The gamble of short-term pain for long-term gain

By Frank Partnoy
Published: February 4 2008 02:00 | Last updated: February 4 2008 02:00

Last Thursday night, when Steve Ballmer, chief executive officer of Microsoft, signed a letter announcing its proposal to acquire Yahoo, he probably knew the markets would punish his company's shares. When bold acquisitions are announced, the acquirer's shares typically decline. Indeed, although the markets were up on Friday, Microsoft shares tumbled 6.6 per cent, or more than $20bn. Mr Ballmer's personal stake in Microsoft lost nearly $900m.

Why would a smart leader agree to sacrifice so much of Microsoft's, and his own, share value? Although the deal raises many interesting antitrust, economic and technology issues, it also illustrates the central conundrum of modern business strategy: should corporations focus more on short-term share prices or long-term value? Put another way, the question is: should we trust markets or managers?

Whereas finance theory posits that managers should focus on share prices, today's managers see radical stock price volatility as a source of danger, not discipline.

According to this view, modern CEOs are like sailors in Greek mythology: they must shoot the gap between a high perch of mania and a whirlpool of panic. To maximise the long-term value, they must steer clear of short-term price pressures.

Last year, many managers sought private equity buyers, in part to avoid market over- and under-reaction. Now that the credit crisis has decimated those deals, the tables have been turned: fully-financed strategic buyers are hovering over companies, ready to pounce when prices fall. Microsoft's move is just the start. For example, consider MBIA, the multibillion dollar insurance company whose share price recently swung through a one-week trapeze act from $16 down to $7 and back to $16 again. What if an acquirer had offered to pay double for MBIA's shares when they hit $7?

As for Microsoft, its managers have cited an opportunity "to drive long-term economic value for our shareholders". Mr Ballmer wrote that: "Microsoft's consistent belief has been that the combination of Microsoft and Yahoo clearly represents the best way to deliver maximum value to our respective shareholders." Yet market reaction was that this belief is wrong, and that Microsoft is digging a massive financial hole by overpaying for Yahoo. Microsoft's chief financial officer has alluded to an "opportunity to drive at least $1bn of synergies". Even $1bn of synergies would recoup just 5 per cent of Friday's loss.

Microsoft shareholders must trust these words, and hope the directors' big ownership stakes are enough to align their incentives. Because Microsoft is much larger than Yahoo, the proposal was not significant enough to require shareholder approval. More-over, the board's decision to make the proposal will probably be protected by the business judgment rule, a judicial presumption that courts will not scrutinise the actions of directors unless they involve gross negligence or self-dealing.

Yahoo's shareholders are in a different boat. The markets say Microsoft's $31-per-share offer is a good one. On Friday morning, that offer was at a 62 per cent premium to Yahoo's then share price. A year, or even three months ago, when Yahoo's price was much higher, $31 per share would have been laughable. Yet even after traders digested the offer, Yahoo's closing price on Friday was below $29, reflecting an expectation that Microsoft's proposal might be the best Yahoo could do. Risk arbitrageurs have bought Yahoo and shorted Microsoft, expressing their belief that Microsoft will succeed.

Interestingly, Yahoo's board already has parroted Microsoft's "long-term" mantra, saying it will "pursue the best course of action to maximise long-term value for shareholders".

The language is stan-dard, but also ironic. If Yahoo's directors are so inclined, they can reject Microsoft's proposal as inadequate to maximise long-term value. Indeed, if "long-term" means what Microsoft says it means, Yahoo should hold out.

Its board has adopted a "poison pill" shareholder rights plan, which provides defensive leverage against unwelcome acquisitions, and its shareholders have the right to vote against Microsoft's proposal, if they believe the board can do better. Moreover, because the proposal is life-changing for Yahoo, its directors will be held to a higher standard than Microsoft's. They will feel pressure to get a better deal.

The most likely outcome is that the companies will combine, perhaps with Microsoft paying an even higher price. As other strategic ac-qui-rers opportunistically seek targets with depressed share prices, they also will suffer short-term declines in exchange for potential long-term gains. The markets will punish them, just as they reward targets. Meanwhile, shareholders will continue to be baffled about who they should trust.

The writer is a law professor at the University of San Diego and author of The Match King: One Bullet and the Financial Scandal of the Century, forthcoming from Profile Books