Politics meets Wall Street

May 15, 2006

Politics Meets Wall Street

Occasionally we come across magazines or articles which are truly unique in their slant on events. Reading a recent issue of the, "The Deal," we came across the article below. Along the way to making its own claims about the effects of the "Jobs Act," a number of their "off point" comments bear emphasis.

In short, the author laments the 2004 Jobs Act failed to generate "mergers and acquisition" (M&A) activity. He founded an investment bank specializing in M&A, making us wonder if his hammer is lamenting a lack of nails?

It has been our long-standing belief M&A is the polar opposite of creating jobs. Quick, name any merger or acquisition where they needed to add jobs! When H-P bought Compaq, didn't they cut thousands of jobs? When Oracle bought PeopleSoft, didn't they immediately announce 5,000 job cuts?

If M&A was really expected to be a by-product of this jobs bill, did its supporters really think ANY net jobs would be created? Or was it all a cynical manipulation?

Below was hand-typed from the physical article the magazine's web site is "under construction." Any bad grammer (besides the run-on sentences) is our mistake. All emphasis was added.

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Mr. Politics, Meet Ms. Wall Street

The 2004 Jobs Act Has Neither increased jobs - Nor M&A

Of the myriad tax bills to emerge from Congress over the past few years, the ambitiously (some would say misleadingly) named Jobs Creation Act of 2004 provided a temporary change in U.S. tax policy that allowed U.S. Corporations with profitable foreign subsidiaries to temporarily move those profits back to the U.S. at a lowered tax rate of 5.25%.

Although a U.S. company is taxed on its profits regardless of the place where profits are generated, if the company earns profits through a foreign subsidiary, it doesn't pay taxes on direct profits. Instead, the taxes dues are the difference of the higher U.S. tax rate and the foreign rate (with tax credits given if the foreign rate is higher) and the taxes are due only when the profits are repatriated as a dividend back to the U.S. parent. In other words, if the money stays off-shore, then the taxes due on the difference between the foreign (let's say 10% rate) and U.S. tax (let's say 35% rate) is deferred - possibly forever.

As a result, some classified these foreign-held funds, estimated at over $470 billion as "trapped" overseas. Traditionally, these monies have been used to fund foreign operations and investments by the ultimate U.S. parents.

Didn't the headlines assume some humungous figure ($470B?) would be pumped into the US economy by our heroic politicians?

In 2003 Congress got involved, partly as a result of an EU -U.S. trade dispute, partly due to an atmosphere of support for tax cuts for multinational corporations. (Oh really? Do you remember feeling sympathy for multinational corporations. Maybe we need to talk with these news outlets here in California.) The act temporarily allowed deferred dividends to come into the U.S. if used for investment purposes but capped the tax due at 5.25% of the difference between the U.S. and foreign tax rates. The proposition was that instead of investment in foreign countries, the "new" money would be invested in the U.S., in the form of new plants and equipment, which would generate jobs. Lawmakers also expected the act to result in increased mergers and acquisitions. Right? Wrong.

OK, the jobs part we recall. Anybody besides us drawing a blank on the mergers and acquisitions part?

First, the politicians incorrectly assumed corporate America wasn't already using this "new" cash. Most of the economists who weighed in on the issue concluded that although the premise of deferrals provides an apparent incentive for companies to use the deferred profits toward overseas investments, it's not actually the way companies make decisions about international investments.

Funny, we didn't hear any companies jumping to explain they didn't need this tax break.

According to an article published last year in the National Tax Journal by Harry Grubert of the U.S. Treasury Department, "Once the capital is abroad, repatriation taxes have no impact on the firm's decision whether to repatriate earnings in the present or to instead reinvest them abroad."

Didn't anybody think to ask?

Applying theoretical models and empirical data relating to the cost of capital, investment yields, local and foreign taxes and potential investments and repatriation strategies, economists examined the ways that multinational corporations actually moved around investments. They concluded that there are multiple strategies to yield the "equivalent of repatriation, i.e., getting cash to the parent, without incurring tax costs of repatriation." Simply put, the treasury departments of corporate America figured out how to "free" the trapped money when they saw fit.

As a consequence, economists predicted the since the repatriated cash is pretty fungible with the existing cash of a company, the "new" cash will likely be used for paying down debt (as several have announced) or for already planned investments, allowing "old" cash to be paid out as dividends. (Where are "new jobs" on this list?) While there might be a temporary bump in repatriated cash, mature companies already had plans involving when and which cash they would repatriate, so that the impact of the act will cause a decrease in repatriated cash for several years, followed by a normalization. As it turns out, a position counting all those new jobs created may not be such a good career after all.

Just like all the tax cuts and stop-gap measures applied over the last five years by the local drug pushers (err, politicians), they're passing out a short-term fix that will be paid back in future years. There is no free lunch!

Additionally, since the companies had access to their cash all along, the idea that the "repatriated cash inflow" will cause M&A activity seems probably without merit. M&A activity correlates more closely with equity market valuations than with cash on hand. Since 2000, the equity market valuations of publicly traded techno9logyu companies dived from almost $4 trillion to less than $2.5 trillion, then back up to $3.3 trillion at the end of last year. Still down 18% from the end of 2000. During that same time period, the amount of cash (and short-term investment) held by technology companies rose by 60%, to $462 billion, from $289 billion. What happened to M&A? Did it also increase by 60% over the same time period? Nope, it was down 71% on deal value and flat (up 2%) on deal count. Alth9ough one could spend a lot of time on regression analyses on the available data, the clarity of the overall truism is crystalline - M&A tracks the equity market valuations much more closely than available cash.

At the risk of stating the obvious, who would ever pay actual cash when they can instead print up some extra stock and give that away instead? The "trick" is the stock has to be high enough so that they don't print so much that their (non-insider) shareholders start to notice. And there are signs non-insiders are starting to notice all the printing...

According to a major company CFO roundtable, there may be negative tax consequences of using repatriated money for substantial M&A activity.

Therefore, while the Jobs Creation Act of 2004 may have made some political careers, it's not going to be the cause of an increase in M&A. It's the economy, stupid.

Eric Gebaide is a managing director of Innovation Advisors, a global investment bank he founded in 2001 to provide mergers-and-acquisitions and private-capital-raising advisory services focused on the technology industry.