June 6, 2022 | Updated | One of the downsides of the era of technology is that people tend to lose the ability to discern when a data point displayed on a screen is clearly wrong. We don’t code or compute by hand any longer, instead we have automated tools that display metrics. The world of finance, with all manner of derived metrics, derivatives and outright frauds, is a forest of opaque indicators and misleading signs.
As a result of the adoption of "artificial intelligence," the 21st Century investor is mostly a victim in waiting. We bide our time before the next convulsive shift in politics or monetary policy turns the idealistic speculation of today into tomorrow morning’s road kill. No amount of warning or protestation prevented millions of people around the globe from losing big in crypto or aspirational stocks. And there were no metrics visible to retail investors to warn of the reversal. The risk is lost in the fog of complexity.
Leaving aside the surreal but rapidly fading world of pretend currencies, the supposedly “real” work of investing in stocks and bonds also is rife with problems of definition and transparency. Vendors such as Bloomberg LP and S&P's Capital IQ provide investors with lots of data and metrics, but they rarely display how the metric was calculated from, say, a public company’s financial statement. Most vended financial data, let’s keep in mind, is hearsay evidence that has been consumed and “adjusted” so that the vendor may claim ownership, breaking the fidelity with the public record.
The result of errors in calculation and/or presentation, however, can also allow issuers of securities to mislead investors. Just because the presentation of the data is allowed under GAAP or industry convention does not mean that it is not misleading. Whenever you simplify a piece of data by aggregating it into a derived metric like a P/E ratio or price multiple, fidelity and context is lost. And all too often the presentation of value is incorrect because the global providers of financial data are ignorant of context and the always moving target of GAAP accounting as interpreted by accountants and lawyers.
Let’s take the question of calculating a very basic metric, namely the book value of equity. This is one of the most important measures in the global equity market but also one where changes in convention and presentation can mislead investors. One of the more significant issues we’ve noticed in our work of late at The Institutional Risk Analyst is the “non-controlling interest,” a once de minimis line item that has become more and more relevant in recent years as private equity investors defend their entitlement to double-digit equity returns.
If you search on the SEC’s EDGAR portal, the term “non-controlling interest” appears in quarterly (10-Q) and annual (10-K) reports more than 10,000 times over the past five years, in most cases appropriately so. The convention in the world of data and analytics is to exclude this item from the definition of equity and that is mostly the correct approach. The result in some cases, however, is understating the actual capital of the enterprise and overstating all of the metrics derived from capital.
Take, for example, Rocket Companies (RKT), the owner of Quicken Mortgage. If you look at Yahoo! Finance, the market capitalization is shown as $1.1 billion and the price to book value multiple is shown as 1.85x. But this is clearly wrong. Not only is RKT trading at a discount to recent values like the rest of the mortgage industry, but it is trading at a steep discount to the 30x book value shown on Bloomberg. Let's see, $16.8 billion MVE / $8.7 billion BVE = 1.93x book.
We asked one of the leading Sell Side research analysts in the sector to explain why the metrics shown on Yahoo! Finance and Bloomberg are wrong:
”The issue is that Bloomberg doesn’t include the “non-controlling interest” line item in total equity which distorts the price to book value multiples. For example, RKT has $8.7B of total equity but $8.2B of it is ‘non-controlling interest’ so Bloomberg uses $0.5B of equity as the denominator which increases the price-book value multiple.”
Likewise in the case of United Wholesale Mortgage Corp (UWMC), the 46x price-to-book value multiple shown on Bloomberg is clearly wrong. Let's see, $6.4 billion / $3.1 billion = 2x book. But the real issue is the distortion caused by the GAAP accounting.
The relevant section of UWMC’s most recent 10-Q is shown below. Notice that of $3.2 billion in total equity underneath the company, 99% of UWMC’s capital is somehow considered a “non-controlling interest.” And do notice all of the different classes of preferred and common stock in the UWMC capital structure.
UWMC
Obviously the derived calculation on Yahoo! Finance of 2.6x book value is in error. The same number on Bloomberg, BTW, is 45x book for UWMC, again very obviously wrong. But how could these two big time data shops fail to get this right? Easy. It is not just the calculation but the business context that matters.
The challenge for Bloomberg, Capital IQ and other data providers and also the SEC, is more subtle in this case than simply accounting. In the age of QE, the accountants, lawyers and bankers have contrived a structure for public offerings whereby you hide the majority of the equity of an issuer behind a legal façade of “non-control.” This legal fiction obscures the true economic capital of the enterprise.
The presentation of non-controlling interests found in many SEC filings today is the functional equivalent of Jim Fisk and Jay Gould manipulating a stock with a hidden investment pool 150 years ago, but it is permissible under GAAP. If you are the head of analytics at Bloomberg, for example, how do you decide when a company’s use of a “non-controlling interest” classification in its equity account that is allowable under GAAP is nonetheless misleading to retail investors? Let’s look at another example, namely Switch Inc (SWCH).
As of Q1 2022, the company reported $338 million in total Switch, Inc. stockholder equity, a $287 million non-controlling interest, and total stockholders equity of $625 million. Bloomberg shows SWCH at 14x book value vs an $8.3 billion market cap. Is this right? If Bloomberg was true to form and used the $338 million for the book value calculation, then the answer is no. Half of SWCH's equity is hidden from view.
In fact, the “non-controlling interest” is created from the inception of the corporate structure, and is true equity in the business and should be included in total equity for calculating all metrics for investors, particularly retail investors. But the needs of the private equity community have distorted the world of capital finance to the detriment of retail investors in public equities.
A retail investor looking at the metrics for RKT, UWMC or SWCH might conclude that these stocks were outperforming other companies in the sector, when it fact the opposite is the case. The fact that Bloomberg, Capital IQ and other data vendors post these erroneous metrics and the derivatives therefrom should draw the attention of regulators and members of the trial bar.
Part of the reason that many public companies have chosen to misstate their financials via “non-controlling interests” is the use of the umbrella partnership - C corporation structure (“Up-C”). This is an indirect way for an operating partnership to conduct an initial public offering (“IPO”), notes a 2019 Mayer Brown comment. Essentially fund investors use the non-controlling interest strategy to boost short-term share valuations by concealing the true float of the issuer.
“Private equity-backed and venture capital-backed companies generally favor the Up-C structure because these financial investors often use flow-through entities to hold their interests in portfolio companies. The Up-C structure is a convenient tool to offer the portfolio companies’ shares to the public through an IPO,” notes Mayer Brown.
Up-C derives its name from the Up-REIT structure, widely used by real estate investment trusts since the 1990s. An Up-C is composed of two entities: the parent company, which is organized as a C Corporation), and a subsidiary usually structured as a limited liability company or a limited partnership.
By manipulating the presentation of the equity interest in the public company, the private partnership can make the public entity look more attractive to investors than its true fundamental performance dictates. That seems to be the explicit intention of the owners of RKT, UWMC, and SWCH; to conceal the true equity capitalization of the enterprises to make metrics such as price-to-book and return on equity appear superior until the private investors cash out.
Naturally the Up-C structure has been particularly popular among private equity investors in recent years, who seek to maximize short-term equity returns over long-term performance. By allocating capital to early investors and advisers higher up in the capital structure via different classes of common or preferred stock, the partnership can manipulate the timing and size of equity returns taken by insiders in the public markets. And all of this is permitted under GAAP and SEC regulation.
Remember, there are literally dozens of other examples of public companies that have used the rules of GAAP and the SEC’s Reg SX to distort their financial statements under the canard of non-controlling interests. Since the SEC long ago mandated XBRL data tagging for Form 10 filers, all that SEC Chairman Gary Gensler needs to do is ask the question. How many filers of Form 10’s have reported a “non-controlling interest” that is > 10% of the total stockholder equity of the enterprise?
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