff it is under the heading of “should index funds be illegal?” If all of the companies in an industry are owned by the same people, and if that common ownership tends to encourage all the companies to work together rather than competing, then that normally—not now, but normally—is the sort of thing that makes antitrust regulators nervous. One objection to this worry, normally, is: Sure there might be theoretical incentives to reduce competition, but there is no mechanism for them to work; it’s not like big institutional investors actually call up all the companies in an industry and tell them not to compete with each other. Except that is exactly what is happening now! Obviously everything is weird now, and maybe this is a one-off, but does seem like proof that big investors sometimes do call up companies and tell them not to compete too hard.
There is a deeper strangeness. We started out saying that solving any big societal problem is generally a high-stakes competitive endeavor for the for-profit companies looking to do it, and that this might not always be good for the world. But it is the normal way we structure capitalist society, and usually we think that it’s pretty good. There’s a thing that people want, and if you build it you will add a lot of value to the world; you will be able to sell the thing at a price that reflects that value, and capture some of that value for yourself in the form of profits. This is good for you because you get rich, but it’s good for society because it provides incentives: You will work hard to invent things that people want, because the more they want them the more money you can make. This is basic capitalism stuff.
The argument that we are making here, though, is that common ownership by institutional investors provides another way for companies to capture the value of what they do, besides selling it for a profit. If you build a thing that people want, if you make customers better off, if you add value to the world, you can internalize that value not by charging people for it but by owning all your customers, or rather by having the same owners as your customers. Someone else benefits from the thing you make; they capture all of the surplus, and you capture none of it, but it’s fine, because you and they are in some sense the same person. You all work for the same super-company—the company of the index funds—and so you are motivated to pursue the common good rather than your own individual profit. Maybe the index funds really are the vanguard of socialism.
Take only what you need
This is the corporate banking equivalent of grocery stores limiting toilet paper sales to one package per customer:
Among the most novel changes popping up in new deals are anti cash-hoarding measures designed to ensure companies don’t tap revolving credit facilities until they actually have a need for the funds.
That’s been a growing frustration among bankers over the past month-and-a-half as lending desks stretched to the limits operationally have been inundated with drawdown requests.
In the case of Valero Energy Corp.’s recent $875 million one-year revolver, the stipulation limits access to the funds to working capital needs, according to a company filing. A provision in a new credit facility for health-care supplier Henry Schein Inc. prevents the company from exceeding a certain cash balance. Similar clauses are expected in other upcoming short-term loans currently in discussion, according to people with knowledge of the deals.
That’s from an article by Bloomberg’s Paula Seligson about how “the largest U.S. banks, flooded with requests for loans from blue-chip companies in recent weeks, are starting to use their newfound leverage over corporate America to insert safer, more favorable terms into billions of dollars of deals,” terms like Libor floors and mandatory prepayments that are “more commonly found in junk-rated transactions or bridge loans” but are now “creeping into investment-grade financings.”
Banks give companies revolving credit lines that they can draw down if they need it. Ordinarily companies will only draw on their revolvers if they need the money: The revolver is for emergencies, and there is a sense that it is a bad look for a company to draw too much of its revolver. In recent months, though, the whole concept of “a bad look” has sort of evaporated, and companies have been fully drawing their revolvers even when they don’t need the money, just because no one is sure if there will ever be money again. So in new revolvers, banks are including explicit provisions that you can only draw on the revolver if you need it. Here, for instance, is Valero’s:
The proceeds of such Borrowing, together with the Consolidated Cash Balance at the time of and immediately prior to giving effect to such Borrowing, shall not exceed an amount equal to the working capital requirements of the Borrower and its Subsidiaries during the period from and including the date of such Borrowing to but excluding the date that is thirty (30) days after the date of such Borrowing, as reasonably determined in good faith by the Borrower.
This seems less like protection against credit risk—if companies borrow more money than they need, that probably makes it more likely that they can pay it back—and more like a protection against funding risk. If everyone wants money all at once, the banks have to come up with a lot of money, which is administratively challenging even for a bank. Better to ration the money to companies that need it rather than let everyone take it all at once.
Honestly the theme of today’s column might be financial communism. “From each according to their ability,” say the index funds. “To each according to their need,” say the banks. Weird times.
PandeMAC II
In February, Sycamore Partners, a private equity firm, agreed to buy a majority stake in Victoria’s Secret, the retail clothing business, from L Brands Inc., which currently owns it. That looked like a better decision in February, when Victoria’s Secret stores were open, than it does in April, when they mostly aren’t. Sycamore sensibly wants to get out of the deal, or to pay a lower price for the business.
So it sued L Brands in Delaware court, saying that it had a right to terminate the deal. We talked about this lawsuit yesterday. It’s kind of weird. When Sycamore and L Brands were negotiating the deal, they knew that the coronavirus was a concern. So they specifically wrote in the agreement that, if Victoria’s Secret’s business collapsed due to a pandemic, Sycamore still had to close the deal. Then Victoria’s Secret's business collapsed due to a pandemic, and Sycamore is trying not to close the deal.
Their argument is not that the business collapsed. Instead, it’s that L Brands broke its promise to run Victoria’s Secret “in the ordinary course consistent with past practice.” L Brands has not, I think it is fair to say, run Victoria’s Secret “in the ordinary course consistent with past practice” over the last month or so—it has shut stores, furloughed workers, cut salaries, etc.—but of course it is not alone; very few businesses are operating normally these days. You can’t exactly blame L Brands for not running Victoria's Secret normally in a pandemic. But Sycamore is not blaming L Brands, really; it’s just asking to get out of the deal.
Now when stuff like this happens—when unexpected circumstances arise that require you to change how you run your business—between signing and closing of an acquisition, there is an ordinary way to deal with it. What the seller does is go to the buyer and say “look, something strange happened, and we have to respond to it. Here's what we plan to do. Are you okay with that?” If the buyer is okay with it, the seller can do it, and the buyer can’t later argue that it breached the covenant. That is specifically contemplated by the transaction agreement between Sycamore and L Brands: L Brands has to run Victoria’s Secret “in the ordinary course consistent with past practice,” except “as consented to in writing by Buyer (such consent not to be unreasonably withheld, conditioned or delayed).” The covenant doesn’t really mean that L Brands can’t make any changes in how it runs Victoria’s Secret; it just means that it has to ask Sycamore first.
So when the world ended, L Brands could have just emailed Sycamore and said “hey uh we’ll probably have to close all our stores and furlough our workers, are you okay with that?” And then Sycamore could have responded “yes,” in which case it would be fine and they would have no excuse to get out of the deal, or “no, here’s a better idea,” in which case maybe L Brands would have taken their advice, or just “no,” in which case probably there’d be a lawsuit, with L Brands arguing that Sycamore “unreasonably withheld” its consent for L Brands to do clearly necessary things to respond to the pandemic.
Why … didn’t … it … do … that? Like the decisions to shut Victoria’s Secret’s stores and furlough workers weren’t secret, or unreasonable; why not just email Sycamore for permission first?
Well, yesterday L Brands countersued Sycamore, demanding that it close the deal, and one of its arguments is, look, of course Sycamore gave us permission to do all of this. From L Brands’ complaint:
L Brands advised representatives of Sycamore of these actions before taking them. Sycamore did not object to these steps. To the contrary, Peter Morrow of Sycamore expressed his appreciation for being kept in the information loop. ...
L Brands representatives had an extensive meeting with Peter Morrow and Adam Weinberger of Sycamore on March 25, 2020 during which L Brands’ representatives provided a broad array of information about the Victoria’s Secret business and the steps L Brands was planning to take to address the impact of the COVID-19 pandemic. Once again, Sycamore did not object. To the contrary, the Sycamore representatives told L Brands that the steps L Brands was taking to address the impact of the COVID-19 pandemic were reasonable and consistent with steps Sycamore Partners was taking on behalf of its own retail portfolio companies. Mr. Morrow also told the L Brands representatives that Sycamore could not slow L Brands down and acknowledged that L Brands was doing what was best for the Victoria’s Secret business. Further, Mr. Morrow again stated that he appreciated the information that L Brands was providing and notably said that Sycamore believed it was in an awkward position because it did not own Victoria’s Secret and could not direct the decisions L Brands was planning to make.
It’s not ideal; the transaction agreement requires consent “in writing,” and really it might have been smart for L Brands to put this all in an email, send it off to Sycamore, and add “please reply in the next two hours to acknowledge that you’re okay with this.”[1] Still if you have a long meeting with the buyer and tell them everything that you’re doing, and they say “this is all smart and reasonable, thanks for telling us,” it’s a bit ridiculous for them to later sue saying that they didn’t give permission.
L Brands has other arguments. One is that the actions it took “were taken to comply with Applicable Law and Governmental Authority”: The covenant to run the business in the ordinary course also has an exception for extraordinary actions “required by Applicable Law or Governmental Authority,” and a lot of governments did require nonessential stores to close. I am not sure that covers every action taken by Victoria’s Secret, though; Sycamore complains about things like cutting salaries and not paying rent, which were not required by law.
A better, more interesting argument is that all of the extraordinary things Victoria’s Secret has done recently actually were “in the ordinary course,” since after all everyone else is doing them. Running a retail business with no stores, no employees and no revenue is the new normal:
L Brands did not need Sycamore’s consent to take the steps catalogued herein to protect the Victoria’s Secret business, because those steps were taken to comply with Applicable Law and Governmental Authority, and were taken in the ordinary course as reflected by the fact that such steps are consistent with the steps that nearly every other retailer across the country has taken. These steps are consistent with steps L Brands has taken in the past when faced with global economic upheaval, including with respect to the treatment of inventory, capital expenditures, employee compensation, and other items.
In fact they’re so ordinary that Sycamore, a retail specialist private equity firm, did the same things in its other businesses:
Indeed, the actions that L Brands believed prudent and responsible to take in response to the COVID-19 pandemic and government orders were consistent with those taken by other retailers. For example, on March 17, 2020, the retailer Talbots, which Sycamore Partners acquired in 2012, announced that it would temporarily close all of its retail stores “in order to help protect our communities and contain the spread.” On the same day, Belk, a Charlotte, North Carolina-based retailer in which Sycamore Partners is an investor, likewise announced that it would temporarily close all of its retail stores and continue providing compensation and benefits to affected employees. On March 27, 2020, Belk further announced that it would furlough certain store associates, and would reduce pay for most employees who remained working—including up to 50% for its most senior employees.
We are not sure that it’s “the ordinary course consistent with past practice,” but in spirit I am basically with L Brands here. They note that Sycamore’s real goal is to renegotiate the deal price, and that that deal price was negotiated—in February!—with the understanding that Sycamore would bear the risk of a pandemic:
Sycamore had conceded to L Brands by April 13, 2020, that it wanted to close the Transaction but not on L Brands’ preferred timeline. Sycamore also had conceded that closing the Transaction was “tricky” in light of COVID-19, and that it wanted to renegotiate the deal price “to take account of the COVID-19 situation,” a risk that Sycamore had expressly agreed to bear in the Transaction Agreement. In an attempt to avoid that agreed-upon risk allocation, Sycamore continued to refrain from calling the COVID-19 pandemic what it actually is—a pandemic—instead referring to it crassly as a mere “situation.”
L Brands is basically right that the deal price they reached in February did take into account the Covid-19 situation, or at least the risk of it, and allocated that risk to Sycamore. As they say:
Sycamore ignores a fundamental problem with its apparent case of buyer’s remorse: At the time the parties negotiated the Agreement, the world was already well aware of the existence of COVID-19, and the parties agreed that Sycamore would bear the risk of any adverse impacts stemming from such a pandemic. … Sycamore and its representatives may wish that the world did not have to face the pandemic that now confronts us, and may regret that they did not negotiate the allocation of pandemic risk differently in the Transaction Agreement. But having made that commercial choice, Sycamore must now live by it.
We think that is generally true for a lot of deals that were struck in the months leading up to the coronavirus crisis: The buyers mostly took the risk that the sellers’ businesses would collapse for generally applicable reasons, like a pandemic, and now a lot of those sellers’ businesses have collapsed. A lot of buyers now wish that they hadn’t taken that risk, because it has come true in a particularly terrible way. But for the most part that is the deal they signed up for.
Junk
We have suggested a few times that there might be good reasons for credit ratings agencies to take the next few months off. A lot of formerly investment-grade companies—companies with good stable businesses and strong balance sheets—don’t have revenue anymore, and not having revenue for months is going to impair anyone’s credit. So a lot of companies should be downgraded, and probably will be; many have been already. But it is not clear to me that these downgrades make anyone much better off. It is not like bond investors haven’t noticed that commerce has stopped, or can’t figure out that that’s bad for businesses. It is just sort of superfluous for credit ratings agencies to say “oh yeah, lending money to businesses whose revenue has stopped is riskier than it used to be.” Yes, right, duh.
Netflix Inc. pulled in record subscribers after people hunkered down at home amid the virus pandemic. It’s also pulled in record-low yields for its bonds.
Investors clamored for Netflix’s latest $1 billion offering of dollar-denominated and euro bonds, after the streaming service emerged as a beneficiary of the unprecedented health crisis keeping people at home.
Demand was so strong, with orders at about ten times the offering size, that Netflix was able to reduce yields on both portions on Thursday from earlier discussions, according to people familiar with the matter. It sold $500 million of bonds at a 3.625% yield, among the lowest ever seen in the U.S. high-yield bond market and in line with prices typically offered on investment-grade bonds. The 470 million euro ($507 million) portion priced at 3%.
Netflix is rated Ba3/BB- by Moody’s and Standard & Poor’s. It is not a conventionally safe investment. It “posted its first quarter of positive free cash flow since 2014” last quarter, and “remains a few years away from achieving sustained positive free cash flow.” Also though it is earning money right now! Its revenue has gone up! That is good! Everyone else is doing badly, and Netflix is doing well! If you are looking to lend money to a company that will probably pay you back because it is making money, Netflix, right now, looks unusually good, and a whole bunch of strong safe investment-grade companies look unusually bad.
And so the market is sort of ignoring credit ratings and bidding up the price of junk-rated-but-good-now companies like Netflix.
We don’t really know what that tells you. One possibility is “investors are short-sighted and will buy five-year bonds based on some buzz and one good quarter of earnings; they really need ratings agencies to give them a dispassionate clear-eyed fundamental credit analysis.” Another possibility is “the market is good at reacting rapidly to changes in the economy and figuring out which companies benefit from them, while inflexible and backward-looking credit ratings are useless in telling investors what is actually safe and what is risky.” In any case there sure seems to be a disconnect.
Magic: The Arbitrage
Toy financial systems are nice because they can teach you essential things about finance without a lot of the path-dependent accumulated historical baggage of the real financial system. This is why crypto is so fun. Also, though, the card game Magic: The Gathering. (There is a connection: One of the early big crypto exchanges was Mt. Gox, which originally stood for “Magic: The Gathering Online Exchange”; later it became a Bitcoin exchange, and then, of course, blew up.) Players of Magic can buy, sell and trade cards to improve their chances of winning games, and the market for the cards is fascinating and well analyzed. One of my favorite Planet Money episodes is about the Magic economy, and now here’s a delightful Wired article about Magic trading that is full of stylized financial lessons.
For instance here’s a story about cross-border arbitrage:
From the buyer’s side of the booth, Aaranson explained how he travels to and from Japan every other month or so to arbitrage, taking advantage of price differentials between the US and Japan. Ping-ponging between about 30 shops in Tokyo’s geeky Akihabara district, Aaranson grabs inventory fast and cheap, he says, since all the little stores compete against each other. Select cards they bring from the US are worth 30 to 40 percent more over there. Selling them in Japan, Aaranson says, more than pays for the trip. Likewise, a Magic format hugely popular in the US, Commander, is quite rare in Japan, making Commander deck staples significantly cheaper over there.
Aaronson launched into an excited riff describing his arbitrage efforts: “We have a fixed cost of about $500 to $1,000 for a week in Japan. You go over there with a bunch of Fetch lands”—a card that efficiently generates mana—“that you bought here presumably for $40 or a ‘Misty Rainforest’ that sells for $70 in the States. You can get $70 on a ‘Force of Will’ in Japan and use that for a credit bump for cards that don’t see play. And then once you get over there, you can get a card called ‘Sol Ring,’ which is the most popular card. In English it’s $1 and in Japanese it’s from $0.10 to $0.50. So you buy a thousand of those, and you come back here and sell those Sol Rings you bought for a dollar for $3 to $4 dollars each. Cyclonic Rift is another. They were 300 yen for a long time and they’re $20 in the states.”
Asked how his taxes work, Aaranson, 25, referred me to his accountant.
A quirk of the Magic card market is that, in our increasingly connected and digitized world, arbitrage is miraculously still possible as domestic card prices rely heavily on domestic data and trends in gameplay. On top of that, the logistics and financial burden of shipping $5 cards internationally and at scale on TCGPlayer or Amazon or Ebay incentivize store-owners to keep things local.
You can have market segmentation based purely on cultural factors: If one group of buyers prefer X for non-financial reasons
