As a capital allocation decision, share buybacks intersect all three of the main corporate finance activities of investing, financing, and dividends[1]. Buybacks continue to be very divisive, evoking comments like “derangement syndrome” by Cliff Asness, “economic illiterates” by Warren Buffett and “paper manipulation” by Sen. Warren. One of the deep-seated reasons for the splitting of opinion is that share buybacks transfer wealth between shareholders[2]. In this article we consider the board’s responsibly to balance various factors whilst we keep our primary focus on the implementation process of these different buyback rationales.

Part of the board’s responsibility is to ensure capital allocation decisions are made with a rationale founded in creating good long-term total shareholder returns. The board needs to manage the conflicts between the agents, the principals and indeed between the longer and shorter-term shareholders within the principals. All these different actors can get impacted in various ways depending on both the rationale and the circumstances in which a share buyback gets implemented.

Different Buyback Rationales – and Their Implementation Objectives

We will consider each of the three corporate finance-based rationales for buybacks, being investment, capital restructuring and excess capital return or dividend. However, these three buckets are interconnected, a share buyback for the purpose of returning excess capital to shareholders, will also affect the company’s capital structure and the share price of that buyback relative to the company’s fair value still transfers wealth between the holding and selling shareholder. The point being that although the logic for each of these rationales is distinct, the very act of doing a share buyback influences the whole of the corporate finance ecosystem. The board must consider the buyback and its implementation through all three of these lenses regardless of the primary rationale. With that in mind, what are the key considerations to measure for the implementation of each rationale?

Simplification of Measurement

To design for, and measure the results of, a share buyback implementation we are going to use a very simple equation.

Cash Value of Buyback = Cost of Shares Purchased + Frictional Costs[3]

There are two simple numbers within this relationship that we are going to focus on: counting how MANYshares are purchased, and how MUCH of the value attributed to the buyback is used to buy shares after the frictional costs have been applied.

Cost of shares purchased = number of shares * purchase price (gross price)

Frictional Costs = taxes + commission or broker fee/PnL[4]

There is a relationship between how many shares are purchased and how much of the value of the buyback is used to purchase shares, they are not mutually independent of each other. However, within each rationale below we are going to highlight the dominant metric for the board to focus on.

Capital Allocation Decisions to Create Total Shareholder Return

It has been well argued that some of the best value creating capital allocations decisions that a company can make are to buy back their own shares at very cheap share prices, assuming the company is healthy and well financed of course. William Thorndike’s book “The Outsiders” highlights how some of the greatest shareholder value creating CEOs are capital allocators. They have bought back when share prices were cheap and issued, usually to acquire other companies, when their shares are expensive. The key point here is the share price of the transactions relative to the business’s current valuation really matters.

Buybacks for Investment

Part of the boards job is to be objective on the business’s current valuation. Share buybacks implemented at share prices that are different from the fair value of the company transfer wealth between the buying and selling shareholders. It has been argued that share buybacks based on the current share price being cheap vs the boards current valuation, should be measured in a similar way to any other capital investment, and evaluated on their long-term total rate of return. Similarly, the evaluation of the implementation of a buyback based on this rationale should be primarily based on how MANY shares are purchased for the value allocated to the buyback programme. As with all share buybacks implementation, but especially ones for this rationale, a share price cap is necessary, as the attractive valuation logic, by definition, cannot hold true at all share purchase prices[5].

Buybacks for Financing

A company can alter the debt-to-equity ratio of its capital structure by issuing debt and/or buying back shares. Evaluating the success of the implementation of a buyback, if the company is issuing debt to finance a share buyback is more nuanced. The share buyback and debt issuing funding legs are contingent on each other. To evaluate accurately, it is necessary to consider the whole process more like a ratio, with an understanding of the associated effects on the net income on the company. For simplicity we will limit the key determining factor for measuring the success of the execution of the buyback leg to be how MANYshares are purchased.

Buybacks for Dividends

We find it helpful to think of the buyback mechanics[6] of transferring cash off the company’s balance sheet and returning it to shareholders as being independent to the number of shares and therefore the purchase price of those shares. Consider a company that wants to return $1bn, and that there are no frictional costs or market abuse rules to consider, and the market provides infinite liquidity to trade the shares (we know but humour us please). If the average share purchase price is $50, $100 or $200, then buying 20mil, 10mil or 5mil shares will still transfer the same $1bn to the selling shareholders. In this instance the key determining factor to measure is how MUCH of the value attributed to the buyback is used to purchase shares, and how much is lost to friction. The variable component of friction can be the brokers execution fee if it is linked to the execution performance.

Execution Strategy and Measurement Considerations

Keeping frictional costs constant, the key factor that will determine how many shares are purchased is the average price at which the shares are bought. Share prices move over time and the amount that they move is called share price volatility. The level of a share’s volatility has a direct relationship with how much risk the share price has of moving within a given timeframe. As the share price rises and falls, a constant value spent will buy a variable number of shares. For this reason, once the decision has been made to implement a share buyback programme, then all else being equal, the quicker this risk is reduced, the lower the risk is for the shareholders. As an example of this risk, if the share price was to say double, only half the number of shares would be bought, halving the benefit of the buyback for the residual shareholder.

There are also human biases relating to share price that need to be highlighted. Often the decision makers and the implementation teams are not the same groups of people. The implementation team can fear the risk of being second guessed. If the share price falls after they have bought most or all the shares, they might fear looking like they have done a poor job. This reason is frequently used to explain a strategy known as pound or dollar cost averaging. Dollar cost averaging is rarely critiqued, however here is Cliff Asness on this subject[7] (substitute in the company’s desire to do a buyback in place of the portfolio:

…take dollar-cost-averaging. It’s dumb. To prove that, imagine you were handed two portfolios, one the final equity portfolio you really want, the other all cash. Many, even most, investors wouldn’t immediately buy the final desired equity portfolio. No, that risks massive regret. Not buying any also risks massive regret. But if you average in slowly, perhaps you minimize this regret? But it’s a silly thing to do on just the numbers. For instance, if you were handed the all-equity portfolio you actually ultimately wanted, instead of being handed cash, you would not sell it just to average back in, would you? Of course not. So, the averaging-in strategy is silly.

We rest our case on averaging in[8], however implementing a share buyback in a risk responsible way has degrees of complexity. There are very standard processes for managing these complexities that are part of the every-day process of the professional asset manager community and their brokers. This process involves detailed pre-trade and post-trade analysis of key risk metrics that help manage the trade-offs between the speed at which the risk inherent in the buyback is reduced and balanced with the trading impact costs. What we find worth highlighting is that the processes used by the professional fund managers to execute large buy orders is not replicated in all the processes and products used to implement share buybacks.

For many mid and large cap companies in the UK and EU, share buybacks are implemented using Open Market Repurchases (OMRs)[9]. In the US OMR programmes account for about 90% (by value) with the remaining 10% of programmes being implemented using derivative products called Accelerated Share Repurchases (ASR’s).

ASR’s and a set of execution products, captured within OMR’s, with nicknames such as “VWAP[10]-minus” and “VWAP-discount” all share one troubling attribute in common. They are not designed to support the board’s responsibility to their shareholders. They do not use an execution strategy that solves to maximise how MUCH of the buyback value is used to purchase shares, or how MANY shares will be bought.

These products[11] focus on out-performing an unusual trading benchmark which introduces a share price risk mis-management issue[12]. In addition, the broker fee/PnL structure is at times in direct conflict with how MUCH of the value of the programme is used to buy shares[13]. Another concerning factor is that this unusual benchmark appears not to adjust for the most basic of corporate actions, such as cum-dividend and ex-dividend share price differences and their effect on the corporates per share purchase costs[14].

It is for this reason that boards are advised to pay attention and seek the help they might need from independent equity execution experts. These experts can guide them and help consider all the relevant factors required to match a suitable execution strategy and fee structure for the rationale of their share buybacks. Shareholders are starting to ask more questions about who is taking care of their best interests through the buyback’s implementation process. Those boards that have unwittingly allowed their companies advisors and bankers to help sell them these highlighted products are being found wanting.

Conclusion

When the shortcomings of these share buyback execution products are viewed through the lens of the scale and increased popularity of share buybacks globally the whole issue comes into sharp focus. Candor Partners estimate that 30 to 40% of the $5.6tril buybacks executed by companies in the UK, EU and US over the last 5 years alone are likely to have been affected. These “problem products” have been used to implement share buybacks for over 25 years, and the damaged caused by this leaked value continues to compound with time. It is hard to see how there will not be any consequences as a result. Boards, please take a lead, and action the required changes to seek unconflicted guidance now. If your firm is or has used any of these “problem products” to implement share buybacks, then waiting and following the crowd on this is itself a governance issue.

ENDNOTES 

[1] Prof Aswath Damodaran, Prof of Finance, Stern School of Business: Musing on Markets

[2] M. Mauboussin & D. Calahan, Morgan Stanley IM: Total Shareholder Return

[3] The implementation of a share buyback incurs frictional costs. These costs are taxes and fees (including advisory, legal, execution commissions, broker PnL etc). Companies account for these costs in different ways, however when we refer to the value allocated to the buyback, we include these frictional costs.

[4] Some share buybacks are implemented using execution products that involve the broker guaranteeing certain outcomes, as a result the broker can have a profit or loss (PnL). Seigne and Osterrieder have written extensively on this topic, most papers are published on SSRN, the foundation paper being “The Great Deception”.

[5] 68% of ASR’s have no price cap or collar- Chen, Kai, Press release management around accelerated share repurchases (April 7, 2020). European Accounting Review (2021) 30(1): 197–222, Available at SSRN: https://ssrn.com/abstract=3572543

[6] Seigne and Osterrieder have authored a paper published by the Harvard Law School Forum on Corporate Governance covering some aspects of the governance issues for boards on share buybacks vs dividends as they relate to certain mechanics of buyback implementation.

[7] Cliff Asness co-founder of AQR – The Illiquidity Discount?

[8] A case can be made for averaging if the cash flows of the company are funding the share buyback as it progresses, but this is not the normal case we are considering in this paper.

[9] Open Market Repurchases are executed in many ways including using various types of broker products that can guarantee certain outcomes for the company.

[10] Volume Weighted Average Price (VWAP) is a robust execution benchmark. In the land of share buybacks, the difference with the “unusual” execution benchmark frequently used is the simple average of the daily VWAPs over a trading time frame. Because the benchmark is not volume weighted across days, and the broker has control over the length of the programme, beating this benchmark does not correlate with buying more shares.

[11] All these highlighted “problem products” are sold by brokers who also have an in-depth understanding of the professional asset managers execution processes involving pre and post trade metrices for execution risks etc.

[12] The value to brokers in these products is released if the share price moves away from the benchmark price especially in the later stages of the programmes, this causes the broker to typically trade the share price risk down slower than what would be optimal for the boards to uphold its responsibly to shareholders.

[13]In this Royal Mail case study over 8% of the value of the buyback was used to paying the broker fee. There is a direct conflict as the fee causes the friction to increase as the execution out-performance of a benchmark increased. This out-performance is unrelated to the objective of transferring as MUCH of the capital as possible to the selling shareholders.

[14] In this BNP Paribas case study of Trance 1 of their €5bn 2023 share buyback programme, it appears like the share price going ex the €3.9 per share dividend explains the 50% increase in daily value being spent buying ex-dividend shares at a higher cost to the company than the cum-dividend shares earlier in the programme.

This post comes to us from Michael Seigne, founder of the share-buyback consulting firm Candor Partners Limited, and Jörg Robert Osterrieder, a professor at Bern University of Applied Sciences.