After more than a year of negotiations, Family Dollar’s shareholders have agreed to be acquired by Dollar Tree. I wrote about this transaction last August in a column. Although I correctly predicted that Dollar Tree would prevail after improving its offer, I was completely wrong about the length of time it would take to resolve this matter. According to the regulatory filings, Family Dollar’s CEO first talked to Dollar General in October 2013 about a potential transaction. Apparently nothing came of the meeting. Then in February 2014, Morgan Stanley approached Family Dollar, which began the process that culminated in the sale of the company about two weeks ago for $76.59 per share. I am revisiting the saga of Family Dollar because there are a variety of additional lessons we can take from this deal.
This week we’re going to learn that, despite all the smart people running Family Dollar and investing in its stock, luck played the dominant role in the decline of the company’s profits and its subsequent sale, that the highest price doesn’t always win, that the hedge fund industry consists of a variety of species of piranhas that feed on deals such as these, and that some folks can lose money even if a deal is successfully completed.
The saga of Family Dollar is a powerful reminder of one of the most important lessons I learned during my career: Luck, rather than skill, plays a dominant role in business and investment. Levine and his management team have come in for a lot of blame for the relatively poor performance of Family Dollar, while the hedge fund managers who pushed the company into play are seen as skilled investors who created value. As a result, many analysts and commentators view the sale of Family Dollar as the byproduct of management failures.
Price is not always king
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In reality, most of Family Dollar’s woes were outside the control of the company’s management. You can point to the power of Wal-Mart, the troubling financial condition of Family Dollar’s customers, or a variety of other factors that slowed the company’s sales and depressed its margins. Similarly, most of the conditions that led to the tie-up between Family Dollar and Dollar Tree were beyond the control of all those hedge fund managers who pushed for the sale of the company. A rising stock market and cheap credit were probably more important for the outcome than anything a hedge fund did or didn’t do. As investors we give to much credit to corporate management and money managers when things work out and too much blame when things don’t. Sadly we pay all these professionals far too much money, whether they succeed or not. The exorbitant levels of compensation are particularly inappropriate given the large role luck played.
The second lesson is that the highest price doesn’t always win. After declining to engage with Family Dollar at the outset, Dollar General eventually returned with a hostile bid of $78.50, which it eventually raised to $80.00. As I wrote last August, Dollar General was a better strategic fit than Dollar Tree, allowing it to offer more money but also saddling its proposed deal with antitrust concerns. Dollar General eventually agreed to divest up to 1,500 stores and pay Family Dollar $500 million if they couldn’t get approval from the Federal Trade Commission.
However, as 2014 came to a close it became apparent that the FTC would require Dollar General to cast off far more than 1,500 stores. Moreover, the agency was going to need many more months to reach a final decision on Dollar General’s proposal. In the end, institutional investors voted to cash in their profits sooner rather than later and take the relative certainty of Dollar Tree’s merger proposal.
Third, Family Dollar’s fate was probably determined several years ago. The sale of the company wasn’t the result of anything management did or didn’t do. The company’s shareholder base began to shift in 2013. For many decades, mutual funds and other passive investors owned Family Dollar’s stock. If they didn’t like the performance of the company or its stock, most of these investors simply sold the stock, leaving Levine and his management team to run the company as they saw fit. However, as those passive investors sold, a new more aggressive set of owners, usually in the form of hedge funds, entered the picture. This change of ownership was like adding piranhas to the Family Dollar ecosystem.
In Family Dollar’s case it was Nelson Peltz and his company, Trian Fund Management, who showed up. After trying to take over Family Dollar, Peltz settled for a board seat. Under pressure from Peltz, Family Dollar changed its product mix, re-evaluated its growth strategies and upped its share repurchases. However, change didn’t come quickly enough. The company’s earnings weren’t going in the right direction. As a result, Family Dollar was pushed to consider more radical steps such as selling the company, which, in turn, encouraged more piranhas to consume Family Dollar’s stock. As is common in these situations, when investment bankers begin to explore strategic alternatives, a euphemism for selling the company, a variety of hedge funds caught wind of this activity and started buying shares. By the end of 2013, Family Dollar was under attack.
By last May Carl Icahn had joined the fray. While Family Dollar’s management continued to talk about evaluating options, so-called activist hedge funds were actually in charge of the company’s fate. As Family Dollar negotiated with Dollar Tree, a host of other short-term oriented hedge funds known as event-driven and special situation managers entered the battle. Rather than maximizing the return of long-term investors, these folks were simply out to pocket a quick profit.
Last summer as Family Dollar reached a definitive agreement with Dollar Tree, yet another kind of hedge fund appeared. Merger arbitrage specialists entered the fight. The more conservative among them were only interested in exploiting the difference between Family Dollar’s stock price and Dollar Tree’s bid. However, a more aggressive breed of merger arbitrageurs were attracted by the possibility that Dollar General might be willing to pay more than $76.59 per share. By September a wide variety of piranhas were feasting on Family Dollar, and the stock price was above Dollar Tree’s bid.
Smart money is wrong
Many of the smartest hedge fund managers in the world were convinced that they could get $80 per share or more. Although they aren’t household names to retail investors, Och-Ziff, Elliot Management, Highfields Capital, and Pentwater Capital became the largest investors in Family Dollar. While Levine and his family and other long-term shareholders will make hundreds of millions of dollars, and while the activist shareholders will pocket a handsome payday, some of the smartest hedge fund managers in the world will wind up with losses. For example, Elliott Management, managed by billionaire Paul Singer, appears to have purchased stock at above Dollar Tree’s purchase price in the belief that Dollar General would eventually win with a bid north of $80 per share.
Elliott Management went so far as to demand that Family Dollar replace most of the members of its board so that company would walk away from its agreement with Dollar Tree and pursue a deal with Dollar General. Despite its great intellect, Elliott Management appears to have completely misanalysed the antitrust obstacles to merging Family Dollar into Dollar General. In short, the smart money can get things completely wrong.
This spring Family Dollar will merge with Dollar Tree. For a while, Family Dollar will operate as a subsidiary. However, at some point, the combined company will run into headwinds (bad luck), and the hedge funds and investment bankers will be back.
Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/