Market for Control Flashcards
The basic problem of corporate finance is
how to overcome agency problems between shareholders and management
Complete contract
specifies exactly what the manager should do in every possible instance
Is complete contract employed in practice
No,
- Its impossible to foresee every scenario or pre-plan every BR
- Managements is hired in the first place to make judgement calls
- Courts rarely get involved with business decisions
Resulting in a lot of management discretion and the residual control rights lies with the manager
Examples of Transfer pricing
- Buy supplies from a management-owned company for above market prices
- Sell for below market prices (typical in Russian oil industry)
- Sell of a subsidiary for a below-market price
- Acquire a management-owned company for above average price
Transfer pricing
The prices of goods and services that are exchanged between companies under common control.
CEO Misbehavior 1: Perks
Non-monetary compensation, not strictly
necessary for the accomplishment of the employee’s
duties.
Some authors see it as a pure reduction in firm value. Others believe it is a more tax-efficient way of paying management and part of the overall compensation mix.
Many perks are useful to the firm -> private plane may be more efficient than flying commercial
Yermack finds that firms with high perks underperform the market by about
4%
On announcement of a plane acquisition shares drop by 1.1%
Perks dont decline with management share holdings
CEO Misbehavior 2: Empire building
CEO pay is often linked to the company size, and remuneration committee will look at comparable companies to determine CEO benefits package (comparably sized), and then assume their CEO is above average so set benefits at least 30% above the mean
This provides incentives for the CEO to engage in rapid expansions at the expense of profits
Hope and Thomas look at profitability after a new disclosure regulation where firms no longer had to disclose separate earnings by location and found
After the regulation went into effect, non-disclosers have a greater expansion of foreign sales, lower profit margins, and lower firm value.
Without disclosure its more difficult for shareholders to monitor inefficient expansions, so firms overexpand
another way to expand is (AAP)
aggressive acquisition policy
Although takeovers have been good for target shareholders, they have been almost zero or even negative for the acquiring firm’s shareholders
Small or large acquirers have better returns?
Small acquirers.
Between 1980-2001, on average large firms even destroyed shareholder wealth through acquisitions
Returns from serial acquirers tend to get
worse and worse from one acquisition to the next, despite having more experience with acquisitions, which suggests overconfidence and increased empire building
CEO Misbehavior 3: Pet projects
Investing in their own favorite “pet projects”. It can also be used as a method for entrenchment: Investing in projects where this particular CEO has the most value-added makes it more difficult to replace that CEO
CEO Misbehavior 4: Corporate philantropy
CEOs get busy with corporate philanthropy and their pet charities. (spending profits on impressionist paintings for instance)
With dispersed ownership comes
Low monitoring of ownership, it is not easy to investigate a company even if you’re a shareholder. For small stake shareholders the cost of monitoring exceeds their capital gains, so it is better to rely on other shareholders doing it for you: free riding. Even large shareholders may rely on others.
It may be optimal for monitoring to have
A single large shareholder, and many atomic dispersed shareholders
Disciplinary takeovers
They take place, because existing management is not maximizing shareholder value: excessive growth and diversification, strategic mistakes, lavish perks, overpayment to employees and suppliers, debt avoidance.
What is usually done with through hostile takeover
Taking over to replace inefficient management, without integrating the firm after acquisition, just installing better management
Grossman and Hart model: Disciplinary takeovers in practice can be
Very hard, thus not enough, and regulation should try to encourage them more
Explain Grossman and Hart model
- A bidder believes that Target company is worth V per share, while current price is Q
Conclusions of Grossman and Hart model
So, although shareholders would collectively be better off selling
at price P (given that if the bid fails the value will only be Q and
not V), individually they are better off refusing to sell, hoping to
become a minority shareholder with a share value V.
However, if a majority coalition (more than half) would accept
the bid, all shareholders would be better off.
Unfortunately, there is always a strong temptation for
coalition members to break ranks.
tender offer
a bid to purchase some or all of the shareholders’ stock in a corporation. Tender offers are typically made publicly and invite shareholders to sell their shares for a specified price and within a particular window of time. The price offered is usually at a premium to the market price and is often contingent upon a minimum or a maximum number of shares sold.
Unconditional offers
An unconditional bidder has a large risk of paying higher than the current price for a minority position in a firm that is worth this current price.
Suppose V=11, Q=7, C=1
By making an unconditional bid of 9, shareholders will sell for 9, but as the 50% is approached, no one will want to sell for anything less than 11
Conditional offers
The bidder only actually buys the shares if at least 50% are offered in the tender.
Combined with the Mandatory Buyout Rule: If you own more than 90% you have to buy out the remaining minority shareholders at the same price you paid for the rest
What happens if bid fails in conditional offer
Shareholders will be no worse off not having offered their share
What happens if tender acquires 50-90% in conditional offer
Shareholder is better off not having offered the share and becoming a minority shareholder with higher value
What happens if tender acquires >90% in conditional offer
Shareholder’s shares will be bought out for the bid price (the low price) and will not be worse off not having offered the share.
Toeholds
A toehold purchase is an accumulation of less than 5% of a target firm’s outstanding stock by another company or individual investor with a particular goal in mind.
What happens if bidder use toehold
The bidder doesn’t announce its bid, but
simply starts buying up shares silently in the open
market.
• This may push up prices a bit towards 𝑇 ≥ 𝑄
• Now suppose the bidder manages to acquire a fraction
𝑥 of outstanding shares at price 𝑇 and then makes a
bid for the outstanding shares at the full valuation
price 𝑃 = 11
• As long the bidder makes enough profit 𝑉 − 𝑇 on 𝑥
the toehold shares, she can recover her costs:
• 𝑥 (𝑉 − 𝑇 ) ≥ 𝐶
What solves the Grossman-Hart problem
silent toeholds
Regulatory toeholds
To encourage takeovers (and threaten bad
management), the regulator simply sets toehold limit 𝑥
high enough to encourage takeovers.
• But: this creates unequal treatment of
shareholders:
• The lucky ones that get the full valuation 𝑃 = 11
• The unlucky ones that sold at 𝑇 < 11
• Plus, insiders
will also buy up shares before the tender at 𝑃 = 𝑇.
• Thus, in practice the number of shareholders that sell at T
may well be much larger than just 𝑥
• Regulators have to balance this cost of the “unlucky”
shareholders and the activity of insiders against the cost of
entrenchment of inefficient management.
• The threshold 𝑥 is also a measure of how much of the gains in
efficiency due to the takeover should accrue to the bidder, and
how much to the existing shareholders
Toehold limits in the US and NL
US - 5%
NL - 3%
Implicit contracts
voluntary and self-enforcing long term agreements made between two parties regarding the future exchange of goods or services
The relationship between management and stakeholders relies a lot on
implicit contracts
Implicit contracts are often
long-term and rely on trust:
suppliers making firm-specific investment, employees
learning firm-specific skills in return for long term
employment/business.
Management and shareholders must be
trusted by stakeholders in order to make long-term firm-specific investments.
There is a lot of evidence that takeovers create a lot of
Net equity value
• Target’s valuation increase on average by about
30%
• Bidder’s valuation stays basically flat
Bidder can realize a takeover premium by
Willing to breach implicit contracts, for instance by lowering wages when promised not to, forcing lower prices on suppliers that had made firm-specific investments
A large part of takeover premia may represent transfers from
stakeholders to shareholders
• The disruption cost may well exceed the social benefit.
• Moreover:
• Long-term implicit contracts will only be committed to in
a world in which stakeholders trust management.
• In a world where takeovers are constant, such loyalty is no
longer warranted.
What can aid in
securing long-term implicit contracting?
Anti-takeover defenses
In practice valuations are
Highly uncertain, especially for outsiders
Assuming incumbent management knows the value of the firm better than the bidder, they can organize a
White knight: A rival investor that is likely to be friendly to existing management
Bidder vs White Knight
What happens if the bidder under/over estimated
• In case the bidder had underestimated the true
value, will lose a bidding war with the White
Knight (not succeed)
• In case the bidder had overestimated the true
value, will win the bidding war, but overpay (overpay)
Lady Macbeth strategy
Sometimes parties pose as White Knights and then turn around and support the hostile bidder anyway
Poison pills
The term poison pill refers to a defense strategy used by a target firm to prevent or discourage a potential hostile takeover by an acquiring company. Potential targets use this tactic in order to make them look less attractive to the potential acquirer.
• Management hands out securities to existing shareholders
(typically in the form of a dividend), that will give the
holder a right to buy additional shares at a discount when
a bidder acquires a significant stake.
• These additional shares will dilute the share of the bidder.
• This makes it much more difficult to complete the
transaction
What happens if the board rescinds the poison pill
• Usually, the board is able to rescind the poison pill,
thus inducing the bidder to attempt a friendly
takeover instead of a hostile one.
• Or offer a hostile tender conditional on the pill
being rescinded.
• The board may then face pressure from
shareholders to rescind the pill.
• Alternative: a dead hand poison pill, which is
very difficult to rescind
Shark Repellent
: Generic name rules that make it harder to
replace existing boards or hold shareholder meetings
Shark Repellent : Staggered boards
Only part of the board can be replaced
at any given shareholder meeting, making it more difficult
for an acquirer to take control.
Shark Repellent: For cause provisions
Directors can only be replaced ’for
cause’, also making it more difficult for an acquirer to
replace the board.
• Limiting number of shareholder meeting
Shark Repellent: Reincorporation
re-incorporate to a more
takeover unfriendly state
Shark Repellent: Advanced notice provision
requiring advance notice
before any shareholder meeting (as much as two months)
to buy time
Shark Repellent: Super voting stock
Give friendly shareholders more
voting rights.
Greenmail
the practice of paying a potential acquirer
to leave you alone.
• It consists of an offer to buy back the acquirer’s toehold at
a premium, in return for a standstill agreement.
• This can also encourage financial firms to fake takeover
attempts in order to attract greenmail.
• Nowadays some companies have no-greenmail provisions on their books to discourage tenders
Pac man
Sometimes firms turn around and try to take over
the firm that is trying to take them over.
Scorched earth policy
Firms sells off it’s most valuable
assets (”crown jewels”) to discourage the takeover bid.
Golden Parachutes
Large severance packages for top
management make a takeover more expensive. On the other
hand, it may make them more likely to accept an offer.
Leveraged Recapitalization
the firm takes on additional
debt to make dividend payments, making it a less attractive
target
When target board takes defensive measure
It is half likely that the takeover fails, or A) target taken over by rival bidder or white knight, B) hostile bid succeeds
There is some support for the notion that takeover
defense strategies make management
more entrenched,
hurting shareholders
When the bid does finally succeed, shareholders can
force the bidder into paying much higher premiums,
benefiting shareholders
US Takeover Law: Williams Act 1968
Aim was to prevent lightening fast take overs
• More disclosure by the bidding company
• As soon as a bidder’s stake is above 5% has to submit
to the SEC
• Stakes of a ’concert party’, affiliates or banks working on
behalf of the bidder, are counted towards the total
• Have to submit identities of bidders and purpose
of the acquisition, and have to submit a business
plan (helps shareholders decide)
• Minimum tender period: 20 days (more time to decide)
• Target management has to file an official recommendation to
shareholders with the SEC.
• If another bidder comes forward, offer period extended by
10 days.
• Bidder must accept all shares offered.
• Bidder must pay the same uniform price for all offered
shares
• But can be two-tiered: Different price in first
tender period Can be conditional on getting a
controlling stake, getting regulatory permission,
etc
EU Takeover Directive 2004
General Principles: • Equal treatment of all shareholders • Tender offers have to be open between 2 to 10 weeks • Board neutrality rule: • Post-bid takeover defences are forbidden unless with express shareholder permission. • But board can still look for other bidders (including white knights) • And give it’s recommendation to the shareholders. • Optional rules against dual shares systems, ownership limitations.
Regulations in the NL: Mandatory bids
• Any entity, alone or in concert, owning more than
30% of the target’s voting shares, has to make a
mandatory bid for the company.
• Offer at an “equitable price”: highest price paid by
the bidder in the past year.
• Certainty of funds: a bidder has to prove that it has the
necessary funds (cash or equity) to pull off the acquisition
offer.
• The target’s board has to organize a shareholders meeting
at the latest 6 days before the end of the offer period.
• The board has to publicize it’s recommendation
to the shareholders at least four days before the
meeting.
• For bids for the entire company, the minimal offer
period is 8 weeks, the maximum is 10 weeks.
• For partial bids, the minimum is 2 weeks, the
maximum still 10 weeks.
• Bidders are allowed to increase their offers during
the offer period.
• However: Offer period will be extended in case the
increase is less than 7 days before the end of the
offer period.
• When a competing bid emerges, this automatically
extends the deadline
Regulation in NL: Toehold disclosure rule
Shareholders owning more
than 3% of issued capital in a company have to report
to the AFM without delay.
Regulation in NL: Put up or shut up Rule
• A target company can ask the AFM to force a
potential bidder to either make a bid, or abstain.
• If potential bidder doesn’t make a bid, it is
forbidden from making a bid for the next six
months, and is not allowed to hold more than
30% of the shares
