Yesterday, the DC City Council voted on a plan to support a local hospital in danger of closing — see Hospital Deal Gets Financing From D.C. – washingtonpost.com. This vote came in spite of a last minute warning by the city’s Chief Financial Officer. Part of the warning in the CFO’s Fiscial Impact Statement is because the hospital’s “liabilities exceed tangible assets by approximately $34 million.” The company’s financial statements carry $34 million of goodwill.
I’m not an accountant and I haven’t seen the company’s financial statements. Thus, I am in no position to argue one way or another on the CFO’s bottom line concern that “should the business plan fail, it is likely that additional funds of substantial amounts will be needed to keep the Hospital running.” I think that is probably a truism — if any business plan fails, additional investments are probably needed to keep the operation going. The risk that city is taking is that it is potentially signing on to a long term hospital subsidy (but that is exactly the risk they may need to take to provide health care — a question well beyond my job description).
I do find the CFO’s reliance on only tangible assets of specific interest. Again, without having looked at the company’s financials, I can’t make a call here. Many financial sins can be hidden under the category of “goodwill” (which is exactly why FASB eliminated pooling and requires companies to break out intangibles from goodwill in acquisitions). But I have to believe that that well-run hospitals have a huge amount of intangible assets.
The Post story gets to this point:
One of [CFO Natwar] Gandhi’s main points of contention involved Specialty’s claim of $34 million in “goodwill” assets, which the company expected the city to accept as proof that it could cover its liabilities.
“Goodwill” is an accounting term used to characterize assets that are not tangible — the value of a company’s name or its customer base, for example. In Specialty’s case, the goodwill referred to the value of its two other D.C. hospitals, which provide skilled nursing and long-term acute care. The company maintains that the facilities are worth more than the simple value of their medical equipment.
But Gandhi decided that goodwill represents “intangible assets” that should not count toward Specialty’s ability to meet its liabilities, government sources said.
[Company representative George] Lowe disputed Gandhi’s analysis. He said Specialty had $84 million in gross receipts and turned a profit of $14 million this past year. He noted that its hospital in Southeast sits on 66 acres appraised at $35 million, and its Capitol Hill facility is worth $15 million for its business operations alone.
“The company is not insolvent,” Lowe said. “The company is performing very well.”
Audited financial statements back up its claims, he said.
(Apparently those audited financial statements were never made available to the city’s CFO).
Earlier this year, I posted an item on the new rules for account of state and local intangible assets.. Again, without having seen the company’s financial statements, and not being an accountant, I can’t say whether applying these rules would result in a different outcome by the CFO.
The other part of this transaction that concerns me is whether the intangible assets were included in the deal. Not having seen the details of the deal, I can’t speak to whether any of the company’s intangible assets might be used as collateral to backstop the city’s investment. But if the company is going to claim intangible assets as a major part of their asset base, the city should have a claim on those assets if the deal goes south. It appears from the CFO’s analysis that the only backstop for the city (outside of being a standard unsecured creditor) is part of the real estate.
Given that hospitals are a prime example of a knowledge-based, intangible-heavy institution, there was a missed opportunity here. Completely excluding intangible assets results in an incomplete picture of the company (and the investment proposals) and in a failure to capitalize on those intangibles as part of the deal. The fiscal impact statement should have included an analysis of the intangible assets and the deal should have been structured to incorporate those intangibles into the financial arrangements.
From Business Week – A Life in Invention: Xerox’s chief scientist Robert Loce talks with Jessie Scanlon:
These days it’s hard to come up with a really useful widget. You have to integrate what you’re doing into a system. And when you’re working with a system you have to work with experts in multiple fields. So, for instance, I’m an imaging scientist, but I might need to work with experts in sensors and programming and actuators. To have an invention that’s really critical, you need people with different skills working together.
On the innovation process:
Occasionally I’m part of the product team that actually helps develop a finished product. Other times I’ve invented something, and thrown it over the wall to good engineers who improve my idea and get it to work. Finally, if a Xerox product team isn’t interested, I work with the Xerox licensing department to find an outside organization interested in the technology.
On defensive patenting:
A patent is really a contract you have with the government to prevent others from doing your idea.
. . .
in the late 1980s, Xerox was issued a patent on one of my inventions that sat dormant for quite a while. At some point I told a person in our legal department to not bother paying the maintenance fees on that patent because it did not seem to bring Xerox any value. But it turned out that a competitor had approached us on this patent. For some reason we did not work out a licensing agreement. As a result, this competitor didn’t fully implement the feature that they desired. Also it took quite a while for them to bring their scaled-down version of the feature to market. So, our patent seems to have blocked their use of a technology and might have resulted in longer development to work around our patent.
From a public policy point of view, I agree with everything except the last point. I take defensive patenting as the dark side of the process — in order to spur innovation (by providing monopoly incentives) we have to give someone the right to throttle innovation (by granting that monopoly).
An interesting system.
Apparently, the intangible of reputation is not as important as we might have thought on Wall Street. From Dennis K. Berman’s column in today’s Wall Street Journal – Stakes Change Rules on Value Of Reputation:
But it turns out that there are natural limits on how reputation — the esteem with which one is held by others — can affect behavior. We’re seeing those limits now, as the world’s credit crisis plays out before our eyes.
“Reputation matters until you get to some serious pain,” says Edward Rock, co-director at the Institute of Law & Economics at the University of Pennsylvania. “It matters if the stakes are low. Somewhere between $25 million and $1 billion, it shifts.”
How else to explain how banks, private-equity firms, bond salesmen, boards of directors, and hedge funds are wheedling, reneging on and resetting all sorts of business contracts and promises.
“I would love to say yes, that reputation matters,” said one top deal maker on Friday. “In principle it does. Still, the line is not as bright as that implies.” Indeed, the breadth of this current crisis has created what might best be described as a reputational free-fire zone.
. . .
“People can plead that ‘I’m not a bad actor. I haven’t broken my word if everyone else is doing it,’ ” says Lisa Bernstein, a legal scholar at the University of Chicago who has studied the role of reputation among tight communities such as cotton and diamond traders. “It’s going to give quite a bit of cover.”
Ms. Bernstein has found that reputation-enforced business networks work best among tight-knit groups. Once these networks expand, business people are forced to rely on formal legal contracts. The irony is that these contracts — hundreds of pages thick — are often no more effective than simple informal agreements based, essentially, on reputation.
That’s reflected in the larger structural changes on Wall Street. In 1907, it was J.P. Morgan himself who helped calm a dangerous credit crisis, putting his good name behind a rescue plan. Today, J.P. Morgan Chase & Co. is an immense and largely faceless institution of 180,000 people, full of committees and project teams. Its reputation is harder to pin down because it’s difficult to assign responsibility in the first place.
It’s also easier to engage in reputation-damaging behavior if there are few competitors looking to take away business. By all indications, it would be very hard for both corporations and private-equity firms to lock out J.P. Morgan and Bank of America because they balked at funding the $25 billion acquisition of student lender Sallie Mae. The two banks simply have too much sway in the market.
In other words, when money talks, reputation walks. At least on Wall Street.
One of the projects I am working on is the monetization of intangible assets — essentially, how can companies (and individuals) raise capital based on their intangibles. Part of the process is looking at the securitization of certain intangibles, specifically trade names/brands and patents. With the recent fiasco in the subprime mortgage market, the entire process of securitization has been under scrutiny. Rating agencies actions on these mortgage backed bonds are being questioned and as is the process of trying to divide up the risk of these bonds into tranches (a mechanism that appears to have failed miserably as a risk reduction technique).
Now, there is a new twist in the attempts to police the securitization process — the assignment of liability. One of the concerns raised by the mortgage process is the lack of accountability for abuses. The securitization process removes the actions of the loan originators from any negative consequences. They collect their fee and someone else holds the loan. So there is no market incentive for the originators to avoid pushing too risky loans on consumers who are ill-equipped to handle them.
Likewise the securitizer is not necessarily accountable for the failure of the loans, since they just package the loans and sell them to investors. There is a market risk — the securitizers can and have gone bankrupt as the value of their portfolios evaporates. But the securitizers do not have a strong incentive to scrutinize the original loans as long as they are given an investment grade rating.
Yesterday, three Congressmen, including House Financial Services Committee Chairman Barney Franks introduced mortgage lending reform legislation to tighten up standards and practices. That bill includes a provision to assign limited liability to loan assignees, including securitizers, for rescission of the loan and the consumer’s costs. Now, this liability is very targeted. Here is the important kicker: it only applies if the loans do not meet certain standards. And it does not apply to pools of loans.
As such, the provision will not provide a great incentive for securitizers to increase their analysis of individual loans. It will provide an incentive for the adoption of the mortgage standards called for in the legislation. After all, why expose yourself to additional liability when you can easily avoid it by only dealing with loans which conform to the standards.
The debate over the use of liability to encourage the adoption of mortgage standards — and over the standards themselves — will be very instructive for the issue of intangible monetization. One of the barriers to monetization of intangibles has been their one-off nature. Each deal is almost unique. There is little standardization. How standards might be created and enforced in this area is likely to take a cue from what happens in the much larger mortgage-back asset market.
UPDATE: This morning’s papers have the beginnings of the debate. See Bill Allowing Mortgage Lawsuits Expected to Stir Fierce Opposition – New York Times, Finance Panel’s Chairman Seeks Overhaul of Mortgage Regulations – WSJ.com, Proposed mortgage rules face hurdles – Los Angeles Times, and Bill Would Tighten Mortgage Standards – washingtonpost.com.
The Wall Street Journal piece spoke directly to the liability issue:
The issue of assignee liability will likely be one of the more controversial aspects of the legislation. Federal Reserve Chairman Ben Bernanke has said limited and clearly defined assignee liability could prove beneficial, but Treasury Secretary Henry Paulson has said assignee liability could scare away investors.
The Washington Post story had a critique from the other side:
[Mike] Calhoun [President of the Center for Responsible Lending] also said the bill does not go far enough in holding the secondary market liable for loans gone bad. Investors failed to correct abuses and in some cases actively supported them, he said. It’s unclear if the provision that allows borrowers to sue is enough to help borrowers who are wronged. “Will it simply become the cost of doing business?” he asked.
The House Financial Services Committee will hold a hearing tomorrow (Wed) on Legislative Proposals on Reforming Mortgage Practices
Last month I posted a piece of the failed buy-out of Harman Industries. Here is the update —Deal Is Struck to End Harman Buyout – Mergers, Acquisitions, Venture Capital, Hedge Funds — DealBook – New York Times:
Kohlberg Kravis Roberts and Goldman Sachs agreed to terminate their merger agreement with Harman International Industries on Monday and reinvest in the audio speaker company.
The settlement ends another dispute over an ailing deal, a situation that has cropped up with increasing frequency as the buyout boom has lost steam.
According to the terms of the deal, the buyout agreement struck in April will be dissolved, with no litigation or payment of a termination fee. Instead, Kohlberg Kravis and Goldman Sachs will buy $400 million of notes with a 1.25 percent interest payment, which are convertible at a price of $104 a share. (Shares in Harman closed at $86.40 on Friday.)
Brian F. Carroll, a member of Kohlberg Kravis, will also join Harman’s board. The company said it would use the proceeds to buy back stock.
Looks like KKR decided that Harman — with all that R&D — is a good investment after all. Or maybe they just want to avoid a messy lawsuit.
Jon Entine and Rick Miller at the American Enterprise Institute (AEI) have written a short paper on Managing Brands Under Siege. The paper lays out a three-pronged approach:
* Employ due diligence to assess potential liabilities and take action. The assessment should be completed before a crisis occurs. And, it should be done in conjunction with a company’s manufacturing organization, legal and communications counsel, and insurance carrier.
* Aggressively take responsibility for the problem. If your brand is on a product, it’s your problem in your customers’ eyes. This is especially true when a company makes products for children. Parents are fanatical about their children’s safety–and rightly so. Go above and beyond what is required by law to protect the brand by adding a margin of review, such as independent testing, which Mattel and Disney have announced they will begin. This may offer a huge opportunity for more high profile brands. Although they are the most vulnerable because their products are easily identifiable, bigger brands have more resources and technical expertise to monitor the train wreck that is China’s supply chain, and subsequent recalls, and cultivate public trust.
* Establish a credible narrative with customers and the media, and put a human face on the issue. In a recall, this is the CEO. People want to know what happened, why it happened and what the company is doing to never let it happen again–and that the person at the top is personally involved.
Good advices — especially the part of going above and beyond what the law requires. And this is from a generally anti-government think tank.
The Numbers Guy in the Wall Street Journal has taken off on the valuation of intangibles – Efforts to Quantify Sales of Pirated Goods Lead to Fuzzy Figures:
Counterfeit and pirated goods are a big problem for global business, costing hundreds of billions of dollars, according to manufacturers and trade groups. But their estimates tell more about how difficult it is to assign a value to lost sales than about the actual size of the counterfeiting problem.
The main problem he points out is the lack of good data. Those selling pirated goods don’t report their sales and extrapolations from products seized by the Customs Service at the border are iffy.
But there is another issue which he doesn’t mention: the pricing problem. Most of these estimates of counterfeiting assume full manufacturers suggested retail price (at least the one’s I’ve seen). But counterfeits usually sell on the street at deep discounts. The purpose of using full retail price rather than street value is to estimate the size of the loss to the manufacturer — not to understand the size of the economic activity. But to use full retail value, you have to assume that customers would purchase the product at full retail value if the counterfeit was not available. That is simply an unrealistic assumption.
To go back to the problem facing the valuation of intangibles – economist generally believe that something is worth what the market says it is worth. If a copy of the Lion King sells in China for $1, then that is what it is worth (and Disney has a good case for collecting some portion of that dollar in royalties). With many intangibles however, there is no market price – or very thin markets with volatile pricing. One is left with constructing prices. For example, the intangible value of a Rolex might be the difference between what it sells for retail and what a fake Rolex sells for on the street. I guess I would put as much credibility into that number, however, as I do to the estimates of the cost of counterfeiting.
For more on the piracy data, see the Number Guys blog discussion – The Numbers Guy : What’s the Real Cost of Counterfeiting? – where he cites the studies and provides links to at least one study on the benefits, in consumer surplus terms, of counterfeiting.