Remember how David Einhorn got in trouble in England for insider trading on Punch Taverns stock and he was all “what?” and we were all “what?“? Well, you can judge it for yourself because now the entire disputed call with Punch is available online (at the back of this). So go read it, or read the highlights here. The FSA still thinks it’s insider trading, but the count of people confused by the whole thing is rising, and now includes the Merrill banker on the call. There’s lots of insider traderiness on this side of the pond today too so we should talk about that in a bit.

For now, though, two other things. One is quick – no one can resist one part of the call and I can’t either so here it is:

DAVID EINHORN: Hi, I’m sorry I didn’t get to see you when you were in New York.
PUNCH CEO: No, no, we — well, we’ve — we’ve only had the chance to speak once, although we have seen [reference to Greenlight Analyst] a few times since then.
DAVID EINHORN: Oh, you’re — you’re — you’re getting more than — than I could help with anyway. So, this is good.
PUNCH CEO: Okay. That’s fair enough. Well, one day we’ll get you around on a pub crawl around some English pubs.
DAVID EINHORN: Oh, that sounds fun.
PUNCH CEO: It is. You’re right.

English readers: Is it? I just assumed that Punch Taverns are rather grim places, like TGI Friday’s but with more … punching? … but maybe I’m totally off base here. Also, here is a hypothesis: vice investments do well because, for the same level of profitability, they get more analyst/investor coverage and enthusiasm. Wouldn’t you rather go on a pub crawl instead of like a tour of an auto parts factory in Queens? Would that influence your stock recommendations / money allocations? Someone should do a study.

But the call is mostly interesting as an insight into Einhorn’s thinking about his investments – you don’t get public access to a lot of candid (non-earnings-call) conversations between CEOs and investors, so these insider trading charges are a nice bonus for those of us not, y’know, paying the fines. The thesis here is actually textbook straightforward:

Right. You know, it seems to me that — that much of the potential attractiveness of coming and selling equity at this point stems from probably the fact that a few months ago the equity was at 40 pence, and now it’s at a £1.60 or something like this. And so, it’s up from the bottom. On
the other hand, if you look back a couple of years ago, it’s — the equity is really down a lot. It trades at a very low multiple of the book value and, you know, the comp – the company — the equity continues to trade as if it’s really an option on the debt side of the capital structure. That’s — that’s the way that we look at it. And we think it’s a very cheap option because of the types of things that you’ve been — already been able to execute on, and I think that you’re going to be likely to be able to execute on, uh, going forward. I think that in — if the equity was — was overpriced and you had an opportunity to reduce the financial risk of the company, I think it would make some sense to considering equity at that point. But I think, if you just looked in a slightly different world and thought “Jeez”, if the stock had come from where it was and it had never gone to 40 pence but instead was sitting at 1.60, then 1.60 represented a new low, down from whatever previous higher price it had used to have been at, I don’t even think you would be considering selling equity at this point. And — and so, I think the mere fact that the stock went to some lower price is not reason to — to dilute the — to dilute the equity in a substantial way, you know, at this time. The — the next point would relate to, I guess, the amount, and I guess that would look — you could look at that two ways. I suppose if it was a very small amount of equity being raised it would not be all that dilutive, and so there wouldn’t be a reason to have a very big concern about it. But, on the other hand, if there was a small amount of equity that was being raised, it wouldn’t really solve any of the company’s intermediate or longer term risks. And if there’s a large amount of equity to be raised, well, then it’s massively dilutive, then it — it will dramatically — I — from my perspective, worsen the risk/reward from — from owning the stock. So, I — I would — I would suggest continuing executing what you’re doing right now, which seems to be doing very well. I agree with you, it seems like there’s going to be a lot of debt in different parts of the capital structure that seems like it’s going to be available at attractive prices, and I — and I wouldn’t allow myself to get browbeaten by convertible bondholders or, excuse me, Merrill Lynch investment bankers or whatever else, you know, that — that is more transaction oriented. I think we create a tremendous amount of value by selling, you know, by selling pubs at reasonable multiples of EBITDA and then repurchasing debt at big discounts, and we’re hoping as equity participants not to make 10 or 15 percent of a year, you know, as market equity, but we’re looking for a significant revaluation of this company on the basis that at some point the world looks at it and says, “Yes, you are — you — you — you have — you are clearly solvent, and you clearly deserve some kind of a multiple,” and — and the thing that would cut that off would be issuing so many equity shares that, you know, that – that — that the upside disappears.

For an investor like Einhorn, there is not a lot of value in the company taking conservative – but dilutive – measures to make sure that it stays out of bankruptcy. Einhorn is fine with a very large probability of the stock going to zero – as long as there’s, say, an equal probability of it going up tenfold. The disaster scenario for him is not bankruptcy; it’s the company delevering itself into a conservative drinking establishment with a stock that sits at £1.60 (or less).

That is probably the right way to think about Punch Taverns, for a shareholder: if you stand to lose £1.60 on a bankruptcy and make £11 on a recovery, there is no sense in delevering to reduce the chances of the downside scenario if doing so requires you to increase your downside (by putting in more money) or reduce your upside (by getting diluted). Is it how the CEO thought? Here’s a neat exchange:

PUNCH CEO: Yeah, I mean, I am — to make it quite clear, you know, and we’re — you know, I’m the largest private shareholder in the business and I’m very, very clear in terms of my responsibility –
DAVID EINHORN: No, I’m pretty sure — I’m pretty sure I’m the largest private shareholder.

Ha! And “DYKWTFIA!” And – well, the CEO sort of meekly makes the point that Einhorn is actually running money for other people but, yeah, fair, it’s quite a lot of his money, so fine. Einhorn’s incentives seem well aligned with his investors’ interests here.

But Einhorn sort of accuses the CEO of listening to his debtholders (convert holders, technically) and his bankers, whose interests are, respectively, in (1) getting paid back with little risk and (2) doing big transactions to get big fees. Is this true? Well, it’s worth saying that the CEO is probably more risk averse than Einhorn is. Sure Einhorn had a lot of money in Punch, but it’s not all that much of his net worth, it’s just one of his positions, and he’s just a shareholder. Losing all his Punch money isn’t that big a deal. For the CEO, Punch going to zero would mean losing a good chunk of his wealth, his future salary, the respect of a vocal contingent of drunks, and – well, he’s not a knight, is he?

Anyway, it stands to reason that he would listen to his bankers and feel more like his convert holders than his shareholders: he wants the upside, but not at the costs of a greatly increased chance of filing for bankruptcy and losing a job that pays him and allows him to take investors on pub crawls. That – rightly! – pissed off David Einhorn. It probably made the bondholders happy. Should we care? Maybe, maybe not.

But as it happens I spent yesterday evening talking to some smart people about financial industry compensation. One thing that we’ve talked about before is how to align banker incentives with what is best for society: you want bankers to take reasonable risks, but not too many.

Lots of people worry about this, like Moody’s, which is fretting about the big banks in part because of their incentives. Some people don’t, like bank shareholders. And why should they? As Einhorn said to Punch, “as a rule of thumb, if the market capitalisation of the equity is less than half of the face value of the debt, the — the stock remains sort of in an option area” – meaning that management should try to increase that option value by keeping leverage high and taking risks. Banks tend to have equity worth closer to 1/10 of their debt. On that standard, bank shareholders are really, really just option holders.

There are lots of reasons that this conflict gets obscured, including by people calling for banks to be boring utilities. One reason is that shareholders mostly don’t go around saying things like “we’re fine with an increased risk of bankruptcy as long as we have undiluted exposure to the upside if we don’t go bankrupt.” It’s fortuitous that this little Punch scandal gives us an example of a major shareholder saying exactly that. The systemic risk of a Punch bankruptcy is quite small (though I won’t be saying that to any English drunks), so it’s hard to find anyone who objects much to Einhorn’s substantive point. You might think a little harder about it, though, if that were a Lehman shareholder telling Dick Fuld not to delever and to just roll the dice.

Final Notice: Andrew Osborne [FSA]
Highlights Of the Einhorn-Punch Call [Kid Dynamite]
The Punch Call [FTAV]

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Comments (24)

  1. Posted by Guest | February 16, 2012 at 2:22 PM

    I admit it, I think I am missing the whole point of the "pub crawl" concept. Is it to go to a pub hoping to find some fun and excitement, end up being severely disappointed, and then hope that maybe the next pub on the list will be better, only to have the process repeat?

    Why not just do the research and find a good pub where you won't be disappointed? Or, if they are all equally disappointing, just pick one and get all your disappointment in one place?

  2. Posted by Guest | February 16, 2012 at 2:38 PM

    Okay we'll be at Minetta's.

  3. Posted by ugh | February 16, 2012 at 2:39 PM

    Not sure if your ignorance is legitimate, or if it was intended to be funny. Either way, shut up.

  4. Posted by Guest | February 16, 2012 at 2:58 PM

    Longest quote ever?

  5. Posted by S. Wynn | February 16, 2012 at 3:07 PM

    How to do a capital raise:

    'It is the job, and you can take this as a final statement on the subject going forward. It is the job of board of directors and especially of the CEO to take advantage of the market when that market movement is extreme. When a company increases its value by 100% in 60 days, that’s an unnatural movement of value and the market also goes the other way sometimes.

    These unnatural movements in value, no company gets to be worth twice as much in 60 days as it was before to any intelligent person, so when that happens, we take advantage of it. If everybody is so hungry for shares, we let them have some. If the shares go down, we buy them. And that, that is a statement of policy in this company, period."

  6. Posted by Guest | February 16, 2012 at 3:12 PM

    My ignorance is legitimate. The very concept of a "pub crawl" is as foreign to me as live action role playing or a Tupperware party. I simply do not understand the underlying concept.

    – Guy who still does not get it and will not shut up

  7. Posted by Beerio | February 16, 2012 at 3:16 PM

    I know the cool kids all enjoy hating on Matt, but I really enjoy his posts. I like that he thinks differently about things to most people. I even (horrors) enjoy his writing style.

  8. Posted by Guest | February 16, 2012 at 3:21 PM

    I liked the article, but I have to question some of the assumptions underlying Einhorn's thinking.

    – First, it is assumed that there is a potential upside. If there isn't, taking on more debt simply reduces the profit of the company. Just because the stock price can move up doesn't mean it will – just ask the owner of pretty much any stock penny company.

    - Second, rolling over debt is fairly critical to the ongoing operations of a company. If the risk represented by not rolling over the debt is high enough, that pretty much overshadows the leverage effect. Upside is always a potential, never a guarantee; for a company that can't roll over debt, shutting down is pretty much a guarantee.

    - Finally, the leverage and the risk are operating on different timeframes. Companies can shoot up in valuation, but usually they don't. It can take years for a company, especially a boring one like a hospitality business, to double its valuations. if debt is high enough, however, the risks it poses are very immediate. That's what is particularly problematic for banks – they can pay out good returns, but those returns come over years of performance, while funding operations is, or can be, a month-to-month, day-to-day crisis. If debt is short-dated and profits are long-term, that creates a highly volatile situation where lower debt may be better.

  9. Posted by early_hominid | February 16, 2012 at 3:29 PM

    We all enjoy Matt's thesis-length defenses of the dark imaginings of felony (or, as you put it, "thinking differently about things"). If we seem critical its because we care. And because we know he can do better.

  10. Posted by FKApmco | February 16, 2012 at 3:30 PM

    Underlying concept is drink and have fun and maybe get lucky if you can still stand up at the end of the night.

  11. Posted by David St. Einhorn? | February 16, 2012 at 3:37 PM

    Well, I don't really think that the end can be assessed as of itself as being the end because what does the end feel like? It's like saying when you try to extrapolate the end of the universe, you say, if the universe is indeed infinite, then how – what does that mean? How far is all the way, and then if it stops, what's stopping it, and what's behind what's stopping it? So, what's the end, you know, is my question to you.

  12. Posted by guest | February 16, 2012 at 4:13 PM

    DAVID EINHORN: No, I’m pretty sure — I’m pretty sure I’m the largest private shareholder.

    lol

  13. Posted by Guest | February 16, 2012 at 4:15 PM

    Are you *sure* you are not a man? I have not, in my entire life, ever heard a woman say that she "got lucky"; for women, there is no luck necessary, it is easier than falling off a horse, the only luck involved is if he actually calls her when he says he will.

  14. Posted by hangtime79 | February 16, 2012 at 4:36 PM

    Real simple, the Merrill Broker and the CEO tried to feed Einhorn a "s**t" sandwich by getting him to wall cross and sign an NDA. Einhorn was having none of it and has played the game long enough to see it coming and refused. It should be on the CEO and Broker not to engage the discussion if the investor is smart enough not to sign. Einhorn was totally in the clear, but the FSA is too stupid to understand the difference. If I tell you don't talk to me about it and you do anyway that's your stupid fault not mine.

  15. Posted by FKApmco | February 16, 2012 at 5:32 PM

    I'm sure I'm not a man. And that's why "I got lucky" is funny, Guest…as your experience suggests, women don't typically use it. Do we need to get Joke Briefer to stop by for a session on the subversive humor of pmco?

  16. Posted by Duncan | February 16, 2012 at 5:52 PM

    London pub-crawling is fraught with pitfalls for an American.
    Don't wear trainers, or you won't even get into the grimy joints sales traders go to for Friday lunch/dinner.
    For that matter, find out what a trainer is before you pack your bags.
    And don't pack trainers.

    Also, don't expect any bar food, as we know the term in America.
    English pub food is Lovecraftian – you're less likely to vomit if you drink on an empty stomach for 10 hours.
    If you love life, avoid any dish that includes "bangers".

    The beer is almost always cold, though – that warm beer stuff is from last century.
    They drink scotch without ice, and in startlingly small portions.

  17. Posted by Guest | February 16, 2012 at 5:56 PM

    You do not have to show that a trader was in breach of a contract or (semi-)fiduciary responsibility to the company in order to find that they have engaged in insider trading in the UK. The FSA is not required to have the same definition as the SEC, and as a professional investor Einhorn is expected to know the rules…

    Einhorn was found by the FSA to have learnt some material information (there would be a dilutive equity capital raise in the near future), information which he knew was not generally available to the public, and he was found to have traded based on that. All this talk of NDA is irrelevant in the UK context.

  18. Posted by FKApmco | February 16, 2012 at 5:59 PM

    I'm sure I'm not a man. I was using "get lucky" with ref to you Guest.

  19. Posted by AnotherGuest | February 16, 2012 at 9:08 PM

    I think it's irrelevant in the US too. In the old days (before the definition used by enforcement got even more abstract and therefore more stringent), the rule was simple: is the information material and non-public (check – Einhorn explicitly acknowledges his understanding that it is) and do you know that it comes from a source with a legal duty of confidentiality (check).

    I don't know the specifics of the UK rules, but if it were a US company Einhorn would be guilty of criminal insider trading and should be in jail, possibly his trader and analyst as well. Osborne would be in clear breach (I don't know if it's criminal) of FD.

    Another way to look at it: how is this different from Raj's trades in Goldman? Other than geography and the fact that one bought and one sold (which is irrelevant legally), there's no real difference. Raj receives a call from a board member of Goldman, with an obvious duty of confidentiality, telling him before it's public that Goldman is selling equity. Raj trades, goes to jail. Einhorn receives a call from a CEO telling him they're selling equity. Einhorn trades…

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  21. Posted by didyouspillmypint | February 17, 2012 at 2:40 AM

    It's not *quite* as grim as it sounds, Matt. If you were to show up in Britain and look around for a "Punch Tavern", you wouldn't find one on the high street with a big orange neon "Welcome To The Punch Tavern" sign up outside it like TGI Fridays. The pubs owned by Punch Taverns are just normal pubs like the Cat and Fiddle, The Old Stab And Glass, The King's Head and so on. The only way that you can tell the difference between them and a pub that's owned by an independent publican is that they tend to have clean carpets, not much atmosphere and the same limited range of beers.

    The reason that companies like Punch Taverns exist is that in the Olden Days, most pubs used to be owned by breweries. This was considered bad by the anticompetition regulators, and so they passed some regulations or other that I suppose you could look up if you cared. On the other hand, independent publicans often find it difficult to get mortgages or business loans, because of the drinking and the unreliability and all that. PubCos like Punch are meant to bridge that gap.

  22. Posted by pmco | February 17, 2012 at 7:13 AM

    Not a man but an hermaphrodite.

  23. Posted by TWadorno | February 19, 2012 at 4:40 PM

    Matt, you miss the point. Einhorn is not saying lever up like crazy, ratchet up the risk and amp the upside for us equity holders. He is saying raise capital from sales of pubs and stealthily buy back the debt you can at large discounts. He realizes that equity trading at half or less of outstanding debt levels is not a good thing per se. But it represents an opportunity … sell off assets, repurchase debt, and the market will start to realize you are strong and solvent and reward you with higher valuations. It's not quite as clever as you seem to suggest. After all, a bought option only has value if you can exercise it.

  24. Posted by TWadorno | February 19, 2012 at 4:49 PM

    and that's how you play the game when you have lots of convertible debt. It'll trade at large discounts when the conversion value is busted, so if you have assets you can sell off at decent prices, you do it and quickly turn around and buy available chunks of the debt at 60% or less of face value. Wouldn't be surprised to learn Einhorn was positioning himself in the converts … he wouldn't sell at 60%, but the buybacks would quickly spike the value of the debt.