Dan's Perspective: From Enron to WeWork

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As part of our regular equity research process, we recently met with a management team running a global private equity firm. During the meeting, the executives made two very profound comments that have stuck with me: “There is no more private market discount, private markets are more expensive than public markets” and “It’s good that you’re a large-cap manager because in a few years our industry is going to own all the small-mid cap companies.” This got me thinking; How did private markets balloon to this size? How did we get here?

Picking up the pieces after Enron

It’s hard to imagine today, but in the early 2000’s, WorldCom, Tyco, Waste Management and Enron shook the business world to its core. Enron stood apart from the other accounting failures due to its sheer scale. Peaking out at $66 billion in size and a price-to-earnings ratio of 63x, the fall of Enron was a financial and reputational disaster, as markets were already reeling from the tech wreck the previous year. Leaders at Enron were experts at using “special purpose entities” to hide debt in multi-step related party transactions. They also painted a rosy picture of the businesses to investors by liberally using “mark to model accounting,” a problematic and subjective tool which we will come back to later. Imagine if you went into a classroom and every student was marking their own exam. What grade would you give to yourself?

Chart: Enron Stock Price

Enron stock price

Source: Bloomberg Finance L.P., CFA Institute

Sarbanes Oxley: Holding the leaders responsible

After the collapse of Enron and their accountants Arthur Anderson, the business world had to adopt a new piece of legislation that promised to never again allow the sins of the past to be repeated. The Sarbanes-Oxley Act had arrived with a 99-0 vote in the U.S. Senate, with similar legislation enacted across many other countries. With this sweeping law came many changes that forced the management teams of public companies to clean up their acts. If you, as the chief executive officer or the board of directors were found to have knowingly mislead investors, then there were severe criminal penalties for being caught. In addition, the accounting teams inside a company had to review and take accountability for the quality of their internal controls. After 2005, not only would the leaders of companies face serious consequences, they also couldn’t turn a blind eye to poor internal controls and pretend to not know about the problem (for us accounting geeks, it was Section 404 being implemented in 2005). This led to fewer restatements of business results and if they did occur it became much smaller in size (see the chart below “Largest Negative Restatements”), giving investors far more confidence in the accuracy of financial statements. But, with all good intentions there were also some unintended consequences, which brings us to WeWork.

largest negative restatements

Source: Center for Audit Quality

The posterchild of today’s private markets, WeWork

Sarbanes Oxley was very successful in cleaning up the public markets, but it was more flexible when it came to private markets and it simply made it more complicated for a company to go public. This created an incentive for aggressive management teams with riskier business models to stay under the cloak of darkness in private markets. In addition, investors in these private companies also benefitted from the ability of smoothing out their investment results by infrequently having to mark to model their portfolio (remember this from Enron’s strategy where they graded their own test?). This lack of accountability of management teams and the perception of smooth returns for investors created the perfect environment for private markets to balloon in size.

This is the environment that led to the rise of WeWork, a real estate company with only leased assets branding itself as a technology firm. Investors were promised fast growth by tapping into the Generation Z trend of co-working and tripped over each other to hand over capital to WeWork that measured growth in its key metric “community-adjusted earnings before interest, taxes and amortization – EBITA” (This is the first time we ever came across this term). As the company gorged on capital provided by private markets, the chief executive officer maintained super-voting rights, effectively controlling the company, along with a long list of activities that public shareholders would deem unacceptable. After the sudden rise to a $47 billion valuation led by SoftBank Group, WeWork tried to go public, only to find that public market investors were far stricter on valuation and what acceptable behavior looks like. In the end, it was SoftBank that took control of WeWork after its failed initial public offering for $8 billion, a fall in value of 83% in just eight months from their prior investment earlier in January 2019. The most recent news we have heard is that with the recent market dislocation SoftBank Group is trying to find a way out of its obligation for at least $3 billion of the $8 billion total, creating further issues for WeWork.

private market valuation

Source: Financial Times

Closing thoughts

Public markets have benefitted over the last 15 years from greater financial clarity and greater personal accountability by management teams after the painful lessons learned from Enron. As we are conducting our bottoms-up due diligence, we are benefitting every day from the rigorous controls set forth in Sarbanes-Oxley, giving us more time to focus on meeting companies and analyzing their business models without having to question the accuracy of their accounting.

When it comes to investing, our focus remains on finding high-quality business models trading at a discount to their intrinsic value in public markets. We will not be gambling your hard-earned savings on speculative frenzies such as WeWork.

Dan Rohinton, Portfolio Manager

 

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