Unrealized gains, free cash flow, and the "Magnificent 7"
Everyone is watching FCF and CAPEX for the dominant, highly influential, mega-cap tech and tech-adjacent firms: Nvidia, Apple, Microsoft, Alphabet, Amazon, and Meta. I am watching even more closely.
Acquisitions are one way managers spend cash instead of paying it out to shareholders. Therefore, the theory implies managers of firms with unused borrowing power and large free cash flows are more likely to undertake low-benefit or even value-destroying mergers.
The theory predicts value increasing take-overs occur in response to breakdowns of internal control processes in firms with substantial free cash flow and organizational policies (including diversification programs) that are wasting resources. It predicts hostile takeovers, large increases in leverage, dismantlement of empires with few economies of scale or scope to give them economic purpose (for example, conglomerates), and much controversy as current managers object to loss of their jobs or the changes in organizational policies forced on them by threat of takeover.
Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers
Author(s): Michael C. Jensen Source: The American Economic Review, May, 1986, Vol. 76, No. 2, Papers and Proceedings of the Ninety-Eighth Annual Meeting of the American Economic Association (May, 1986), pp. 323-329 Published by: American Economic Association Stable URL: https://www.jstor.org/stable/1818789
I had a really nice little back and forth with Professor Stephen Bainbridge on a recent newsletter where he analyzed insider trading laws related to LeBron James’ decision to change teams.
My last post delved into the intricacies of insider trading law via a set of hypotheticals based on LeBron James signing with the NY Knicks.
It elicited a response from Francine McKenna of the estimable Substack The Dig.
Ms. McKenna commented:
I’d love for you to go back and analyze the Sokol case with this framework
Prof. Bainbridge granted my wish.
Enjoy his revisit of a case of “usurpation of a corporate opportunity”, a great example of what can happen when corporations, especially controlled conglomerates, have too much cash, don’t pay dividends, run out of ideas, and employ unethical self-interested executives.
David Sokol pursued the acquisition of Lubrizol as an executive of Berkshire Hathaway, but not until he had first invested in the company himself. Professor Bainbridge concludes, as I did many years ago for Forbes:
Sokol learned of the Lubrizol opportunity in his capacity as a Berkshire Hathaway fiduciary. The investment bank brought him the acquisition proposal precisely because he had Buffett’s ear. He then used the information that had been entrusted to him for corporate purposes to make a private profit. Even if that’s an unusual form of corporate opportunity case, it still reeks of self-dealing.
Given all the related-party transactions, partnerships and alliances, circular investments by customers in vendors, vendors in customers, and tech behemoths in everyone — public and private— there is likely plenty of potential self-dealing and bad dealmaking by the Magnificent 7 and in the AI data center construction ecosystem. That’s what we should be focused on when we scrutinize the billions in non-cash investment gains and losses recognized by some of the biggest names in tech.
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