- Capital Gains
- (Some Of) The Economics Consultants, Bankers, and Accountants
(Some Of) The Economics Consultants, Bankers, and Accountants
When's It a Good Deal To Pay Someone To Tell You What You Want to Hear?
Anthropologist David Graeber’s theory of bullshit jobs and economist Deirdre McCloskey’s concept of persuasion argue for similar things with the opposite mood affiliation: a lot of the work done in the world is not meant to create new things, but to shuffle them around in a way that's at least arguably zero-sum.
Most of this persuasive activity involves pushing people to choose a different option than the one they originally chose (i.e. shuffling things around).1 But there's another category of persuasive activity where people get paid, nominally for advice, but in practice to tell whoever is paying them to do what they actually wanted to do.
This is the maximally cynical view of consulting and some parts of investment banking. It can also apply to audits and credit ratings—the buyer is not hiring KPMG to tell them they're defrauding shareholders, and they aren’t hiring Moody's to inform investors that they're definitely going to default. When a company hires McKinsey and says they're looking at whether or not to cut costs, what do they expect? Cheaper coffee in the breakroom, or layoffs?
But this kind of advisory work, the kind that results in shuffling, does produce something of value: reputational bounty. You aren't paying EY to say you're a fraud, or even to lie and say that you're not—they don't want to do the latter, even if, through bad luck or negligence, it happens from time to time. What you're really doing, in addition to complying with the legal requirement to produce audited financials, is paying them to tell you which accounting judgments you could insist on that would lead them to drop you as a client2 . Stocks drop when auditors leave; sometimes they drop quite fast. That puts the auditor in a position where they're leasing their reputation, getting paid for the risk that they'll make a mistake (whether of accounting practice or moral judgment). This saves everyone the trouble of running their own personal quasi-audit.
Some of these service providers aren't lending reputation on behalf of the client company itself, but are partly lending reputation, among other things, to executives who hire them to push through internal plans. One of the uses of consultants and other outside experts is to borrow experience; it might be a company's first round of layoffs, but it won't be the consulting firms'. That, of course, is the party line. But sometimes consultants are also a forcing function: they're a way to precommit to taking a difficult action by taking an easier one first.³
And in many cases, the transaction is a bundle: a bit of "how?" and a bit of "how much?" It can be clearer to a company that it needs to take some action than to know, say, how much cutting is a prudent response to changes in the market, or how much is overcorrecting based on current pessimism.4
There are also narrow tactical concerns around a layoff. There's a mix of concerns here: at one level, the optimal choice for a company is to make a layoff as surprising as possible, because no one is as unproductive as someone with their foot out the door. In the worst case, they're being paid a full-time salary for a full-time job hunt. On the other hand, starting a layoff rumor in a controlled way is a decent way to let people self-select into planning-to-stay or planning-to-jump cohorts—the decision about exactly who needs to go is a lot easier when you can look at whether a given person's productivity inflected up or down once layoffs were on the table. And it's almost a kind of informal severance to make it clear in advance that cuts are coming.
Consultants aren't the only "Clever Hans"-looking transaction where managers pay for someone to tell them they ought to do what they already plan to do. Investment banking has a lot of this. Some deals get pitched by banks, and, statistically, most deals will be pitched by banks simply because banks suggest lots of hypothetical fee-generating deals all the time and eventually some of their clients will decide that the deal in question is a good one. But, as with layoffs, there's room for significant variance in which deal gets done and at what price. M&A premiums are typically about 25-30%, but some deals are done at a smaller premium, like Continental Resources being acquired by its founding family at a 15% premium; some are mergers-of-equals done at roughly the market price, like the recently announced Six Flags/Cedar Fair transaction; and some are priced at a wild premium, like Hilton Grand Vacations' offer for BlueGreen at 111% more than its market value.
The optimal premium is partly a question of what the target's board will accept, but since the stock price tends to reflect roughly what the market thinks of the company pre-merger, and since board composition tends to change when shareholders agree that the stock is too cheap (and also agree that current management is the reason for it), this is a limited factor on its own. A more important factor is the risk of a competing bidder; the optimal bid is the lowest number that scares off the next-highest bidder. Since it's much easier to raise a bid an incremental 5% than to make it in the first place, counter-bidders have to ask what the maximum is that the original bidder would pay, and their best proxy for this is how high the original bid is. There was probably an initial offer for Straight Path Communications ($, WSJ) that AT&T could have made in order to scare Verizon off from a counteroffer, but AT&T's initial bid, while 4x the prevailing price from before the transaction, wasn't high enough, so Verizon ended up almost doubling it by the end of the bidding war.
A more dubious part of this process is the "fairness opinion," when a bank is hired to look at a proposed acquisition and to share a range of plausible valuations and justifications that put the target right in the middle of it. There is basically always some way to do this, and it doesn't seem like there are cases where a bank has actually judged a deal as unfair. But there's still some signal there. The last time this was a live issue, back in 2005, Aaron Ross Sorkin made a decent argument that there are long-term incentives against being too egregious. And as it turns out, fairness opinions do actually do a decent job of predicting what a company is worth in the event that a deal falls apart for valuation-unrelated reasons.5
Markets are imperfectly efficient, and they certainly do produce waste. Especially when that waste is a small share of a large transaction, because it's so much easier for all sides to ignore. But there's also value in paying an outside actor to take a second look, reassure everyone that whatever's being planned is in the range of normal possibilities, and possibly even to provide some advice on how to get it done.
Read More in The Diff
The Diff has frequently covered these different industries, especially M&A advisory and accounting. A sample:
A Rollercoaster Ride to Industry Consolidation ($) is a closer look at the output of these processes, in the form of the Six Flags/Cedar Fair merger-of-near-equals.
In The Market for Intermittently-Useful Information ($), we look at another adjacent phenomenon, that of paying people to sit around and be on-call in case their expertise is needed.
Compartmentalizing Complexity ($) examines a company that gets paid—through the valuation gap in what it buys—to deal with all the transaction-structuring cruft that arises in real estate.
Accounting standards aren’t static, so one thing accountants get paid for is to help deal with when they change. ($)
1. You can view the ad business as mostly, in the long run, determining which fairly-disposable products end up in which landfills. (Or which cultural artifacts end up in the "mental landfill" of things that were a fun way to spend a couple hours, but which will have no long-term impact.) But that's still positive-sum if there's a benefit to matching the right person to the right product. And the existence of those products isn't exogenous, either! It's a function of demand, which sometimes gets discovered with increasingly fine-grain and highly-targeted ads. A search engine, or an e-commerce site with search, will learn what it's missing from the searches that don't produce any good results.
2. This in itself is a form of risk management. Companies are incentivized to capitalize on the inherent ambiguity that is accounting, and figuring what you can and can’t get away with is something worth paying for—reputational bounty aside.
3. It's like the studies on how you can collect more charitable donations from people by asking them in advance if they'd like to donate time to charity (people like saying yes to low-commitment hypotheticals that make them feel good about themselves) and then asking them, a bit later, if they'd like to donate to a specific charitable cause.
4. The clearest metric for sentiment is market value, but that tends to be noisy, especially because downturns are when weaker and stronger companies differentiate the most (the maximum amount of differentiation between two companies being one one of them survives and the other doesn't).
5. Because they’re based on internal projections and a discounted cash flow model, this may actually be a reflection of the general outperformance of the value factor.
Share Capital Gains
Subscribed readers can participate in our referral program! If you're not already subscribed, click the button below and we'll email you your link; if you are already subscribed, you can find your referral link in the email version of this edition.
Help us learn more about you!
We're building a media kit and need some anonymous aggregated subscriber data. If you work in finance and have time for a 3-question survey, that would be very helpful: