M&A Research: Event Studies
Most empirical studies utilize the statistical method called event studies.
Event analysis is conducted to evaluate and quantify the impact of a major catalyst incident or event on a company’s market value. Although it is mostly used in empirical financial research, experts in other disciplines, Such as accounting, management, and forensic economics have also been utilizing event studies.
The underlying principle is, relevant events may quickly cause a change in the market value of the firm depending on the efficiency of the market. Thus, the more rational a market, the more accurate the response will be. For example, researchers may examine whether investors think the merger would generate or kill value in announcing a fusion of two business entities. The basic concept is to identify the anomalous return due to the case being analyzed by accounting for the return resulting from the market as a whole’s price fluctuation. Another example is the analysis of stock market reactions to incidents. Such as market disruption or devastating incidents around the economy.
M&A Research and Event Studies
In M&A research, event studies try to measure the effectiveness of an M&A-related occurrence on the value of the companies involved. Such events include the announcement of a takeover bid or the implementation of specific takeover defense. To recap, a merger or an acquisition can be defined as a combination of two firms. Where the bidder usually pays a premium depending upon the synergies involved.
Cumulative abnormal returns, or CARs, are being measured in such a phenomenon. It is defined by measuring the difference between the expected value produced by the capital asset pricing model (CAPM) and the observed actual return. The difference is specifically called the abnormal returns, which are those that cannot be explained by market movements generated by CAPM.
Market Model
The market model defines the returns as shown in this formula.
Rit = αii + βmtRmit + έ it
where:
Rit is the cumulative dividend monthly stock return for the ith firm in month t;
Rmit is the return on a market portfolio month t relative to the announcement
of offer;
∞, β are the regression parameters; and
εit is a stochastic error term with a mean of zero.
Abnormal returns for firm i and month t are defined as follows:
ARit = Rit − αii + βmtRmit
CARs are guides to abnormal effects in a wide array of event studies in M&A research. To know the defined time period to arrive at CARs, the abnormal returns should be added.
In this model, the analysis suggests using a pre-event estimation window to derive the company’s standard stock relationship and a regression index to be discussed later.
Reference Index
Gathering data regarding the returns of the company being studied and the reference index are necessary for conducting an event study. One reference index is the S&P 500 which is typically used in measuring the performance of the whole market, although it is not exactly a measure for the overall market. This reference index is an index that reflects the performance of 500 stocks selected by Standard and Poors. But it is often connected with other often-cited market indices like the Dow Jones Industrial Average. This reference index, on the other hand, only includes 30 big capitalization companies.
In verifying the statistical significance of the estimated parameters such as α and β, standard econometric tests are used. T statistics, for instance, are used to test if the beta coefficient, β, is statistically significant. Usually, 2 or 1.96 is the value in excess of a certain significance threshold. Leading the researchers to conclude that there is a statistically significant relationship between the changes in the value of the returns on the market and the returns on the security in question.
In estimating the model, it is important for event studies researchers to always take note of the time periods they use in their historical data. Since different time periods may result in different values for the estimated parameters. And if the earlier time period featured unusual volatility, the returns could be abnormal. Although this could have been a function of the significant economic conditions and not a product of the event itself.
How to Conduct an Event Study
In conducting research with regards to m&a-related event studies, the initial step is usually to define the event window, which is the time when the event had its main effect. Researchers try to keep the event window short while making sure it is also long enough to capture the full effect. Considering that the longer the period, the more influence it has on the changes in the CARs.
Another strategy here is to define how frequently the data occurs. It depends on the type of study being done. The different types of studies could be used monthly or even minute-by-minute data. Although daily returns are more common in M&A research.
The Overall Market
The more variables, the greater the data needs. Other models can still be used, though, such as those with more explanatory variables that could consider other factors beyond the overall market. Historical data from a specific period are used to estimate the models used to measure the effects of an event. The basic market model is employed in M&A-related event studies to filter out the influence of the market. This is to measure the effects of events like the announcement of a merger. In estimating the parameters for showing the expected returns, regression analysis is used. Then, they are compared to the actual returns that occurred during the event window. So if an acquirer’s returns decline by more than can be explained by market movements following an announcement of a proposed acquisition. It can be said that this is because of the market disapproving of the deal.
Event studies can also be affected by outliers, just like in statistical analysis. These can be more of an issue with small samples. However, there is an array of methods that can be used here like the elimination of these observations.
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European Competition Policy
As a closing to our Legal Framework chapter, we will discuss the European Competition Policy. In this article, you will learn about the European Union, the EU Merger Control Procedures and more.
European Competition Policy
The European Union adopted what is most commonly referred to as the merger regulation as of December 1989. However, the merger regulation policy was not put into effect until September 1990, but it was later amended.
What did the regulation focus on? It focused on mergers and joint ventures that have an impact on the degree of competition beyond one nation’s border. All mergers that have significant revenues need to receive European Commission or EC approval under the regulation.
European competition policy vs U.S. system
The European competition policy is different from the U.S. system. In the U.S system, antitrust regulators must go to court to block a merger. However, the EC’s regulatory system does not dependent on the courts.
According to Mats A. Bergman, Malcolm B. Coate, Maria Jakobsson, and Shawn. Ulrick, “Comparing Merger Policies in the European Union and the United States, ” the latest revision of the EC mergers and acquisitions regulations are now broader than the previous version. In this latest revision, they mention market dominance, however, it is now merely an example of an anticompetitive condition.
The market power is determined before and after every deal as part of its analysis. However, before that, the EC must first define the market. In addition to that, different factors including barriers to entry are taken into account as part of its determination.
European Commission Analysis
After the said analysis is finished, the EC does a further analysis. They do so by utilizing its own horizontal merger guidelines. The said merger guidelines start off with post-deal market shares greater than 50% giving rise to concerns. On the other hand, those shares that are below 25-30% tend not to raise much concern.
Additionally, the EC is less likely to raise concerns when the HH indexes are below 1,000. The same can be said when the HH indexes are below 2,000 but the post-deal delta is low (for instance, the post-deal delta is between 150 and 250). For more information regarding HH indexes, refer to our previous article titled Measuring Concentration and Defining Market Share. On the other hand, the transactions that the EC finds particularly objectionable can or may be brought to the European Court of Justice.
There are a number of companies from the United States that do business in Europe. These companies must first secure European Union approval first in addition to the approval by the U.S. antitrust authorities.
European Union
As you might think, this can be a time-consuming process sometimes. For instance, the European Union once launched an investigation into Oracle Corporation’s $7.4 billion takeovers of Sun Micro systems Inc. that lasted for over six months. The EU later approved the deal in January of 2010.
It is no secret that the U.S. antitrust authorities and their European counterparts sometimes disagree on the competitive effects of mergers and acquisitions. In fact, these instances receive a lot of attention. However, contrary to what the media says, the U.S. antitrust authorities and they often agree on the effects. You may remember when the U.S. antitrust authorities and EC disagreed with the proposed $40 billion General Electric-Honeywell merger.
The European Opposition
The European opposition to the GE-Honeywell deal raised a lot of eyebrows since there are some who felt that the European Union was using its competition policy to insulate European companies from the competition with larger U.S. rivals. There are also some who concluded that the decision was the product of an inadequate analysis on the part of the EC. The merger was not opposed to the United States.
This $40 billion conflict led to a lot of discussions to make a more consistent competition policy in both markets. Then-antitrust chief Mario Monti, who also happens to be a former Italian economics professor, used an economic doctrine that is known as collective dominance when reviewing the impact that mergers may have on the level of competition within the EU for the EC antitrust regulators.
In the EU those with market shares that are below 40% could draw enforcement of action. On the other hand, those with much higher thresholds such as 60% may apply in the United States of America.
As a way of limited monopoly power and helping consumer welfare, the European regulators have framed their opposition to certain mergers and acquisitions. However, not everyone was sold. There are still some that are cynical about their motives.
For instance, Aktas, de Bodt, and Roll analyzed a sample of over 290 proposed acquisitions
that were examined by the European regulators in the 1990s. In their analysis, they found that there is a higher chance for regulators to oppose the merger and acquisition when there is a greater chance of adverse impact on European rivals resulting from deals by foreign companies.
EU Merger Control Procedures
In able for the European Union to review a deal, the EC sets certain deal sizes or turnover thresholds. The size is defined in terms of both worldwide and EU business volume.
Before a merger is completed, the EC should first be notified. The merger partners should complete a number of prepared templates by the EC.
There are plenty of deals that do not get much scrutiny from the EC. However, if a certain deal results in a combined horizontal market share of 15% or 25% in vertical markets, you can expect the EC to do an investigation.
Usually, the investigation process starts with Phase I which is completed within 25 business days. A majority (90%) of all cases are expected to be cleared in Phase I.
The remaining 10%, however, have attracted competition concerns, these concerns will be addressed in Phase II.
Phase II
The participants of the deal are expected to put forward or agree to remedies that will guarantee continued competition during Phase II. This phase is usually completed within 90 business days. However, should they wish, the EC can apply an additional 15 days to this time limit.
Upon further review, and if the EC agrees to the remedies, it will then appoint a trustee to oversee the implementation of the remedies. This is done to ensure that the remedies are enacted.
Once Phase II is almost complete, the EC will indicate whether the deal is unconditionally clear or will be approved if remedies are implemented or if it is prohibited. All of the decisions made by the EC are also subject to a review by the General Court and potentially by the Court of Justice.
In 2014, the EU adopted a new set of rules in which companies can submit a shortened version of FormCO. Under these new rules, the parties could submit initial information-seeking EU approval stating that they did not believe the deal raises antitrust concerns.
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Measuring Concentration and Defining Market Share
The market share of the alleged violator of antitrust laws is one factor that courts rely on during antitrust cases, as well as the degree of concentration in the industry. Varying standards and methods in measuring market share and concentration of the Justice Department have been changing through the years. They have also been set forth in various merger guidelines.
Here are some of the changes that have occurred.
1968
The 1968 Justice Department merger guidelines were first issued and showed the types of mergers that the department opposes. These were utilized in interpreting the Sherman Act and the Clayton Act. These guidelines helped the government present definitions of highly concentrated industries in terms of specific market share percentages. They were also grounded on the idea that reduced competitions are a result of increased market concentration.
The 1968 guidelines made use of concentration ratios. These are the market shares of the top 4 or 8 in the industry. Here, a highly concentrated industry has 75% of the market acquired by the top four largest firms. It also set forth various share thresholds for acquiring and acquired companies that would drive regulatory attention. Compared to today’s standards, these share thresholds are way smaller.
1982
The 70s was a time when the 968 guidelines were criticized for their limitations. Many argued that a policy that allows more flexibility is needed, that is why in 1982, a new set of guidelines were instituted. William Baxter, a lawyer, and economist was the head of the antitrust division of the Justice Department. He introduced certain quantitative measures in the antitrust process to make it more predictable and consistent with prevailing economic theory.
The HH index or the Herfindahl-Hirschman index was the chief measure in the American antitrust policy, which is the sum of the squares of the market shares of each firm industry. With this new index, a more precise measure is provided than the 1968’s top four or 8 firms in the industry. It accurately measures the impact of increased concentration that would be brought on by a merger of two competitors. However, when using this, it is important to examine the assumption that each of these merged firms would maintain their market shares’ needs. Always consider the post-merger combined market shared even when this may be difficult.
This index has many properties that should always be taken note. For instance, it increases with the number of firms in the industry. It also weighs larger firms more heavily than smaller firms as it sums the squares of firms in the industry.
1984
Another revised merger has been introduced on June 14, 1984, to further refine the antitrust enforcement policies. Just like the criticisms on the first guidelines, the 1982 guidelines were still inflexible and overly mechanistic, especially the HH index. To resolve this issue, the department permitted the consideration of qualitative information aside from the quantitative measures it has been using. This would include things like the efficiency of firms in the industry, the financial viability of potential merger candidates, and the US firms’ ability to compete in foreign markets.
It also introduced in the 1984 5% test, which requires the Justice Department to judge the effects of a potential 5% increase in the price of each product of each merging firm. This is anchored on the assumption that there may be an increase in market power due to the merger. If this happens, the merged firms may have the ability to increase prices. It also tries to know the effects of this increase in competitors and consumers.
Elasticity is one measure in macroeconomics that can indicate the responsiveness of consumers and competitors. The consumers’ responsiveness to a change in the product price can be indicated through the price elasticity of demand, measures are:
- e> 1 Demand is elastic, the quantity adjustment rate is more than the price change percentage.
- e=1 Unitary elasticity, the percentage change in quantity is equal to the percentage change in price.
- e<1 Inelastic demand, the percentage change in quality is less than the percentage change in price.
Greater market power is one implication of an inelastic demand over the 5% price change range. But if demand is elastic, then consumers are not as adversely affected by the merger.
This new guideline, along with the 1982 guidelines, recognized that efficiency-enhancing benefits from mergers are possible. Even if they do not have the force of law, the 1968 guideline can warrant legal considerations.
1992
The latest set of merger guidelines was introduced in 1992 by the Justice Department and the FTC. It was revised in 1997 and is similar to the 1984 guidelines since potential efficiency-enhancing benefits of mergers were also recognized. Here, a merger will be challenged through price increases even if demonstrable efficiency effects exist.
These guidelines clarified the definition of the relevant market which is critical to an antitrust lawsuit. They state that the market is the smallest group of products or areas where a monopoly could raise prices by a certain amount. It also employs the HH index to measure the competitive effects of a merger.
The 5-step process that enforcement authorities follow
- Market. Assess if the merger increases the concentration by considering the relevant market which can be an issue of dispute.
- Competitive effects. Consider the possible anticompetitive effect of the contract.
- Entry into the Market. Does the potential anticompetitive effect have the possibility of being mitigated by entry into the market? The existence of barriers to entry needs to be determined.
- Efficiencies. Could there be certain offsetting efficiency gains that can happen due to the deal? And could offset the negative impact of the anticompetitive effects?
- Failing firm defense: Know if the parties would fail or exit the market but for the merger. These possible negative effects are then weighed against the potential anticompetitive effects. Take note that antitrust authorities are willing to consider the net antitrust efforts of a merger. The participants need to show that the benefits are for the merger.
The 1997 revision highlighted how merger-specific efficiencies may allow companies to compete better and could possibly be translated to lower prices for consumers. However, they can only be attained through a merger.
It is also worth noting that the 2010 merger guidelines clarified that the Justice Department did not really follow the mechanistic, step-by-step process but focused on competitive effects and the analysis and research needed to clarify.
In 2011, the Antitrust Division of the Justice Department issued a Guide to Merger Remedies, emphasizing the proposed remedies for mergers to ensure preserved competitions. They must also guarantee that these have benefits for consumers instead of market participants.
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REGULATION OF INSIDER TRADING
There are remedies for shareholders who have had losses due to insider trading specified by the SEC. The SEC Rule 10b-5 bound insiders, stating that the insider is required to disclose or abstain from trading the securities of the firms.
This rule derives from an SEC response to a 1940s complaint regarding a company that provided indications. That earnings would be weak while it planned to announce much stronger performance. The company’s president then bought shares knowing the true earnings. Two decades later, the SEC informed the market that it would bring civil claims under this little-known rule. However, it was not until the late 1970s that the SEC and federal prosecutors used the rule to bring criminal lawsuits.
Securities Fraud Enforcement
Insider Trading and Securities Fraud Enforcement passage underpinned the law on insider trading. This provision required maximum penalties reaching up to $1 million, as well as 10 years of imprisonment. While also setting up a bounty program where up to 10% of the insider’s profits can be collected by the informants.
This law also developed the possibility of top management being responsible for the insider trading of their subordinates. During the wake of Enron, the Sarbanes-Oxley law increased the maximum penalty for insider trading. It reached up to $5 million and a possible 20-year sentence in jail. The 1988 law followed the passage of the Insider Trading Sanctions Act of 1984. This gave SEC the power to seek treble damages for trading on inside information. The statute offered a 2-pronged approach for regulators. They can finally seek remedies aside from the criminal alternatives available way before the 1984 act was passed. It is possible for illegal insider trading to occur.
For instance, it is possible for insiders, acting on information that is unavailable to other investors. To sell the firm’s securities before an announcement of poor performance. The investors who do not know about this bad news might pay a higher price for the securities of the firms. The opposite may happen if the case is insiders bringing the firm’s stock or calling options before announcing a bid from another firm. Here, stockholders may not have sold the shares to the insiders. If they had known of the upcoming bid and its associated premium.
The Insiders
The insiders are more than just the management of a company. They may involve outsiders like attorneys, investment bankers, financial printers, or consultants who can be deemed as the temporary insiders. However, under rule 10b-5, the US Supreme Court held outside parties. Those who trade for profit according to their acquired information did not have to disclose their inside information. This was the case during 19801980 in Chiarella v. U.S. During the case. A financial printer acquired information on an upcoming tender offer by reviewing documents in his print shop.
Rule 10b-5 will apply if an individual misappropriates confidential information about a merger or acquisition and bases the trade on it. This rule is only applicable to proceedings of SEC enforcement or criminal actions. However, it is not applicable to civil deeds under the Insider Trading Sanctions Act of 1984. It’s because this permits the recovery of treble damages on the profits earned or the loss avoided. One example of an illegal insider trading was the well-known 1963 Texas Gulf Sulphur case.
The company discovered which were not disclosed for many months. In fact, the firm even denied the public the discovery in a false press release. On the other hand, the directors and the other members bought undervalued shares based on their inside information. The insiders faced a lawsuit successfully filed by the SEC. The short-swing profit rule does not allow any officer, director, or owner. With 10% of a company’s stock from a purchase and sale, or a sale and purchase within six months. Profits obtained from the purchases should be paid to the issuer whether or not the transactions were made based on insider information.
When Insider Trading Violation Occurs
Just because a provision of insider information by a tipper to another party or a tippee exists does not necessarily mean it constitutes a violation that requires penalties related to insider trading laws. A personal benefit is required to be derived by the tipper, and this was clarified in 2017. During this time, the Salman decision showed that the US Supreme Court concluded that a tipper giving such valuable information to a family member or friend could be considered to have derived a profit even if there was no monetary exchange.
Can Insider Trading Laws effectively Determine Insider Trading?
A study by Seyhun questioned the effectiveness of laws in stopping insider trading. Another empirical study by Meulbroek confirmed that stock price run-ups before takeover announcements reflect insider trading. There is more research that indicates how these laws have significant effects that are deterrent. For instance, Garfinkel investigated insider trading around earnings announcements and knew that insiders adjusted the timing of their transactions after the passage of the Insider Trading and Securities Fraud Enforcement Act.
Despite the positive effects, insider training seems to remain a part of the merger and acquisition activity of public companies. In more recent research, Augustin, Brenner, and Subrahmanyam found statistically significant abnormal trading volume in US equity options within 30 days before the announcement of an M&A.
They tried to study the trading volume in equity options in days before announcing an M&A in 1,859 corporate transactions from 1996-2012. Then, they compared them to randomly selected days. The obvious observation was that unexpected M&A announcements mean no statistical significance in the trading volume, But the results were opposite as the volume preceding M&A announcements was significantly greater.
This occurred so often in their samples. It proves that, while the SEC exerted effort to publicize its insider trading enforcement actions in some high-profile cases, M&A-related insider trading is not only quite prevalent but also largely unpunished by the SEC. This is evident in smaller M&As as many traders are engaging in insider trading here and get away with it.
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U.S. STATE CORPORATION LAW AND LEGAL PRINCIPLES
There are major issues concerning US state corporation laws. As well as legal principles underlying some court law rulings that have analyzed these statutes. Here are some of them.
Business Judgment Rule
This term refers to the standard where corporate directors are judged. They exercise their fiduciary roles when trying to employ a takeover. Here, it is presumed that they will act consistently with their fiduciary duties to the shareholders. Hence, any party that contests this presumption is required to conclusively demonstrate a breach of fiduciary duties.
If the company or individual in the US brings a case against a company’s directors and establishes this. Then the directors will carry the burden of establishing that the transaction was “entirely fair”. There have been certain court law decisions that emphasized relevant issues. About how directors should act when employing anti-takeover defenses. Through such choices, standards like the Revlon duties and the Unocal Standard have been established.
Director’s duties
With regard to the Delaware Law, the directors’ duties are to manage the affairs of the company. This is by taking these three obligations into consideration:
- They should be loyal.
- Will demonstrate care for the interest of the shareholders
- They have the duty of carrying these in a manner that is always n the best interest of the corporation and its shareholders.
In terms of mergers and acquisitions, the business judgment rule does not necessarily mean that the directors of the target have to jump up. And react emphatically to bids that come down the pike. It is important for them to be informed about their company’s value and other details being presented to them. They don’t have to enter an active negotiation with the bidder. They can just say no to the bid, stay apathetic, and be uninformed about its financial aspects. And what merits it may have for their shareholders.
Delaware Supreme Court
Directors are also vulnerable to lawsuits, even for approved deals by the shareholders. There are two Delaware decisions that have been improved for the legal position of director defendants. In one case (Singh v. Attenborough), the Delaware Supreme Court law favored the director defendant. As it made it easier for them to obtain early dismissal of the claims thrown at them. If the sale was an orderly one in which shareholders were fully informed and not coerced.
After two months of making this decision, the Delaware Chancery Court law extended those protections to two-step mergers done pursuant to Section 251(h) deals. This section of the statute allows deals to go through without a formal shareholder vote. If the percentage of shareholders that would have been necessary to win such a vote tendered their shares to the bidder. As a result, the tender offer then has a cleansing effect on the fairness of the said deal.
Unocal v. Mesa Petroleum
Meanwhile, in Unocal v. Mesa Petroleum, the actions of the Unocal board of directors were reviewed by the Supreme Court of Delaware. As they implemented an anti-takeover strategy in order to thwart the unwanted tender offer made by Mesa Petroleum. Its CEO was Boone Pickens. This strategy included a self-tender offer in which the target made a tender offer for itself in competition with the offer initiated by the bidder.
Upon making a decision, the court law considered its concern that directors might be acting for their own interests, such as in this case. In which they were allegedly favoring the self-tender as opposed to simply objectively searching for the best deal for shareholders. When this is the case, directors should demonstrate their reason to believe. That there was a danger in pursuing a corporate policy that was in the best interest of shareholders. Moreover, they should show that their actions served their interests.
Responsibilities
The Unocal Standard made subsequent courts refine their responsibility:
- Reasonableness test. The board should clearly demonstrate that its actions were reasonable. In terms of the perceived beliefs about the danger to their corporate policies.
- Proportionality test. They are also required to show that these defenses were aligned to the magnitude of the perceived danger to the policies.
The normal presumptions about the director’s behavior under the business judgment rule may apply once the standards are met. When a board is offered by an unwanted bidder and is trying to know whether to accept it or not, the business judgment rule is the operative standard. But when they move from rejection to taking active steps to fight off the bidder, then the Unocal Standard kicks in.
There is a contradiction between the standards of the directors’ fiduciary role in the US. And those of some other nations that have active takeover markets. For instance, the United Kingdom’s self-regulatory system in effect precludes the development of detailed case law on this issue. As such cases rarely reach the courts in the United Kingdom.
Revlon Duties
In the prominent case of Revlon v.MacAndrews and Forbes Holdings, the Delaware Supreme Court law ruled on what obligations a target board of directors have when they are faced with an offer for control of their company. Court law ruled in this transaction that there are certain anti-takeover defenses that are in favor of one bidder over another and was invalid.
The court laws knew that instead of promoting the auction process, which should result in maximizing shareholder wealth, these antitakeover defenses which are a lockup option and a no-shop provision inhibited rather than promoted the auction process. It’s clear that the sale or breakup of the company is inevitable and Revlon duties come into play here. Here, the directors are responsible for changing their focus from actions that they normally would take to preserve the corporation and its strategy to actions that will lead to the greatest gains for shareholders, such as making sure they get the highest bid possible.
Auction Process
The court law decided that the use of these defenses was invalid. These actions may be consistent with the board’s Revlon duties if they promoted the auction process by letting one bidder be more competitive with another for prices to get higher. They also did not go as far as to require the target boards to solicit bids. They chose not to narrowly circumscribe the actions that target boards can take. But the court law implied that directors should have a good reason for not considering an auction process.
Remember that Revlon duties do not necessitate the conduction of an actual formal auction to the target’s board even if it is preferable, as long as the directors can show that they possess reliable information about the company’s market value.
The Supreme Court of Delaware stated in 2015 that if a deal receives majority approval from fully informed, non-coerced, disinterested shareholders then the Revlon Standard is not enough for post-cloning the damage claims.
Blasius Standard of Review
The Delaware Chancery Court put forward the compelling justification in 1988. This was in support of a target board’s decision to take action to limit a dissident shareholder’s abilities to elect a majority of the board. Along with the Unocal Standard, this gives relevant power to a target’s board which makes abuse of power more possible.
This standard was clarified in later decisions where the Delaware Chancery court noted that it would carefully analyze a board’s decision to guarantee that shareholders’ rights are being exercised and that the board would not abuse them.
Mercer v. Inter-Tel
In the 2007 case of Mercer v. Inter-Tel, the Delaware Chancery Court saw that the directors had a reasonable argument for postponing a shareholders’ meeting to prevent the defeat of a merger proposal. But the court’s concern was an abuse of the Unocal and Blasius standards, which is also parallel to other cases like Portnoy v. Cryo-Cell International. Here, the court noted that if the interests of shareholders were thwarted by a board, it would grant shareholders relief.
Entire Fairness Standard
When considering steps in approving the sale of a company or opposing a bid, directors need to remember that a Delaware court will determine their decisions based on fairness to the shareholders. They have agreed that there is no single characteristic that determines fairness and that each matter brings its own unique factors that are important to the overall fairness of a transaction or the steps fo the deal to be stopped.
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Antitrust Laws & Filing Requirements
In a previous article, we discussed the different Antitrust Laws, how they came to effect, and their purposes. In today’s article, we will continue with the discussion of the Antitrust Laws and the filing requirements. Check them out below.
Size Requirements for Filing
The law has established size thresholds for filing because there are instances where small mergers and acquisitions are less likely to have anticompetitive effects. And so, these thresholds are divided into different levels.
Namely, those levels are size-of-transaction levels and size-of-person levels, both of these will be discussed in detail below. Those who fail to file will be subjected to monetary penalties of $16,000 for each day that the filing is late.
Size-of-Transaction Threshold
First, we have the size-of-transaction threshold. This is applicable if the buyer is in the process of acquiring voting securities or assets of $80.8 million or more. Any deal above that level will require a filing. However, there is no HSR filing requirement for smaller deals. Next, we will move on to the size-of-person threshold.
Size-of-Person Threshold
Aside from the size-of-transaction threshold, there is also the size-of-person threshold. This one is a test that is only met if one party to a transaction has $161.5 million, or more in sales and assets and the other has $16.2 million or more in sales and assets.
However, regardless of the size-of-person test, any deal that can be valued at $32 million or more has to be reported. At this point, it is a crucial thing to remember that the Justice Department and the Federal Trade Commission still have the authority to challenge any merger and acquisition on antitrust grounds. This is true even if a filing is not required under the HSR. All of this is possible under the Sherman Act and the Federal Trade Commission Act which we discussed in a previous article.
Deadlines for Filing
Now, you must also be informed of the deadlines of filing. As soon as a bidder announces a tender offer or any other kind of offer, it is required that the bidder must also ile under the Hart-Scott-Rodino Act.
After this, the target is required to respond, the said response comes in the form of the target’s filing. The target must file 15 days after the bidder has filed.
Different Types of Information to Be Filed
The form that needs to be filed can be downloaded from the Federal Trade Commission website. It is 15 pages long and is required by the law.
According to the NorthAmerican Industrial Classification System or NAICS codes, it is also a requirement to submit or provide business data. Describing the business activities and revenues of the acquiring and target firms’ operations. This should be easy enough because most firms already have this information. It is a requirement to submit this business data to the U.S. Bureau of the Census.
Additionally, in order to analyze the competitive effects of the transaction, the acquiring firm must attach certain reports that it may have compiled. Now, as you may have imagined, an interesting conflict arises from this.
When a transaction is first proposed within the acquiring firm, it is not unlikely for the proponent to exaggerate the deal or transactions’ benefits. Now, if this exaggeration comes in the form of presenting a higher market share than what might be more realistic.
As you can see, this affects the firm’s ability to attain antitrust approval, and it may be hindered. It is for reasons like this that the firm must keep the antitrust approval in mind when it is preparing for its premerger reports.
Moreover, there is no need to make the filing public. Although there are agencies who may choose to disclose some information if the deal has already been announced publicly. Certain fees must also be paid along with the submission of the necessary data. The greater the size of the transaction, the greater the fees.
Filing Time Requirements
The filings also have a time limit, there is a 30-day waiting period provided by the HSR. However, if the deal is a cash tender offer or a bankruptcy sale, the waiting period shortens to just 15 days.
Now, if it is determined that a closer inquiry is necessary, either the Justice Department or the Federal Trade Commission may put forward a second request for information. The second request will extend the waiting period of 30 days. This is true except for 10 days in the case of a cash tender offer for bankruptcy sales.
Additionally, most filling companies also request early termination of the waiting period. This can be done on the grounds that there are clearly no anticompetitive effects. Most of the time, the majority of these requests are granted. However, there are some exceptions, and these investigations can take a lengthy amount of time.
Disclosure of HSR Filing
Technically speaking, any HSR filing is considered as confidential filing with the government. This means that it is not meant for public disclosure. However, there are instances where target companies receive a notice and are required to respond to the government. This is one of those instances where the target is made aware of the bidder’s intentions.
This is significantly different from the disclosures that are required for tender offers where it is designed to notify both the target company and the market of the bidder’s intentions. Additionally, the antitrust authorities will publish the early termination decision if the target applies for early termination of the HSR review process and is approved. In return, the market is right away made aware of the offer.
Significance of Notice of Government Opposition
The Justice Department can also choose to file a suit to block a proposed acquisition. This is usually done at the end of the deal. Legal battles with the government can most likely last for years. This is why it may not be in either company’s best interest to go toe to toe against the government even if either company believes they may ultimately prevail in the lawsuit.
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Antitrust Laws
Antitrust legislation limits the ability to merge with or acquire companies. There are many antitrust laws that help maintain competition in the form of mergers. The intervention of the government on antitrust grounds makes firms not even try to attempt mergers. Other mergers are stopped when it becomes apparent that the government will likely oppose the merger.
Since 1890, the government has made various changes to the antitrust statute consequences of mergers. They have been evolving and are geared towards advocating a free market. The view of the free-market favors a more limited government role in the marketplace. Although many horizontal mergers were opposed during the 1980s, many others proceeded unopposed. This phenomenon is far from the 1960’s situation, where the government interfered. Here, mergers and acquisitions including businesses only remotely similar to the acquiring firm’s business were often conflicting on antitrust grounds. It prompted many conglomerate mergers which were not generally opposed.
Another major change occurred in market conditions. They now offer deals that would have been objectionable in the past. In 1997, a merger between Staples and Office Depot was objected by the Federal Trade Commission. But a few years later, this merger proposal would have been acceptable. For instance, in 2013, competitors such as Amazon, Wal-Mart, and Costco selling office supplies. And taking market share from the large office supply companies. The number-two company, Office Depot, and the number-three, Office Max, were allowed to merge.
Sherman Antitrust Act of 1890
The Sherman Antitrust Act of 1890 is the foundation of all antitrust laws in the US. The most important provisions on this statute are in the first two sections.
Section 1 prohibits all contracts, combinations, and conspiracies in restraint of trade. Meanwhile, Section 2 prohibits any attempts or conspiracies to monopolize a particular industry.
These first two sections already make it obvious that these and the rest of the sections are written and passed to cover all types of uncompetitive activities. Despite this, the first great merger wave still took place when the law was passed.
This act is the core of monopolies and other attempts to restrict trade unlawful and criminal offenses punishable under federal law. Lawsuits can be filed by the government or the injured party under the Sherman Act of 1890. The punishment, on the other hand, will be decided by the court. It can range from an injunction to more severe penalties, including triple damages and imprisonment.
Merger’s Wave
The first wave of mergers occurred from 1897 to 1904 when monopolies were established. The effects of this on industries mixed with the formation of many powerful monopolies. It was revealed that the Sherman Act was not performing the functions it’s first two sections implied. The ineffectiveness was partial because of the law’s wording and other technicalities. Specifically, it said that all contracts that restricted trade was illegal. During the early interpretations. However, the court refused to enforce this part of the law because it implies that all contracts could be illegal, and they can’t find an effective substitute. For instance, the 1895 Supreme Court ruling that the American Sugar Refining Company was not a monopoly in restraint of trade made the law a dead letter for more than a decade after its passage. The government also had a hard time enforcing the law because of the lack of resources.
The law started to evolve and make an impact on industries under President Theodore Roosevelt and his successor, William Howard Taft. They tried to alter and correct their weaknesses in terms of the wording of the law and the lack of enforcement agencies. The states decided to make a more explicit statement of its antitrust position. This effort came with the passage of the Clayton Act.
Clayton Act of 1914
Grounded on the Sherman Act, the Clayton Act specifically proscribes certain business practices. It started to allow activities that were not already illegal under a broad interpretation of the Sherman Act. But the more current act clarified which business practices unfairly restrain trade and reduce competition. It did not solve problems about the lack of enforcement agencies in the Sherman Act with responsibilities for implementing the antitrust laws.
The Clayton Act originally focused only on stock acquisition but was resolved to include asset inquisitions in 1950. In section 7, which is relevant for mergers and acquisitions, it states: “No company shall acquire the entire or any part of the stock, or all or any part of the land, of another company. Where the impact of such an acquisition on any line of trade in any part of the country may be to significantly reduce competition or create a monopoly.”
Federal Trade Commission Act of 1914
As mentioned, one weakness of the Sherman Act was that it did not give the government an effective enforcement agency to investigate and pursue antitrust violations. During that time, the Justice Department did not have adequate resources to be an effective antitrust deterrent.
Thankfully, this Federal Trade Commission Act which was enacted in 1914 tried to address this problem by establishing the FTC. The FTC was charged with enforcing both the Federal Trade Commission Act and the Clayton Act. In particular, the FTC Act was passed in order to make an enforcement agency for the Clayton Act.
Section 6 is an antitrust provision that does not allow unfair practices of competition. Even if the FTC was given the control to initiate antitrust lawsuits, it was not given a role in the criminal enforcement of antitrust abuses. The Act also broadened the range of illegal business activities beyond those mentioned in the Clayton Act.
Celler-Kefauver Act of 1950
Before the passage of this act, firms used the asset loophole mentioned earlier to effect acquisitions without buying stocks from the target. This act prohibited this activity in 1950, not allowing the acquisition of assets of target firms when the effect was to lessen competition.
While the previous antitrust laws were aimed at horizontal mergers, the new act does not also allow vertical mergers and conglomerate mergers when they were shown to reduce competition. Horizontal mergers are combinations of firms producing the same product. The Celler-Kefauver Act set the stage for the aggressive antitrust enforcement of the 1960s.
Hart-Scott-Rodino Improvements Act of 1976
The previous changes in the antitrust laws in the United States were huge, but this one made the most impact. The Hart-Scott-Rodino Antitrust Improvements Act was passed in 1976 and the power of the Justice Department and FTC, two antitrust enforcement agencies, increased.
As mentioned, the enforcement agencies used to not have the authority to require third parties, the competitors of the merging companies, to provide them with their private economic data. This situation led them to drop many investigations because of the lack of data. The act gave the Justice Department the right to issue “Civil Investigative Demands”. The merging companies but also third parties to gather data prior to filing a complaint. It is also worth noting that this statute allowed the government to require the postponement of proposed M&As until the authorities gave their approval of the deal.
This act makes the Bureau of Competition of the FTC and the Justice Department required to be given the opportunity to review the proposed M&As in advance. According to the Act, an acquisition or merger may not be consummated until these authorities have reviewed the transaction. The two enforcement agencies should choose which of them will investigate the transaction. It avoids consummation of a merger until the end of the specified waiting periods. Hence, when they fail to file in a timely manner, the completion of the transaction may be delayed. It was also passed to avoid the consummation of anti-competitions. Thus, the Justice Department would be able to avoid disassembling a company. That had been formed in part through an anticompetitive merger or acquisition, also known as unscrambling eggs.
The 1970 law
The 1970 law is important as the government cannot halt transactions through the granting of injunctive relief while it attempted to rule on the competitive effects of the business combination. Mandated divestiture, designed to restore competition, might not take place for many years when injunctive relief was not obtainable after the original acquisition or merger.
It was enacted to avoid these problems before even occurring. It regulated and made a waiting period for tender offers beyond what was already in place with the Williams Act. The length of time it takes to receive the antitrust green light is a factor to consider on whether antitrust approval slows down a tender offer.
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Components of Second-Generation Laws
Second-generation rights are also known as social and economic rights. These laws incorporated provisions on the following:
- Fair price
- Business combination
- Control share
- Cash-out statute
Fair Price Provision
This provision aims to discourage hostile takeovers. A successful tender offer lets shareholders receive the same price whether or not they have accepted the offer. This will help with the prevention of abuses occurring in two-tiered tender offers. These typically encompass first-tier tenders being offered a high price. Meanwhile, second-tier members are offered lower prices or with fewer advantages such as securities of uncertain value instead of cash.
Business Combination Provision
Here, target companies and the bidding company are not allowed to have business agreements for a certain period. The provision helps prevent leveraged hostile acquisitions and to avoid the transformations of local firms with low-risk capital structure into riskier companies. The wording of a business provision, for instance, may rule out the sales of the assets by the bidding company. Another example is when an acquiring company may be relying on the sale on the sales of assets by the target since it assumes a huge debt to finance a takeover. By doing so, they can pay the high-interest fees required.
Control Share Provision
Before purchases are allowed in acquisitions, current target stockholders should first approve. They usually apply to stock purchases beyond a certain percentage of the outstanding stock. Control share provisions are effective if the current share ownership has groups of stockholders who support the management. This may include employee stockholders.
This also sets limits on “creeping acquisitions” above 20%. Once it exceeds, the other shares must approve the controlling shareholder of the other shares prior to exercising its votes associated with the shares it owns.
Bidders usually have neutral feelings about this provision they do not like nor dislike it. Hence, they can serve as an early referendum on the possibility of a bid. Shareholders usually not vote against the bidder since they do not want to be deprived of the chance to get a good takeover premium. With that, the bidder can use this to put pressure on the board of the target. They may say that the shareholders are in full support of the bidder, not the board.
Not all states have this statute, such as Delaware. Ohio, Michigan, and Pennsylvania are among the states who practice this law.
Cash-Out Statute
The cash-out statute also sets boundaries to tender offers, just as the fair price provision does. If a bidder buys a percentage of stock in a target firm, they will be required to purchase every other outstanding share at the same terms during the first transaction. Acquiring firms who lack financial resources for a 100% stock acquisition are the most affected in this statute. Bidders who want to assume an even greater amount of debt with the associated high debt service are also at risk in terms of leveraged acquisitions. They may be discouraged to receive financing for a 100% purchase or simply because they do not believe their cash flow will service the increased debt.
Constituency Provisions
This provision lets the board consider how a deal may affect the relevant stakeholders like the worker or the community. In an offer that is in the financial interests of the shareholders, this is not so powerful. Still, it may give the board a secondary point to raise after saying that the offer is insufficient.
This statute is not present in all states.
Delaware Anti-Takeover Law
Deemed as one of the most important anti-takeover laws, this has helped the 850, 000 corporations in the state which are abundant compared to other states. Examples of corporations here are General Motors, Exxon Mobil, Wal-Mart, and DuPont. Half of all publicly traded companies are incorporated here, along with 63% of the Fortune 500 companies.
Many companies really prefer to incorporate in the state since its laws are developed well and the court system is sophisticated. It is considered sophisticated because it has very knowledgeable judges that can handle corporate lawsuits better than juries.
The low incorporation fees are also an obvious reason why Delaware is preferred by many companies. In fact, they are cheaper than all but 8 states. They also do not charge non-Delaware companies with Delaware corporate taxes. Lastly, companies love Delaware since companies and their shareholders do not need to be a resident of the state to incorporate there.
Researchers Bebchuk and Cohen stated that the law on anti-takeover has been an essential factor in decisions about which state to incorporate in. Meanwhile, Robert Anderson found that one of the most important factors influencing a company’s decision on where to incorporate was what law firm was representing the company around the time when the firm was formed. Delaware is the best selection when the law firm is a major national firm. But if it is merely local, the choice is usually incorporating in the particular state.
Wisconsin law
The anti-takeover law was actually passed on and signed late, as compared to the Wisconsin law which is more restrictive. The Wisconsin law was passed in 1988 but was made retroactive on December 23, 1987, the day before corporate raider Carl Icahn acquired 15% of Texaco Corporation. It was a response to an intense effort by companies to have a protective statute. They said they will reincorporate in states without anti-takeover laws if such a protective statute was not passed. Of course, the threat was effective as their fees account for about 20% of the Delaware state budget. The choice of the effective date testifies to the power of this lobbying effort. It states that an unwanted bidder who buys more than 15% of a target company’s stock may not complete the takeover for three years except under the following conditions:
- the bidder buys equal too more than 85% of the target company’s stock. This percentage may not include the stock held by directors or those by employees.
- If two-thirds of the stockholders approve this acquisition
- if the board of directors and the stockholders decide to waive the antitakeover provisions of this law.
Officially Section 203 of Delaware Corporation Law, this statute is designed to set limitations on takeovers financed by debt. The need to pay off the debt quickly becomes significant in the case of the billion-dollar takeover, as in the 1980s when interest payments were as much as half a million dollars per day. However, the law may not be effective when it comes to cash offers.
Effects of Anti-Takeover Laws on Wealth
In a study done by Karpoff and Malatesta, 40 state anti-takeover bills introduced from 182 to 1987 were examined. It is discovered that there is a small but statistically significant decrease in stock prices of companies incorporated in the various states contemplating the passage of such laws. Even those well-known businesses suffered the phenomenon. Additionally, Szewczyk and Tsetsekos found that Pennsylvania firms lost $4 billion during the time this state’s antitakeover law was being considered and adopted. Despite this, the loss was a short-term effect only as it was a result of the reactions of traders in the market during that time.
In another study, Comment and Schwert analyzed a large sample of takeovers in an effort to determine the impact of both the passage of state antitakeover laws and the adoption of poison pills. The found that laws didn’t really deter takeovers, but enhance them in terms of bargaining power. This, in turn, raised takeover premiums.
Effects of the 2nd-Generation laws
On the other hand, Bertrand and Mullainathan were curious about the effects of the 2nd generation laws on blue- and white-collar wages. They found that their wages went higher but did not pay for themselves. This is because operational efficiency was lower even years after the law was passed. There was a decline in plant creation and destruction. They generalized that the law insulates entrenched managers to “live the quiet life,” which may come at the expense of shareholders, although not of workers.
The impact of the passage of the 30 business combination statues on the performance of companies was studied by Giroud and Mueller. It was realized that in uncompetitive industries, there was a deterioration in the operating performance after the passage. In such industries, input costs, wages, and overhead increased, meaning competition can help reduce “managerial slack. The researchers also knew that the market correctly expected this.
In recent studies by Cain, McKeon, and Solomon, hostile takeovers and the passage of 17 takeover laws in 1965-2014 were the focus. Their results contradicted the usual results garnered. For instance, there were no wealth effects from the new laws while they found that fair price statutes were associated with reduced takeover activity, which, in turn, translates to fewer takeover premiums. They also found that greater takeover protection has a relationship with higher premium takeovers.
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Special Purchase Acquisition Vehicles
Companies that raise capital in an IPO are called special purchase acquisition vehicles or SPACs. Other terms for it include blank-check companies and cash-shells. In this very different type of IPO, funds are reserved for acquisitions. Unlike others, this does not raise capital to grow a company and create liquidity for the closely held shares.
SPACs are like private equity investments, that is why they are also referred to as “single-shot” private equity fund. While smaller investors can enjoy some features as private equity when they invest in SPACs.
History of Special Purchase Acquisition Vehicles
SPACs have only been around in the 90s, and they were unsuccessful. David Nussbaum is considered to be the creator of SPAC. After founding an investment bank called EarlyBirdCapital, in 2003, he filed an S-1 to take Millstream Acquisition Corporation. And was able to raise $20 million to acquire NationsHealth in 2004. The boutique investment bank boasts its recent transactions with different corporations. Such as Graf Industrial Corp., TKK Symphony Acquisition, etc.
From 2006 to 2007, SPACS became more well-known yet declined for some reason. But 2008 was the year that SPACs rose to popularity. This happened due to the New York Stock Exchange and NASDAQ starting to list SPACs.
SPACs raised more capitals in 2015 up until 2017 but still remained below their peak levels during 2007. This was due to the fallout from the subprime crisis and the Great Recession that followed.
In 2017, however, the business rebounded as the New York Stock Exchange. Updated its rules governing them in order to be more competitive with NASDAQ.
SPACs – How it Works
SPACs undergo the usual IPO procedure in which they submit a declaration of registration and firm commitment. Generally, they start out as corporate shells. As they are registrants with properties consisting only of cash and cash equivalents. The Securities Act of 1933 provides that. The founders purchase the shares of the shell at a nominal price to be used for the IPO. This transaction requires a Form S-1 like any other IPO. Here, the founders may disclose details like the nature of the acquisition targets they will need.
SPACs, especially those regulated by the NYSE or NASDAQ, place 90% of the funds raised in the IPO. An independently seen trust account that earns a rate of return, while the company seeks to invest the monies in the acquisition. The trust account funds are usually invested in, or retained as cash in. Short Term U.S. government securities and are released to fund the company mix. Typically it also requires deductions of interest earned on the assets to fund franchise and income taxes.
The new policy of NYSE done in 2017 included the aforementioned requirement, About the placement of 90% of the funds raised in a trust account. As well as the rules on approval of the acquisition. And also lowering the minimum listing size of a SPAC from $200 million to $80 million. NASDAQ also became more lenient to maintain the competition in NYSE.
Founders of SPACs receive a share, usually 20% of the value of the acquisition. They normally do not receive remuneration other than the ownership positions. Their shares are then locked up for a period, about three years, after the IPO date.
Comparison to Other IPOs
One key difference between SPACs and other IPO offerings is that they sell in units that involve a share and one or two warrants. Which usually detaches from the shares and trade a couple of weeks after the IPO. The selling price is $10 per unit. They are also considerably quicker as financial statements are short. And can be prepared in just a few weeks, although they can be risky investments. Due to the possibility that a company may not complete an acquisition. The return on investment is lower and they do not know what targets will be acquired in advance.
There are factors that lead to a value-destroying M&A strategy. But with SPACs, there are only a few strategies as they seek to convert their liquid cash. Into an equity investment in an unknown company. In a study of 169 SPACS from 2003-2010, the researchers, Jenkinson and Sousa, found that over half of the deals immediately destroyed value. After comparing the per-share value of the SPAC at the time of the deal with the per-share trust value. They thought that the SPAC should be liquidated and the acquisition should not go on. If the market value is equal to or less than the trust value.
Why SPACs are Still Popular
Despite the negative results of studies, SPACs continue to rise to popularity. As investments are liquid and the shares are sold to the market in the initial IPO. This is far better than private equity investments which are not very liquid. As mentioned in the first part, they are also available to small or non-institutional investors.
Jenkinson and Sousa, in spite of the fact that they concluded market prices as of the acquisition approval date. Indicated deals can be value-destroying. They found that investors who went along with the recommendations of the SPAC founders. In spite of a negative signal from the market suffered –39% cumulative returns within six months and –79% after one year. It’s not surprising that SPAC founders recommend deals. Since they derive their compensation by receiving 20% of the capital value of any acquisition. Hence, they try to pursue investors to approve in order to get their money. Despite causing them to lose. This is because it can still make a significant return on the founders. Even if SPACs perform poorly, it’s impressive how the investors still approve almost three-quarters of deals.
Lastly, another research about which types of SPACs fared better found out that success is more favorable to SPACs that are more focused and had a management team from an industry with a track record of success. Those that tend to fail more are foreign SPACs.
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Financing for Leveraged Buyouts
Secured and unsecured debt, often used together, are the two types of debt utilized in LBOs. The former is sometimes called asset-based lending. It contains two more types, the senior debt, and the intermediate-term debt.
These two are often considered as one in smaller buyouts. On the other hand, larger deals have multiple layers of secured debt. Depend on the term of the debt and the types of assets used as security.
Unsecured Debt
The latter, unsecured debt, is also called subordinated debt or junior subordinated debt. It lacks the protection of secured debt but carries higher returns to offset this additional risk. Subordination refers to the fact that more senior creditors. It needs to have their obligations satisfied before payment can be made to the subordinated creditors and equity investment is added to the debt financing. The percentage of the total financing that the equity component constitutes varies, usually in the 20% to 40% range.
The Dealmaker
The sponsor or the dealmaker works with the investment banks or those who provide financing. These banks conduct due diligence on the proposed deal. They will present this deal to them once they are confident that they will meet the criteria. They may present for the various prospective lenders. Wherein it shows its analysis and the reasons why lenders should feel secure providing capital to finance the deal.
A similar roadshow-type process may be conducted to develop an interest in an offering of high-yield bonds. That may be part of the overall deal financing structure. These are usually preceded by a memorandum related to the bond offering. Before this becomes final, it will usually require SEC approval.
If the banks approve of the proposal, they will initially provide a commitment letter that includes the terms of the loans. In some cases, banks will hold some of the debt in their own portfolio. While seeking commitments from other sources of finances while syndicating the rest of the debt.
Debt Capitals and Leveraged Loans
Debt capital comes from revolving loans or amortizing term loans that bank lenders provide. These banks typically involve commercial banks, savings and loan associations, and finance companies.
Long Term Debt
Longer-term debt commitments typically come from institutional investors such as insurance companies, pension funds, and hedge funds. Note that term loans can be investment grade or non-investment grade.
The latter group is referred to as leveraged loans. Unlike a revolving loan facility, which can be paid down but also reborrowed, Term loans usually have a fixed amortization schedule and are to be paid over a set loan period. Once payments are made, they cannot be reborrowed.
Bond Issuance
Another partial source of the debt capital may be a bond issuance. Which would probably require the investment bank to provide a bridge loan to close the time gap between when all the funds are needed to close a deal. And when the bonds can be sold in the market.
As previously stated, under asset-based lending or secured debt. We have senior debt and intermediate-term debt. Asset-based lending is secured by relevant current assets if the business being acquired in the LBO. It has a high volume of assets like inventories or receivables.
Senior Debt
Lending with such facilities is a function of the allowable “borrowing base,” which may define which assets are eligible. For example, older receivables or out-of-date inventories might not be eligible. In addition, the lending percentage will usually be less than the borrowing base to allow some protection cushion for the lender.
The former type of secured debt consists of loans secured by liens on particular assets of the company. Physical assets like land, plants, and equipment are the collaterals or those that provide the downside risk protection required by lenders.
The term of this kind of debt can reach five years or more. It also has different forms depending on the target’s business’ nature as well as the types of collaterals they may provide.
Moreover, the senior debt may make up between 25% and 50% of the total financing of an LBO.
The interest rate tends to be in the range of prime plus 2% to 3%. It also often comes with maintenance covenants, which impose financial restrictions on the target over the life of the loan. Furthermore, bank debt is usually priced above some variable base market rate, such as LIBOR or prime rate.
Asset-Based Lendings
Asset-based lending, whether senior or intermediate-term, is ensured stable cash flows, flows as determined by examining the pattern of historical cash flows for the company. The more erratic the historical cash flows, the greater the perceived risk in the deal. Even in cases in which the average cash flows exceed the loan payments by a comfortable margin, the existence of high variability may worry a lender.
Another characteristic that is deemed desirable is stable and experienced management as seen by the length of time that the management is in place. This will assure lenders that they are more experienced, implying that there is a greater likelihood that management will stay on after the deal is completed.
Creditors often judge the ability of management to handle an LBO by the cash flows that were generated by the firms they managed in the past. That is why is their prior management experience was with firms with liquidity problems, lenders will be more cautious about participating in the buyout.
Another thing that lenders tend to look for is room for cost reductions. reductions. Assuming additional debt to finance an LBO usually imposes additional financial pressures on the target, these pressures may be alleviated somewhat if the target can significantly cut costs in some areas, such as fewer employees, reduced capital expenditures, elimination of redundant facilities, and tighter controls on operating expenses.
Lastly, they see to it that the LBO candidate owns noncore businesses that can be sold off to quickly pay down a significant part of the firm’s post-LBO debt. With this, the deal may be easier to finance. This characteristic is also sometimes considered by unsecured LBOs.
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