Lazard, Evercore and the TSLA/SCTY Deal: Keystone Kops or Crafty Bankers?
It is get easy to get outraged by events around you, even when that outrage is not merited. I have learned, through hard experience, that writing when outraged can be cathartic but it can also be dangerous. After all, once you have climbed on your high horse, it is easy to find fault with others and wallow in self-righteousness. It is for that reason that I have deliberately avoided taking issue with specific banking valuations of companies, much as I may disagree with the practices. I understand that bankers make money on transactions and that their valuations are more sales tools than assessments of fair value. Once in a while, though, I do come across a valuation so egregiously bad that I cannot restrain myself and reading through the prospectus filed by Tesla for their Solar City acquisition/merger was such an occasion. My first reaction as I read through the short descriptions of how the bankers in this deal (Evercore for Tesla and Lazard for Solar City) valued the two companies was “You must be kidding me!”.
The Tesla/Solar City Deal
In ___, Tesla announced that it intended to acquire Solar City, a surprise to almost everyone involved, except for Elon Musk. The specifics of the deal are still being ironed through but the broad contours of the deal are captured in the picture below:
Chris Hohn the founder and manager of TCI Fund Management was the star speaker at this year's London Value Investor Conference, which took place on May 19th. The investor has earned himself a reputation for being one of the world's most successful hedge fund managers over the past few decades. TCI, which stands for The Read More
At the time of the deal, Mr. Musk contended that the deal made sense for stockholders in both companies, arguing that it would … While Mr. Musk has a history of big claims and perhaps the smarts and charisma to deliver on them, this deal attracted attention because of its optics. Mr. Musk was the lead stockholder in both companies and CEO of Tesla and his cousin, , was the CEO of Solar City. Even Mr. Musk’s strongest supporters could not contest the notion that he was in effective control at both companies, creating a potential for conflicts of interests. Those questions have not gone away in the months since and the market concerns have been reflected in the trend lines in the stock prices of the two companies:
The boards of directors at the two companies, and especially at Tesla, have recognized the potential for a legal backlash and as this New York Times article suggests, they have been careful to create at least the appearance of an open process, with Tesla’s board hiring Evercore as its deal banker, while Solar City chose Lazard.
The Banking Challenge in a Friendly Merger
In any friendly merger, the bankers on the two sides of the deal face, what at first sight, looks like an impossible challenge. The banker for the acquiring company has to convince the stockholders of the acquiring company that they are getting a good deal, i.e., that they are acquiring the target company at a price, which while higher that the prevailing market price, is lower than the fair value for the company. At the same time, the banker for the target company has to convince the stockholders of the target company that they too are getting a good deal, i.e., that they are being acquired is higher than their fair value. If you are a reasonably clever banking team, you discover very quickly that the only way you can straddle this divide is by bringing in what I call the two magic merger words, synergy and control. Synergy in particular is magical because it allows both sides to declare victory and control adds to the allure because it comes with the promise of unspecified changes that will be made at the target company and a 20% premium:
In the Tesla/Solar City deal, the bankers faced a particularly difficult challenge. Finding synergy in this merger of an electric car company and a solar cell company, one of which (Tesla) has brand name draw and potentially high margins and the other of which is a commodity business (Solar City) with pencil thin margins) is tough to do. Arguing that the companies will be better managed as one company is tricky when both companies have effectively been controlled by the same person(Musk) before the merger. In fact, it is far easier to make the case for reverse synergy here, since adding a debt-laden company with a questionable operation business (Solar City) to one that has promise but will need cash to deliver seems to be asking for trouble.
The bankers could of course have come back and told the management of both companies (or just Elon Musk) that the deal does not make sense and especially so for the stockholders of Tesla but who can blame them for not doing so? After all, they are paid based upon whether the deal gets done and if asked to justify themselves, they would argue that Musk would have found other bankers who would have gone alone. Consequently, I am not surprised that both banks found value in the deal and managed to justify it.
It is with this perspective in mind that I opened up the prospectus, expecting to see two bankers doing what I call Kabuki valuations, elaborately constructed DCFs where the final result is never in doubt, but you play with the numbers to make it look like you were valuing the company. Put differently, I was willing to cut a lot of slack on specifics but I found failed even the minimal tests of adequacy in valuation. Summarizing what the banks did, at least based upon the prospectus (lest I am accused of making up stuff):
Conveniently, they provide backing for the Musk acquisition story, with Evercore reassuring Tesla stockholders that they are getting a good deal and Lazard doing the same with Solar City stockholders, while shamelessly setting a range on value so wide that they have legs cover, in case they get sued. There are many parts of these valuations that I can take issue with, but in the interests of fairness, I will divide up my critique into that of practices that are bad but the defense can be that everyone does it and practices that are indefensible.
1. Use of management forecasts of unaudited numbers:
2. No internal checks for consistency:
3. Discount Rates:
4. Growth Rates and Terminal Value:
Not content with turning one set of questionable valuations, both banks doubled down on what they called a sum of the parts valuation of Solar City.
First, sum of the parts valuation makes sense only if you have separable assets and it i