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 boringutilities. 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.