Matt Levine - Payment For Order Flow

6/29/2019 Carl Icahn Wants to Fight Dell Again - Bloomberg
Finance
Carl Icahn Wants to Fight Dell Again

Also Robinhood, Uber, crypto custody and pre-dating.
By Matt Levine
October 16, 2018, 8:28 AM PDT
Icahn v. Dell II.
In 2013, Michael Dell and his private-equity backers at Silver Lake took Dell Inc. private for about
$25 billion. A lot of investors, and for a while a Delaware court, thought that the price was too
low, and that Michael Dell had sandbagged investors by giving them a pessimistic view of Dell’s
prospects so that he could buy it cheaply himself. Arguably those complaints turned out to have
some merit, as Dell has done very well in private hands and is now looking to return to the
public markets.
In 2015, Dell—then a private company—agreed to acquire EMC Corp., a public company, for about
$67 billion. EMC owned about 82 percent of VMWare Inc., another public company, and to make
the math work Dell paid EMC’s shareholders a combination of (1) cash and (2) a tracking stock
that referenced 65 percent of VMWare. In theory, owning a share of Dell’s tracker—it’s usually
referred to by its ticker, DVMT—should be about as good as owning a share of VMWare. (Well,
about 1.01 shares of VMWare. 1 ) And when Dell bought EMC, the investment bankers on the
deal predicted that the tracking stock would trade at a minimal discount (or even a premium) to
VMWare’s actual shares. In reality, though, the tracking stock has always traded at a big discount:
It ended June at $84.58, more than a 40 percent discount to VMWare’s $146.97 price. And Dell
has been ruthless about capturing this discount, selling VMWare shares back to VMWare for
cash and using the money to buy more DVMT shares, giving its non-tracking-stock owners (that
is: Michael Dell and Silver Lake) a more concentrated stake in VMWare.
Earlier this year Dell (now called Dell Technologies Inc.) announced that it would swap the
DVMT tracking stock into regular common shares of Dell. This would turn Dell into a bit more of
a normal public company: Instead of having private normal shares owned by Michael Dell and
Silver Lake, and public tracking shares representing the VMWare stake, everyone’s shares would
be public and would represent ownership of all of Dell’s assets.
But there are questions about how to swap DVMT shares into Dell shares. Specifically:
https://www.bloomberg.com/opinion/articles/2018-10-16/carl-icahn-wants-to-fight-dell-again 1/10
1. Should the DVMT shares be valued like VMWare shares (representing their proportional claim
on the VMWare stock, and the deal that Dell was promising to EMC shareholders back in 2015
when it created those shares), or at a substantial discount to VMWare (representing the actual
trading prices of the stocks)?
2. Since the rest of Dell is not yet public, how should its stock be valued?
And Dell answered both of those questions pretty much as ruthlessly as possible. DVMT shares
are getting swapped out at a big discount reflecting their actual trading prices rather than Dell’s
promises, with a headline value per DVMT share of $109 (VMWare closed at $144.04 yesterday).
That will be paid partly in cash and partly in stock, and the headline price also assumes a pretty
optimistic value for Dell’s own stock; DVMT closed at $95 yesterday, suggesting that the market
doesn’t believe that valuation. (My Bloomberg Opinion colleague Brooke Sutherland has done
excellent work critiquing Dell’s math over the past few months, and my views here are largely
based on her analysis.)
So I think it is reasonable to say that this deal is not particularly generous to DVMT shareholders.
Those shareholders have to vote to accept the deal, and they could always say no. The problem is
that if they say no, it’s not clear they have better alternatives. Dell could just say “fine, keep your
discounted tracking stock.” Or Dell could do a regular initial public offering of its normal stock,
and then force DVMT shareholders to convert. Dell’s charter provides a mechanism for that
forced conversion that is very favorable to Dell: Basically Dell can choose to convert based on the
trading-price ratio between Dell and DVMT over any trailing 10-day window, meaning that it can
pick the opportune moment to hose DVMT shareholders.
It is all a bit grim, is the basic point here. Dell’s private owners have had a lot of leverage points
to squeeze value out of their public shareholders and keep it for themselves, and they’ve been
pretty aggressive about using all of them. And there is not a lot that the shareholders can do
about it.
But then Carl Icahn showed up! Icahn actually fought against the original Dell buyout in 2013—he
managed to extract a small price bump—and he has arrived to the Dell/DVMT fight with his ardor
undimmed. Here is the open letter to DVMT shareholders that he released yesterday, announcing
that he owns 8.3 percent of DVMT and intends to vote against Dell’s proposed deal. He lays out
many of the problems I discussed above, and adds some more. He dismisses the possibility that if
shareholders vote no Dell might continue with the status quo or push through an IPO. (“Could
you even find an investment bank willing to risk its reputation (not to mention the potential
liability) with a Dell IPO under such circumstances?” asks Icahn, and I will tell you the answer is
yes, yes you could find an investment bank to underwrite a Dell IPO, in about five seconds.)
But Icahn also might put some more money where his mouth is. Sutherland explains:
Icahn isn't just going to vote against the deal; he's also contemplating a partial bid for DVMT
stock in the event of a raised offer that's more modest that what he believes is warranted. This
would provide liquidity for those holders that need to exit while allowing those who want to
fight to do so. ...
Shareholders grumbling about the terms of Dell's offer have acknowledged to me that the risk-
arbitrage community isn't necessarily a reliable ally here and some funds may be willing to
cash out at lower levels than what mathematically seems fair. Should Icahn proceed with this
partial transaction, Dell and Silver Lake would be left dealing mostly with shareholders whose
pushback to the transaction runs much deeper than meeting annual-return goals.
Icahn’s commitment isn’t exactly firm—he writes, “I intend to continue evaluating this idea and
determine whether other interested parties, including financing sources, may want to participate
in, or finance, a transaction of this nature”—but of course I am rooting for him to do it. It is
so clarifying. There are people who are willing to get out of their DVMT stock at a big discount to
the underlying VMWare value. Let them. But they don’t have to do it by selling to Dell and
rewarding Dell’s let’s say aggressive governance choices. Let them get out by selling to Icahn, so
he can build a bigger stake for his fight to the death with Dell.
There are two deep ways to think about making money in investing. In one, you get paid for
being smarter than everyone else: You see something that the market doesn’t see, and you buy it,
and eventually the market sees what you see and you get rich. This is pleasant for you, but it is
somewhat hard to predict and understand and replicate: How can you know in advance that
you’re so much smarter than everyone else?
In the other, you get paid for providing a service, for taking on work or risks or difficulties that
other people just don’t want to bother with. You don’t assume that you’re smarter than everyone
else, but you know that you’re more willing than everyone else to bear some risk or to slog
through some tedious garbage, and you trust that everyone else will pay you to do that for them.
2
Carl Icahn, here, does not think that he’s any smarter than anyone else. His letter begins by
saying that this trade wasn’t his idea—DVMT shareholders approached him for help—and he notes
that “the massive undervaluation of DVMT … exists in plain sight for all to see.” Instead, he is
banking on his sheer obstinacy, on his flamboyant annoyingness, on his ability to follow through
when normal investors would give up, on pitting his particular kind of shamelessness against
Dell’s. Icahn writes:
The Tracker has basically zero governance rights and is trapped within a capital structure that
has some of the worst corporate governance in America (at Dell, the Certificate of
Incorporation even requires that the CEO has to agree to replace the CEO!), however, investor
fear of this poor governance is overdone and we believe strong activism combined with
litigation, if necessary, can mitigate the governance risks.
Your fear is overdone, Icahn tells DVMT investors; you really can get much more out of Dell than
they’re currently offering. But, he quickly goes on, it will take a strong stomach and a lot of
patience—“strong activism combined with litigation”—and if you don’t have the appetite for that,
Icahn will do it for you. You can just sell to him at close to Dell’s price so that he can push for his
price. He will take a cut for his service. Arguably he’s worth it.
Robinhood.
Ahahaha sure:
Robinhood Markets Inc. has built a reputation on its origins in finance counterculture and a
steal-from-the-rich ethos. But the firm, which offers no-fee stock trading, is making almost
half its revenue from one of the most controversial practices on Wall Street.
The startup, valued at $5.6 billion, was bringing in more than 40 percent of its revenue earlier
this year from selling its customers’ orders to high-frequency trading firms, or market makers,
like Citadel Securities and Two Sigma Securities, according to three people with knowledge of
the matter, who asked not to be identified because the details are private. Almost all retail
brokerages employ the practice, called payment for order flow, but it’s an unlikely strate y for
a company built on an anti-Wall Street message.
Well, but who are the rich if not Citadel? Robinhood’s business model is:
1. Citadel gives it money.
2. It uses the money to give you free stock trades.
That really is taking money from the rich (high-frequency traders) to give to the poor, sort of
(millennials who want to trade stocks on their phones). Who did you think was giving it money?
Not only that. Payment for order flow really is “one of the most controversial practices on Wall
Street,” but the controversy tends to be confused and obfuscated. The basic idea of payment for
order flow is that electronic market makers want to be left alone to quietly make the spread:
They want to buy stock for $99.99 and sell it at $100.01 and clip two cents on each trade. If their
orders are random—if sometimes people buy and sometimes they sell, with no pattern—then that
works out well for the market makers. But their big risk is what they call “adverse selection”:
Sometimes, when a customer buys 100 shares at $100.01, it then buys another 100 shares at
$100.02, and another 100 shares at $100.03, and keeps going until it has bought 10,000 shares
and pushed the price up dramatically. The market maker who sold it the first 100 shares—and
who is probably now short and needs to go out and buy those shares at a higher price—has been
run over.
This is a risk of being a market maker on the public stock exchanges: Sometimes you sell 100
shares to a small retail investor and it’s random noise; other times you sell 100 shares to Fidelity
and you get run over. But if a market maker can guarantee that it will only interact with retail
customers—if it can filter out big orders from institutional investors—then its risk of adverse
selection goes way down. The way the market maker does this is by paying retail brokers to send
it their order flow, and promising those brokers that it will execute their orders better than the
public markets would. (This is called “price improvement,” and allows the retail brokers to fulfill
their obligation to give their customers “best execution.”) So if a stock is quoted at $99.99 bid,
$100.01 offered on the public exchanges, the market maker might buy it from retail customers for
$99.991 or sell it to them at $100.009. (It’s not usually much price improvement.) It can offer a
tighter spread than the public markets—and have money left over to pay the retail brokers—
because it doesn’t have to worry about adverse selection. If the retail broker is, say, one designed
to let young people day-trade for free on their phones, then those orders are probably
particularly valuable, because they are probably particularly random.
There are two objections to this practice. One is that it is bad for investors whose orders
aren’t sold to market makers, the institutional investors who instead trade on public stock
exchanges. Payment for order flow fragments the markets, takes retail order flow away from the
public stock exchanges, widens out spreads on those exchanges, and, by segregating retail and
institutional orders, makes institutional execution worse. This objection is probably true! If
you’re a hedge-fund manager, you should dislike payment for order flow, because it makes public
markets worse for you. (If you invest through mutual funds, as I do, you should also dislike it, for
the same reason.)
The other objection is that payment for order flow is bad for investors whose orders are sold to
market makers, the retail investors whose orders never touch the stock exchange. If the market
makers are paying to get their orders, surely they are doing something nefarious with them,
right? Otherwise why would they pay? This objection seems mostly wrong. Very occasionally
there is some evidence of market makers doing naughty stuff with the retail orders that they buy,
but for the most part, particularly for simple market orders, the result is straightforward: Retail
customers are instantly able to buy stock at a price at least as good as, and usually better than,
the best price available in the public markets. And the market makers pay their brokers for the
privilege, so the brokers can offer cheaper (even free!) stock trades. They are unambiguously
better off than they would be if their brokers didn’t sell their orders.
So by selling its customers’ orders to market makers, Robinhood is actually stealing from two sets
of “the rich”: Rich market makers like Citadel are paying it directly for the orders, while rich
hedge-fund managers are getting worse execution on public stock exchanges so that Robinhood
customers can get better executions off those exchanges. Big institutions are paying to subsidize
free trades for Robinhood’s customers. It feels pretty Robin-Hood-y! If I were Robinhood I would
advertise that!
Of course the problem is that it didn’t:
Until its Friday letter, it was difficult to find any mention of payments for order flow on the
company’s website, though it linked to required disclosures about the practice in fine print. In
the past, Tenev has credited Robinhood’s efficiency for giving it an edge. “Some of these
legacy brokerages are running on paper and fax machines and have legacy mainframes that
have been sort of operating their businesses for many, many decades," Tenev said at a June
conference in New York, explaining why it can offer free trading while competitors can't.
People hate payment for order flow, but really this is a failure of imagination. “We make big high-
frequency trading firms bid to do your stock trades, and pass the benefit on to you” ought to be
a good talking point. If you believe in the market structure that you’re using, why not brag about
it?
How much is Uber worth?
Sure, why not, $120 billion:
Uber Technologies Inc. recently received proposals from Wall Street banks valuing the ride-
hailing company at as much as $120 billion in an initial public offering that could take place
early next year, according to people familiar with the matter.
That eye-popping figure is nearly double Uber’s valuation in a fundraising round just two
months ago and more than General Motors Co., Ford Motor Co. and Fiat Chrysler
Automobiles NV are worth combined.
Goldman Sachs Group Inc. and Morgan Stanley last month delivered the valuation proposals
to Uber, the people said. These documents, which typically advise on how to position shares
to potential investors, are a common step before banks are formally hired to underwrite IPOs.
You know, those valuation proposals are free. You can just type a number in them. It’s not like
Goldman or Morgan Stanley made a binding bid to pay $120 billion for Uber. Obviously the
number needs to be supported by some plausible logic, but in general the higher the number you
type into the presentation, the more likely Uber is (1) to be excited about going public and (2) to
want to hire you to do the IPO. (“They must really understand our story if they think it’s worth
$120 billion!”) Much of the skill of being a capital markets banker is in typing in a very high
number in those initial presentations in order to win the mandate, and then imperceptibly
walking it back so that by the time the IPO actually prices the client is satisfied, even if the price
is much lower.
Fido insto crypto.
If you are a hedge fund and you want to trade a weird financial product, what you do is you call
up your coverage salesperson at one of your usual investment banks and say “hey can you buy
me 100 gabzorks?” And the salesperson says “yes let me get you a quote from our senior gabzork
trader,” and makes you a market, and sells you gabzorks, and sends you a trade confirmation,
and takes custody of your gabzorks, and sends you periodic account statements telling you how
many gabzorks you have and what they’re worth, and generally does a lot of the work of
administering your gabzorks for you. For this, the bank gets to make a lot of money trading
gabzorks for you, and financing your gabzorks, and maybe offering you complex bespoke
gabzork derivatives.
This far into the crypto revolution, it is maybe a little weird that big investment banks
mostly don’t do any of that stuff for Bitcoin? There is a lot of talk about it, sure—Goldman Sachs
Group Inc. gets headlines every now and then about its plans for crypto custody services—but
not much in the way of actual products used by big institutional investors. Instead the
institutions seem to be rolling their own:
Fidelity Investments is jumping into the emerging cryptocurrency arena with a new business
to manage digital assets for hedge funds, family offices and trading firms.
The mutual fund giant will offer security and storage services, trade execution and customer
service for digital assets, Fidelity said Monday in a statement.
If you are a hedge fund looking to trade, like, stocks or bonds or interest-rate swaps or gabzorks,
your first thought wouldn’t be to set up a custody account at Fidelity and call a Fidelity trader for
quotes. Goldman, sure, Fidelity, not so much.
Why then in crypto is this a service offered by the buy side rather than the sell side? I don’t
know. One possibility is that the volatility and general scruffiness of crypto makes it a bit hard for
investment banks to offer it as a product: If Jamie Dimon says that Bitcoin is a fraud, and then
JPMorgan opens a crypto desk and sells lots of Bitcoins to lots of customers, and then Bitcoin
does crash, that is going to be awkward for JPMorgan. Banks have unfortunate recent experience
with selling customers products that the banks themselves thought were bad, and getting in
trouble for it. Fidelity, on the other hand, is presumably setting up this infrastructure because it
wants to own Bitcoins for its own investors. If you’re doing the work anyway so that you can
invest in crypto, you might as well offer it to other investors too.
Audit pre-dating.
Oh, I cringed reading this Securities and Exchange Commission enforcement action from last
Friday:
The Securities and Exchange Commission today suspended three former BDO USA LLP
accountants for their improper professional conduct during an audit of an exchange-listed
insurance company.
According to the SEC’s order, BDO fell behind schedule while conducting its 2013 integrated
audit of AmTrust Financial Services Inc. and ultimately failed to complete necessary audit
procedures before AmTrust’s deadline to file its annual report with the SEC. To create the
appearance that BDO’s audit was in fact complete, the senior manager on the audit
engagement, Lev Nagdimov, instructed BDO’s audit team to sign off on all work papers and
audit programs regardless of whether its work was finished. Nagdimov further instructed
BDO’s audit team to load and sign blank or placeholder work papers in BDO’s electronic files.
Consistent with Nagdimov’s instructions, the audit team improperly “predated” audit
documentation by signing blank or incomplete work papers and audit programs. After
AmTrust filed its 2013 annual report, the audit team finished its necessary audit procedures
and preserved the predated sign-offs in BDO’s electronic files by overwriting existing
documentation in the placeholder work papers.
Who among us? I have a lot of insightful and witty things to say about this case but I am just
going to hit send on Money Stuff now and fill them in later.
Things happen.
Goldman Bankers Deliver Surprise Gain for Solomon. Morgan Stanley Tops Rivals With Jumps in
Trading, Deal Fees. China May Have $5.8 Trillion in Hidden Debt With ‘Titanic’ Risks. A Drama
CBS Can’t Cancel—the One in Its Boardroom. The Sears Bankruptcy Is a Cautionary Tale for
Hedge Fund Managers. Governments Should Be Run More Like Businesses. People are freaking
out about Tether. A robot just gave evidence to a committee of MPs. Cops use Doritos to lure
escaped pig 'the size of mini horse' back home.
If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link.
Thanks!
1 There are about 199.4 million shares of Dell’s Class V tracking stock, which represent
claims on“approximately 202million shares of VMware common stock as of August 31,
2018, which represented approximately 61.1% of the approximately 331million shares of
VMware common stock that constituted the sole assets of the ClassV Group as of such
date,” according to Dell’s proxy. (These numbers are different from the original
numbers in the EMC deal because both Dell and VMWare have since done stock buybacks.)
That means each tracking share should be “worth” about 1.01 VMWare shares. (The
original ratio was 1 to 1.)
2 Paul Singer describes his approach to investing as “buying a bond in a company and
being in a multi-year struggle where we say, ‘Our bonds are senior to yours.’ And they
say, ‘No, you’re not.’ And we go back and forth yelling about that for a few years.”
And: “What I came to feel relatively early on in my career is that manual effort—
making something happen, getting on the committee, becoming part of the process, try
to control your own destiny, not just riding up and down with the waves of the
financial markets—was actually not only a driver, an important driver, of value and
profitability but an important way to control risk, dig yourself out of holes when you
slip into a ravine.” That is a perfect statement of the providing-a-service view of
hedge-fund performance: You trust that other people will be happy to leave the “manual
effort” to you, and let you make some money from it.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
To contact the author of this story:

Matt Levine at mlevine51@bloomberg.net
To contact the editor responsible for this story:

James Greiff at jgreiff@bloomberg.net
Matt Levine is a Bloomberg Opinion columnist covering finance. He was an editor of Dealbreaker, an
investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz,
and a clerk for the U.S. Court of Appeals for the 3rd Circuit.
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6/29/2019 Carl Icahn Wants to Fight Dell Again - Bloomberg

Carl Icahn Wants to Fight Dell Again

Icahn v. Dell II.

1. Citadel gives it money.

2. It uses the money to give you free stock trades.

Of course the problem is that it didn’t:

How much is Uber worth?

Sure, why not, $120 billion:

Automobiles NV are worth combined.

Fido insto crypto.

To contact the author of this story:

To contact the editor responsible for this story:

Read more opinion

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