Revisiting Jensen’s Agency Costs of Overvalued Equity
After the dot com bust, Michael C. Jensen wrote a paper comparing overvalued equity to managerial heroin:
When a firm’s equity becomes substantially overvalued it sets in motion a set of organizational forces that are extremely difficult to manage — forces that almost inevitably lead to destruction of part or all of the core value of the firm. (Jensen, M.C., 2005. Agency costs of overvalued equity. Financial management, 34(1), pp.5-19.)
What is amazing about the equity overvaluation created by meme-based investing (the reddit and Robinhood retail investors) is that far from destroying companies, it is resuscitating companies that were earlier presumed to be beyond salvation. On Tuesday, AMC Entertainment Holdings, Inc. raised $230 million by selling 1.7% of its equity to a hedge fund, Mudrick Capital, which promptly turned around and sold the shares into the market at a profit. AMC which claims to be “the largest movie exhibition company in the United States, the largest in Europe and the largest throughout the world with approximately 950 theatres and 10,500 screens across the globe” was struggling because of the pandemic and had plenty of uses for the money: it stated that:
The cash proceeds from this share sale primarily will be used for the pursuit of value creating acquisitions of additional theatre leases, as well as investments to enhance the consumer appeal of AMC’s existing theatres. In addition, with these funds in hand, AMC intends to continue exploring deleveraging opportunities.
With our increased liquidity, an increasingly vaccinated population and the imminent release of blockbuster new movie titles, it is time for AMC to go on the offense again.
The prospectus related to this sale described the risks very clearly:
it is very difficult to predict when theatre attendance levels will normalize, which we expect will depend on the widespread availability and use of effective vaccines for the coronavirus. However, our current cash burn rates are not sustainable.
during 2021 to date, the market price of our Class A common stock has fluctuated from an intra-day low of $1.91 per share on January 5, 2021 to an intra-day high on the NYSE of $36.72 on May 28, 2021 and the last reported sale price of our Class A common stock on the NYSE on May 28, 2021, was $26.12 per share.
the market price of our Class A common stock has experienced and may continue to experience rapid and substantial increases or decreases unrelated to our operating performance or prospects, or macro or industry fundamentals, and substantial increases may be significantly inconsistent with the risks and uncertainties that we continue to face; our market capitalization, as implied by various trading prices, currently reflects valuations that diverge significantly from those seen prior to recent volatility and that are significantly higher than our market capitalization immediately prior to the COVID-19 pandemic, and to the extent these valuations reflect trading dynamics unrelated to our financial performance or prospects, purchasers of our Class A common stock could incur substantial losses if there are declines in market prices driven by a return to earlier valuations;
AMC shares rose after this capital raise, and AMC followed up on Thursday with a at-the-market offering of an additional 2.3% of its shares that raised $587 million at a price of $50.85 per share. The prospectus came with an even more blunt disclosure:
We believe that the recent volatility and our current market prices reflect market and trading dynamics unrelated to our underlying business, or macro or industry fundamentals, and we do not know how long these dynamics will last. Under the circumstances, we caution you against investing in our Class A common stock, unless you are prepared to incur the risk of losing all or a substantial portion of your investment.
Michael Jensen considered the possibility that capital raising could eliminate overvaluation, but ruled it out:
Some suggest that one solution to the problem of overvalued equity is for the firm to issue overpriced equity and pay out the proceeds to current shareholders. I have grave doubts that this is a sensible or even workable solution for several reasons.
AMC has shown that Jensen’s fears about regulatory obstacles and disclosure requirements were totally misplaced. But Jensen also raised an ethical issue which goes to the very foundations of corporate finance:
I believe it is impossible to create a system with integrity that is based on the proposition that it is ok to exploit future shareholders to benefit current shareholders. I realize this is not a generally accepted proposition in today’s finance profession, not even among scholars, but it would take us too far from my topic today to discuss it thoroughly.
I am not however impressed by this ethical argument because capitalism depends on allowing trades between two parties with differing beliefs and expectations without worrying that one party is mistaken and is therefore being exploited by the other. I see the AMC capital raises as capitalism working nicely to harmonize heterogeneous beliefs and expectations through the mechanism of mutually beneficial trades.
Posted at 4:07 pm IST on Fri, 4 Jun 2021 permanent link
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