Conflicts of Interest in Management Buyouts
Management buyouts can encounter a clear conflict of interest. Running the corporation is the manager’s responsibility. This is to maximize the value of stockholders’ investment and provide them with the highest return possible. They also take on a very different role when they have to offer stockholders to purchase something. When RJR Nabisco presented an offer to stockholders to take Nabisco private in an MBO, for instance. The offer was quickly superseded by a competing offer from KKR and other responding offers from management.
Some argue that managers cannot perform this dual and contradicting role as an agent for the buyer and seller. Why does management advocate an offer that was not in the stockholders’ best interest? Is it trying to make the most out of the stockholders’ investments?
Earning management to conflict management
Additionally, a conflict in management buyouts involves “earning management”. Before the activity, interested managers who are planning to buy the company from the shareholders could have an incentive. This is to pay less for the acquisition and to lower reported profitability. Discretionary accruals were manipulated in the predicted direction prior to the public announcement of the MBO. Perry and Williams found in the study of 175 management buyouts from 1981-1988.
The researchers developed a control sample wherein matched firms for each bought company were selected. The accruals were found to be associated with a reduction of income in the MBO group. These pieces of evidence should be causes of concern and extra vigilance. Such are increases in depreciation expenses or decreases in noncash working capital.
Neutralized voting
A possible solution that is commonly proposed is neutralized voting. This happens when proponents of a deal do not participate in the approval process. If these proponents are stockholders, their votes would not be counted. Still, they have to participate in the voting because of state laws. The quorum may not be possible without the participation of those who hold a certain number of shares.
The appointment of an independent financial advisor is a common second step in the process. It is meant to help reduce the conflicts of interest and render a fair opinion. It should be noted that certain practical considerations may limit their effectiveness even if precautionary measures are adopted. The members of the board of directors who may profit from the LBO may not vote for its approval. Other members of the board may have a close relationship with them and consider themselves obligated to support the deal.
Stockholders filing lawsuits to sue directors for breach of fiduciary duty have places limits on this tendency. Investment bankers who have done much business with management or may have financial interests in the deal. This put fair opinions forward but are usually of questionable value. Despite these steps in trying to reduce conflicts that are innate in the MBO process, for instance. The issues of the manager being both the buyer’s and seller’s agents are not yet addressed. To have mandated auctions of corporations presented with an MBO is one proposed solution by many.
Prohibited bid
According to current case law, directors are prohibited from favoring their own bid over another bid once the bidding process has begun. In addition, they are not allowed to do so since it is deemed unfair bidding. This was set forth by a number of important court decisions. Such as in Revlon, Inc b. Forbes & MacAndrew Holdings, Inc., PLC Hanson Trust v. SCM Corporation, and in Edelman v. Fruehauf.
The Revlon, Inc v. MacAndrews & Forbes Holdings, Inc. case, the court came to a decision of ruling that Revlon’s directors breached their fiduciary duty. Granting a lockup option to white knight Forstmann Little & Co. Considering the bid as an unfair process that favored the latter over hostile bidder Pantry Pride.
As for Hanson Trust PLC v. SCM Corporation, the Second Circuit Court took a similar position on the use of lockup. Options to favor an LBO by Merrill Lynch instead of a hostile bid by Hanson Trust PLC. Hanson Trust firs. This made a tender offer for SCM at $60 per share. They upped the bid to $72 as a response to Merrill Lynch’s LBO offer at $70 per share. The final ruling of the court stated that SCM gave preferential treatment to Merrill Lynch by granting lockup options on two SCM divisions to Merrill Lynch.
The last example is the case of Edelman v. Fruehauf, where the circuit court concluded that the board of directors had decided to make a deal with management. And did not properly consider other bids, such as the all-cash tender offer by Asher Edelman. They ruled that the Fruehauf board of directors did not conduct a fair auction for the company.
Prebuyout and post buyout
Even if the initial decisions establish a precedent that an auction for a firm must be conducted fairly, the courts stop short of spelling out the rules for conducting or ending the bidding process. Furthermore, the law is also vague to when or if there is an action required that will be facilitated by the independent directors’ committee. This process is often used when management has proposed a buyout. Similarly, they will usually respond by creating a special committee. When faced with a management proposal to take the firm private in order to endure that shareholders are fair value for their investment.
Moreover, another equity is provided by outsiders even when management is the buyer of the business unit. That is why management may not be in control of the post-buyout business. This depends on how much equity capital is needed. And how much capital the managers have and are willing to invest in the deal.
One study by Kaplan in 1980-1986 used a sample of 76 management buyouts. It showed the median to compare the pre and post buyout share ownership percentages of the CEOs and all management. He concluded that these percentages rose from 1.4% and 5.9% to 6.4% and 22.6%. In conclusion, management ownership tripled after the buyout. In theory, it motivated the company to guarantee and moves closer to maximizing efficiency levels for profit.
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Globalization of LBOs
The leveraged buyout (LBO), or the use of debt to purchase the stock of a corporation has been popular for decades now. In the United States, the value and number of LBOs peaked between 2006 and 2007. After that declined, and then significantly rose again in the following years.
Although there were very few LBOs in Europe in the 1980s, the volume of these deals increased in the 1990s. These had their value exceeding US LBOs’ from 2001 up until 2005.
Europe vis-a-vis the United States
The number of LBOs in Europe was almost double the number in the US by 2005. Also, in many years the average value of European LBOs was below that of the United States,. Indicating that more LBOs were completed in Europe but they were smaller than the LBOs that took place in the US. But although the LBO deal value increased in Europe during 2006-2007, the US was experiencing more dramatic growth.
Considering that 7 of the 10 largest LBOs took place in 2006-2007 and were all American deals, LBOs in both areas declined during the subprime crisis and rebounded afterward. Although the slower European economy dampened somewhat the rebound in Europe. Moreover, some of the LBOs that took place in the United States were significantly larger than in Europe.
From public to private
LBOs occur when the management of a company decides to take a publicly-held company or a division, private is called a management buyout. These are deals where a unit of a public company is bought by managers of that division. In the past ten years, both the volume of the dollar and the number of unit MBOs have risen.
Some trends that are visible in the total LBO data are also visible in the management buyout data. Both numbers and values fell after the fourth merger wave ended but made a comeback while in the fifth wave. But the dollar value of MBOs never returned to the levels witnessed in the fourth wave. While the number of these did come close to the mid 80s levels in 2012.
Greatest buyout in history
One great example, the greatest one in history, is the management buyout of pipeline company Kinder Morgan. This buyout costs $13.5 billion. Management proposed to contribute just under $3 billion of the total acquisition price. This equity contribution was augmented by a $4.5 billion investment by a group of private-equity investors. Investors were led by Goldman Sachs Capital Partners and the Carlyle Group.
The buyers planned to assume over $14.5 billion in debt, giving the deal an enterprise value of over $22 billion. Kinder Morgan was formed in late 1996 by a collection of assets. That was disposed of by Enron for approximately $40 million. These assets rose markedly in value due to its strong acquisition program in 1999, while Enron fell.
Management Investments
Investments may be made by the managers in an MBO using their own capital in the deal. But another equity capital is sometimes provided by investors and the bulk of the funds are borrowed. This deal often entails a sponsor working with the group, providing capital and access with investment banks. All this will work to raise the debt capital. The purchased company becomes separated from its own shareholders, the board of directors, and the management team.
The process is typical when the buying group is insiders in an MBO and the outsiders in an LBO. The former, however, has better access to information about the company’s potential profitability than an outside buying group. This is considered to be one factor that might give a management buyout more chances of being successful than a leveraged buyout. However, better information is still not enough. If the parent company has been seeking to sell the division due to poor performance, the management is assumed to be blamed for this attribute.
MBO vis-a-vis LBO
An MBO leaves the company still in the hands of the same managers, whereas in an LBO the new owners may install their own managers. These new ones may be less tied to prior employees and other assets are more willing to implement the changes that are important to make the company a more profitable one.
Companies should normally sell divest divisions to outside parties when they do and only a few of the time do they sell them to managers. For instance, between 2007–2016, only 2.3% of all divestitures were unit MBOs.
Still, the numbers are significant. On the other hand, the total dollar value of unit MBOs was $769 million in 2016, down from $3 billion in 2015, with the average deal size in 2016 is $154 million. By merger and acquisition standards, these are considered smaller transactions.
Secure Financing
When managers come to a decision of pursuing an MBO, they can work to make sure that they can finance themselves securely, typically with their investment bank’s help or a private equity firm they work with which can offer a fair percentage of the financing.
Fidrmuc, Palandri, Roosenboom, and Van Dijk’s study of 129 PTP transactions from 1997-2003 in the United Kingdom, they were able to present that managers tended to turn the private equity route when they cannot secure the financing by themselves. They do this since managers may give up control in exchange for the assistance of private equity partners.
Thriving Buyout
As previously mentioned, the company Kinder Morgan announced the biggest buyout in history, resulting in the diverging fates of Kinder Morgan and Enron. This all happened because of the strategies they used. Enron, a pipeline company, became a risky energy-trading enterprise. Meanwhile, Kinder Morgan, a company founded in 1927 in Houston as K N Energy, just stayed in the pipeline business and just thrived within the limits of his industry. With its acquisitions, it became an increasingly larger player in the less risky segment of the industry, lowering its risk profile due to the steady performance, and therefore enabling management to attract private equity investors.
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Historical Trends in LBOS
Leveraged buyout, a term for a financing technique where a company goes private, has been around since the early ’80s. Despite this, the activity itself has been done for a longer period. Such as in 1919, when the Ford Motor company wanted to be free from public regulations. This is true in terms of manufacturing and selling their Model Ts. It is also significant to note that Ford was affected by some problems that befell the LBOs. For instance, they incurred a cash crunch when the US economy was declining. They thought the company wouldn’t be able to service the huge debt load obtained from the buyout. Their strategic responses were a halt in production, layoffs, and cost-cutting actions.
Henry Ford exercised rights in his agreements with Ford dealers and shipped them the mounting inventory of cars. Even though they did not necessarily need them. The dealers were required to pay and Ford Motor Company was able to cope with the cash infusion it needed. This strategy was done instead of seeking distressed financing.
Start of Deconglomeration
As mentioned earlier, LBOs became prominent in the 1980s than they did in the ‘70s. High stock prices of ‘60s motivated private corporations to go public and allow entrepreneurs to enjoy the profit. Even firms that are not of high quality had their stocks absorbed rapidly by the bull market. But when the stock lowered between 1972 and 1974, so did the low-quality companies and their prices. As a result, managers of some of the companies that went public in the 1960s chose to take their companies private in the 1970s and 1980s. There was a so-called de-conglomeration.
Those that had been built through large-scale acquisitions dissembled through sell-offs. It took place through the sale of divisions of conglomerates through LBOs, ongoing through the 1980s and is partially responsible for the rising trend in divestitures that occurred during that period. The LBOs formed during this decade were Kohlberg Kravis & Roberts, Thomas Lee Partners, and Frostmann Little who created investment pools to benefit from finding undervalued assets and firms, as well as using debt capital to finance their profitable acquisitions. Later on, these became known as LBO firms, and many other firms joined them in the activity.
Peak of LBOs
The 80s were the peak for LBOs, especially during the end of the decade, reaching up to 200, 000 in terms of value worldwide. Larger companies were the target of LBOs, and the average transaction went from $39.42 million in 1981 to $137.45 million in 1987. Despite this, there were still very few LBOs and their value was deemed low. For instance, there were 3701 mergers in 1987 but only 259 LBOs, hence the latter accounts for only 7% of the total number of transactions. You can learn about types of merger in this article “Type of mergers:short-form Mergers”.
It was in 1987 when LBOs made up 21.3% of the total value of transactions. It shows that the typical LBO tends to have a larger dollar value than the typical merger. LBOs were too efficient that many thought it would replace the usual public corporation, but they thought wrong. The fourth merger wave experienced a more limited number of sponsors or LBO dealmakers and also providers of debts. The sponsor was able to pursue deals using high leverage percentages.
The high returns during the ‘80s and the minor barriers attracted many competitors. The barriers to entry were really the access to capital, which proved not that challenging. Given the very large number of pension funds and endowments aggressively seeking diverse investments in the hopes of achieving higher returns. These provided the equity capital, and the access to bank financing and public debt markets provided the rest. As theorized by microeconomics, growth in competition precedes a fall in return.
90’s Drama
The start of the ‘90s was also the start of their dramatic fall. The decrease coincided with the decline in the junk bond market that started in late 1988 and the 1990–1991 recession that followed a few years later. This is proven by Cao and Lerner’s study which reported that the established funds between 1986 and 1999 earned less than 10%. Despite the average buyout firm formed that generated 47% internal rate of return.
The value and the number of worldwide LBOs still increased during the fifth wave of mergers. By 1998, the number reached its highest until 2000. The number of deals in 2000 was approximately double the 1980 level even though the total value was only half. The deals of the fifth merger wave were not the mega-LBOs of the fourth wave but smaller and more numerous.
Decade of Recovery
During the new decade, the number of LBOs fell along with the value. 2001 and 2002 coincided with a recession and an initially weak recovery, so the event was predictable. But by 2004, the LBO volume rose along with mergers and acquisitions until 2007, making it the most robust of all. The growth was strengthened by readily available capital at somewhat modest rates through the collateral debt obligations markets.
Aside from the LBOs increasing, the average size of deals also grew, with 7 out of 10 deals taking place during this period (2006-2007). The instant growth happened because of a combination of a very robust economy, with a rising stock market and a housing-market bubble. The low-interest rates made the cost of debt financing for debt-laden LBOs unusually inexpensive. There were readily available equity and capital, and there were even more of the latter than there were good deals to pursue. This all came to a rapid halt when the subprime crisis took hold and the global economy entered a recession in 2008. This also resulted in low-interest-rate due to the stimulative monetary policy. Whereas pursued by most central banks, credit availability dramatically shrank.
The dealmaking of LBOs fell to a near term low during 2009 and remained below the heady levels of 2004-2007 despite making a rebound in the years that followed. One company affected was RJR Nabisco, which used to be the largest LBO until 2006.
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Hedge Funds Activism and Firm Performance
Hedge funds Activists want to obtain great returns through their agitation. In order to get the company to make meaningful changes that will uplift their stock price. Instead of aiming to take over a company in which they assume an equity position.
Hedge Fund Study
One study by Brav, et al. noticed that the performance of the companies improved after being targeted by hedge funds. Especially an anomalous average return of 7%. They found this out by analyzing the market’s reactions to activists. Hedge funds’ announcement assuming positions in companies over the period 2001 up to 2006. They also found out greater CEO turnover and increased use of pay for performance. They generalized how useful to powerful CEOs who may fail to bring about stock price growth hedge funds are.
In another study by Bebchuk, et al., operating performance was found to improve after activist interventions. Based on a sample of 2040 activist interventions over the period 1994-2007. Focusing on performance measures like return on asset and Tobin’s Q. They also concluded that these performance improvements were not offset by falloffs somewhat later. Which could have implied that they were just temporary and perhaps a function of accounting manipulation. This study found the same results as Solarz’ with a smaller sample. He found that if the hedge funds indicated in their filings that they made specific actions like board seats or a proxy fight, they are activists.
This kind of hedge fund also shows the short-term. And excess returns that are greater at about 10% than passive investments, as shown in the data provided by the researcher. More specifically, the study measured the performance of companies with active and passive investors. He found out that after a two-year period there were improvements in the company’s return on assets for the active group and declines in the passive group. He also found that shareholders gained through increases in leverage and a greater dividend payout ratio.
Activist Hedge Funds
As previously mentioned, activist edge funds oppose takeover bids since they included an insufficient takeover premium. Private equity buyers’ goal is to get the target as cheap as possible and to sell it later at a higher price. Target shareholders do not usually bargain for a higher premium and rely on boards to act in their best interests. But when the target shareholders’ ranks include an activist hedge fund with great stock or have at least one seat on the board. Everything is different and does not go well for the private equity buyer.
For instance, Huang found out that a one standard deviation increase in the fraction of equity of the target. That is held by hedge funds prior to a buyout announcement that was associated with a 3.6% increase in the buyout premium through an analysis of 237 buyout proposals for US public targets. He also concluded that mutual funds, pension funds, and other shared held by other types of institutional investors did not affect buyout premiums. Moreover, the premium uplifting effect was greater for management buyouts than outside initiated buyouts. And also stronger for club deals where more than one buyout firm combines to make a joint bid than solo buyout offers.
It should be remembered that managers of hedge funds will take much higher relative roles than other organizations. Because of this, diversified portfolios are not required by law. And may allow investors to commit for a period of 2 years or longer to “lock-up” their investments. In comparison, the law requires mutual funds to hold a diversified portfolio. And selling securities within a day to satisfy redemptions from investors.
Institutions vs Retail Investors
Institutions have been owning great percentages of equities than retail investors do for many years now. The former vote their shares while the latter do not bother to vote at all. Considering there are also rules adopted that limit a broker’s ability to vote uninstructed retail shares in street names. Thus, institutions become the concentration of voting power.
Aside from opposing takeover bids, activist hedge funds also do not hold very large equity positions in the target. Nevertheless, large-cap companies’ holdings represent a large financial investment for them, despite relying on institutional investors’ financial support. These institutional investors haven’t really been activists in their investment approach. And they also own the bulk of the shares in a typical public company.
Statistical Analysis
According to Broadridge Financial Solutions, Inc in Retail ownership of public company shares There is a declining percentage of total shares outstanding owned by retail investors. A few very large institutional investors have a disproportionate interest in large-cap companies. Meanwhile, according to data provided by CamberView Partners in Sullivan and Cromwell LLP Memo. Shareholders and their voting power have been more controlled by a few major financial institutions. The statistics show the percentage of shares, a rising percentage, in the S&P 500 companies held by just four firms: Blackrock, Fidelity, State Street, and Vanguard. It went from above 15% but below 20% in 2012, and above 20% in 2016.
This means that these institutions’ support for activists is really vital to the success of the activists’ campaigns. When it became clear to institutional investors that when an activist targets a company, share values can rise and performance often improves. Institutional investors gained a financial incentive to support their activist initiatives. Even if institutions have raised concerns about the short-term orientation of various activists, they are also the ones who are under short-term performance pressures and have the tendency to positively respond to proposals. That will allow them to make short-term returns and bonuses for fund managers.
Index Fund
The institutional support of activists can be even greater for index funds managers since these investors are not discretionary. They do not vote with their feet and they may be locked in an equity position in a company that generates low returns. These kinds of managers are more likely to support activists who plan to improve performance and generate higher returns. Many mutual fund investors have changed to lower-cost index funds from active funds with the increased awareness that these managers frequently fail to make enough returns to compensate their fees. Therefore increasing the importance of index fund and their voting power.
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Hedge Funds as Acquirers
Takeovers, which used to be the exclusive fund territory of private equity funds, have been eyed by businesses. Ever since hedge funds began feeling pressure from competitors to generate high returns. Some examples include Edward Lampert’s takeover of Kmart in January 2000. Nelson Peltz’s acquisition of Wendy’s in 2008 and merged it with Arby. In 2011, they sold Arby’s to a private equity firm, the Roark Capital Group.
Dramatic Evolution
In 2014, the takeover business made a dramatic evolution. William Ackman’s Pershing Square Fund teamed up with Valeant Pharmaceuticals to bid for Allergan at $45.6 billion. Ackman wasn’t only good in financing but also in skills. From being a successful activist throughout the years, purchasing 9.7% as a toehold in Allergan. But this value could fall if the bid does not succeed, which is what happened to Ackman’s innovative bid. Actavis outbid the team with a $66 billion cash and stock offer. Although Ackman did not win the bidding contest, he did win financially. As Allergan’s largest shareholder since the bid was expensive and it made good returns on Ackman’s holding.
Hedge funds take an interest in investing in companies for great returns. One of their focuses is the debt of distressed companies. In fact, they have been engaging in debt financing of M&As. Commercial banks become sources of M&A debt financing. The syndicate to hedge funds that assume what usually is second lien debt. This new origin has changed the total capital available for M7&A financing.
M&A Volume
As for activist hedge funds and M&A, the former usually have short-term goals. As they seek to obtain short gains from their share positions in the investment. Usually, one or more hedge funds offer to acquire a position in an undervalued company to be restructured. As a result, it contributes to an increase in M&A volume. Acquirers’ transaction also helps increase overall M&A volume. When activists pressure a company to sell certain assets. But if the goal of the activist is to pursue a strategic merger that pays gains long term. The hedge fund opposes the deal and it leads to a lower overall level of M&A. Activists indeed have impacts on overall M&A volume.
When the M&A volume is low, activist funds have to use different strategies. That may even lead one to become a financial engineer or one who uses balance sheets to buy back shares. One can be an operational activist. By getting more involved in the company’s operational performance and may want to have the company run differently.
Based on a study by Boyson, et al., activist hedge fund interventions significantly increased. The likelihood of the target being taken over. When another party implements a takeover, the target receives higher bids and premiums. Even when the bid failed, the operating and equity market performance of the targets improved in the years that followed. However, these positive patterns were not present when the activist was the actual bidder as opposed to a third party.
Accumulation of n Equity
Moreover, the accumulation of an equity position by an activist hedge fund can have great effects on the stock price, and that is evident in the well-known Carl Icahn’s situation. There are also various studies that prove the announcement of hedge fund activism. That has a correlation with abnormal returns over a short window around that announcement date. It is also worth noting that a study by Clifford in 1998-2005 found that companies that were targeted by activists realized higher excess stock returns. Specifically a 3.39% cumulative excess return around the announcement date. They also showed great operations proven by the return on assets.
Klein and Zur confirmed these findings and added a comparison regarding the market effects of activist hedge funds. Sharing accumulations with those of what they called entrepreneurial activists. These consist of individuals or asset managers who act for private equity firms and venture capitalists. They are activists if they aim to bring about change in the company. That would raise the stock prices and provide them with a profit from their investment as a result of their activism.
Hedge Funds
The two types are associated with positive abnormal stock returns. But hedge funds showed 10.2% returns while the entrepreneurial group was associated with a 5.1% return. Hedge funds had a 60% success rate. While the entrepreneurial group was successful 65% of the time, meaning both were often successful in their bidding. Both seemed to target different companies too. Where hedge funds target those in better financial conditions, than did the entrepreneurial activists. Hedge funds seemed to seek out companies that had higher cash resources. Then they tried to pressure them into buying back shares and make other changes. Like lowering senior executive compensation and increasing dividends. The entrepreneurial activists tended to focus more on the company’s strategy. Both also achieved their goals through a proxy process.
Shareholder Wealth Effect
Meanwhile, Greenwood and Shor analyzed the source of positive shareholder wealth effects. Through huge samples of companies that filed Schedule 13Ds. They then cross-referenced this sample to the 13F filings, which are made by institutions. Leading to a bigger sample which included many passive investors that had to be deleted. The DFAN14A filings, which are filings made with the SEC by those non-management investors considering pursuing a proxy fight were examined. The must be filed with the SEC by any registrant when there is a shareholder vote. The researchers found that period returns of greater than 5% for those companies that were eventually acquired. This is almost double of other companies’ returns. Therefore, activists have the ability to generate above-average returns because of the target being sold to their own advantage.
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Leading Activist Hedge Funds and Institutional Investors
Some of the major activist hedge funds who have been in the “activist business” for a long time. Now include Carl Icahn, David Einhorn, and Bill Ackman, as well as Nelson Peltz who are often seen in the media. Other entrants in the business include David Einhorn, Ralph Whitworth, Barry Rosenstein, Jeffrey Ubben, and Jeffrey Smith
CalPERS and CalSTRS
Activist investors have played a huge role in establishing funds. And so are institutional investors who are starting to engage more in activism, such as CalPERS, and CalTRS who have become so active in the market recently. They are well aware that activism funds generate great returns. That they are encouraged to abandon the traditional buy and hold method and other investment strategies. Funds have started to establish internal departments to address activism issues. Institutional investors sometimes even interact with the activist to support each other and benefit from the trend.
Terms of Approach
Although activists go through similar transactions, they may still vary in terms of approach. Some are aggressive and public that they may launch an attack at a company through media saturation to pressure the target company’s management and board. On the other hand, there are those who announce ownership of shares discreetly, as well as demand from the company in a toned-down manner.
Aggressive activists also have a tactic of acquiring shares in the target and then pressure them to put one or two of its representatives on the board. This would make them be able to directly monitor the activity of management. As well as the deliberations made, allowing the activists to have a say in each meeting. One example of such an event happened in 2016. When William Ackman and his activist firm Perishing Square Capital Management which owned 10% of Chipotle. Then asked to get two seats on the board of directors. Ackman and his firm agreed not to comment publicly about this for two years. They are also restricted from raising their stake above 12.9% over that same time period.
Short Term Value
These investors and the target’s management and board have common interests but the former is really short-term value investors. The activist wants to bring this about as quickly as possible and with a different means. For instance, activists may want the company to be put up for sale immediately. While management may even agree that an eventual sale is a good idea but they may not think this is the right time.
Smaller companies used to be the targets of smaller companies, but the landscape changed in the years 2012-2014. Making large companies like Microsoft and Apple targets. The large activist funds can acquire a really large percentage of a smaller target’s shares and overpower the board and management. But all companies, big or small, are vulnerable to attacks by aggressive activists. Take Carl Icahn for example. He tried to invest billions in a large company’s stock (AOL TimeWarner). However, he had trouble as he could only hold less than 5% of the shares. Still, he got positive returns on his investment in the company.
Downsides and Benefits
When an activist obtains 5% or more of a company’s share, they usually prefer a brief 13G filing. However, this is difficult to take with the SEC considering the nature of the business. They take control of the companies and take actions that result in the sale of a firm. With that, they will more likely be required significant disclosure and updating under the requirements of 13D.
The fact that any company is vulnerable to activists’ attacks has its downsides and benefits. It can be good if it encourages managers to run the company for the sake of shareholders for a good return on their equity. Moreover, it pressures them not to accumulate assets. Just like large cash holdings without showing how these are better off staying in the hands of the company to the shareholders. However, the drawback is that companies may be hindered to pursue a long-term plan. That is feasible because of the pressures of activists which are usually short-term.
With larger funds and AUMs, larger companies are needed to produce significant returns. That is why activists started to pursue larger target companies. Even if they are challenging, it can be worth it as the larger AUMs demand that bigger prey be pursued.
Near-Term Exit Strategy
It is worth noting that activists are short-term investors. After acquiring a position in a company, they usually have a near-term exit strategy. Companies are pressured to immediately take action to make the stock price rise. It enables them to exit the investment at a profit. The bigger downside here is that they might be forced to sacrifice their long-term profitability and growth. Meanwhile, a public company is pressured to meet the near-term goals of the activist. The counter-argument of activists is that it was the company that has sacrificed their long-term profitability. Way back which only gave investors a chance to correct the problem as if they’re heroes and not bullies.
The Full Control of the Board
Over time, activists even want multiple representatives on the board of their target company. Sometimes, it even called for full control of the board. The type of people nominated to boards by activists can vary. They often are people on the payroll of the fund, including possibly the head of the fund. They also could be industry experts or people who have been employed in the industry for some time. Other times, the investor already has in mind. The people who can assume active management positions at the target company if their activism is successful.
Although the process seems aggressive, there is a give-and-take process occurring. The activist may propose three candidates that include the portfolio manager of the fund and two outside industry people. The company may come back and say it accepts the two outside people but does not accept the internal fund representative. This then can lead to negotiations and will be a function of the relative bargaining positions of both parties.
This board seat issue is the main focus in terms of the activists’ demands. After this comes the return of monies on the balance sheet to shareholders including the activists. Irrelevant in the activist battles are the staggered boards or poison pills where the activist is looking to accomplish its goals. That means by replacing just a few members of the board. If this is possible, then the majority control of the board may not avoid the activist from attaining its goals. Given that it’s complicated for the staggered table. Outside pressures also forced many companies to abandon their staggered boards.
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Hedge Funds as Activist Investor
Over the past few weeks, we have discussed a multitude of topics regarding mergers and acquisitions. From tender offers, long-term mergers, structuring deals, anti-takeover measures, we have covered a lot. This article about Hedge Funds as Activist Investors opens up a whole new spectrum of topics we can discuss. This is an introduction to Hedge Funds as Activist Investors.
Hedge Funds as Activist Investors
As a substitute for open-end investment funds or mutual funds, hedge funds were produced. This limited partnership uses high-risk methods so as not to make public solicitations for capital to investors and so as not to be required to report as their mutual counterparts do. Since the reporting requirements are low, investors have less access to return data.
Hedge funds grew during 2013-2007, those were the years when the economy was strong. The truth is, it nearly doubled during those years. During those times, the industry has shrunk and many weak players had no choice but to leave the business as hedge fund assets grew.
The growth resumed in 2009 since there were large amounts of institutional capital to invest. Two years later, both the number of funds and assets outdid the progress in 2007. This progress resumed but declined later on.
The Two Types of Hedge Funds
With regard to mergers and acquisitions, there are two types of hedge funds. First, we have the risk arbitrage and second, the activist hedge funds. Both of which shall be discussed in this article. Before we continue further, it is worth noting that activist hedge funds grew in the post-recession period and even surpassed other types of investments. Hedge funds have actively entered the activist arena from 2009 to 2015 and rose to $123 billion from $29 billion during 2005.
Along with this growth comes the changes in a number of campaigns. The activist assets’ dramatic rise in terms of value is inherently linked to a marked increase in the number of activist campaigns. Two situations can be observed: the many campaigns conducted by new activists as opposed to a limited group of large activists, and the fact that these campaigns had an expanded focus, including more smaller-cap companies.
All these trends grew dramatically partly because of the great returns. In relation to this are the various deterministic macroeconomic factors that created a favorable environment. For such returns to be realized which will be discussed later on.
What is a company A target for Customer Activists?
Going back, activist hedge funds are those that make big enough investment in a company to participate in the management and firm decision-making. Hence, it enables the investors to obtain positions on the company’s boards to influence changes in the company.
Factors for Activist Investors
There are a few factors that make a company become a target for activist investors. For example, if it is not well operated, a corporation becomes a target for activist investors, has high costs, and as a private company could be run more profitable. However, it can also be a target if the activist investor has other issues that can be resolved to make them more competitive and profitable.
Another factor that makes a company a target is its past performance. It may be left with high levels of liquid assets that the investors want them to use to return cash to shareholders in the form of a stock buyback.
Carl Icahn
Such was the case with Carl Icahn way back 2014. He pressured the billion-dollar company Apple to use its cash to fund a more rapid stock buyback program. Carl Icahn got the multinational company to buyback $14 billion within two weeks. Still, he did not succeed because he took on a huge target that was pursuing a buyback program already. Apple’s shareholders failed to rally around the activist and ISS failed to endorse Icahn’s initiative.
Sign of an Activist Hedge Fund
Activist investors can be looked at as long-term oriented since they take a private equity approach to public markets. They enjoy investing in companies where management has insufficient incentives to maximize shareholder value. It’s because, without proper incentives, management can make excessive compensation and benefits and cancel free cash flow. Because of their less diverse portfolio, they vary from conventional funds. Another sign of an activist hedge fund could be the filing of SEC form 13D that must be filed when an investor purchases 5 percent or more of the stock of a company.
Evaluating Macroeconomic Factors
These transactions are related to deterministic macroeconomic factors. For instance, the 18-month long Great Recession from 2008 to June 2009. It was a very relevant downturn since the Great Depression. However, unlike other deep recessions, we had in 1973–1974 and 1982–1983. Originally, It was a very anemic recovery from the Great Recession. Particularly with respect to the labor market, which is inextricably linked to consumer spending.
US economy reached its peak after the growth in 2009, helping stimulate a rebound in equity markets. During this recovery, the stock market was quite strong and indices such as the S&P500 reached record levels. While it can be advantageous for some companies, the laggards and others were not able to keep up, becoming potential targets of opportunistic activist funds.
Additionally, the low-interest-rate environment is a macroeconomic factor that helped many activist funds. It prevailed in the United States and Europe, making the costs of debt financing lower for potential acquirers. Along with this is the fact that many companies had rising cash balances which could also be used to finance acquisitions. These factors made it easier for activists to claim that there were many potential bidders who could finance the acquisition of the target company.
Stay Tune
We hope that this article has helped you understand Hedge Funds as Activist Investors better. In the next few articles, we will discuss this topic in further detail. Tune in to our website to find out more about Leading Activist Hedge Funds and Institutional Investors, Hedge Funds as Acquirers, and Hedge Fund Activism and Firm Performance. In the meantime, check out our previous articles for more important and informative lessons about mergers and acquisitions.
© image credits to Anni Roenkae
Takeovers and International Securities Laws
In this article, we will talk about some of the different takeover laws in different countries. We have focused so much on the United States laws for the past few months (William Act), it is time to shed some light on other countries’ laws.
Over the past quarter of a century, global financial regulation has substantially evolved. As time goes on, thousands of companies have become more globalized. With this, large variation in securities laws has become an impediment to growth.
It is also noticeable that there is a trend toward common regulations across many nations, as well as securities regulations. And of course, there is no exception to mergers and acquisitions.
Europe
Great Britain
There was a time when the British takeover regulation was a form of self-regulation by the corporate sector and the securities industry. The City Code on Takeovers and Mergers is one of the main principles of the regulations. Its purpose is to have all shareholders treated fairly and equally.
It also helps prevent target firms from adopting antitakeover measures without the approval of shareholders. There are plenty of important provisions that the City Code provides, below are great examples:
- Bidders must only release information regarding the bid in a manner that is consistent with the Code.
- Investors who are acquiring 30% or more of the company’s share must bid for the remaining shares at the highest price paid for the shares that have already been acquired.
- A clarifying announcement must be made by the potential bidder if rumors of the bid occur.
European Union
On the other hand, takeovers in Europe are regulated by the European Takeover Directive. The Code we referred to earlier has been diluted by different countries that wish to give their indigenous companies more ability to oppose hostile takeovers if the bid is from another country. This was done through negotiations among members of the European Union.
It is required that a bidder must make a mandatory offer after they have purchased a certain number of shares. This will help protect the shareholders of minorities. Additionally, the bid must be submitted to shareholders and it should be made at an equitable price. The bid must also have certain disclosures relating to the offer and bidder.
Moreover, the target shareholders only have less than two weeks to evaluate the bid. The said directive should also contain provisions to limit the use of poison pills. Members may also choose to opt-out of the provisions should they find that the provisions are not in their interest.
France
The takeover activity in France is more common compared to other nations in continental Europe. In this beautiful country, the Financial Markets Authority or the AMF regulates the bid. The AMF is a group of 16 members with each member elected for terms that last for five years.
The disclosures a bidder makes must be submitted to the AMF. And the filing period is only within five trading days of crossing various shareholding thresholds. Additionally, the bidders who are planning to acquire additional shares is also required to disclose their holdings on a daily basis.
The offers are also required to remain open for at least 25 trading days, however, it should not be longer than 35 trading days. In France, antitakeover laws also exist. It provides protection top potential targets.
Germany
Now we move on to Germany. In Germany, they are more supportive of management. They are also more accepting of antitakeover defenses. In this country, they put up a system of worker codetermination. This means that it is common for a representative of management to sit on the board of directors and seek to exercise a worker’s claim to corporate profits. The same can be said for the Netherlands.
There are several laws that regulate takeovers in Germany. These include the Takeover Act and are supervised by the Federal Office of Supervision of Financial Services. The Federal Office of Supervision of Financial Services is similar to the FSA in Great Britain and the SEC in the United States.
The offers in Germany must be kept open for 28 days. The maximum days an offer should be open is up to 60 days. As for the target company, they are required to respond to the offer within two weeks. Not only that, but the offers in Germany must be publicized in national newspapers.
Ireland
The Takeover Panel Act of 1997 regulates the takeovers in Ireland. Disclosures are required for acquisitions of shares that are 5% or more. For purchases of 1% or more of the target shares, additional disclosure is also required. The minimum offer period in Ireland is 21 days. On the other hand, hostile bids must be responded to by the target within 14 days.
In Irish takeover rules, equal treatment must be given to all shareholders. This way, minority shareholders will also be protected should the controlling position be acquired by any person.
Italy
In Italy, the takeover rules divide tender offers into two parts: voluntary and mandatory offers. Voluntary bids can either be hostile or friendly. On the other hand, if the bidder acquires enough shares to gain control of the target’s board, a mandatory bid is required.
As expected, the time periods for these two types of tender offers are different, too. Voluntary bids have an offer period of 15 to 40 trading days. On the other hand, Mandatory bids are open for 15 to 25 trading days.
Spain
Hostile bids are also common in Spain. The National Securities Market Commission must be notified if the bidders are planning to acquire 5% or more of a target’s stock. Additionally, bidders are required to make a formal announcement of the bid. The announcement is made public by at least two national newspapers and the commission’s Official Gazette. All of these must be done within five days of making the offer.
In Spain, the offers may be kept open for up to four months. Additionally, the country also requires the controlling party to make a bid for the shares of the remaining shareholders. The said bid must be at the highest price paid by the bidder for the shares in the target that were acquired within the prior 12 months.
These are only some of the takeovers and international securities laws in different countries. Which countries do you want us to feature next?
©image credits to Anni Roenkae
Merger Approval Procedures
In a previous article, we have discussed merger negotiations and what happens in a merger negotiation process. After the negotiation stage, a merger needs to be approved in able for it to happen. Today, we will talk about merger approval procedures.
Adopt Resolution
Each state in the United States has a statute that authorizes the mergers and acquisitions of corporations. Sometimes, the rules differ for domestic and foreign corporations. After the negotiation and both board of directors of each company reach an agreement, they adopt a resolution approving the deal they agreed to.
Now, this resolution should always state the names of the companies involved in the deal. It should also include the name of the new company. Additionally, the resolution should also include the financial terms of the deal and other relevant information. Relevant information such as the method that is going to be used to convert the securities of each company into securities of the surviving corporation.
Moreover, should there be any changes in the articles of incorporation, any changes in the articles of incorporation, it must be referenced in the said resolution.
At this point in the deal process, target companies should be taken to the shareholders for approval. Shareholder approval is required if the bidder is financing the offer using 20% or more of its own stock, NYSE, NASDAQ, and AMEX.
According to recent research, when bidders issue as much as 20% or more of their shares to acquire the target company, the bidder should experience a 4.3% increase in their announcement returns.
This could be related to greater expected synergies and a less chance of overpayment, or so it is presumed. Additionally, the researchers have found that this effect was concentrated among acquirers with greater institutional ownership. These usually are the investors who are in a better position to evaluate the deal.
Friendly Deals
Typically, shareholders are the ones who approve friendly deals. After the shareholders’ approval, the merger plan will now be submitted to the relevant state official. Usually, this is approved by the secretary of state.
Once the state official is satisfied with the proper documentation and determines that all documentation has been received by the state, it issues a certificate of merger or consolidation. A proxy solicitation should be accompanied by a Schedule 14A as per SEC rules.
The 14th item of this schedule sets forth several specific information that must be included in a proxy statement when there will be a vote for approval of a merger. Additionally, it should also include the sale of substantial assets or liquidation or dissolution of the corporation.
This information should also include the terms and reasons for the transaction. It should also state the description of the accounting treatment and tax consequences of the deal. This is true for all mergers.
Moreover, it is also required to present the financial statements, a statement regarding relevant state and federal regulatory compliance. Not only that, but it is also required to include more documents such as fairness opinions and other related documents. Fairness opinions will be discussed later.
Once the deal is completed, the target company or the registrant must then file a Form 15 with the SEC. This terminates the target’s public registration of its securities. Here are some more important details that come into play when it comes to merger approval procedures.
Special Committees of the Board of Directors
When it comes to mergers and acquisitions, the board of directors has the right to choose or form a special committee. The aforementioned special committee will then review the proposed merger. For instance, directors who might personally benefit from the merger should not be members of the said committee. To explain further, directors who will benefit when the buyout proposal contains provisions that management directors may potentially profit from the deal.
There are higher chances of a special committee to be appointed the more complex the transaction gets. However, the committee cannot do all the evaluations by themselves. We also need legal counsel assistance. The legal counsel will help guide the committee on legal issues.
These legal issues can include the fairness of the transaction, the business judgment rule, and other legal issues they might face. It is paramount that the committee and the board itself carefully considers all of the relevant aspects of the transaction.
Otherwise, they might overlook important details in the decision-making process and later on be scrutinized by the court. The same happened in the Smith v. Van Gorkom case where the court found the directors personally liable because it thought that the decision-making process of said directors was inadequate.
Fairness Opinions
Earlier, we mentioned fairness opinions, but what does it really mean? Well, this phrase can mean different things. When it comes to mergers and acquisitions, fairness opinions focus on the financial fairness of the consideration paid by the bidder to the target.
On the other hand, in connection with a divestiture, a fairness opinion focuses on the fairness to the corporation as opposed to the stockholders of the company. Additionally, the fairness opinion could also focus on fairness to the holders of the seller’s shares if, and only if, the shareholders directly receive the buyer’s consideration.
Deal Closing
Now, we move on to the closing of a merger or an acquisition. This often takes place after the agreement has been reached. Why? Simply because there are plenty of conditions that have to be fulfilled prior to the eventual closing. This may include the formal approval of the shareholders.
Additionally, it may also be required for both parties to secure regulatory approvals from government authorities. These government authorities may include the Justice Department or Federal Trade Commission as well as regulators in other nations if it is a global firm. In a lot of cases, the final purchase price will be adjusted in accordance with the formula specified in the agreement.
That is it for Merger Approval Procedures. Check out our website to learn more about Mergers and Acquisitions.
©image credits to Amber Lamoreaux
Merger Negotiations
When it comes to mergers and acquisitions, a friendly negotiation isn’t what initially comes to mind. In reality, most mergers and acquisitions are negotiated in a friendly environment. It may be hard to believe because of the terms “takeovers” “hostile takeovers”, but it is the reality.
Differences in Merger Negotiations
Usually, in buyer-initiated takeovers, the process begins when one firm’s management contacts the management of the target company. This is often done with the help of the investment bankers of each company.
On the other hand, seller-initiated deals are done by hiring an investment banker. The investment banker will then contact the prospective bidders. If the contacted prospective bidders are interested, they will sign a confidentiality agreement and agree not to make an unsolicited bid. Additionally, potential bidders may also receive nonpublic information.
Next, the seller and their investment bankers can conduct an auction if they choose. Or they can also negotiate with just one bidder if they think they can reach an agreeable price.
When it comes to auctions, these can be conducted formally or in a less formal manner. Formal auctions usually have specific bidding rules established by the seller.
The management team of both the buyer and the seller must keep their respective board of directors up-to-date with any information and progress of the negotiations. This is because the board of directors usually has to approve of the mergers.
Examples of Different Merger Agreements
If the process is smooth-sailing from start to finish, a quick merger agreement commences. One great example of ta quick merger agreement was Pfizer’s acquisition of Wyeth Corp. back in 2009. It was an investment worth 68 billion dollars.
Usually, deals with this high of a price aren’t done in a quick manner. However, the quick meeting between the corporate minds and management of both firms leads to a quick and friendly deal.
This doesn’t mean that quick and friendly deals are often the best way to go, however. It depends on different circumstances. For instance, the $48 billion acquisition of TCI by AT&T was done in a swift and fast manner. Ultimately, it was found that the buyer did not do his homework and the seller did a fantastic job of fulfilling the buyer’s desires to make a quick sale at a higher price.
At a certain point, speed can help ward off unwanted bidders. But it can also open the possibility of working against close scrutiny of the transaction.
Negotiations Breakdown
There are also instances where friendly negotiations may break down. It leads to an end to the deal or a hostile takeover.
For example, let’s take Moore Corporation’s tender offer for Wallace Computer Service Inc. In this contract, talks in the area of business types and printing business between two archrivals have been going on for five months.
Time period of Negotiation
They were called after just five months of negotiations and it resulted in a hostile offer of $1.3 billion. Back in 2003, Moore and Wallance reached an agreement for the acquisition which led to the formation of Moore Wallace. A year passed, and with MooreWallace, RR Donnelley merged.
There are also instances where the target immediately opposes the bid and the transaction will lead to a hostile one quickly. In 2003, the takeover battle between Oracle and PeopleSoft immediately led to a very hostile bid.
It is one of the most infamous takeovers because it was unusual. Because of its protracted length, the takeover contest was considered unusual. A year before PeopleSoft finally capitulated and accepted a higher Oracle bid, the takeover battle continued.
Material adverse change clauses are usually included in most merger agreements. Where there is a major change in circumstances that would ultimately change the value of the deal, either party may be allowed to withdraw from the deal.
A great example of this is a merger that happened in recent history. The merger between Verizon and Yahoo! In 2017 made headlines because of the changed value. Because of Yahoo data breaches! both companies both agreed to reduce the price to $4.48 billion. That is $350 million less than the original agreement price.
Auctions v. Private Negotiations
There are a lot of people who believe that auctions may result in higher takeover premiums. There is a lot of research to back this too. The 377 completed and 23 withdrawn acquisition takeover processes that occurred in the 1990s were analyzed by Boone and Mulherin. In their analyzation, they found that 21 bidders were contacted and 7 eventually signed a confidentiality and standstill agreement on average.
On the other hand, the deals negotiated in private featured the seller dealing with a single bidder. Additionally, Boone and Mulherin found that more than half of the deals involved auctions. The question of why all deals are not made through auctions was raised by the belief in the financial effects of auctions, too.
One would argue that it may be the agency costs. And so, Boone and Mulherin analyzed the issue further. They used an event study methodology. In this study, they compared the wealth effects to targets of auctions and negotiated the transaction.
However, they failed to find support for the agency theory, which also comes as a surprise to most. The results of the analysation failed to show a lot of difference in the shareholder wealth effects of auctions compared to privately negotiated transactions. Additionally, there has been some vocal pressure to require mandated auctions which led to some important policy implications to the result.
The examples provided above shed light on important merger negotiation tactics and lessons. This should help you decide and plan mergers and acquisitions strategically. It also helps in deciding which route to take when it comes to merger negotiations, and which route is more beneficial to your company.
In the next article, we will talk about Merger Approval Procedures in depth. See you then!
© image credits to Sharon McCutcheon