Regret in the here and now, joy in a parallel universe

Morgans

Steven Davidoff, the New York Times’ Deal Professor, thinks that management and shareholders at the Morgans Hotel Group got suckered back in October 2009 when they sold their souls a PIPE for cash. Davidoff implies that the investor, Ronald Burkle’s Yucaipa Companies, is doing fine, while management and the other shareholders are squirming to escape as various control triggers are closing in on them.

There are many different kinds of PIPEs (a private investment in public equity). One class involves contract terms governing important contingencies: usually these grant the PIPE investor additional cash flow rights and control when things aren’t going well. This was the type of PIPE that Morgans sold to Yucaipa, and it is the terms of those contingencies that are ensnaring the company today.

So why did Morgans and Yucaipa put those terms into the contract? In any deal, there are alternatives and tradeoffs. Lots of PIPE deals do not include such terms. So why is one type of deal right for one company, and another type right for another company? That is the question addressed in a good analysis of PIPEs by Susan Chaplinsky and David Haushalter (free version here). Although this study was obliquely referred to in Davidoff’s column for two other points, he completely ignores this main focus of the study.[1] They point out exactly when a PIPE deal with this type of contingent contract terms is negotiated:

  • “Contracts that only include purchase discounts [and no contingencies] are often used by the lowest risk issuers and are rarely used by the highest risk issuers.”
  • “The use of contracting terms that make funding or control contingent on an issuer’s post-issue performance increases with the risk of issuer.”
  • “Finally, the choice of contingent contracting terms varies with the type of issuer risk. In particular, terms that can transfer control to investors are most commonly used by companies that are in the weakest financial condition and the closest to running out of cash.”
  • “In contrast, warrants are used by issuers with a greater variability of returns but have a relatively less urgent need for financing.”

Without these contingent contract terms, it is unlikely that Morgans could have gotten the cash—not because management was so bad at bargaining, but because investing in Morgans was a dicey proposition made better through such terms. The terms actually improved the likelihood of long run success.

Davidoff buttresses his complaint about shareholders getting suckered by citing this statistic from the Chaplinsky/Haushalter study:

Unfortunately, this comes at the expense of other shareholders. This same study, of over 2,500 such deals, found that after the investment, existing shareholders receive average returns of negative 22 percent, compared with average gains of 27 percent for the PIPE investor.

Those numbers reflect how things turned out for the two sides of the deals over the period 1995-2000 covered by the study. It would be dangerous to draw any conclusions from this statistic, just as it would be dangerous to make any portfolio decisions based on which investments performed well in the last 6 years. There will always be winners and losers ex post. Drawing reliable conclusions about ex ante decision making is much trickier business. Morgans’ experience is a useful illustration of what can happen, but it is incorrect to use it as a morality tale. It is deceptively easy to tell a story backwards when you already know its end.


[1] Davidoff follows the maddening NYTimes style of referring to the study obliquely, giving no meaningful reference or link.

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