Xperi-menting with premortems 🔮
Why and how you should do premortems. Why and how Metis Ventures bid on Xperi.
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One of the highlights from my Spring semester was spending twelve weeks in Mauboussin’s class, and since I tend to internalize learnings post factum, I’ve decided to muse out loud on some of the topics that piqued my interest over the last few months. Today we’ll talk about premortems and the closely related prospective hindsight.
In keeping the trend with spotlighting recent M&A (non-)activity, we’ll use Xperi as a case study. The company earned a mention here (drew the short straw) in large part (exclusively) because while finalizing its merger with Tivo, it received an offer from its former CEO to acquire the business (ex-Tivo). Without going too much into whether the merger makes sense, we’ll take a deeper dive into the assumptions made by the new bidder and propose some counterfactuals to bring our premortem analysis to life.
Premortems 🔮
The method was developed by Gary Klein as a tool for risk-identification, helping teams surface important and sometimes path-critical issues apropos proposed projects that may otherwise go unnoticed. Drawing on the 1989 paper “Back to the future: Temporal perspective in the explanation of events” by Mitchell, Russo, and Pennington, the premortem method leans on the author’s conclusion that prospective hindsight increases the ability to correctly identify reasons for future outcomes by 30%. The paper found that “explanations for sure events tended to be longer [and] to contain a higher proportion of episodic reasons.” Applying this to practice, premortem proposes the following (adapted from Mauboussin):
Prepare
Imagine a certain fiasco
Generate concrete reasons for failure
Consolidate the lists
Revisit the plan
Periodically review the list
The process works because it reframes the problem and creates psychological safety among the group to bring out individual concerns. If everyone is on the red team, people are less likely to withhold views that disagree with the highest-paid individual in the room. The exercise is geared towards team decisions, but since I’ve furloughed my interns due to current events, you will have to make do with my solo work below.
As a cautionary note, Klein, along with two Columbia professors, published a 2019 paper (the title is a work of art) outlining the misuse of premortems in investing. The piece presents a case study of a failed premortem and provides outlines for conducting the process more effectively.
Target 🎯
Xperi (fka Tessera, which is how I will refer to the business pre-DTS acquisition) creates, develops, and licenses audio, imaging, semiconductor packaging, and interconnect technologies. The company owns IP for chip packaging, and (with 2017 acquisition) the DTS codec, as well as related audio solutions. While the product licensing (DTS, HD Radio, IMAX Enhanced) revenue has remained relatively flat, semiconductor and IP licensing revenue slumped from $206M in 2017 to $82M in 2019 (with the slump in part due to Samsung settlement and license agreement executed in 2018; S&IP bookings remained flat around $200M).
Founded in 1990, Xperi grew its business through licensing chip packaging technologies to manufactures like Samsung and Intel and feverishly defending its IP throughout countless litigations. All that litigation earned the company mention on BIs 2012 Most Fearsome Patent Trolls list. Or, as Roy Kaller put it:
“[Xperi] Tessera – Licenses their portfolio of semiconductor packaging and imaging technology patents. Their continued revenue growth requires them to acquire and author new patents to replace portfolio patents that expire or are determined to be invalid by the courts or government patent offices. Companies like Tessera, Rambus and Patriot Scientific are not so affectionately referred to as patent trolls in the industry. They don’t have much in the way of a sales force, but they are expert intimidators and litigators.”
Fighting it out with activists
The company was going about its merry way until Starboard Value started poking around circa 2012 and decided it wanted to nominate new candidates for the company’s Board of Directors. After initial discussions with management, Starboard opted to retreat and allow Tessera, as it was called at the time, time to execute on its existing strategy. However, by December 2012 the investor’s patience grew thin and, armed with a 6.0% equity stake, Starboard delivered a letter to Tessera nominating Tudor Brown, George Cwynar, Peter A. Feld, Tom Lacey, George Riedel, Jeffrey C. Smith and Don Stout for election to the Board at the 2013 annual meeting. Starboard’s involvement was driven by:
Tessera stock significantly underperforming NASDAQ Composite and PHLX Semiconductor indices
Revenue declining 22% over the trailing three years, while expenses grew 40%
Company’s dismal performance redeploying earnings from core business into early-stage technologies
Poor margins compared to other IP licensing peers (34% Tessera vs. 70% closest comp)
In short, “you see all that money you’ve spent on early-stage tech and excess overhead? It’s time to pay the piper.”
The really colorful stuff was brought to light in Tessera’s public response to Starboard dated March 4, 2013. In the true spirit of 2010’s activists, Starboard went after Robert Young (then CEO) for “possible improper misconduct” involving “an inappropriate relationship with a female employee of the Company.” Here is Starboard’s Tessera investor presentation that illustrates their views (sans personal attacks on Young).
After a handful of maneuvers (expanding board size, replacing Young with Richard Hill as the Interm CEO, and an aggressive public campaign), Tessera settled with Starboard Value and announced Thomas Lacey (one of Starboard’s BoD nominees) would lead the company as CEO going forward.
Over the next two years, Lacey and the new board delivered on Starboard’s vision and expanded EBITDA margins from mid 30%’s to low 70%’s while growing revenue to high $200M’s. As revenue growth stalled, the board began evaluating other avenues for value creation, ultimately landing on DTS.
(Aside: around this time, Tessera also began describing their licensing fees as recurring revenue which naturally (and appropriately) drew skepticism because “recurring revenue” ≠ “Recurring Revenue”)
Acquiring DTS
DTS Inc develops and licenses multichannel audio technologies that compete primarily with Dolby Digital. The format made its debut when Speilberg used it for Jurassic Park in 1993, driving over 1,000 theaters to adopt the technology. The company has since exited the cinema business but maintains a presence in home audio/video, digital media, and (with 2015 acquisition of iBiquity) HD Radio. While it effectively controls the HD radio market, DTS sound format is lagging adoption where it matters most -- streaming (e.g., Netflix and most other streaming services use Dolby Digital or DD+ for surround sound).
Tessera acquired DTS in 2016 for $946M, or 28.1x LTM EBITDA, with RBC providing some $600M of debt to finance the transaction. Shortly thereafter Tessera announced the name change to Xperi, and within two months from that, Lacey informed the board of his desire to retire as CEO. Jon Kirchner, formerly CEO of DTS, assumed the CEO role of Xperia in June 2017.
(Pending) Merger with TiVo
In December 2019, Xperi announced that it would merge with TiVo in an all-stock deal that values the combined business at nearly $3B. Investor presentation here.
TiVo initially hired LionTree to evaluate potential strategic transactions in 2018, and after approaching 50 counterparties (27 strategics, 23 financial), it received nine preliminary offers of varying flavors (buyout, carveout, minority convertible pref stock). TiVo was in the midst of its own patent litigation dispute at the time (and still is), and the board ultimately felt that offers on the table did not adequately reflect a potentially favorable outcome — its difficult to provide a contingent upside to selling public shareholders. Other offers gave less in terms of certainty.
Meanwhile, in late 2018 Xperi started a process to sell its IP licensing business. The bids fell short of expectations due to “none of the potential buyers ascribing a valuation to Xperi’s IP licensing business above its cumulative existing under contract net cash flows.”
In June of 2019, TiVo got in touch with Xperi to discuss a potential transaction regarding TiVo’s IP licensing business. The conversations evolved over the second half of the year, and the two companies agreed to a merger of equals-ish deal where (i) TiVo shareholders would receive a slight majority of the combined business, but (ii) go-forward C-suite and BoD would be comprised mainly of Xperi members. That deal was publically announced in December 2019 and was well documented. (WSJ, Bloomberg, proxy statement)
And then Tom Lacey decided he wanted another shot at the company…
Bidder 💰
On February 21, Xperi board received an offer from Metis Ventures to acquire the company for $23.30 per share (33% premium to the 30-day average prior to proposal; 11% premium to Xperi’s price before the announcement of the TiVo Transaction). Despite strong wording (I’ve seen LOIs softer than this), the proposal was obviously non-binding, and the Xepri board decided it was not worth pursuing further.
Metis Ventures is the name of the firm formed by Tom Lacey and Amir Ansari. It doesn’t appear that the firm does anything else or whether it contemplated other potential investments. Evidently, Lacey was less than pleased with the stock tumbling from mid-$30’s to low-$20’s (pre-COVID), though it’s difficult to tell whether he actually had any skin in the game (last time he had to file Form 4, in 2017, he held 231k shares). Ready for another shot on goal, he got together with Ansari and raised some funding to bid on Xperi.
While it’s unclear if anyone else is sharing in the equity ticket, Metis received a debt commitment letter from Method Investments for $1.5B. Method describes itself as a quantitative asset management firm with capital markets and advisory capabilities. Based on LinkedIn employee titles, the firm also offers family office advisory services. AUM is not listed.
The debt commitment in excess of original TEV is notable. Analysts note that it’s unlikely that Metis would launch a hostile bid and go directly to the shareholders, so the extra debt commitment gives Lacey flexibility to improve the proposal.
As it stands, Xperi’s Board decided not to engage with Metis, and with the TiVo vote approaching on May 29, 2020, Metis is yet to improve its offer (or provide additional information to assuage the Board’s concerns).
Offer 🖋️
Announcement date: February 2020
Equity Value: $1.23B ($23.30 per share)
Enterprise Value: $1.46B
26.2x EV / TTM EBITDA
6.5x EV / NTM EBITDAAcquisition Debt: $1.5B debt financing committed by Method, potentially paving the way for Metis to increase its offer
The typical shareholder lawsuits: Discussed here, the two lawsuits filed focus primarily on insufficient disclosures relating to the TiVo merger, Metis offer, and impact of COVID-19 pandemic on the proposed transaction. The Board makes an effort to address some of those concerns ibidem.
Premortem 📝
The fact that it doesn’t appear Metis will up their bid, fortunately, does not prohibit us from conducting an illustrative premortem. So we begin with the premise that the Metis buyout of Xperi has failed catastrophically, the Method investors are clawing at the collateral, @KayeWiggins is drafting a post-mortem, and the fine folks at Petition11.com already selected a meme for the piece headlined “Special Edition: Failed Xperi-ment.”
What went wrong?
Despite the aforementioned furlough, my interns decided it was in their best interests to cooperate with this piece and offered to share their perspectives on why the plan failed. These will, by design, be more radical than the typical items included in the “Risks” section of most IC memos. When discussing in a group setting, each person lists a single reason per round.
Value of IP drops significantly
— Dolby continues to secure its market share across streaming platforms, DVD sales (which include DTS formats) continue to fall
— Open-source format for audio processing emerges
— Internet streaming, with the advent of 5G, overtakes HD RadioCustomer loss
— Loss of key customer may catalyze a domino effect; if one customer can find an alternative solution, others may followExecution challenges
— “Catch-all” for managerial blundersCaught up in resource-consuming litigation
How can we mitigate these risks?
Once the cumulative list of potential reasons for demise is laid out, everyone contributes suggestions to avoid or mitigate the risks. A non-exhaustive list, in no particular order.
Strengthen relationships with manufacturers
Promote DTS/IMAX Enhanced formats with the creative community
Develop new relationships with streaming platforms
Offer incentives to lock-in longer-term contracts
Lead the effort in opensource audio processing, adjust the business model to focus on services, proprietory modules, and training
Aligning management incentives
Putting it all together
Had we been working on the proposed investment, the next step for the deal lead would be to revisit the original plan. Drawing on the insights gleaned from this exercise, the team can adjust diligence plans, identify potential weak spots, consider structures to protect the downside (less relevant in public-to-private), tailor the 100-day plan, and, if needed, adjust the purchase price.
Post-transaction, the portfolio team should periodically review the list, make adjustments
Learning from the mistakes of others
If you are having trouble visualizing failure, a great way to work that muscle is by learning from the mistakes of others.
“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”
— Charlie Munger
Determinants of bankruptcies in leveraged buyouts: previous bankruptcies, public to private, and younger companies are more likely to go through bankruptcy post-LBO; secondary buyouts, privatizations, and cross-border transactions less likely
Anything on TXU (FT, NYT, Matt Levine): stay away from energy
Edward Bodmer has written about failed project and corporate finance investments: you’ll have to do some digging for the relevant cases
Just Google “failed LBOs”
Promortem 📊
More recently, Klein has also advocated for the use of pro-mortem analysis, which is precisely what it sounds like. Here you visualize success and work backward to imagine what happened in the process to bring you there. The goal is to list specific items that will be different between now and your set time horizon. While the post-mortem is very close to traditional goal-setting methods, it brings with it some fresh perspectives on the task:
The analysis begins with the certainty of success, not what you would like to see happen
Focus on observable outcomes, not aspirations
In line with the premortem framework, team members work in parallel to develop their lists and present items one at a time, providing an aggregation mechanism for independent views
While this is not a far stretch from how private equity firms organize their post-acquisition initiatives, it can help prioritize competing resources (attention) and enable better execution. In my experience, much of this is already being done at the subconscious level, mostly through pattern recognition. A fund sees a deal that resembles a successful investment from its recent past, and the VP/MD brains start spinning on how they can apply the same playbook to the new deal. (NB: eager Associates and VPs enthusiastic about a particular new opportunity will occasionally try to frame the deal in close comparison to firm’s successful investments (seller dynamic, product opportunity, market tailwinds, etc) to get Partner buy-in to dig deeper). Having a more systematic approach, like the promortem, can help investors better organize collective views and evaluate the feasibility of their plans.