Three Questions: Prof. Jacob Thomas on Tesla’s Bid to Go Private
This week, Tesla CEO Elon Musk prompted headlines when he tweeted that he was considering taking the electric car maker private. We asked Yale SOM’s Jacob Thomas, an expert on stock prices and company valuation, how Tesla might benefit from going private and what the market reaction can tell us about the prospects for the plan.
What prompted Tesla to consider going private?
In his email to employees, Elon Musk says that going private will improve operations. In particular, it will mitigate three problems: employees being distracted by wild swings of the stock price; management’s excessive focus on short-term results, created by the quarterly reporting cycle; and incentives for short sellers to attack the company. He points to SpaceX as an example of the benefits that will be achieved by taking Tesla private.
The first two reasons likely carry less weight. Tesla’s stock price has long been associated with wild swings, and investors have treated Tesla differently: they show patience and do not demand short-term results. The third reason seems more important. Equity investors are very divided about Tesla’s fundamental value: it is described as “the most-shorted stock in the history of the stock market.” Short sellers, who believe the share price is too high, disagree mainly with other investors who think the price is too low. In some cases, short-sellers also disagree publicly with managers, given their incentives to emphasize negative aspects of current and future performance. In Tesla’s case, sell-side analysts—a group that typically supports managers—have also recently expressed concerns about Tesla’s share price. These concerns might affect negatively other stakeholders (principally customers), which in turn negatively affects profitability.
At a personal level, Musk may be exhausted. He runs multiple companies, and has been working tirelessly for a number of years, dealing at a granular level with both internal and external constituencies.
What are the advantages of going private? What are the downsides?
In addition to the benefits mentioned in Musk’s email, avoiding the cost of public disclosure and securities regulations is often cited as a benefit of going private. Not so much the out-of-pocket costs of complying, but the knock-on effects of publicly disclosing many aspects of operations. Disclosing high levels of profitability, for example, might cause suppliers to raise prices, customers to demand price reductions, and competitors to pick off more profitable products or geographies. Also, dealing with a smaller, more homogeneous group of equity holders reduces costs created by information asymmetries between managers and owners and related conflicts of interest.
The primary downside of going private is the higher cost of capital that investors demand for the lack of liquidity (being able to buy and sell at a fair price at short notice). In Tesla’s case, it leveraged its public ownership to increase buzz. The media provided free advertising, for example. Those benefits will be reduced if Tesla goes private.
The data suggest that the preference between private and public ownership varies over a firm’s life cycle. That is, the relative advantages and disadvantages of private versus public vary over time. Musk also mentions in his email that he intends to return Tesla to public equity at a later date.
How hard will it be to actually take Tesla private?
There are a number of hurdles. Musk says that financing is lined up, and shareholder approval is easier in this case as he owns 20%. But he assumes that many current shareholders will not need to be bought out, as they will roll over to holding private equity. Many shareholders may not be willing to take the implied “haircut” (value declines when the cost of capital increases) and some institutional shareholders are not allowed to hold private equity. And if a sufficient number of shareholders hold out for a higher bid, the cost of financing goes up further. While debt financing is often used in going private transactions, here it would be harder to carry as operating cash flows are insufficient to cover the large periodic payments coming due.
A simple formula we use in our Yale SOM course Sourcing and Managing Funds can be used to estimate what investors think about the likelihood that Musk will overcome those hurdles. Assume there are only two scenarios: the deal goes through at $420 (an odd number to choose if you want to be taken seriously) or the deal collapses and share price falls to about $340, the pre-tweet price. If investors felt this was a done deal, the price would rise to $420. But if they thought it was a 50/50 chance, for example, the price would rise to $380, halfway between $340 and $420. The share price at close on Tuesday was around $380, suggesting that the odds are about 50/50. As investors receive and digest new information about the probability of the deal closing, the price rises toward $420 or falls toward $340. Tesla opened today at $365.