Corporate Finance Comprehensive - Paper

Submission
Anish Shankar Menon
May 30, 2014
Abstract
This paper tries to analyze certain issues that are relevant to
raiders and minority shareholders in the context of corporate takeovers.
1 Introduction
In the case of corporate takeovers, there are issues that both the raider and
the target (especially the minority shareholders face). This study analyzes
the welfare implications and the free-rider problems facing the raiders and
the minority shareholders in the context of takeover legislations in India and
the United Kingdom(UK).
The papers structure is as follows. First a brief introduction of the
takeover legislation relevant to the analysis is given in both the Indian and
UK scenarios. The next section presents the analysis and the nal sction
concludes.
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2 The two scenarios
Given below is a brief account of facts of the two scenarios (as given in the
problem statement)
2.1 The Indian Scenario
The regulation as per the Securities and Exchange Board of India (Substan-
tial acquisition of shares and takeovers) Regulation, 2011 states that if an
acquirer along with others acting in concert want to acquire shares that en-
title him to 25% or more of the voting rights of the target company, then in
order to acquire such number of shares, the acquirer has to make a public
announcement of an open oer for acquiring the shares. This means if the
acquirer (raider) wants to own a substantial block of shares in a company
(assuming equal voting rights hence substantial voting rights also) then he
has to make an oer to all the shareholders of the target company. The
regulation also states that such an open oer should be for atleast 26% of
the total shares of the target company.
2.2 The UK Scenario
The UK Takeover Code states that when a person or a group acquires inter-
ests in shares carrying 30% or more of the voting rights of a target company
then a cash oer must be made to all other shareholders of that company
at the highest price in the 12 months preciding the announcement of the
oer. Furthermore if interests in shares carrying 10% or more of the voting
rights of a class have been acquired by an oeror(bidder) in the oer period
or in the preceding 12 months, the oer must contain a cash alternative for
all shareholders of that class at the highest price paid by the oeror in that
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period. Further, if the oeror acquires any shares for cash during the period,
a cash alternative at that price must be provided at the minimum.
3 Analysis
The analysis is with regard to the welfare implications and the free-rider
problem for both the raider and the minority shareholders when the com-
pulsory open oer in the Indian context increases from 26% to 100% of all
shareholders. It is assumed that the shares are widely held. The study looks
at the problem in two dierent cases. The rst case is where the raider is
operating in an environment with no nancial constraints and the second
case looks at a situation where the raider faces a nancial constraint.
4 General Overview
The general observation is signicant gains for the target and a slight or
neutral return for raiders. An explanation of this phenomenon was given
by Grossman and Hart (1980), and was termed the free-rider problem.
The problem essentially is that the existing shareholders will not be willing
to sell their shares at less than its post-acquisition price. However if the
raider pays this value to the target companies shareholders (and assuming
that the transaction costs are zero) then his payo is zero since he acquired
the shares at a price higher than before acquisition or to be exact at the value
after acquisition. In case the raider has to bear some transaction costs, then
his payo is negative. The shareholders on the other hand have clearly got
a higher value for their shares i.e., a value higher than the current market
price. The assumption in the model by Grossman and Hart (1980) is that the
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shareholding is widely held. The problem is termed as free-riding since the
shareholders are better o not tending their shares until the premium they
recieve is atleast equal to or more than the value addition of the takeover.
This is because the shareholder does not take into account his own impact on
the likelihood of takeover and instead free rides on the willingness of other
shareholders to submit shares and enable the raider to take over the rm.In
eect until the premium is equal to or greater than the value added by the
takeover, each shareholder would want the other shareholder to tender his
shares and would hold on to his own shares and obtain the full value addition
of the takeover. It is clear that in such a scenario if we assume that both the
raider and the target shareholders are rational expected value maximizers
then ceteris-paribus, there would be no takeover.
Grossman and Hart (1980) make ve important assumptions. They are:-
1. The bidder maximizes prot and diers from the current management
in the ability of running the rm.
2. The target rm is owned by a large (innite) number of shareholders
and is widely-held i.e. each shareholder is negligibly small and thus
will ignore his impact on the outcome of the bid.
3. The bidder and shareholders are rational and stochastic outcomes of a
bid are ignored i.e. a bid only succeeds with certainty if the price to
tender equals at least the expected future market value.
4. Unconditional bids, which means that the bidder is willing to buy all
shares tendered.
5. No uncertainty about the rms future market value i.e. all information
is revealed (symmetric information).
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There are several solutions proered to the free-rider problem. The Gross-
man and Hart (1980) provide that dilution of share value is a method to
overcome this impasse. Once the raider assumes control over the target com-
pany, he then dilutes its share value. This can be done in multiple ways. The
raider can pay himself an exorbitant salary, thus depleting the cash reserves
of the company. He can issue new shares to himself at a below market cost.
Ha can also sell output or assets of the target company below cost to one of
his own companies. By doing this, the raider makes it unattractive for small
shareholders to hold their shares since they will not enjoy the full value of
the increase in rm value post-takeover.
A second method is the raider having a substantial toehold in the target
company. In such a case, the raider enjoys all the surplus accruing to the
toehold shares.
Other models include the one by Shleifer and Vishny (1986). In their
model, a large shareholder has the proper incenive to monitor the managers
as this is the most bencial course of action for him. The minority shareholder
are most likely to follow him since his incentives are properly aligned.
Bagnoli and Lipman (1988) analyze a single raider with nitely many
shareholders. They show that the raider can make some shareholders pivotal
and overcome the free-rider problem without excluding some shareholders.
Bebchuk (1989) develops a model in which he shows that takeover bids
can be successful even if there is no dilution in the minority stake and the
raider has no initial toehold in the target company. This is possible when
the assumption of being able to predict successful bids with certainty as
proposed by Grossman and Hart (1980) is dropped. He says that in particular
a bid which is below the expected value of the minority shares but above
the independent targets per share value is likely to succeed with a positive
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probability.
Holmstrom and Nalebu (1992) develop a model in which the sharehold-
ers hold divisible shares (unlike the Grossman and Hart (1980) where the
shareholders have a single share). In such a case, there is a mixed strategy
equilibrium and the shareholders tender the shares in order to increase the
value of their untendered shares. The argument is that in the Grossman and
Hart (1980) model, each of the shareholders feel that they are non-pivotal
i.e., their individual actions will not aect the outcome of the raid. However
in the Holmstrom and Nalebu (1992) model, every shareholder has a lot of
shares and therefore each one could be pivotal.
There are numerous other models that oer solutions to the free-rider
problem. These models focus on what would happen in the case of dierent
kinds of securities such as non-voting shareholders, debt-holders and other
security holders.
In the analysis of the UK and Indian scenario, we assume a Grossman
and Hart (1980) world in general.
5 Takeover in the Indian Scenario
Assume that the raider has no toehold in the target company. Then in
order to obtain control rights he would have to acquire at least 26% of the
target companys shares. If he is able to obtain these shares then he would
depending on his interest in the target increase his shareholding. Suppose he
increases his shareholding then it is clear that he would dilute the shareholder
value. In such a case, the minority shareholders will be put at a loss. If he
is not able to obtain the controlling stake then the takeover will fail.
Suppose the raider already has a toehold in the target, this the chances of
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the success of the raid are higher. as mentioned earlier he would completely
extract the value added of the toehold shares. Once he crosses the threshold
of the minimum shares required for control (26% in this case) then he would
act in a manner similar to that described above.
There could also be a case where there is a positive raider surplus when the
raider derives a private benet from control. This is kept exclusively by the
raider. This private benet cannot be extracted by dispersed shareholders.
Large shareholders can extract this if they have some leverage in negotiation
and the raider has cash.
It is quite clear that as the percentage of the raiders shareholding in the
target increases, the probability of dilution of shareholder value decreases.
Hence if the shareholding requirement is enhanced from 26% to 100% then the
minority shareholders do not have to suer a loss due to dilution. However
the free-rider problem that the raider faces still remains.
Now we look at the nancial constraints that the raider faces. Suppose
there is a private benet that a raider obtains from the takeover. The raider
will not be able to extract it unless he pays an amount over the value of
shares. Suppose he has no nancial constraints i.e., he has cash, then, he
would pay the extra amount for the control. However if he has a credit
constraint then, according to Burkart (1995) and Zingales (1995) he will not
be able to extract the private benet since his nanciers would be unwilling to
pay more than the value of the shares. However it is seen that in most cases
the raider uses high leverage (in the form of a shell acquirer company with
no assets but only debt which is nally merged with the target company) to
nance the raid. In a manner, the raider sells the value of the future benets
of the new merged company for the current value of the target company. In
such a case, the minority shareholders are put at a loss since they some of
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the debt when the shell acquirer company is merged with target.
6 Takeover in the UK Scenario
In a Grossman and Hart (1980) world, there would not be much dierence
in the analyis of the UK scenario from that of the Indian scenario. Let us
rst examine the case of the highest price in the past 12 months. In the case
of the Grossman and Hart (1980) analysis, the shareholders free-ride in the
hope of extracting the future value of the shares post-takeover. This would
depend on the probabilities that they would attach to the expected future
value. This value discounted at the appropriate discount rate should be equal
or more than the highest value of the share in the previous 12 months for
them to accept the oer. There is a high degree of uncertainty with regard
to this future value and hence the free-rider problem would still exist though
maybe not at the levels it would exist in India.
The other dierentiating factor is the compulsory cash oer. The advan-
tage with the cash oer is that it prevents any agency problems that might
emerge in the valuation of the shares to be given in lieu of the target com-
panys shares i.e., it might be overvalued. Payment of cash eliminates this
problem.
According to Payne (2011), the takeover provisions of the UK law provide
a good deal of protection to minority shareholders in the sense that they are
treated on par with the other shareholders. However minority protection does
not solve the free-rider problem. It is true that the law would bring equality
in the price obtained by all classes of shareholders. However that does not
prevent the shareholders from not selling their shares and free-riding.
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7 Conclusion
In this paper we have analyzed the various aspects of takeovers with regard
to the raider and the minority shareholders. We have dened and analyzed
the free-rider problem and also seen dilution as a solution to this problem.
We have further examined the eects of dilution on minority shareholders.
Though dilution might be a solution, it is not easy to implement due to the
legal protection of minority rights and the duciary duty of the management
towards the minority shareholders. We have also seen the impact of nancial
contraints on both the raider and target companies. Finally we have seen the
advantage of an all cash oer with respect to an oer of cash and/or shares.
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