The Introduction made reference to how some exceptional individuals, essen- tially speculators by nature, took advantage of their better vision of a company’s worth to acquire it, turn it around, and use it as cash cow – or sell it at huge profit. The statement was also made that a good part of the concept underpin- ning this strategy should be credited to Geneen and Thornton.
A standard acquisition procedure with both empire-builders has been to tell the owners that everything will stay the same, and then to tell staff to double earnings.
Most evidently, this goal cannot be met by working ‘as usual’. Neither were the new owners willing to be lax with
● Lost sales
● Lagging products, and
● Variances from budget.
Once asked why he was so eager to buy other companies, Thornton answered:
‘We don’t buy companies. We buy time.’ The time element, sales distribution, and total cost have been dictating the choice. The CEO is not on top of the com- pany’s central issues by watching book value. He definitely needs:
● A realistic estimate of fair value ‘plus’
● Where ‘plus’ means an added value over fair figures, the entrepreneur feels that it is there, and it can be exploited.
In imposing his Basic Acquisitions Policy, in March 1965, Harold Geneen told the ITT board: ‘… our primary interest in any acquisition is its rate of growth for the future.’4 Since ITT was growing at a rate of 10% or better yearly, in compound
• CASH
• LOANS
• SECURITIES
• COMMODITIES
• HOLDINGS
•CURRENT ACCOUNTS
•SAVINGS ACCOUNTS
•TIME ACCOUNTS
•MONEY MARKET ACCOUNTS
•OTHER ACCOUNTS
•DERIVATIVE FINANCIAL INSTRUMENTS
ASSETS LIABILITIES
Figure 10.1 The original balance sheet taxonomy of assets and liabilities has been enriched by a class of items which find a home only after establishing their fair value
numbers, any firm being acquired had to have the potential of growing more than that in the aftermath of the new management’s efforts.
Every empire-builder, of course, has his or her own criteria for cherry-picking.
Britain’s James Hanson provides an example different to that of Geneen. In the 1980s, with a string of well-placed deals, the share price of his company outper- formed the UK’s top 100 firms by 368%, a ‘first’ in Europe. Eventually, however, the warlords get tired and lose their grasp. Or, in the case of public companies, they are forced to retire. By the mid-1990s, Hanson’s company shares were falling in a rising market. The intense scrutiny of some takeovers led many investors to question the sustainability of its profits, which had come to depend in part on complex tax deals.
The message the reader should retain from this story of rise and fall is that – through assiduous picks and turnarounds, based on fair value ‘plus’, James Hanson had built a transatlantic business that, at its peak, employed 90 000 peo- ple. Most importantly, his strategy of rewarding managers for maximizing share- holder value and focusing on cash generation became standard business practice, imitated by other corporate raiders who:
● Improved upon it
● Capitalized on financial mistakes of current management, and
● Created a new basis for dynamic asset valuation and revaluation of a going concern.
The principle is that in many companies management is wanting and rationality in decision-making has gone on leave. An example, which recently came to the public eye, is that of Banca Popolare Italiana (BPI), Italy’s tenth largest bank, whose balance sheet, if marked at market prices, will further reduce its weak- ened assets.
Reportedly, gambling on the value of its assets BPI has promised to pay Deutsche Bank Euro 330 million for 30 million shares of Bipielle Investimenti (BPI’s own subsidiary). Deutsche had bought these assets in 2003 for only 198 million euro, but at the end of 2004 they were worth a mere 174 million euro5– roughly half BPI’s derivatives commitment to the German bank.
Other entrepreneurs, however, make a fortune out of their wizardry in develop- ing new financial products. With some rocket science added to it,6 this new development basis has become known as financial engineering, providing a dif- ferent, more market-oriented way of valuing assets. The original rocket science
part was contributed by Lewis S. Ranieri, who has been one of the first to recog- nize that:
● Mortgage securitization is a mathematical art, and
● There is a market for securitized loans, starting with mortgages.
To develop more sophisticated instruments, Ranieri hired PhDs who designed collateralized mortgage obligations (CMOs), which turn pools of 30-year mort- gages into collections of 2-, 5-, and 10-year bonds, albeit at a level of higher-up risk. Today securitization is applied to a wide range of receivables from credit card balances to auto loans.
Taken together, these examples make the point that the fair value of assets depends a great deal on business vision, management quality, mathematical mod- elling, and experimentation, as well as the novel way an entrepreneur approaches the market. Valuing assets is an art:
● With many preconditions, even if every artist exercises what he or she con- siders to be their prerogatives, and
● With factors that both qualify and quantify embedded value.
One of the major challenges is to establish the fair value of a company’s debt.
Today, this is determined using pricing models reflecting one percentage point shifts in appropriate yield curves. Estimating the fair value of investments calls for a combination of pricing and duration models.7Duration is a linear approxi- mation that works well for modest changes in yields and generates a rather sym- metrical result.
In conclusion, whether we talk of valuing assets or debt, we stand a better chance by targeting order of magnitude accuracy than trying to provide greater preci- sion. This is no good for financial reporting, but it is perfect for management accounting.