2007 Vol. 2


Valuation in New Industries

Pansy Yang, Ph.D.
Executive Director of the Fink Center for Finance & Investments
(Bio)

As the trend of private equity firms going public appears to gain momentum, capturing headlines and the attention of millions with the extraordinary numbers behind the deals, an age-old question resurfaces -- exactly what goes into the valuation process?

The valuation process and IPO underpricing has interested financial economists for decades. It has inspired an entire branch of literature with theories and models that seek to explain the rationale behind the difference in a firm's first-day offer price and subsequent prices at which shares are traded. If the valuation process in mature industries still harbors unanswered questions, one can only imagine how challenging valuation is in the context of new industries, in which there are few market comparables, if any. Valuation in new industries is the heart of this issue's bulletin, which takes a closer look at the biotechnology and nanotechnology IPO markets in particular.

Kuntara Pukthuanthong-Le, Assistant Professor of Finance at San Diego State University, provides this issue's academic perspective. A condensed version of her paper titled "Underwriter Learning about Unfamiliar Firms: Evidence from the History of Biotech IPOs," published in the Journal of Financial Markets, appears in the following pages. Kuntara presents fascinating results on the key attributes of biotech firms that drive market value, how underwriters appeared to make valuation mistakes in earlier biotech IPOs, and how they learned to do better over time.

This issue's industry perspective is provided by Darius Sankey, Managing Director at Zone Ventures. Zone Ventures is an affiliate of Draper Fisher Jurvetson (DFJ), a leading technology venture capital firm. There are very few public nanotechnology firms and DFJ is one of the select venture capitalists involved in nanotech IPOs. Darius shares some valuable observations on nanotechnology firms and on current valuation practices. >>PLEASE SEND YOUR COMMENTS

In Theory ...
Underwriter Learning about Unfamiliar Firms: Evidence from the History of Biotech IPOs

Kuntara Pukthuanthong-Le
Assistant Professor of Finance, San Diego State University

Valuing an early-stage company or IPO is difficult because much of the company's current value depends on expected future revenues from products yet to be marketed. Valuing an IPO in a nascent industry is even more difficult since there is no historical information for comparison. This article reviews the ability of underwriters to properly value unfamiliar firms and to develop improved valuation methods over time. The biotech industry provides a natural laboratory experiment, as the first biotech IPO occurred in 1980 and there have been almost 450 more in the subsequent 25+ years. >>READ PAPER

In Practice ...
Valuing Nanotechnology Companies: An Industry Perspective

Dr. N. Darius Sankey
Managing Director, Zone Ventures

In order to determine how to value nanotechnology companies from the perspective of the venture capital (VC) and private equity community and ultimately public markets, one must first understand how these various investors define this category of companies. The view that nanotechnology constitutes an industry on its own is not shared by the investor community. In the late '90s, the VC community began investing in nanotech companies with the promise that nanotechnology was the answer to all kinds of market problems, including drug discovery, new materials for computer chips, and alternative energy sources. This belief was translated into a primary thesis that nanotechnology would spawn a whole new industry with companies valued in the tens of billions of dollars, if not hundreds of billions of dollars by the middle of this decade. It was hoped that by 2005, the nanotechnology market place would be well-defined as an industry in which investors would gain the sort of returns that were generated from the computer and software industries in the early '80s, biotechnology in the late '80s, and the Internet in the late '90s. >>READ PAPER

Events at CFI

March 12, 2007
R.O.I. '07
Panel discussion featuring Larry Fink ('76), Stephen Schwarzman and Maria Bartiromo presented by the UCLA Anderson Center for Finance & Investments. The Museum of Television and Radio, New York City. Read a review or watch video.

May 4, 2007
Alternative Assets Conference
A Nobel Laureate, a BusinessWeek top-ranked finance professor in teaching, private equity and hedge fund titans -- the list goes on. These are but a few of the speakers and attendees at a unique gathering of intellectuals, both academics and practitioners from leading institutions and firms across the country at a recent conference about alternative assets. The conference was held at UCLA Anderson on May 4th, 2007, jointly sponsored by the Center for Finance & Investments and the Ziman Center for Real Estate. Read a review of the event.

CFI Working Paper

"M&As: The Good, the Bad, and the Ugly"
Kenneth R. Ahern and J. Fred Weston

Can't we all just live in a world of 'Good?' According to Kenneth Ahern and Fred Weston, when it comes to explaining why mergers occur, it turns out that we do. In a new working paper, they examine the role of each of the three competing M&A theories in explaining mergers, but using a broader definition of mergers.

The proposed broader definition of M&As follows: "M&As should be defined to include mergers, acquisitions, takeovers, tender offers, alliances, joint ventures, minority equity investments, licensing, divestitures, spin-offs, split-ups, carve-outs, leveraged buyouts, leveraged recapitalizations, dual-class recapitalizations, reorganizations, restructuring, and recontracting associated with financial distress and other adjustments."

The authors point out that previous research has focused primarily on mergers with little emphasis on the other forms of M&A, despite many of the other forms occurring more frequently, being "less severe than an actual merger", and also creating value. Furthermore, previous work has not paid much attention to the interactions between the various M&A forms and the firm's growth strategy, while this paper does.

A quick primer on the three theories. Neoclassical economic theory ('the Good') states that mergers take place because they create value, i.e. they are positive net present value investments. The prediction is that the new combination of existing assets will be more productive than the sum of its parts. In other words, mergers create value because of potential synergies.

Redistribution theories (the Bad) argue that the motive for mergers stems from the desire to reap benefits associated with wealth redistribution. Two examples are tax savings and market power. The tax saving resulting from a merger, which has been shown to be substantial in prior studies, falls in this category as redistributing wealth from the government. The second example is one in which firms seek to merge so that they can increase market share, and hence power. In the extreme monopolistic setting, market power enables the firm to transfer wealth from the consumer to the firm, by allowing actions such as setting prices above a competitive level.

Behavioral theories (the Ugly) examine mergers in the context of imperfect markets or participants. The most commonly cited behavioral theory is Roll's hubris hypothesis (1986), which states that mergers may be the result of decisions by overconfident managers of acquiring firms who believe their valuation of a target firm is more accurate than available public market values which include a probability of some takeover premium. In this scenario, bidding managers overpay for the target. Another behavioral theory is when there is asymmetric information between managers and investors. Mergers are created by stock market misvaluations of the combining firms, and are related to the level of the market as a whole. In this case, markets are inefficient, while managers of firms are rational, taking advantage of stock market inefficiencies through well-timed merger decisions, while in Roll's theory markets are efficient but participants are irrational.

In addition to an excellent summary of existing M&A research, the paper takes a closer look at various firms and industries and contemplates how existing theories support the broader definition of mergers. One example is analysis of M&A activity in the defense industry. Exhibit 7 in the paper summarizes the various types of merger activities of the five top defense contractors over the period 1980-2004.

Note that these firms engaged in a total of 589 multiple growth activities, averaging 39 a year, suggesting that in addition to a lot of activity, prior work that has focused on just one of those activities (namely, mergers) may not have considered the entire picture.

Exhibit 8 presents 11-day cumulative abnormal returns (CARs). The abnormal return from all deals for all firms is .63% and statistically significant. Mergers on average created value, with a significant CAR of 1.02%. The authors perform additional analysis, revealing a change in capabilities and readjustment of strategic focus in several of the defense firms over the 15 year time period.

The main findings are: (1) M&A activity represents a wide range of methods to develop growth opportunities. (2) M&A programs have long and multiple year time horizons. (3) Companies continuously revise the portfolios of products and markets in which they seek to develop value increasing investment programs. Hence, M&As in the broader sense do create value, assist managers in creating superior returns to shareholders, and are in line with neoclassical theory. - P. Yang

>>Read the paper, "M&As: The Good, the Bad, and the Ugly" by Kenneth R. Ahern and J. Fred Weston (PDF)

CFI Research Note

Executive Summary of Investor Reaction to Inter-corporate Business Contracting
Fayez Elayan (Brock University), Kuntara Pukthuanthong (San Diego State University) & Richard Roll (UCLA Anderson)

Although simple business contracts are perhaps the most common forms of inter-corporate agreements, they have not been widely studied. This is in sharp contrast with the sizeable literature about integrating agreements such as mergers and joint ventures. Our paper's goal is to begin filling this gap.

One might at first think that the valuation effects of corporate contracts are obvious because both parties, the contractee who grants the contract and the contractor who provides the good or service, freely enter into the contractual agreement and bind themselves to its terms. Since both sides must anticipate benefits, one might be tempted to predict that both firms would enjoy stock price increases around the contract announcement.

Yet things are not as simple as they might appear. If both contracting parties are perfectly competitive, so the contractee has no monopsony power and the contractor has no monopoly power, the contract should provide no monopoly profits to either side and there should be little if any stock market reaction.

The theory of incomplete contracting, however, suggests that moral hazard and other problems could create a situation that benefits one side at the expense of the other. Unless both parties are rational and take full account of incomplete contracting problems, the stock price gain of one party might correspond to a stock price loss of the other party.

Another consideration is that contractors are generally bidders with competitors. The winner's curse phenomenon implies that they should bias up their bids relative to expected costs. This suggests that the winning bidder will receive a quasi-rent and that the stock market will respond favourably. Similarly, if the winning bidder, usually the lowest bidder, reveals by winning that it is a low-cost producer, the stock market might interpret this as a positive signal about the winning contractor.

We study announcement period abnormal returns of contractors and contractees in a short window around contract announcements. We find that winning contractors experience material and significant abnormal stock price increases and abnormally high volume. In contrast, there is no perceptible stock price reaction for contractees. These results rule out monopsony power for contractees and they are also inconsistent with behavioural insufficiency in taking account of moral hazard and other problems associated with incomplete contracting. Moreover, since winning contractors do experience stock price increases, the results are inconsistent with a simple form of perfect competition.

A behavioural version of incomplete contracting theory suggests that moral hazard is more probable when the contractor has specific assets, yet empirical proxies turn out to be insignificant. Also, using a matched sample, we find no evidence that one party's stock market gain corresponds to a loss by its counter party.

This leaves as viable the winner's curse hypothesis (quasi-rents for winning contractors) and the low production cost signalling hypothesis. There is some additional evidence in favour of both hypotheses; for example, the announcement period abnormal return of contractors increases with return volatility, a proxy for uncertainty in contract costs, which should in turn be associated with a greater danger of the winner's curse.

Similarly, the contractor's market to book ratio, an indicator of intangible assets, is associated with higher announcement period returns. This is indirectly consistent with the cost-signalling hypothesis because signals have a more pronounced impact on stock prices when there is information asymmetry, and such asymmetry should be larger when assets are intangible.

These results are obtained while controlling for a number of other possible determinants of announcement period returns. >>Read the paper, "Executive Summary of Investor Reaction to Inter-corporate Business Contracting" by Fayez Elayan, Kuntara Pukthuanthong & Richard Roll

Distinguished Speakers

January 18
Joan PaydenJoan Payden, CFA, is the President and CEO of Payden & Rygel, the global investment management firm that she founded in 1983. At Payden & Rygel, Joan has overseen the firm's international expansion and its growth to more than $50 billion in assets under management. In 1992, the firm launched Payden & Rygel Investment Group, a family of mutual funds, of which she is Chairman and CEO. Prior to founding Payden & Rygel, Joan was managing director of West Coast operations for Scudder, Stevens & Clark as a national partner of the firm.

January 23
Larry FinkLaurence D. Fink is the Chairman and CEO of BlackRock, an investment management firm that has in excess of $1.2 trillion under management. He is Chairman of BlackRock's Executive and Management Committees, as well as Chairman of the Board of Nomura BlackRock Asset Management, BlackRock's joint venture in Japan, and several of BlackRock's alternative investment vehicles. Prior to founding BlackRock in 1988, Larry was a member of the Management Committee and a Managing Director of The First Boston Corporation.

January 24
Robert ArnottRobert Arnott, founder and CEO of Research Affiliates, established the firm in 2002 as a research-intensive asset management firm. Over $20 billion in assets are managed using investment strategies developed by Research Affiliates. A widely published financial thinker, Rob has been a frequent contributor to leading financial journals and books, including the Financial Analysts Journal, the Journal of Portfolio Management, the Harvard Business Review, amongst other respected journals. Rob is Editor Emeritus at the Financial Analysts Journal and former chairman of First Quadrant, LP, where he developed quantitative asset management products. He also served as global equity strategist at Salomon Brothers (now part of Citigroup), the president of TSA Capital Management (now part of Analytic), and as a vice president at The Boston Company (now PanAgora).

February 7
Ed WedbushEdward Wedbush is the CEO of Wedbush Morgan Securities. Ed was fresh out of college when he and partner Robert Werner each pooled $5,000 to open the first office of Wedbush & Co. on Crenshaw Boulevard in 1957. A half century later, Wedbush Morgan Securities is worth more than $200 million and ranks as one of the top correspondent clearing services in the United States, executing trades for hundreds of small broker-dealers. At 73, Ed still gets to the office every day at 5:45a.m. and spends several hours on the firm's trading floor, gauging the market in front of a bank of computer monitors. His interest in stocks began when he made his first investment at the age of 17.

May 2
David WindreichDavid Windreich ('83) has been a Managing Member of Och-Ziff Management since its inception. Prior to joining the Management Company Mr. Windreich was a Vice President in the Equity Derivatives Department at Goldman Sachs. Mr. Windreich became Vice President in 1988, and began his career with Goldman Sachs in 1983. Mr. Windreich holds both a BA in Economics and MBA in Finance from UCLA Anderson.

May 3
Karlheinz MuhrKarlheinz Muhr ('85) is a Managing Director of Credit Suisse in the Asset Management Division and Head of Credit Suisse Volaris Volatility Management, based in New York. He is also a member of the Chairman's Board of Credit Suisse. Karlheinz was co-founder and Chairman of Volaris prior to its acquisition by Credit Suisse First Boston. He holds a Master's Degree from Vienna's University for Business and Economics and an MBA from UCLA Anderson.

Number One in Finance Publications

UCLA Anderson Ranked #1 in Publications Per Tenure-Track Finance Faculty in Top Four Finance Journals Over Past Five Years (Figures from W.P. Carey School of Business at A.S.U.)

  1. UCLA Anderson - 3.27
  2. Duke - 2.53
  3. Purdue - 2.50
  4. University of Chicago - 2.36
  5. Emory - 2.20
  6. Ohio State - 2.15
  7. Stanford - 2.13
  8. Harvard - 2.08
  9. M.I.T. - 1.95
  10. Utah - 1.92

Finance Seminars
Please click here for details.

October 6
Hanno Lustig, UCLA

January 17
Alex Edmans, MIT

January 22
Adair Morse, Michigan

January 26
Bruce Carlin, Duke

January 31
Dimitris Papanikolaou, MIT

February 7
Hui Chen, University of Chicago

February 9
Nikolai Roussanov, University of Chicago

February 16
Christopher Malloy, London Business School

March 2
Ning Zhu, UC Davis

March 23
Pete Kyle, University of Maryland

April 6
Massimo Massa, INSEAD

April 27
Todd Milbourn, Washington University

May 11
Xavier Gabaix, MIT

May 18
Adlai Fisher, UBC

June 8
Sanjai Bhagat, University of Colorado

Streaming Video

Alternative Assets Conference Keynote Presentation
Myron Scholes

R.O.I. '07
Larry Fink & Stephen Schwarzman

Compliance with FAS 123
Richard Roll

Hybrid Funding Models for R&D

Center for Finance & Investments
UCLA Anderson School of Management
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Los Angeles, CA 90095