Information Effects from the Financing of a Merger or an Acquisition

When management believes that the shares of their own firm are underpriced, they are

less likely to want to finance investments by issuing new equity (see Chapter 19). This

logic applies to acquisitions of other companies as well as investment in capital equip-

ment. Eckbo, Giammarino, and Heinkel (1990) suggest that uncertainty about the tar-

get’s value also tends to lead firms to make stock offers rather than cash offers. Stock

offers have the advantage that the acquiring firm ultimately pays less for the bad acqui-

sitions since the acquirer’s stock price is likely to perform worse after making a bad

acquisition.

20.10Bidding Strategies in Hostile Takeovers

In many of the hostile takeovers, the bidder initially attemps to buy less than 100 per-

cent of the target’s shares. There are two reasons for this. First, the bidder might think

that it is unnecessary to acquire all of the outstanding shares to make the changes

required to improve the firm’s value. Second, some shareholders may not be willing to

sell their shares at any price. For example, the target’s managers are unlikely to sell

their shares if such a sale allows the firm to be taken over and the managers lose their

jobs as a consequence.

The Free-Rider Problem

To simplify the following discussion, assume that the bidder can effectively take

over a firm by accumulating over 50 percent of the target firm’s shares. We assume

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that the bidder buys the shares and uses the voting rights of those shares to appoint

a new CEO who implements the changes that increase the value of the bidder’s

original stake. By following this procedure, the bidder can avoid, in theory, the

free-rider problem discussed in Chapter 18; that is, if shareholders are all small,

none of them will find it in their interest to go to the expense of replacing a non-

value-maximizing management team. However, if one of the smaller shareholders

can accumulate enough shares to become a large shareholder, then this free-rider

problem can be reduced.

Unfortunately, reducing the free-rider problem in this way is not always possible.

We will show that the bidder’s ability to take over a target at a price that allows the

bidder to offset his costs depends on how the bidder treats those shareholders who

refuse to sell their shares. If the firm is able to force the bidder to offer nontendering

shareholders the post-takeover fair market value of their shares, then hostile takeovers

may not be profitable.

Conditional TenderOffers.Suppose that John Douglas discovers that Alpha Cor-

poration, currently selling for $20 a share, can be run more efficiently. Under Douglas’s

management Alpha will be worth $30 a share. Douglas would like to buy enough shares

to gain control of the firm and then make the improvements that will raise the firm’s

share price. Assume that Douglas offers to buy shares in a conditional tenderoffer,

which is an offer to purchase a specific number of shares at a specific price. The offer

is considered conditional because the buyer is not required to purchase any shares if

the specific number of shares is not tendered.

Example 20.4:The Success of a Conditional TenderOffer

Assume that Douglas chooses to make a conditional tender offer for 51 percent of the out-

standing shares at a price of $25 a share.He figures that he is giving the shareholders a

good premium over their original $20 per share value and that he will gain $5 per share

after implementing his improvements.Would you expect target shareholders to tender their

shares at this price?

Answer:To determine whether shareholders will tender their shares, the table below com-

pares the value shareholders receive if they tender with the value they receive if they do not

tender.

Value If Shareholder Value If Shareholder

TendersDoesn’t Tender

Bid succeeds	$25/share	$30/share
Bid fails	20/share	20/share

If the offer is successful, shareholders who tender their shares receive $25 a share.How-

ever, the shareholders realize that if Douglas is willing to pay $25 a share for the stock, it

must be worth more than that after he gains control, so they are better off not tendering

their shares.In this case, the shareholders who do not tender will have shares worth $30 a

share and will thus be better off than those shareholders who do tender.In the event that

less than 51 percent of the shares are tendered and the offer fails, shareholders will retain

their shares whether or not they tendered, and all shares will be worth only $20.Hence,

small shareholders who believe that their decision has no effect on the outcome of the offer

have an incentive notto tender their shares.

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724Part VIncentives, Information, and Corporate Control

Of course, what is rational for an individual shareholder may be bad for the

shareholders as a group. If no one tenders, the shareholders are left with shares worth

only $20 rather than the $25 (or $30) per share they would have received if more

than half of them had tendered. This argument indicates that if most of the share-

holders are small, tender offers will fail unless an offer equal to the target’s post-

takeover value is made. But at this price, the bidder cannot make a profit unless the

value of the shares to the bidder is greater than their value to the original shareholders

after the takeover.¹⁶

Again, we see that significant value improvements may fail to

be implemented because of the small shareholders’incentives to free-ride on the

efforts of others.

Result 20.8

Small shareholders will not tender their shares if they are offered less than the post-takeovervalue of the shares. As a result, takeovers that could potentially lead to substantial valueimprovements may fail.

The above reasoning can be extended to situations where Douglas makes what is

known as an unconditional offeror an any-or-all offer, which requires Douglas to

purchase the tendered shares even if he fails to attract enough tendered shares to gain

control of the firm.

Solutions to the Free-Rider Problem

In reality, acquiring firms find ways to get around the free-rider problem discussed

in the last subsection. First, the acquiring firm may have secretly accumulated shares

on the open market and will profit on those shares when the target is taken over. Sec-

ond, target shareholders may be induced to tender their shares if the bidder can con-

vince them that they will not share in the profits that arise from the bidder’s value

improvements.

Buying Shares on the Open Market.During the 1980s, many bidders secretly accu-

mulated shares on the open market before making a bid. However, U.S. regulations

require purchasers to file a 13D report to the Securities and Exchange Commission in

which they must state their intentions as soon as their holdings reach 5 percent of the

outstanding shares. At that point, the share price will reflect that the firm is a takeover

target and shareholders will again be unwilling to sell their shares for less than their

value after the takeover. However, by purchasing some shares at $20 per share, Doug-

las may find it worthwhile to tender for a controlling block of additional shares even

if he must pay the value of the shares after the takeover. This strategy is illustrated in

Example 20.5.

Example 20.5:Share Tendering Strategies

Alpha Corporation has 10 million shares outstanding that are currently selling for $20 per

share.Douglas believes the shares will be worth $30 if he controls 51 percent of the shares

and implements some changes.The costs of mounting the takeover are expected to be

$4million.Can he take over Alpha profitably?

Answer:Douglas may be able to buy 5 percent of the shares for $20 per share.How-

ever, after reaching the 5 percent threshold, he will have to make a tender offer for an addi-

tional 46 percent of the shares for $30 per share.Although he will not gain on the shares

purchased through the tender offer, he will realize a $10 per share profit on the 5 percent

16

The preceding argument was originally suggested in Grossman and Hart (1980).

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of the shares he purchases on the open market.His total profits on these shares will be

$5million, which exceeds his costs of $4 million, implying that a takeover will be profitable.

In many cases, the potential gain on a bidder’s original stake is not sufficient to

compensate for the costs of making the bid. Douglas would be much more willing to

bid if he could profit from the shares that he purchases in the tender offer as well as

those that he secretly accumulates before the bid. To do this, he will have to induce

shareholders to tender their shares at a price which is less than $30 a share. How can

he do this?

Secret Share Accumulation by Risk Arbitrageurs as a Way to Resolve the Free-

RiderProblem.Recall from Result 20.8 that only smallshareholders will choose not

to tender if the offer price is less than the value of the shares after the takeover. Large

shareholders, who could affect the success or failure of the offer, may be willing to

tender their shares at a price below their post-takeover value. This possibility is illus-

trated in Example 20.6.

Example 20.6:The Advantage of Accumulating Shares before a TenderOffer

Suppose that Joe Raider accumulated 15 percent of Alpha stock following Douglas’s tender

offer to purchase shares for $26.Joe believes that the stock will be worth $30 per share if

the offer succeeds, but only $20 per share if the offer fails.If Joe tenders his shares, the

offer will succeed for sure.However, if he doesn’t tender his shares, the offer has a 50 per-

cent probability of failure.Should Joe tender?

Answer:If Joe tenders his shares he will get $26 per share for sure.If he doesn’t tender

his shares, he will get .5 $20 .5 $30 $25 per share, on average.He is better off

tendering his shares.

Example 20.6 illustrates that so-called risk arbitrageurs like Joe Raider, who buy

shares of prospective targets on the open market in hopes of profiting when the shares

are tendered, can increase the likelihood of an offer. The presence of these individuals

can allow the bidder to increase his profits by tendering for shares at a price below

their post-takeover value.¹⁷

The Free-RiderProblem When There Are Gains Captured Directly by the Bidder.

Up to this point, we have assumed that, following the takeover, the shares are worth

the same amount to both the target shareholders and the bidder. If, however, the bid-

der values control of the firm, he or she may place a value on the shares he acquires

that exceeds their post-takeover value to target shareholders. This will occur when some

of the gains from the takeover can be captured directly by the bidder and not by the

target.

An alleged example of this occurred when Frank Lorenzo, the owner of Texas Air,

took over Eastern Airlines. After the takeover, Eastern sold a number of assets (most

notably its reservation system) to Texas Air at what was alleged to be a reduced price.

¹⁷We

would like to note, however, that the term risk arbitrageuris really misleading. As we

discussed previously, an arbitrageur, by definition, makes money without taking risks; that is, he or she

does not place bets. Individuals who are often referred to as risk arbitrageurs earn their livings by

placing bets on the outcomes of takeover battles. This activity certainly involves risks.

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726Part VIncentives, Information, and Corporate Control

When transfers of this kind can be initiated, the bidder’s value of the target’s shares

exceeds their post-takeover value in the stock market. Example 20.7 illustrates this

possibility.

Example 20.7:How Wealth Transfers Facilitate Takeovers

Suppose that part of Douglas’s $30 per share valuation of Alpha Corporation comes from

the sale of its insecticide division to the Beta Corporation, which Douglas also owns.Since

the division will be sold to Beta at an attractive price, the post-takeover value of Alpha will

be only $27 per share.In this case, can Douglas gain on the shares that are tendered?

Answer:Shareholders realize that their shares will be worth only $27 per share if the

firm is taken over.Therefore, they would be willing to tender their shares at $27 per share.

As a result, Douglas will be able to earn a profit of $3 on each share that is tendered.The

profit comes from the appreciation of his Beta stock, not from a gain on the Alpha stock that

he purchases.

Two-Tiered Offers as a Way of Resolving the Free-RiderProblem.In most

takeovers, the bidder expects to eventually purchase all the target’s outstanding shares.

This could create a substantial holdout problem if there was no way to force remain-

ing shareholders to sell their shares. In reality, however, if a sufficient number of tar-

get shareholders agree to merge the target firm with the bidding firm, the minority

shareholders can be forced to sell their shares.¹⁸

In what has come to be known as a two-tiered offer, the bidder offers a price in

the initial tender offer for a specified number of shares and simultaneously announces

plans to acquire the remaining shares at another price in what is known as a follow-

up merger. In almost all cases, cash is used in the tender offer, but securities, worth

less than the cash offered in the first-tier offer, generally are offered in the second tier.

As a consequence, shareholders are induced to tender their shares to the bidder. Exam-

ple 20.8 illustrates why these two-tiered offers are sometimes considered coercive.

Example 20.8:Coercive Two-TierOffers

Buccaneers Inc.has made a $25 per share tender offer for 51 percent of Purity Corpora-

tion’s shares.If the offer is successful and at least 51 percent of the shares are tendered,

the firms will be merged.The shares not tendered in the first tier will receive a combination

of bonds and preferred stock valued at $22 per share.As a shareholder, you believe the

shares are actually worth as much as $30 per share and would like the takeover to fail.

Should you tender your shares?

Answer:We will assume that you are a small shareholder and, as such, do not affect

the success or failure of the offer.Your payoffs in the event of the success or failure of the

offer are given in the following table.

Value If Shareholder	Value If Shareholder
Tenders	Doesn’t Tender

Bid succeeds	$25/share	$22/share
Bid fails	30/share	30/share

18

In LBOs, the bidding firm is a shell company, created for the purpose of merging with the target.

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As the preceding numbers indicate, you should tender your shares regardless of what you

think they are worth.If the bid succeeds, you are better off having tendered.If the bid fails,

you are indifferent.

As Example 20.8 illustrates, two-tiered offers can be coercive because they force

some shareholders to tender their shares at prices they believe are inadequate. In the-

ory, by making the second-tier offer sufficiently low, a bidder can successfully take

over a firm at a price that all shareholders find unacceptable. There are, however, legal

restrictions that limit how low the second-tier price can be. Although the bidder is not

legally required to provide the target shareholders who do not tender with an amount

that compensates them for all of the synergies brought about by the merger, the bidder

is required to pay “fair value” for the target shares in the follow-up merger.

In many takeovers that occurred in the 1980s, second-tier offers were substantially

lower than first-tier offers. However, most companies currently have what is known as

fairprice amendmentsin their corporate charters which require the second-tier price

to be equal to the first-tier price. Most states also have laws that require second-tier

prices to be at least equal to first-tier prices.