Market for Control

Question 1

The basic problem of corporate finance is

Answer 1

how to overcome agency problems between shareholders and management

Question 2

Complete contract

Answer 2

specifies exactly what the manager should do in every possible instance

Question 3

Is complete contract employed in practice

Answer 3

No,

1. Its impossible to foresee every scenario or pre-plan every BR
2. Managements is hired in the first place to make judgement calls
3. Courts rarely get involved with business decisions

Resulting in a lot of management discretion and the residual control rights lies with the manager

Question 4

Examples of Transfer pricing

Answer 4

1. Buy supplies from a management-owned company for above market prices
2. Sell for below market prices (typical in Russian oil industry)
3. Sell of a subsidiary for a below-market price
4. Acquire a management-owned company for above average price

Question 5

Transfer pricing

Answer 5

The prices of goods and services that are exchanged between companies under common control.

Question 6

CEO Misbehavior 1: Perks

Answer 6

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

Question 7

Yermack finds that firms with high perks underperform the market by about

Answer 7

4%

On announcement of a plane acquisition shares drop by 1.1%

Perks dont decline with management share holdings

Question 8

CEO Misbehavior 2: Empire building

Answer 8

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

Question 9

Hope and Thomas look at profitability after a new disclosure regulation where firms no longer had to disclose separate earnings by location and found

Answer 9

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

Question 10

another way to expand is (AAP)

Answer 10

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

Question 11

Small or large acquirers have better returns?

Answer 11

Small acquirers.

Between 1980-2001, on average large firms even destroyed shareholder wealth through acquisitions

Question 12

Returns from serial acquirers tend to get

Answer 12

worse and worse from one acquisition to the next, despite having more experience with acquisitions, which suggests overconfidence and increased empire building

Question 13

CEO Misbehavior 3: Pet projects

Answer 13

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

Question 14

CEO Misbehavior 4: Corporate philantropy

Answer 14

CEOs get busy with corporate philanthropy and their pet charities. (spending profits on impressionist paintings for instance)

Question 15

With dispersed ownership comes

Answer 15

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.

Question 16

It may be optimal for monitoring to have

Answer 16

A single large shareholder, and many atomic dispersed shareholders

Question 17

Disciplinary takeovers

Answer 17

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.

Question 18

What is usually done with through hostile takeover

Answer 18

Taking over to replace inefficient management, without integrating the firm after acquisition, just installing better management

Question 19

Grossman and Hart model: Disciplinary takeovers in practice can be

Answer 19

Very hard, thus not enough, and regulation should try to encourage them more

Question 20

Explain Grossman and Hart model

Answer 20

1. A bidder believes that Target company is worth V per share, while current price is Q

Question 21

Conclusions of Grossman and Hart model

Answer 21

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.

Question 22

tender offer

Answer 22

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.

Question 23

Unconditional offers

Answer 23

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

Question 24

Conditional offers

Answer 24

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

Question 25

What happens if bid fails in conditional offer

Answer 25

Shareholders will be no worse off not having offered their share

Question 26

What happens if tender acquires 50-90% in conditional offer

Answer 26

Shareholder is better off not having offered the share and becoming a minority shareholder with higher value

Question 27

What happens if tender acquires >90% in conditional offer

Answer 27

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.

Question 28

Toeholds

Answer 28

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.

Question 29

What happens if bidder use toehold

Answer 29

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

Question 30

What solves the Grossman-Hart problem

Answer 30

silent toeholds

Question 31

Regulatory toeholds

Answer 31

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

Question 32

Toehold limits in the US and NL

Answer 32

US - 5% | NL - 3%

Question 33

Implicit contracts

Answer 33

voluntary and self-enforcing long term agreements made between two parties regarding the future exchange of goods or services

Question 34

The relationship between management and stakeholders relies a lot on

Answer 34

implicit contracts

Question 35

Implicit contracts are often

Answer 35

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.

Question 36

There is a lot of evidence that takeovers create a lot of

Answer 36

Net equity value • Target’s valuation increase on average by about 30% • Bidder’s valuation stays basically flat

Question 37

Bidder can realize a takeover premium by

Answer 37

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

Question 38

A large part of takeover premia may represent transfers from

Answer 38

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.

Question 39

What can aid in | securing long-term implicit contracting?

Answer 39

Anti-takeover defenses

Question 40

In practice valuations are

Answer 40

Highly uncertain, especially for outsiders

Question 41

Assuming incumbent management knows the value of the firm better than the bidder, they can organize a

Answer 41

White knight: A rival investor that is likely to be friendly to existing management

Question 42

Bidder vs White Knight | What happens if the bidder under/over estimated

Answer 42

• 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)

Question 43

Lady Macbeth strategy

Answer 43

Sometimes parties pose as White Knights and then turn around and support the hostile bidder anyway

Question 44

Poison pills

Answer 44

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

Question 45

What happens if the board rescinds the poison pill

Answer 45

• 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

Question 46

Shark Repellent

Answer 46

: Generic name rules that make it harder to | replace existing boards or hold shareholder meetings

Question 47

Shark Repellent : Staggered boards

Answer 47

Only part of the board can be replaced at any given shareholder meeting, making it more difficult for an acquirer to take control.

Question 48

Shark Repellent: For cause provisions

Answer 48

Directors can only be replaced ’for cause’, also making it more difficult for an acquirer to replace the board. • Limiting number of shareholder meeting

Question 49

Shark Repellent: Reincorporation

Answer 49

re-incorporate to a more | takeover unfriendly state

Question 50

Shark Repellent: Advanced notice provision

Answer 50

requiring advance notice before any shareholder meeting (as much as two months) to buy time

Question 51

Shark Repellent: Super voting stock

Answer 51

Give friendly shareholders more | voting rights.

Question 52

Greenmail

Answer 52

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

Question 53

Pac man

Answer 53

Sometimes firms turn around and try to take over | the firm that is trying to take them over.

Question 54

Scorched earth policy

Answer 54

Firms sells off it’s most valuable | assets (”crown jewels”) to discourage the takeover bid.

Question 55

Golden Parachutes

Answer 55

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.

Question 56

Leveraged Recapitalization

Answer 56

the firm takes on additional debt to make dividend payments, making it a less attractive target

Question 57

When target board takes defensive measure

Answer 57

It is half likely that the takeover fails, or A) target taken over by rival bidder or white knight, B) hostile bid succeeds

Question 58

There is some support for the notion that takeover | defense strategies make management

Answer 58

more entrenched, | hurting shareholders

Question 59

When the bid does finally succeed, shareholders can

Answer 59

force the bidder into paying much higher premiums, | benefiting shareholders

Question 60

US Takeover Law: Williams Act 1968

Answer 60

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

Question 61

EU Takeover Directive 2004

Answer 61

``` 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. ```

Question 62

Regulations in the NL: Mandatory bids

Answer 62

• 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

Question 63

Regulation in NL: Toehold disclosure rule

Answer 63

Shareholders owning more than 3% of issued capital in a company have to report to the AFM without delay.

Question 64

Regulation in NL: Put up or shut up Rule

Answer 64

• 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