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. The acquiring company assumes the assets and liabilities of the acquired company. The buyer is defined as company with larger market capitalization or the company that is issuing shares for other company’s share in stockfor-stock deal. A consolidation is different from merger for in consolidation a new corporation is born out of the merger. Laconically, merger is a+b = a and consolidation is a+b = c. Despite of these difference these terms(merger, consolidation &takeover) ,as is true for many other terms in M&A are used interchangeably. TYPES OF MERGERS: There are three types of mergers: 1. Horizontal merger: These are mergers in which two competitors combine. Ex: Exxon and Mobil two petroleum companies combined in 1998. 2. Vertical merger: Mergers of companies having a buyer seller relationship. 3. Conglomerate merger: This occurs when two non competing companies which doesn’t have a buyer-seller relationship combine. MERGER PROFFESIONALS: Before any merger companies generally seek advice of professionals which play key role in M&A. These include Investment banks which offer expertise in structuring the deal and handling the strategy. They also provide financing for transaction. Given the complex legal nature of M&A law firms also play an important role. Valuation experts also provide important services in M&A. Another group of professionals who can play an important role are arbitragers. Arbitrage refers to buying of an asset in one market and selling in another. With respect to M&A arbitragers purchase stocks of companies that may be taken over in the hope of getting a takeover premium when the deal closes. MERGER PROCEDURE: Most mergers are friendly. Process begins when management of one firm contacts Target Company’s management often through investment bankers of each firm. Most merger agreements include a material adverse change clause which allows either party to withdraw from the deal if a major change in circumstance arises. When two companies engage in M&A they often exchange confidential information which helps them to know the deal better. This shows another risk of M&A leaking of confidential information. A denial of negotiation when the opposite is the case is improper as companies may not deceive the market.
HISTORY OF MERGERS: Merger activities have seen five majors ‘waves of merger’. The first four occurred in 1897-1904, 1916-1929, 1965-1969, and 1984-1989. The fifth wave began in 1994.the cause of these waves is attributed to economic, regulatory and technological shocks. Economic shocks come in form of economic expansion to grow to meet the rapidly growing demand in economy. Regulatory shocks may come from removal of regulatory barriers that might have prevented corporate mergers. Technological shocks come from technological advancements in industry or even giving rise to new industries. First wave (1897-1904): This included many horizontal combinations and consolidations. Many industrial giants originated in first merger wave such as U.S steel, Dupont, GE, Eastman Kodak, American tobacco. Many monopolies were built. Sherman act which was enforced to prevent monopolies wasn’t effective enough. Second wave (1916-1929): American economy evolved during this time due to post World War I economic boom. This period was dominated by horizontal mergers but also saw many vertical mergers. The period resulted in formation of many oligopolies. The antimonopoly provisions of ineffective Sherman act were reinforced by Clayton act. Many prominent corporations formed during this wave were General motors, IBM and union carbide. Third wave (1965 – 1969): Firms during this period faced tough antitrust environment due to the celler-kefauver act of 1950 which strengthened the anti merger provision of Clayton act. Clayton act made the acquisition of other firms’ stocks illegal when it resulted in a merger which reduced the competition in an industry. However the law had a loophole: it did not prevent the anticompetitive acquisition of assets. The cellerkefauver closed this loophole. Thus firms with financial resources were left with only one way of merging, forming conglomerates. Many of the acquisitions resulted in poorly performing firms which had to be sold or divested. Fourth wave (1984-1989): This wave featured many interesting and unique characteristics. Arbitragers became a very important part of takeovers. The ability of these corporate raiders to receive greenmails (or targets assets) in exchange of their stock made it highly profitable. Investment banks played an aggressive role as well devising many innovative techniques to facilitate or prevent takeovers. Many of the mega deals of 80’s were financed with huge debt. These leveraged buyouts were used to take a public company private. Fifth wave (1992- ): Fifth merger wave is truly a global merger wave with increased number of deals in Europe, Asia, and South America. Fifth merger wave is marked by many mega mergers. There were fewer hostile bids and more strategic mergers. These deals were not highly leveraged, financed through the increased use of equity. In mid 90’s market was enthralled by consolidation deals called roll ups. Here fragmented industries were consolidated through larger scale acquisition of companies called consolidators. Certain investment banks specialized in roll-ups and were able to get financing and were issuing stock in these companies.
REASONS FOR M&A: Two of the most cited reasons for M&A are faster growth and synergy. Growth: This can be internal or external growth (through M&A). Through M&A firm can expand in same or different industry (called diversification). Expanding in different industry is very controversial in finance. If a company expands internally it grows slowly, competitors can take advantage of this and acquire market shares. M&A is also valuable when a firm wants to expand to different geographic market. Unfortunately it is much easier to generate sales growth by simply adding up revenues of both firms than it is to improve the profitability of overall firm. Management needs to make sure that the greater size in terms of revenue has brought with it must commensurate profits and returns for shareholders else it was better off to continue with slow growth. The key question with every M&A is whether the return from the deal is greater than what can be achieved with the next best use of invested capital (opportunity cost). Synergy: Simply stating synergy is 2+2 = 5, which is ability of combination to be more profitable than combining firms. The two main types of synergies are operating synergy and financial synergy. Operating synergy comes in two forms revenue enhancements and cost reductions. Revenue enhancement synergy comes from the new opportunities that are present as a result of M&A. It may come from a company with good brand image lending its reputation to other company. It may arise from a company with large distribution merging with company with large product potential but losing its ability to get to market before rivals seize the period of opportunity. Revenue enhancement synergies are difficult to achieve and difficult to be quantified and built into a valuation method. Another source of operating synergy is economics of scale which is decrease in average cost with increase in output. As according to demand, companies with low level of output will have higher per unit cost, because the fix cost required to maintain manufacturing facility is spread over the low output. Other reasons for gain include increased specialization of labor and efficient use of capital equipment, which might not be possible at low output levels. But after certain level of output per unit cost rises again as company experiences diseconmics of scale which arises from higher costs and other problems related with coordinating a large production.
Financial synergy refers to impact of a corporate merger on the cost of capital to the acquiring firm. The extent to which financial synergy exists; the cost of capital must be lowered. Diversification(growing out of parent industry): This led to the formation of conglomerates in the late 60’s. Having many diverse firms may help company achieve a diverse portfolio, this may help in reducing risk and maintaining a stable dividends. One reason for diversification is to enter more profitable industries but there is a lack of assurance whether this profit will persist long. Competitive pressures bring a movement of long term equalization of rates of return across industries. This doesn’t mean that rates of return of industries are same all the time. Forces of competition are offset by factors such as technological advancement in some industry. These above average industries with no imposing barriers to entry will experience declining return till they reach the average. In long run only industries that are difficult to enter will enjoy higher rate of interest. One area of benefit of diversification is co-insurance. This occurs when firms with less correlated earnings combine and derive a combined earning i.e. less volatile than either of individual earnings. Other Economic Benefits: Horizontal Integration: Economic theory categorizes industries within two extreme form of market structure. On one extreme is pure competition, with numerous buyers and sellers, perfect information and undifferentiated products. On the other is monopoly. The monopolist has the ability to select the price-output combination that maximizes profits. Closer to monopoly is oligopoly which features few (3-12) sellers of differentiated product. horizontal integration involves movement from competitive to the other end of spectrum by merging with the rivals. Market power is defined as the ability to set and maintain a price above the competitive level. In perfectly competitive markets, competitive firms set market price equal to marginal cost. There are three sources of market power product differentiation, barrier to
entry, and market share. Even with a substantial increase in market share, the lack of product differentiation and barrier to entry may prevent a firm from raising its price substantially over marginal cost, as raising the price will attract new competitors who will drive price down toward marginal costs. A monopoly results in higher price and low level of production and thus fewer units are sold. This results in welfare loss. Welfare loss can occur in monopolies but to say that increase in concentration in some industry will result in a welfare loss is untrue. The final outcome might be a oligopoly, which engage in high tend state of competition characterized by competitive prices and differentiated product. Vertical Integration: It involves M&A of firms that are close to either source of supply (backward integration) or to the ultimate consumer (forward integration). reasons for vertical integration are : 1. to be assured of dependable source of supply 2. To lower inventory costs. 3. Not to pay profits to supplier. This is not true though it appears to be because the increased profitability of parent firm comes at the cost of lower profitability of acquired firm. 4. Savings in form of transaction costs, potential disruptions that could occur at the end of contract. 5. oversee company’s standard of manufacturing Another motivation for a takeover may be acquiring firm’s management belief that the target is not well managed and it can do better under their expertise. Hubris, rather than any objective analysis may motivate a takeover, this leads to winners curse. These are the human factors that may motivate a merger. Another reason for M&A is accelerating R&D in which target may be good at. ANTITAKEOVER MEASURES: Antitakeover defenses can be divided in two categories, active and preventive defenses. Preventive measures are to reduce the likelihood of a takeover while active measures are employed when a hostile bid is made. Opponents of these measures opine that these measures reduce the value of stockholders investment. According to them the activities of raiders keeps the management honest and the threats of raiders make them work more efficiently. However the proponents of these measures argue that these prevent firm from hostile raiders who have no long term interest in the firm and are looking only for short term gains. Two hypotheses have been put forward in this regard: Management entrenchment hypothesis and stockholders interest hypothesis. Management entrenchment hypothesis proposes that shareholders experience reduced wealth effect when management takes antitakeover measures. Shareholder interest hypothesis states that stockholders wealth rises when management takes antitakeover measures. This hypothesis also shows that antitakeover measures can be used to maximize shareholders value through the bidding process. Management can declare that it might not withdraw measures unless it receives offer in shareholders interest. The evidence from various takeovers studies is conflicting and doesn’t favor any one of the hypothesis as such.
PREVENTIVE TAKEOVER MEASURES: First step in antitakeover measure is to analyze the distribution of firm’s shares. Certain groups of shareholders such as employees tend to be faithful towards the firm, and will vote against the hostile bid while institutional investors may take advantage of the favorable pricing in a hostile bid. A sudden increased in trading volume of company’s share may signal presence of bidder who is trying to accumulate as many shares possible before announcing bid as that will cause stock price to rise. Types Of Preventive Antitakeover Measures: 1.Poison pills: a)Preffered Stock plan: Invented in 1982 by Martin Lipton, these were the first kind of poison pill. In this target offers its shareholders preferred stocks as dividend that would be converted to some shares of bidder after the takeover takes place. This leads to dilution of bidder’s shareholder’s share. These have certain disadvantages, first they can be redeemed only after an extended period of time, which could be in excess of 10 years, preventing any friendly merger. Secondly, they add immediate long term debt (preferred stocks are considered as long term debt) to company’s balance sheet making it highly leveraged and thus more risky in eyes of investors. b) Flip over rights: This comes in form of rights offered as dividend that allow shareholders to purchase discounted stocks during specified period of time. Following the takeover the rights will flip over allowing the shareholders to buy unfriendly bidder’s shares below market price. The rights are active after some triggering event such as an acquisition of 20% of the outstanding shares by any individual, partnership, or corporation or a tender offer for 30% or more of the target corporation’s outstanding stock. Flip over rights were very innovatively overcome by Sir James goldsmith in 1986. Drawback of this pill is that is this is effective only when the bidder acquires 100% stock, they can’t prevent bidder to have a controlling interest in the firm. c) Flip in pill: Flip in provision allows holders to acquire stock in the target, as opposed to flip over rights which allow holders stock in the acquirer. Flip in rights were designed to dilute the target company regardless of whether the bidder merged target into his company. Flip over and flip in rights combined make effective poison pill. Poison pills cause stock price to decline, presumably because pill-protected companies are more difficult to be taken over. However in event of a bid, bid premium is higher. In face of increased price, target boards are often pressurized to deactivate the pill. 2.) Corporate charter amendment: Changes in corporate charter are common antitakeover devices. Corporate charter changes generally require shareholder’s approval. The majority of antitakeover charter amendments are approved. Common antitakeover corporate charter changes are: a.)Staggered board amendments: It varies the term of board of directors so that only a few, such as one third, may be elected in any year. So the incumbent board will be made up of directors who are sympathetic to the current management. b.)Super majority provision: It dictates the number of voting shares needed to amend the corporate charter or to improve important issues such as mergers. A
supermajority provision allows for a higher than majority vote to approve a merger (typically two thirds). Supermajority charters are effective against partial offers. c.) Fair price provision: It requires the acquirer to pay the minority shareholders a fair market price for the company’s stock. This may be stated in terms of price or in terms of company’s P/E ratio. d.) Dual capitalization: It provides equity restructuring in classes of stocks with different voting rights. They can take place only with shareholders approval. Its purpose is to give more voting rights to those who are sympathetic to the management’s view. Management often increases its voting power by dual capitalization. For this company issues shares with superior voting power which are distributed to various stockholders. Stockholders are then given a right to exchange these with common stock which are more liquid and pay more dividends. However, management who may also be stockholders may not exchange their superior voting rights with ordinary stocks. 3) Golden parachutes: These are special compensation agreements which the company provides to upper management. These are highly lucrative and provide for large payments to certain senior management on either voluntary or involuntary termination of their employment. This agreement is usually effective if the termination occurs within one year of change of control. The amount of compensation is determined by employee’s annual compensation and years of service. A possible compensation could be a multiple of recent year’s annual salary, including bonuses and incentive for a certain number of years. They may be used in advance of a hostile bid to make the target less desirable but as the compensation paid is only a small percentage of total purchase price, they are not very effective. The legality of golden parachutes is questioned as they entrench management at the expense of shareholders. The system has given rise to a new breed of CEOs who join the corporation that have underperformed and tries to sell the business to a buyer. ACTIVE ANTITAKEOVE MESURES: 1.) Greenmail: It refers to payment of a substantial payment for a significant shareholder’s stock in return for stockholder’s agreement that he will not initiate a bid for control. Many management critics opine that managers use such tool to pursue their own interests which may conflict with shareholders interests. Courts rule greenmail legible till it is for legitimate business reasons. Now,’legitimate’ encompasses many broad ideas. It may be manager’s plan to fulfill their plans for the corporation, their long term strategic planning. Some managers feel that these tactics help them to save company from those seeking short term goals by selling off company’s assets. Some studies show that share repurchases from outsider cause shareholder’s wealth to decrease while those from insider cause it to increase. However other studies have shown that downward impact of share purchase was more than offset by increase in share price caused by purchasing the stock, so greenmail goes in favor of stockholders. Share repurchases are also used as an alternative way of providing shareholders a dividend, company repurchase shares at a price that will be attractive to shareholders.
2.) Standstill Agreement: Acquiring firm agrees to not buy more shares of target for some fee. This happens when acquiring firm has accumulated enough shares that it poses a threat for a takeover battle. Standstill agreements often lead to negative returns to the share holders and to fall in stock prices. 3.) White Knight: White knight is another company that would be more acceptable suitor for the target than the hostile bidder. It buys the company for more favorable terms which may be higher price, but a promise not to disassemble the target or lay off the employees. Research shows that such acquisitions have a negative effect on shareholders wealth as these are not planned strategic acquisitions. 4.) White Squire: A white squire is a firm that agrees to purchase a large block of targets stock. White squire is typically not interested in acquiring control of the target. Thus large part of the stock is in hand of firm that will not sell out to a hostile bidder. A potential white squire is given sometimes given a seat on the board or it may also be given a favorable price on shares or a generous dividend. 5.) Capital Structure Changes: These can be used in several ways. a) Recapitalize: After a recapitalization, the corporation is in dramatically different financial condition. A recapitalization generally involves paying a super dividend to its shareholders which is financed through large debts. these plans are therefore also called leveraged recapitalizations. After recapitalization company usually substitutes most of its equity for debt. Other than the super dividend stockholders also receive a stock certificate called stub which represents there new share of ownership in the company. Thus, recapitalization allows company to act as its own white knight. The large amount of debt makes it unattractive to the bidder. Management gets a greater voting control in the target following the recapitalization. The company may issue shares to ESOP. It may also create other security options that may give management greater voting power. Other stockholders will receive only one share in the recapitalized firm (the stub). Recapitalization is similar to LBO because of the tax advantages and the increase in management ownership it provides. b.)Assume More Debt: Although recapitalization increases company’s debt, firm can also add debt without undergoing recapitalization. A low level of debt relative to equity makes a firm vulnerable to takeover. Higher debt can make target riskier because of the higher debt service relative to target’s cash flow. Debt can be added either by borrowing from a bank or by issuing bonds. C.)Issue More Shares: Issuing more shares will change company’s capital structure as it increases the equity while maintaining the current level of debt. By issuing more shares Target Company makes it more difficult and costly to acquire a majority of stock in the target. On the other side it dilutes stockholders equity, leading to decrease in the stock price. Because these shares may fall in the hands of hostile, bidder company issues these shares directly in friendly firms hand (as in white squire defense). Another option firm may consider is to issue the stock to ESOP. d.)Buy Back Shares: another way of preventing a takeover is to buy own shares. Share repurchases help to divert shares away from the hostile bidder as the bought back shares can’t fall in the hands of bidders. It also helps to divert shares from arbitragers. The acquisition of firm’s own shares help company to use its own resources such as excess cash reserve or using firm’s borrowing capacity. They are also useful in white squire defense.
6.) Litigation: Targets generally sue the bidder and the bidder often responds with another countersuit. The temporary halting of takeover can delay the acquisition giving the target time to mount some defense and to look for a white knight. The more common forms of litigations are antitrust, inadequate disclosure and fraud. 7.) Pac-Man Defense: One of the more extreme defenses occurs when the target makes a counter offer for the bidder. This is one of the more colorful takeover defenses, although it is seldom used. TAKEOVER TACTICS: An initial step that is often pursued before using the various tactics of hostile takeover is accumulation of target’s shares; this is called establishing a toe hold. One advantage of this is that if market is unaware of bidder’s action, the bidder may avoid payment of premium. It also provides bidder with same rights as that of other shareholders, thus establishing a fiduciary duty which the board now have to the bidder. Toe holds result in lower tender offer premiums, and also increases probability of tender offer’s success. Options for the hostile bidder are fewer as compared to that of targets. Bidders are typically left with three main tactics viz. bear hug, tender offer and proxy fight. 1. Bear hug: This is done by contacting board of director of target with an expression of interest in target and showing intention of going directly to share holders if these overtures are not favorably received. This puts pressure on board because it must be considered as it is overly generous lest board may be violating its fiduciary duties. When bear hug becomes public arbitragers start accumulating targets stock, taking the firm in play. Bear hug is less expensive and less time consuming but if the target strongly opposes the acquisition it may be unsuccessful, leaving the bidder to pursue expensive tactics as tender offer. 2. Tender offer: These aren’t very well defined, though they are regulated by Williams act, it doesn’t even define it. However, courts have maintained that a publicly announced intention of buying a firm followed by rapid accumulation of target’s stocks at a premium is considered tender offer. Tender offers are more expensive takeover tactics due to legal filing fees and publication costs associated with it. A tender offer puts the company in play which means that it will eventually be taken over, not necessarily by the firm that initiated the process. By a research success rate of tender offers in years 1990 to 2005 is 55%. The targets that were not acquired by the bidder either went to white knights or remained independent. White knights accounted for most of the instances when target fought off initial bidder. The bidder may go with an all cash tender offer or may use securities as part or all of the consideration used for tender offer. Securities may be more attractive to some stockholders as in some cases it may be considered tax free. Sometimes the target shareholders are given an option to receive cash or securities in exchange of their shares. This makes the offer more flexible. Williams act required that purchasers of 5% of the outstanding shares of the company’s stock register with SEC within 10 days by filing a schedule TO. The filing of schedule TO notifies the market of purchaser’s intentions and alerts stockholders to an impending tender offer. If the bidder is able to purchase within
this period, the stock price may be lower than it would be following the notification to the market of the bidder’s intentions. The filing gives stockholders notice that a bidder may be about to make a bid, this increases the demand of the stock making them more valuable. Stockholders will demand higher price to part with their stocks, knowing the forthcoming bid and the premium associated with it. So it is in bidder’s interest to acquire as much stocks of target as possible during the 10 day window. However, it is difficult to purchase large quantity of stock and keep the identity of the purchaser secret. Target company shareholders often view tender offers as favorable development as they tend to bring high offer premium. However, management will resist the bid as this can lead to increase in premium and hence a higher return to target’s stockholders. By resisting a bid target may be able to attract other bidders who may offer higher premium. The risk that target takes when it resists the bid is that the offer may be withdrawn. Tender offers are also viewed as a mechanism to keep the management honest to shareholders. In absence of tender offers managers might be free to take actions that will maximize their own welfare but will fail to produce stock price that will maximize shareholder’s wealth. The bidder may compare the value of company under its management and if it exceeds company’s current market value by sufficient amount than it may offer a premium and still profit from the takeover. Tender offers are sometimes two tiered which means higher compensation for those shareholders who sell their stocks in first tier. The compensation may be broken down into first tier all cash tender offer for 51% of shares and a second tier offer which may provide with non cash compensation such as debt and equity securities. Two tiered tender offers put pressure on shareholders to tender their shares early. Critics maintain that two tiered tender offers are coercive and unfair to shareholders tendering in second tier because shareholders are entitled to equal Equal treatment by Williams law. Before initiating a tender offer bidder may decide whether to make an offer for any and all shares of target or structure the offer so that only certain percentage of outstanding shares are bid for. Any and all offers are considered more effective, partial offers do not have the second step buying transaction which makes it less attractive as shareholders may be left with some or all of their shares which have reduced value after first step partial buyout is complete. Even if the second step does occurs it may not contain the same premium as that of first step which had the control premium. A hostile bidder tries to accumulate as much of target’s stocks before making a tender offer. The purchaser tries to keep these initial purchases secret so to put little upward pressure on stock price as possible. To do so the purchases are often made through shell corporations and partnerships whose names don’t convey the identity of actual purchaser. More the pre offer stocks the bidder holds more is the probability of tender offer or proxy fight success. Even if the bidder fails to take control of the board of directors it may be able to place representative in the board making operations more difficult for the management and enable the bidder to force the targets decisions in its own favor such as payment of high dividends. significant shareholdings purchased through open market purchase may be useful
to offset defenses as supermajority voting provision. They may also be used to convince the target to agree to a friendly tender offer and to discourage potential white knights as they will have to deal with unwanted substantial stockholders even if succeeds in having majority control in the firm. The bidder than may be ready to part with his shares only if a very high premium is offered, leading to greenmail. Open market purchase of stock may be a precursor to tender offer, but it may also be an effective alternative to tender offer. Large scale open market purchases are often done with the help of investment banks which help in locating large blocks of stocks and provide the required financing. The drawback of open market purchase or street sweep is that the bidder can’t be sure that he will be able to accumulate sufficient shares to acquire clear control. Large scale purchases are also difficult to keep secret which give rise to problem of hold out. As stockholders come to believe that a bid may be forth coming they have the incentive to hold out for a higher premium. The hold out problem doesn’t exist with tender offer because the bidder is not obligated to buy unless the required amounts of shares have been tendered. A street sweep may be more effective when the bidder is able to locate large blocks of stocks in small group of investors. When there has been speculation for a bid stocks often become concentrated in the hands of arbitragers who are willing to part with their shares but only when bidder is willing to pay a painful large price. 3. Proxy fight: Proxy fight is an attempt by a single share holder or group of shareholders to take control or bring about changes in a company through use of proxy mechanism of corporate voting. In a proxy fight the insurgent may use his votes and garner support from other shareholders to oust the incumbent board or management. Corporate elections for seats on the board are typically held once a year at the annual stockholders’ meeting. The board of director is particularly important to the corporation because the board selects the management, who in turn runs the corporation in a day-to-day basis. Not all interested stockholders find it possible to attend the meeting because of other commitments. The voting process has been made easier through the use of proxies. Under this system, shareholders may authorize other person to vote for them and to act as their proxy. The ability to call a stockholders’ meeting is very important to bidder who is also a stockholder in the target firm. Upon establishing an equity position the bidder may want to replace the hostile board of directors with a board which may approve a business relationship with the bidding firm. The meeting may also be used to approve of certain corporate actions such as deactivation of antitakeover defenses or sale of certain assets and payment of premium. Most law allow meeting to be held if majority of stockholders request it. As an antitakeover defense, companies sometimes try to amend the company’s charter to put limitation on ability of certain type of shareholders to call a meeting. Typically there are two main types of proxy contests 1.) Contest for seats on board of directors. 2.) Contests for management proposals such as the approval of a merger or acquisition.
The following characteristics increase the likelihood that a proxy fight will be successful: 1. Insufficient voting support for management: Management can usually count on a certain percentage of votes in its favor. Some of these votes might be through management’s own stockholdings and others through brokers who haven’t received any specific instructions from the shareholders. 2. Poor operating performance: the worse the firm’s recent track record, the more likely other stockholders will vote for a change in control. 3. Sound alternative operating plans: The insurgents must be able to propose changes that other stockholders believe will reverse the downwards direction of the firm. These may be proposal to sell assets and proceeds paid to stockholders as dividend. Companies with larger market capitalizations are more insulated from a proxy fight threats than smaller companies where an insurgent can control a large percentage of shares without concentrating too much of investment in one direction. Proxy fight process: 1. Starting a proxy fight: starts when bidder who is also a stockholder decides to attempt a change of control at the next stockholders’ meeting. 2. Solicitation process: Bidder tries to convince other shareholders to vote against management. For this bidder hires proxy solicitor target can also use such firm for its benefit. Proxy firms have their own list of shareholders which they have compiled from various sources. The issuing corporation tries to deal directly with the beneficial owners of the shares. Insurgent group may sue to have the issuing corporation share this information with the insurgent stockholders so to have interested parties on an equal footing. When the shares are issued in names of banks or trust they may or mayn’t have the voting rights. Brokerage firm may use the voting right (if law permits so) if the owner doesn’t give any voting instruction. 3. voting process: The votes of stockholders are grouped into following categories: 1. Shares controlled by insurgents and shareholders group unfriendly to management. The greater the number of these votes, more likely is the success of the proxy fight. 2. Shares controlled by directors, ESOP and officers. This represents the core of management’s support. Directors and officers will surely vote in favor of management. Shares held in ESOPs also tend to vote in favor of management because a change in control may mean layoffs. 3. Shares controlled by institutions. Institutions are the largest category of stockholders. Institutions are historically passive stockholders and have voted in favor of management. However, the situation is starting to change as institutions are becoming more outspoken. If an institution is convinced that a change in control may greatly increase value, they may vote in favor of insurgent. 4. Shares held by brokerage firms. 5. Shares held by individuals. They don’t often compose a large percentage of votes because of the larger equity base of many public corporations; however they may be important sometimes.
Proxy fights are less expensive compared to tender offers. Tender offers are expensive due to the high premium associated with them. The major costs associated with a proxy fight are costs associated with hired professionals as proxy solicitor, investment banks and attorneys, printing, mailing and communication costs, litigation costs and other expenses such as tabulation free. Proxy fights have usually shown positive effect on stockholders wealth. Proxy contests are more effective if the target is performing poorly. Poor performance gives bidders an argument for change in management. LEVERAGED BUYOUTS: A LBO is a financing technique used by corporations. Specifically it is the use of debt to purchase the stock of a corporation and it generally involves taking the public company private. There is much overlap in LBO and going private transaction. A going private transaction is where a public company is taken private. Such a transaction is financed with some debt and some equity. When the bulk of financing comes from debt it is considered a LBO. Many of these transactions involve divesting a division and in doing so it is sometimes sold to the management of that division instead of an outside party. Being a public company carries with certain costs such as periodic filing with Securities and Exchange Commission, for small firms this may be a burden both in money and management time. This may explain why small and medium size firms may want to go private. Management Buyouts: An MBO is a type of LBO that occurs when the management of a company decides that it wants to take the publicly held company private. These managers may invest some of their own capital but often equity capital is provided by some investors while bulk of the funds is borrowed. The purchased company than becomes different entity with its own stockholders, management, and board of directors. One drawback of MBO is that if a company is selling a division due to poor performance than may be this poor performance is attributable to the management which remains same even when the division becomes independent. A clear conflict occurs in a MBO as the managers are to pay the dual role of buyers as well as sellers. The deal should be such that it should maximize shareholders wealth and also should be fair enough to the managers themselves as buyers. Even when management as opposed to outer group is the buyer, other equity is provided by outsiders, so management may not be in complete control after the buyout. It depends on how much equity capital is needed and how much capital the managers have and are willing to invest in the deal. Reasons for a LBO: The pre mentioned reason of synergistic gain for mergers is not true for LBO as the new company formed is an independent firm. Some reasons for a LBO are: 1. Efficiency gains: there are several areas where efficiency gains can manifest themselves in a LBO. The first has to do with agency problems. Managers are human and they may pursue their own agendas and may seek to pursue their own gains at the expense of the shareholders. Managers may know that if they produce an acceptable return it would be difficult for the shareholders to mount a proxy fight. Managers may though know that more profit is possible from eliminating unnecessary costs and setting the output level such that the marginal revenue equals the marginal costs. Managers may be seeking a different agenda, such as to
make the firm larger than it optimally should be so as to maximize their compensation. Managers who have a good sense of the difference between the maximum profit and the profit that company is earning may believe that this is sufficiently large to more than offset the cost of doing the deal and paying service on the debt. 2. Tax Benefits: Cost of capital of a company is the opportunity cost of finance. it is the money that the company misses because of debt and equity in its capital. CC = ∑wiki CC: Cost of capital W: weight assigned to particular source of capital k K: rate for this source of capital T: company’s tax rate Suppose some firm has capital structure comprising of 50% debt and 50% equity and the rate of return on equity is 15% and debt rate is 9% than net cost of capital will be .5*15+.5*9 = .12 or 12%. The debt rate used must be the after tax debt rate which is given by (1-T)*(before tax debt rate). In a LBO Company replaces most of the equity by debt whose cost is less than cost of equity because equity involves higher risk. Though both cost of debt and equity rises because of the higher risk level of the company the net cost of capital decreases. This is one of the advantages of a LBO. The target company’s assets are often used as collateral for large debt taken to pursue a LBO. Thus the collateral value of these assets needs to be assessed. This type of lending is often called asset based lending. Firms with assets that have high collateral value can thus easily obtain loans; hence LBOs are more common in capital intensive industries (common LBO candidates). They may still occur in non capital intensive industries such as advertising industry provided they have high cash flows. The high cash flows provide protection for the lenders. Cash flows LBO are considered riskier for the lenders and have higher debt rate. In a LBO the shareholders of a company sell their equity ownerships to buyer who take borrow bulk of capital to finance the deal. When the entire equity is sold the previous owners do not have any equity interest in the company. In closely held business this is the way for sellers to cash out on their investment and exit the business. Sometimes buyers are unable to raise the full amount due to variety of reasons. In such cases the sellers won’t be able to completely cash out but would be able to make only a partial exit. This happened with Denver based sandwich chain Quiznos. FINANCING FOR LBO: two general categories of debt are used in a LBO – secured and unsecured debt. Secured debt - : within the category of secured debt there are two subcategories – senior debt and intermediate term debt. 1. Senior debt: It consists of loans secured by liens on particular assets of the company. The collateral includes physical assets such as land, plant and equipment, accounts receivable and inventories. Lenders will commonly advance 85% of the value of accounts receivable and 50% of the value of target’s inventories. 2. Intermediate term debt: It is usually subordinate to senior debt. Collateral include fixed assets such as land, plant and equipment. The collateral value of
theses assets is based on their liquidation value. Debt can equal 80% of the appraised value of equipment and 50% of the value of real estate. The collateral value of these assets is based on the auction value of these assets and not on the value they carry on firm’s book. Desirable characteristics of secured LBO: 1. Stable cash flows: One of the most important characteristic of a LBO candidate is regular high cash flows. These are determined by examining the historical cash flows of the company though past can’t be a perfect guide for the future. 2. Stable and experienced management: Stability is judged by the length of time management is in place. Lenders feel more secured when the management is experienced. 3. Room for cost reductions: Assuming additional debt put pressure on the target. This pressure can be alleviated if target can significantly cut costs such as fewer employees, reduced capital expenditure, elimination of redundant facilities, and tighter controls on operating expenses. 4. Equity interest of owners: The equity investment of managers or buyers and outside parties also act as cushion to protect lenders. The greater the equity cushion the more likely the lenders will not have to liquidate the assets. The more the managers’ equity more likely they will stay with the firm when the going gets tough. 5. Limited debt on firm’s balance sheet: the lower the amount of value on the firm’s balance sheet compared to its collateral value of assets, the greater the borrowing capacity of the firm. 6. Separable non core business: if the LBO candidate owns a non core business which can be quickly sold to pay down the additional debt than the financing may become easier. Unsecured or subordinate LBO financing: The unsecured debt is the debt that has secondary claim on the firm’s assets. Lenders typically receive warrants that may be converted in the equity in the target. Warrants are derivative security offered by corporation itself. They allow warrant holder to buy shares for a certain price for a defined period of time. When the warrants are exercised the share of ownership of stockholders is diluted. This dilution occurs just at the time when the target is becoming profitable. At this time warrants become profitable. Although this form of debt may have undesirable characteristics for the management, they may be necessary to convince the lenders to participate in a LBO without any security of collateral. Capital structure of LBO: After the completion of LBO the capital structure of the company taken private is different from its structure before the buyout. The capital structure for a typical LBO is shown below:
Securities Percent of Capitalization Short term or intermediate 5-20 senior debt
Source Commercial banks
Long term senior subordinate debt Preferred stock Common Stock
or 40-80 10-20 1-20
Life insurance companies,some banks,LBO Funds. Life insurance companies, venture capital firms, and private equity firms. Life insurance companies,venture capital firms, managers, and private equity firms.
Companies try to retire the debt as soon as possible and move to normal capital structure. Companies usually try to retire most of the debt within five to seven years of deal. There are various risks associated with a LBO. Business Risk refers to the risk that company going private will not have sufficient earnings to meet its obligations. Interest rate risk is the risk that interest rates will rise, thus increasing firm’s current obligations. Reverse LBO: It occurs when a company is taken private only to be taken public at a later date. Buyers may believe that the company is undervalued, perhaps because of poor management. They may buy the firm and institute various changes such as replacing senior management. If the new management makes the company profitable again it may be able to go through the IPO again. The opportunity to conduct a successful lbo is when the going private transaction takes place when the market is down and the public offering occurs in the bull market. The reasoning however implies that the seller is naïve and doesn’t realize the impact of short term market fluctuations. Trends in financing of M&A: Companies use a mix of cash and stock to finance a takeover. The mix of cash, debt and equity used to pursue a M&A has varied with time and there are various factors that determine the mix. The cash percentage has varied from 51% in 1985 to 56% in 1988 but fell to as low as 22% in 1992. The percentage rose 56% in 2002, 59% in 2003 and 57% in 2004. The reason for this being is increase in average cash holdings of company. When a company has large cash holding it is left with the option of either to do a major acquisition or return the cash to shareholders in form of dividends or through share repurchase. Cash and liquid assets pay a comparatively lower return than most long term assets. Companies, therefore manage the cash levels at such levels that are enough to pay their current obligations as they come due and to have an additional supply of cash for unforeseen event. As, a result when cash is needed to finance an M&A company’s generally resort to debt financing to raise cash. While stock could be used to generate the cash, debt requires lower floatation cost, thereby giving debt a cost advantage over debt. Research shows positive net returns for the target company, independent of deal being cash or stock financed while acquiring firms tend to show zero or negative returns on announcement of takeover.
Managers of acquiring companies who value control may want to avoid stock deals because it will dilute their control. On the same time shareholders of target who value control will prefer stock instead of cash. Also the managers of target firm were more likely to retain their position if they received stock instead of cash. Cash has a clearly defined value and doesn’t have the valuation and liquidity drawbacks associated with securities. Stock financing is more likely to be used when the management of bidding company finds that market’s assessment is overoptimistic and the firm is overvalued. Taking this as a negative symbol that management believes stock to be overvalued, the stock price of the bidder should weaken but this didn’t happen when managerial ownership was high, which shows market believes that when managerial ownership is high deal is not at least value reducing. Managerial ownership is not the only factor affecting the use of stock. Researches have shown that companies that have more of their stocks held by institutions tend not to use stock to finance M&A. institutions directly or indirectly convey to bidder that they don’t want company to issue more shares to finance M&A as it will dilute their holding. PRIVATE EQUITY MARKET: These are funds which have raised capital by soliciting investment from various large investors where these funds will be invested in equity positions in various companies. When these investments acquire 100% of the equity we have a going private transaction. When the equity is acquired through some of the equity capital of private equity funds but through the use of borrowed funds we tend to call them LBO. Private equity funds make other investments such as providing venture capital to nascent business. These investments might exclusively use fund’s capital and not borrowed funds. Having such investments helps Target Company by providing it improved access to debt market after it secured the equity investment from private equity fund. The fund might take majority or minority position in company. Fund established for this purpose are sometimes called venture capital funds. Private equity funds seek out investments that are undervalued. These could be whole companies that are not trading at values commensurate to what the fund managers think would be possible. When private equity firm believes that a company is poorly managed, there may be a gap in the value that it can achieve if new management is installed and other necessary changes are made and the value that the firm estimated based on its future cash flows. This gap allows for negotiations and allow for an agreed upon price. However, when the target is well managed and both are aware of the risk adjusted value of the firm, there is no room for negotiation and less chances of paying the target full value of company. Private equity firms tend to be careful not to overpay as their gains mainly come from the difference between their purchase price and eventual resale price and any money extracted from the company prior to resale. Often this resale is done through initial public offering (IPO). One might think that after the resale firm might be appropriately valued and there are no further acquisitions opportunities exist for the sold company. However, there have been cases when the company was acquired relatively soon after the private equity inspired IPO. This is because of the synergistic benefits which the acquirer might see in the company. Some have been critical of certain private
equity buyers which do no more than to flip companies without adding on any value to it and thus making profits. Private equity firms raise their capital from variety of sources including institutional investors such as pension funds. These investors view private equity funds as a platform of achieving higher returns on their portfolio of investments. Wealthy individuals are also investors in private equity funds. A private equity firm may raise capital to build several different funds. Based on the investors’ participation in the fund investors receive a proportion of return that the fund enjoyed less the management fees for running the fund. HEDGE FUNDS: Managers of hedge funds don’t make public solicitations to investors in general and don’t face public reporting obligations that mutual funds counter parts do. Thus, investors have more limited access to return data. This is good when returns are high as investors won’t care much but when returns fall below expectations investors often want a more complete explanation for the results. Hedge funds have traditionally employed a variety of aggressive investment strategies such as short selling, swaps, arbitrage, and employing leverage to increase return potential. Like private equity funds they raise their capital from institutional investors and wealthy individuals. The management of these funds have the attitude that investors should be happy with the returns they enjoyed and the meager disclosure they were given, and if they don’t they could be replaced by a long line of investors waiting to take their place. As hedge funds started to feel pressure of competition to generate higher returns they started to look at M&A as an investment opportunity which was previously related more to private equity funds. Hedge funds have been more used to acquiring and trading securities and have not been involved in managerial actions of companies they acquire. This is one main difference between private equity and hedge funds. One area where they have focused is debt financing of distressed companies. Recently they have also been involved in M&A debt financing. Hedge funds have become more active for greater return for their equity investment acquired in public companies. Some hedge funds managers have become impatient with weak returns and have pushed for changes including managerial changes. Difference between hedge funds and private equity funds used to be clearer but it has started to decline as hedge funds have started to involve in M&A related investments. Hedge funds have tended to involve in more short term and liquid investments than private equity funds. Hedge funds vary in types of investment they make and securities they purchase. They purchase securities with short term investment horizon and may sell them at most opportune time even if it means short holding period. Hedge funds returns have exceed those of market. However, even if the rate of return is higher, fees such as 1 or 2% plus 20% of profits is also to be deducted. When this is done it doesn’t seem that hedge funds have really outperformed the market. EMPLOYEE STOCK OWNERSHIP PLANS(ESOP): These are involved in M&A in two ways: as a financing vehicle for the acquisition of companies called EBO and as an antitakeover defense. There are two types of pension plans: 1. Defined benefits plan: Under this plan the employer agrees to pay specific benefits to employee on retirement. These benefits may come in form of definite
dollar value per month or some percentage of previous year’s salary according to a preset formula. Government workers often have such plans. 2. Defined contribution plan: Employers commit to making a substantial and recurring contribution to a benefit fund rather than a specific benefit in a defined benefit plan. The employees’ benefit depends on performance of these funds. These funds may be managed by a union that oversees the investment of the funds. This plan is riskier for the employees for the benefit depends on the performance of the firm , which is not guaranteed by the employer. ESOPs are defined contribution plan where the investment is mainly made in the employer’s securities. The main reasons for starting an ESOP are to provide benefit to the employees, tax incentives, and improved productivity. ESOP generally owns a minority position in the company. ESOP can be divided in two categories leveraged and unleveraged. Leveraged ESOP are those that borrow, whereas unleveraged ESOP doesn’t borrow. With LESOP, the corporation’s ESOP borrows to buy employer’s stock. The company than makes contributions to the ESOP which are used to pay the principal and the interest. As the lone is being repaid shares are released to employee account. Corporate finance uses of ESOP: 1. Buyouts: ESOP has been extensively used as a vehicle to purchase companies. Using a LESOP for LBO places less cash flow pressure on company as the company may be able to replace some cash employee compensation payment with stock compensation to ESOP. There also may be more tax deductions as both interest and principal will be tax deductible. This also allows for broader employee participation than a MBO. 2. Divestitures: a new company is created, newcorp, which establishes an ESOP. This ESOP than borrows the funds to purchase newcorp’s shares. These funds are than used to acquire the division whose assets than become assets of new corp. new corp than makes contribution to ESOP to pay the principal and the interest both of which are tax deductible. 3. Rescue failing company: the employees of failing company may use an ESOP as an alternative to bankruptcy. For example the employees of mcclouth steel exchanged wage concession for stock in company to avoid bankruptcy. 4. Raise capital: ESOP can be used as an alternative to public offering. The voting power for shares in ESOP is in hands of board of directors than employees. ESOP helps in improving cash flows. Suppose a corporation makes $ 1000 contribution to the ESOP. Because the contribution is in the form of stock, there is no cash outlay. Tax laws allow the company a $ 1000 tax deduction, which improves the company cash flow by amount of tax savings. Suppose a company makes a public offering for stocks worth $10 million. This will bring in cash worth $10 million less the floatation costs such as investment banking fee and legal charges. If the stock is sold directly to an ESOP, these floatation costs are avoided. Though this leads to decline in the compensation and benefits of employees because the contributed stock takes the place of compensation and benefits. However if the ESOP incurs the interest costs for borrowing the capital needed to buy the stock the tax deduction should more than offset the interest payments.
If the pension plan is eliminated for ESOP, the post retirement income will be function of company’s performance. The employees may not prefer these uncertainties. The employer may have to convince the employee that it will make substantial contributions to the ESOP. Drawbacks of ESOP: 1. equity dilution effect: the tax benefit of borrowing through an ESOP is clear advantage but when the firm is borrowing through an ESOP it is also issuing new equity. From the original stockholders’ viewpoint, result is dilution of equity. The new equity holders will share the gain that the new debt capital will produce. To reverse the equity dilution effect the firm must repurchase at a later date. The ESOP may be structured that there are less dilution effects. If the ESOP purchases currently outstanding shares instead of issuing new shares equity is not diluted. 2. Distributional effects of ESOP: Depending on the price the ESOP pays for the firm’s shares, there may be distributional effect associated with the formation of ESOP. If employees receive shares in the firm at below market price a redistribution of wealth may occur. Employees gain wealth at the expense of non employee shareholders. If employees make other sacrifices, such as lower wages or benefits, which offset the gain on the below market price shares there may not be any distributional effect. 3. Loss of control: Another effect related with the equity dilution effect is the loss of control of the non employee share holders. However, the voting rights of issued shares still lie in the hands of trust which is under the control of the board of directors. When this is the case loss of control may not be that significant. ESOP also enhances productivity if the workers view the reason of their ownership as a reason to take greater interest in performance. BANRUPTCY: Bankruptcy is much more than a transaction a company engages in when it is going out of business. Bankruptcy is a creative tool that can be used for reorganization and can provide unique benefits that are unattainable through other means. There are two broad forms of bankruptcy: liquidation which more severely distressed companies use and reorganization, which is more flexible corporate finance tool which allows companies to operate while it explores other form of restructuring. Bankruptcy however is a drastic step which is undertaken only if other favorable options are unavailable. Bankruptcy filing is company’s admission of the fact that it has someway failed to achieve certain goals. There are two main forms of business failures: 1. Economic failure: economic failure could mean that revenues are less than the costs. It could also mean that the return on the investment is less than the cost of capital or it could also mean that actual returns earned were less than anticipated. Thus the term could be used differently in different situations. Sometimes it means that firm is unprofitable while other time it could also mean that firm is not as profitable as forecasted. 2. Financial failure: It means that company can’t meet its current obligations as they come due which means that company doesn’t have sufficient liquidity to satisfy its current liabilities. Researches have shown that three most common cause of business failure are: economic factors, as weakness in industry; financial factors, such as insufficient capitalization; and experience factors as lack of managerial experience. Financial distress may be caused by high leverage. Leveraged recapitalizations use proceeds of debt to make payout to
shareholders. The failures of leveraged transactions were due to overpricing and poor financial structure. Reorganization process: The reorganization process starts with the filing of bankruptcy petition of relief with the court. In the petition, the debtor lists its creditors and security holders, Standard financial statements, including a statement and a balance sheet. The court then sets a date when creditors may file their proofs of claim. The company than puts together its reorganization plan while it continues to operate. After the filing of petition the bankruptcy company is referred to as ‘debtor in possession’ which is a new legal entity, however, for all practical purposes it is the same company with same management and employees. From the creditors’ point of view this is a problem because the same management is running the company. If creditors strongly oppose the management of the debtor, they may petition the court and may ask for a trustee or examiner to be appointed. If concerns exist about fraudulent actions of management or directors, court may agree. When the petition is accepted automatic stay is granted this is one of the main benefits the debtor receives in chapter 11 filing. Within 10 days of chapter 11 filing debtor is required to file a schedule of assets and liabilities with the court. This schedule must include the name and address of each creditor. The next important date is bar date, which is the date when those creditors who have disputed or contingent claims must file a proof of claim, which is a written statement which sets forth what is owed by the debtor to particular creditor. Failure to file by the bar date leads to forfeiture of the claim. Next important are those associated with the filing and approval of the reorganization plan. One of the problems of the nearly bankrupt companies is the problem is obtaining credit. To assist the bankrupt companies to attain credit, the law gives post petition creditors an elevated priority over pre petition creditors. The reorganization plan, which is a part of larger document called disclosure statement looks like a prospectus. It’s a document which contains the plans for the turnaround of the company. The plan is submitted to all the creditors and equity holders’ committees. The plan is approved when each class of creditor and equity holder approve it. Approval is granted if one half in number and two third in dollar amount of a given class approves it. Once the plan is approved the dissenters are bound by the details of the plan. The reorganization plan must be both fair and feasible. Fairness refers to the satisfaction of claims in order of priority and feasibility refers to the probability that the reorganized company has a chance of survival. A new type of bankruptcy that appeared in the late 80’s is prepackaged bankruptcy. In a prepackaged bankruptcy companies try to have the plans of reorganization approved in advance before the chapter 11 filing. This prevents the time consuming and expensive plan development process and approval which are painstaking negotiation process. The completion of bankruptcy process is dramatically shorter in prepackaged bankruptcy. Both time and financial resources are saved. This is helpful to the already distressed debtor who will try to conserve his financial resources and spend as little time as possible in the suspended chapter 11 state. In this process approval of all the creditors is required. This is difficult when there are many creditors. One solution is to pay the smaller creditor 100% of they are owed and to pay the main creditors an agreed upon lower amount. WORKOUTS: A workout refers to a negotiated agreement between the debtor and the creditors outside the bankruptcy process. The debtor may be convinced to extend the
payment terms, which is called extension, or convince the creditors to accept a lower amount than they are owed which is called composition. In a workout debtor try to convince the creditors that they would be better off with new terms of workout agreement than with the terms of formal bankruptcy. The main benefits of workouts are cost savings and flexibility. They generally cost less to both creditors and debtors in terms of resources participant needs to devote to the bankruptcy process. In addition participants are not burdened to abide by the rules and regulations of the chapter 11 filing. They are free to create their own rules as long as the parties agree to them. Workouts may also help the debtor to avoid any business disruption and loss of employees and overall morale that might occur in bankruptcy. Researches have shown that companies that underwent voluntary restructuring program were less able to reduce their leverage compared to firms filing chapter 11. Difficulty with voluntary restructuring is that creditors may be less willing to exchange their equity for debt when managers of the company may have additional informational advantage over them and they may be able to better assess the value of equity. Other issues being that the institutional investors may not want to exchange debt for equity and voluntarily become equity holders. Bidders sometimes can find attractive acquisition opportunities in companies filing for chapter 11. Reorganization plan can involve finding an acquirer who would takeover the bankrupt company. This was done by Eddie Lampart in acquisition of Kmart. He did this by buying company’s busted bonds and bank debt to become a creditor and than using his position as a creditor to become an equity holder in the company. Thus creditors may receive ownership in the debtor in exchange for other considerations such as reduction amount owed. Liquidation: liquidation is the most drastic step and it is only pursued when voluntary agreements and reorganization can’t be successfully implemented. In liquidation company’s assets are sold and the proceeds are used to satisfy claims. The priority of satisfaction of claims is secured creditors, bankruptcy administrative costs, post petition bankruptcy expenses, wages of the workers, employee benefit plan contribution, federal and state taxes, preferred stockholders and common stockholders. Investing in securities in a distressed company may be of great profit but only if buyer is willing to assume significant risks. Investment firms dedicated to distressed securities field actively manage securities portfolio. Hedge funds have long focused on the distressed securities market for undervalued opportunities. Debtors have to assume significant risk as they could easily see their investment collapse if the debtor’s business deteriorates and is liquidated. Holders of distressed securities try to use the bankruptcy process to convert their discounted bonds and other debt into a significant equity stake in the company that hopefully will have a reorganized capital structure that it can live with. One of the typical changes that a company undergoes in the chapter 11 process is to have its capital structure altered, with some debt being replaced by equity and some or all pre petition equity disappearing. Investors may buy themselves component of bankrupt company by purchasing debt of company and exchanging them for significant equity, taking control of the company. The strategy may yield high result for those who are able to aggressively participate in the bankruptcy negotiations but the negotiations may be quite lengthy and thus this type of takeover strategy is particularly risky.