This morning, Vectura, a UK pharmaceutical business specialising in the treatment of lung ailments which has developed unique inhaled drug delivery technologies, announced the success of a takeover offer from Philip Morris International, the global arm of the Marlboro cigarette business. Fully 74% of Vectura’s shareholders have accepted a bid around 60% above the undisturbed share price, in spite of the qualms that many had over turning over a pharmaceutical operation to a company whose core business causes the deaths of around half its customers.
While some have called it a greenwashing transaction, it is easy to see a commercial reason for the deal from PMI’s perspective. The company states that it is aiming to go ‘Beyond Nicotine’ and has built a series of inhalation operations, including inhaled over-the-counter and prescription therapies. A cynic might note that advanced inhalation technologies may also be useful for delivering its preferred approach in substituting for declining cigarette demand – the delivery of nicotine through heat-not-burn tobacco products.
It is this apparent attempt to reinvent the PMI business that is the theme of this blog. Given that the world economy must decarbonise over the next few decades, many – even most – company business models will need to be wholly reshaped. The decision is most stark for the fossil fuel businesses, and the association between PMI’s transition and the oil transition is brought to life by the ‘Beyond Nicotine’ slogan, with its clear echoes of the now largely notorious bid by Lord Browne to reinvent BP as ‘Beyond Petroleum’, while largely maintaining investment across its oil and gas businesses.
The key question is whether such businesses should reinvent themselves or whether they should stop reinvesting except on a care and maintenance basis, and instead run themselves for cash and run themselves down. Should they turn themselves into the living dead, zombie companies? With the need to decarbonise the whole economy, the corporate world may become littered with zombies if that is the route chosen.
Just as with BP’s unconvincing rebrand nearly two decades ago, it is important to put PMI’s ‘reinvention’ into context. The company’s stated aim is to achieve $1 billion in revenues from ‘Beyond Nicotine’ activities by 2025. Its net revenues for the 2020 year were $28.7 billion (deducting the $47.3 billion in excise taxes PMI pays from total revenues of $76 billion). While disclosure does not allow analysis of the different margins for non-nicotine businesses, one assumes that the pricing power enabled by a highly addictive product enables much greater profitability from nicotine than is possible ‘beyond’ it.
If we are to shift the world economy to a low carbon one, the transformation of fossil fuel businesses will need to be more real than this change appears to be. Replacing former businesses with new ones goes to the heart of Austrian economist Joseph Schumpeter’s vision of capitalism as ‘creative destruction’. This sees capitalism as a way to shift money from old and historic activities into newer and more innovative businesses that offer the prospect of greater profits. Money seeks the opportunity to make more money, which will often be in places other than where money has been made in the past. The old and the historic is left to decay, or is destroyed more actively as the new takes its place.
The key question is whether this is best done within individual companies, or whether it is better delivered by those historic companies being replaced by new innovators in fresh business structures. And that gives rise to the key question for the directors of those old businesses: should they be seeking to reinvent their companies, to go beyond whatever their own inheritance is, or alternatively turn themselves into zombie businesses? When faced with directors’ duties – in the UK expressed as ‘promoting the success of the company’ – is it a valid decision to work towards the destruction of the company?
Companies do not have a right to persist forever, and the assumption that they will is in many ways an odd one. Indeed, the original companies were established for limited periods, covering single trading journeys, the creation of specific infrastructure, or for terms fixed by an arbitrary number of years. Even when the law changed so that they were no longer limited by time, the role of each company was constrained by the objects clause in its constitution, which tied the business to a certain set of activities. Careful legal drafting of objects clauses made these constraints obsolete even before the 2006 Companies Act swept them aside altogether. But whether it is right – economically coherent and in stakeholders’ interests – that companies should be free simply to reinvent themselves is another question.
The discipline of the objects clause, which could only be changed with the voting support of a super-majority of shareholders, had a real value. Shareholders being able to express a clear view before the nature of their business is changed beneath their feet is powerful. After all, not every transformation works or adds value. Many investors still bear the scars from the transformation of the UK’s GEC into Marconi through selling off its aerospace and defence businesses and becoming a pure telecoms equipment business. Deals at the height of the dotcom bubble led to a spectacular business failure. This is but one particularly painful failed transformation that greater constraints on reinvention might have prevented.
This cannot be a call for ossification. The flexibility for companies to persist and to change has had huge benefits. It is one of the theses of Duke professor Timur Kuran’s persuasive and remarkable The Long Divergence that the restrictions of Islamic commercial structures are one of the main reasons that European economies were able to overtake the Middle East’s former business leadership between 1000 and 1800CE. The greater flexibility of corporations under European legal systems, and the growth of the banking sector, enabled developing business models and the build-up of capital to reinvest into the necessary changes. But clearly the flexibilities of modern banking and financial services mean that we face little risk of economic stagnation even if individual companies are hindered from reinventions.
With responsive investors, creative destruction can happen as readily through the creation of entirely new companies as it occurs through the repurposing of existing businesses (and, to be clear, I would classify the relaunch of cash shells as the former rather than the latter). Think electric vehicles: it is far from certain that Tesla and its fellow new electric insurgents will win out against the incumbent manufacturers, but it is clear that there is a good deal of creativity going on, as well as plenty of destruction of prior business models.
Fair use of shareholder funds?
As some of my new colleagues have pointed out, reinventing a corporate business model is a risky activity, and shareholders should want to see that they are properly compensated for shouldering that risk. The ratings of the incumbent carmakers suggest that the market does indeed derate transitioning businesses such that this risk is at least in part priced in. That protects investors from some further downside, but it does not guarantee that there will be none, and nor does it mean that investments into new businesses will be money well spent. It is far from certain that incumbents will have a competitive advantage in the new business lines they seek. Further, the urgency of the need for transition – and the application of arbitrary timelines and targets (such as PMI’s $1 billion revenues by 2025) – increase the risk of overpayments for acquisitions and misallocated capital.
It turns out it is indeed possible within directors’ duties to dismember a company and bring its existence to an end. When challenged to come up with examples of companies that have in effect run themselves down, rather than involuntarily failed, the one that comes to my mind is Old Mutual PLC. The South African insurer in 1999 became a dual-listed entity, with linked corporations in South Africa and the UK, using the London arm as the base for a series of acquisitions. The tacit aim appeared to be geographical diversification away from Africa. By 2016 this geographic expansionism was seen not to be in shareholders’ interests, and through a process of ‘managed separation’ Old Mutual PLC tore itself to pieces, selling off the US operations, and demerging the UK wealth business and the bulk of the South African bank. The rump of Old Mutual PLC has now been subsumed as a largely dormant subsidiary of the continuing Old Mutual in South Africa. Through many discussions with the PLC board over this time, it was clear that their decision-making was not in any way constrained by concerns about whether dismembering the company was a fulfilment of their duty to ‘promote the success of the company’ but rather they saw their central challenge as being how to keep and motivate the central team to the end of a process that would inevitably lead to their losing their jobs.
So it can be done. Carbon Tracker has done some typically great work on how run-down of businesses may actually drive greater returns for shareholders than continuing to pursue investment in lower returning assets (their 2014 report on ExxonMobil is a great example). And the argument that winding down fossil fuel exposure is within directors’ duties is even stronger, for the UK law definition places promoting the success of the company in the context of shareholder interests, and also the interests of broader stakeholders – explicitly including “the impact of the company’s operations on the community and the environment”. Thus, where there is a clear environmental interest in the ending of a business model, it may be easier to explain such a move as being fully consistent with directors’ duties.
The zombies already among us
The boundary between involuntary failure and run-off is not as clear as might be assumed. A number of the retailers that have failed on both sides of the Atlantic in recent times were taken into private equity (or other private) hands and run for cash. Typically, the first step of this process was to load the companies with high levels of debt, and their failures came when the declines of the businesses in the face of the shift to online trading (and often, long-term underinvestment) meant they could no longer sustain their significant debt burdens. Private markets always tend to value low-growth companies – of which zombies would be a particularly extreme form – much more highly than public markets have, largely because of this scope to gear up their balance sheets to levels which traditionally companies with public traded shares have always baulked at.
In many ways this may be what the future of the fossil fuel business looks like: taken into private hands, loaded with further debt so that they have in large part paid for their own takeovers and the equity financing is skinny. This juices up the private returns while reducing risks for the owners. Run for cash with maintenance minimised, they will become zombies. And they will fall over when the change in the world economy means that they can no longer prosper from the public subsidy that comes from being able to externalise the costs of their carbon footprint onto the environment and wider society.
In effect, a number of such zombies already walk amongst us. The US unconventional oil business already looks very like this, with most of its financing coming from the higher yield end of the debt markets. Equity markets increasingly are dominated by lower carbon tech, financials and healthcare businesses (summing to around 46% of the MSCI ACWI, for example), with energy and utilities each only about 3% of the indices. In contrast, debt markets, particularly in the US and particularly in high yield, are much more skewed to energy, utilities and basic industry – typically collectively more than 20% of US debt makets – with commensurately greater carbon footprints. Energy is the largest sector in US high yield, driving typical carbon footprints of portfolios invested in these markets above 450t CO2e/£m invested, in contrast to the nearer 150t CO2e/£m invested in the MSCI ACWI. This tripling of the carbon intensity is the footprint of the zombies already among us. From my discussions with asset owners, these zombie companies will face increasing refinancing risks.
Many in the ESG investment community worry about the sale of fossil fuel businesses to private holders. Perhaps they need not worry so much: potentially, this is the destruction side of creative destruction in action; it is these businesses entering their living dead zombie phase. These companies will fail, no matter who their owners are, if the governments of the world take the right policy decisions and move to make the world economy shift from its fossil fuel dependency. As we know, COP-26 in November is the crucial moment for this to happen.
However, if the signals from our politicians are unclear and the shift does not happen rapidly, then the zombies will be with us a while longer. But the simple inevitability of a shift to a lower carbon world, including a carbon price in one form or another, will lead these zombies to stagger more quickly under the weight of their debt finance – particularly as mainstream investors become increasingly queasy about funding them.
Ensuring fair process
One of the things that some less scrupulous private equity players or other private investors have profited from is an arbitrage between the strict legal requirements and the moral and reputational standards which public companies feel the need to espouse. Any world of the living dead may need to have stricter legal requirements, and stricter enforcement of them, in order to ensure that moral expectations are not avoided.
This may be critical to minimising the collateral harms of these business failures when they inevitably come. In the absence of such greater legal protections, we may see more profits struck while workers’ pensions are denuded, worker pay and benefits cut, and governments bilked of taxes due. Particularly critical legal constraints for fossil fuel businesses will need to be the proper funding of care and maintenance capex, and of the remediation of sites after extraction ends. Both costs must fall on the businesses that have profited from their damage (and their owners if need be) rather than falling to taxpayers to cover. Given that analysis of company accounts indicates that remediation costs continue to be postponed far into the future even while the urgency of the carbon transition grows, there is an increasing risk that not enough money has yet been put aside to cover these costs.
The zombies, if that is what the world’s fossil fuel businesses become, must be required to tidy up their own mess, and not allowed further to offload the burdens onto the shoulders of society. Engagement surely has a significant role to play here, in encouraging companies towards the zombie phase, and then in keeping them on the public markets while they are undead. If they remain on the public markets, accountability and transparency will be greater and the world will have greater assurance that these companies are doing the right thing and playing fair.
PMI, for one, seems determined not to become a zombie. Only time will tell whether that’s the right decision for its own shareholders – or for Vectura’s.
The Long Divergence: How Islamic Law Held Back the Middle East, Timur Kuran, Princeton University Press, 2010
Response to Exxon: An analytical perspective, Carbon Tracker, March 2014
Flying blind – The glaring absence of climate risks in financial reporting, Carbon Tracker, September 2021