Summary A Survey of Corporate Governance by Shleifer Vishny

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Summary A Survey of Corporate Governance by Shleifer

Vishny
Corporate Governance and Restructuring (Maastricht University)
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A survey of Corporate Governance -‐ Shleifer & Vishny

I. Agency Problem
1) Contract between management and financiers
-‐ Complete contracts for managers are infeasible
-‐ problem of allocation of rights
-‐ enforcement by outside courts: business judgment rule often keeps courts out of companies' affairs
-‐ even if investors have the right to interfere, they often lack knowledge, information, size (in case of
small investors) to do so

2) Management discretion
-‐> managers end up with significant control rights (discretion) over how to allocate investors' funds
-‐ managers act for their own benefits
-‐ simple cash out: steal money and run away
-‐ transfer pricing: managers sell assets, etc. to independent companies they own themselves at
below market prices
-‐ use funds for less direct personal benefits such as perquisites
-‐ expanding company beyond what is rational
-‐ managers stay on the job even if they are no longer competent or qualified to run the firm
(costly)/managers resist to getting replaced
-‐ "duty of loyalty" to shareholders; violated if investors would 'bribe' managers not to take inefficient
actions

3) Incentive contracts
-‐ align manager's interests with those of the investors
-‐ possible forms: stock options, share ownership, threat of dismissal
-‐ optimal incentive contract determined by manager's risk aversion, importance of his decisions,
ability to pay for cash flow ownership up front
-‐ problem: incentive contracts create enormous self-‐dealing opportunities
-‐> managers might negotiate for such contracts in situations where they will benefit from it
example: before an announcement that will very likely raise stock price, a manager has a strong
incentive to negotiate for a contract that grants him stock options

4) Evidence of agency costs
-‐ managerial decisions might reflect personal interest rather than those of investors: reinvest instead
of returning free cash to investors
examples: diversification, growth are rather managerial objectives than to shareholders
-‐ evidence: trades of shares with superior voting rights for a premium

II . Financing without Governance
-‐ possible reasons for possibility of financing without Governance: managers and firms have
reputation, excessive optimism of investors
-‐ reputation might make managers deliver on their agreements even if they can't be forced
-‐ motivation for managers: acquire ability to raise funds in the future


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III. Legal protection

-‐ differences of corporate governance systems stem from the difference in nature of legal obligations
of managers to their financiers as well as in the difference how courts interpret and enforce these
obligations
-‐ most important legal right of shareholders: voting
-‐ Stalin: "It is important not how people vote, but who counts the votes"
-‐> how are voting rights protected by courts?
-‐ effectiveness of boards: corporate boards might be captured by management
-‐ OECD adopted idea of management's "duty of loyalty" to shareholders
-‐ "duty of loyalty" main elements: legal restriction on self-‐dealing and issues of additional securities
(such as equity) to management and its relatives
-‐ bankruptcy process often very complicated: multitude diverse creditors -‐> very costly, takes years
to complete, creditors often renegotiate outside of formal bankruptcy proceedings^

IV. Large investors
1) Large investors
-‐ most direct way to align cash flow and control rights of outside investors
-‐ incentive to collect information and monitor management because easier access to disciplining
actions (large investors or concentration of minority shareholders have more power)
-‐ effectiveness of large investors, who govern via their voting rights, is depending on the legal
protection of those rights

2) Takeovers
-‐ rapid-‐fire mechanism for ownership concentration
-‐ management controlled by possibility of takeover (in the course of which it would get replaced)
-‐ problems: sufficient expensiveness leads to addressing of only major performance failures
-‐ problem: increase of agency costs (bidding management might want to take over for private
benefits of control and thus overpay)
-‐ problem: liquid capital market as requirement as vast amount of capital is needed on short notice
(junk bond financing)
-‐ problem: opposition by managerial lobbies (political pressure led to anti-‐takeover legislation)

3) Large Creditors
-‐ banks!!
-‐ variety of control rights when firm defaults or violates debt covenants (which are easy observe and
assess by courts)
-‐ powerful because banks typically lend short term -‐> borrowers have to come back at short, regular
intervals for more funds
-‐ large creditors often combine substantial cash flow rights and ability to interfere in the major
decisions of the firm
-‐ often banks end up with holding equity and debt of firms -‐> similar to large investors, though with
better legal protection (or rather, their rights are easier to enforce)

V. Cost of large investors
-‐ problem: large investors are not diversified (obvious, but not so important)

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-‐ problem: large investor represent own interest that does not necessarily coincide with other
investors, employees, management
-‐ problem: inefficient expropriation through pursuit of personal (nonprofit-‐maximizing)
-‐ problem: incentive effects of expropriation on other stakeholders (expropriation might make
management, employees reduce their firm-‐specific human capital investments)
-‐ problem: expropriation of other investors, employees, managers (large investor might treat herself
at expense of other people involved through special dividends or exploiting other business
relationships with companies they control)
-‐ evidence: relationship between shares with superior voting rights (equals significant private
benefits of control) and expropriation of minorities
-‐ large investors get too powerful resulting of them exploiting the firms they control
-‐ problem might be weakened due to the fact that the large investor might have its own agency
problems

VI. Specific governance arrangements
1) Debt VS Equity
-‐ equity is difficult to valuate, so investors valuate debt (or rather the collateral)
-‐ debt can be seen as a contract that gives the creditor the right to repossess collateral in case of a
default/bad state
-‐ benefit: reduction of agency costs, such as preventing managers from investing in negative NPV
projects or forcing managers to sell assets that worth more in alternative use
-‐ main cost of debt: firms may be prevented from undertaking good projects because of debt
covenants keep them from raising additional funds
-‐ debt -‐> concentrated ownership?!
-‐ legal protection of creditors is generally better than of equity holders
-‐ BUT: concentrated equity (possibly equals direct control over firm) can be more powerful than
concentrated debt
-‐ equity holders have ability to extract some payments from management in form of dividends
(equity holders can threaten managers to vote for fire them or liquidate the firm -‐> management
pays dividends to hold them off)
-‐ dividends for equity equals interest for debt
-‐ equity ownership/financing common for young companies or firms with intangible assets
-‐ mature economies/firms typically use bank financing
-‐ question: how can firms raise equity financing? reputational effects, excessive returns, speculative
bubble, investor overoptimism

2) LBO
-‐ group of investors (old managers, specialized buyout firm, banks, public debt holders) buy out
minority shareholders -‐> concentrated equity ownership -‐> reduction of agency problems -‐> increase
in profits (targets of LBOs often highly diversified companies: noncore divisions are sold shortly after
LBO)
-‐ principal purpose of LBO: temporary financing tool for implementation of drastic short-‐term
improvements
-‐ BUT: LBO typically not permanent organizations, also problems of heavily concentrated ownership


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3) Cooperatives and state ownership

-‐ possible alternative to counter problems of concentrated ownership: cooperatives, state ownership
-‐ BUT: in reality state ownership broadly inconsistent with efficiency argument (1. state firms do not
appear to serve public interest better; 2. state firms are typically extremely inefficient and their
losses result in huge drains on their countries' treasuries)
-‐ bureaucrats end up having extremely concentrated control rights, but their interests are mostly
dictated by political interests; at best only indirectly concerned about profits
-‐> wave of privatization
-‐ common problem of privatization: no large investor is created leaving managers with more
discretion

VII. Which system is best?
1) Legal protection and large investors
-‐ legal protection of investors (voting rights, power to pull collateral; large investors as well as
minority shareholders) and some form of concentrated ownership essential

2) Evolution of governance systems
-‐ political pressure plays an equally important role in the evolution of governance systems as
economic pressure
-‐ legal systems have developed to accommodate the prevailing power (e.g. banks in Germany, Japan)
-‐ no conclusion about which is the most efficient system

3) What kind of large investors?
-‐ US style takeovers (LBO) or more permanent large shareholders (Germany, Japan)?
-‐ contra US style: impose short horizons on the behavior of corporate managers, reduced efficiency
of investment
-‐ pro US style: more radical, possibly effective restructuring of economy; due to extensive legal
protection of small investors, young firms are able to raise capital in the stock market better than
everywhere else
-‐ contra permanent large shareholders/bank system: banks are not really tough in corporate
governance; large-‐investor-‐oriented governance system discourages small investors from
participating in financial markets


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Using Project Finance to Fund Infrastructure Investments Brealey, Cooper & Habib (1996)
Project Finance as a Response to Agency Problems
• Agency problems arise from the differing and sometimes conflicting interests of the various
parties involved in any large enterprise
• In order to solve this problem, all parties must be provided with incentives to work together for
the common good – to a certain extent this can be achieved by a company’s financial structure
o Managers taking equity stakes in their company as one solution to the agency problem –
exposing the manager to part of the business’ risk (inventive creation and transfer of risk
from the shareholder to the manager)
o A problem coming along with this, is that managers generally are not diversified – unlike
shareholders – and hence, managers require higher returns for bearing this risk (this
method is beneficial ONLY to the extent that it improves EFFICIENCY)

• In Project Finance, a complex series and financing arrangements divides the different risks
associated with the project among various parties involved in the project
o These transfers of risk might not be advantageous in themselves but have important
incentive effects
Ownership, Capital Structure, and Incentives
• The reason for the contractual arrangements is to ensure that a project company is not exposed
to an abuse of monopoly power, and to provide all parties to the project with the incentives to
act efficiently by transferring the risk of poor performance to those best able to manage it
• Since there is a limit on how much can be written in such contracts and how efficiently these can
be monitored, contractual arrangements are complemented by financing arrangements
o The equity holdings that the contractor and the operator have in the project company
provide them with an incentive to be efficient by making them residual claimants whose
profits depend on how well the project facility is built and operated
• Generally, project companies are highly leveraged – average debt-‐ratio is around 60%
o Such leverage is used even though there is a shortage of potential lenders for project
finance and that it is costly to structure the project to make these high debt ratios
possible
o Lenders lend directly to the project company rather than to the sponsors & they have
only limited recourse to the sponsors in case of default by the project company
• Modigliani & Miller
o In perfectly competitive markets, company value would be independent of the degree of
leverage; value cannot be enhanced simply by concentrating debt in a subsidiary or an
associated company
o The total CF to all security holders is independent of whether debt is located in a project
company or in its parent company
The Impact of PF in an M&M World
• Under M&M, project finance does not affect the total value of the firm and project finance can
potentially affect value when debt default is costly
• In a M&M world w/o taxes, PF has no impact on the total value of the firm (total CFs are identical
for traditional finance projects and project finance projects)
• In a complete securities market, this guarantees that the total firm value is independent of the
way that financial claims on the firm are structured
• Project Finance rearranges the states of the world in which default occurs – thus, PF can change
the associated costs of default

• Many of these explanations are related to the incompleteness of contracts:


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a) Bankruptcy Costs
• Total CFs to investors are independent of whether the firm employs project financing
when bankruptcy costs are assumed to be zero (as in an M&M world) – however, PF
changes the states of the world in which the debt is in default (from stage 1,2,3 to stage
1,3,5) – thus, PF changes the expected costs of default
• Projects undertaken by project companies usually have low bankruptcy costs since their
assets are largely tangible assets which are largely unscathed in case of bankruptcy
• The low cost of bankruptcy for these companies may thus explain why project companies
carry heavy, non-‐recourse debt loads
b) Taxes
• Only when a project is located in a high-‐tax country, the project company however is in a
lower-‐tax country, the sponsor may benefit from locating the debt in the high-‐tax
country – thus decreasing the company’s tax shield
• Nevertheless, this doesn’t explain why debt has limited recourse nor does it explain the
debt concentration once the sponsor and the project company are located in the same
country
c) Myopia
• Some arguments for placing the debt in the project company assume that lenders are
blinkered – PF allows the debt to be off-‐Balance-‐Sheet to the sponsors
• However, it is doubtful that lenders are misled by such strategems
d) Political Risk
• Need for financing arrangements that make it difficult for the government to take actions
that may render the project unprofitable
• This can be achieved by arranging for the host government to take equity in the project
or to create an extensive reliance on limited recourse financing
• Protection against political risk may go far towards explaining the debt structure of
project companies in developing countries – it does not explain why projects in politically
stable countries are also heavily levered
e) Information Costs
• The granting of a loan clearly requires that lenders evaluate the creditworthiness of the
borrower and monitor his use of the assets financed by the loan
• A possible benefit of PF (and the associated lack of recourse) is that it allows lenders to
the project to confine their evaluation and monitoring to the project only and saves them
from having to evaluate and monitor sponsors as well
f) Free Cash Flow
• Leverage ensures that cash is needed to service debt (and is not frittered away, e.g. by
investing in negative NPV projects as argued by Michael Jensen)
• Thus heavy debt financing can provide stronger incentives both to generate more cash
and to pay out what cash cannot be profitably reinvested in the company
Conclusion
• There are two reasons why the allocation of debt could matter:
1. The parent companies may find it difficult or costly to monitor the efficiency with which cash
is used within the project company, and thus, cannot prevent the waste of FCF
2. When there is more than one parent company, the owners may have different views about
how to use cash – by ensuring that CFs are used to repay debt, such disagreements are
avoided

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Political Risk, Development Banks and the Choice of Recourse in

Syndicated Lending

Christina Hainz
Stefanie Kleimeier

Abstract:
• How to design loan contracts for project finance in countries with high political
risk
o Limited recourse loans and
o participation of development banks mitigate political risks
• Terms of the loan contract depend on the political risk as well as the legal and
institutional environment

2. The Impact of Political Risk and Law & Institutions on the Loan Contract

2.1 Features of the loan contract
• Generally a loan contract contains risk management measures in order to reduce
the risk of the lender (bank) in order to minimize the probability of default, loss
or both
• Two important measures are:
o Which legal entity receives the loan (i.e. how is the contact structured)?
à Limited recourse project finance loans
o Is a development bank participating
à Participation of development banks

Limited recourse project finance loans
• Parties involved in the loan may create a legally independent project company:
o Equity financing from one or more of the sponsoring firms
o Debt financing through the bank loans to the independent company
à ensures that liability is limited to independent firm, lenders have no or
only limited recourse to sponsors (=limited recourse loan)
• Project finance loans are set up with several contractual agreements with
different parties:
o Specific risks (completion, operating, revenue, price… risks) are allocated
to those parties who are best able to manage them
à reduction of project risk, agency cost and increases transparency
about the project


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Participation of development banks

• Structures of syndicates are used to reduce risk
• A particularly important part of the syndicate are development banks (DB)
o DB’s have special status
o Help mitigate risk associated with government policies and practices
o DBs are known as political umbrellas
o International Finance Corporation (World Bank Group) is known to have
high bargaining power because:
• Provide financial aid and finance many projects
• frequently interact with governments

è Limited recourse PF loans and DBs are used to mitigate political and other country
related risks.

2.2 Country-‐level risks
Political risk
• Political risk (PR) is very important factor influencing probability that a loan is
serviced as scheduled.
• Three broad categories:
o Traditional PR
Risks related to
§ expropriation
§ currency convertibility and transferability
§ political violence
o Regulatory risk
Risks arising from unanticipated regulatory changes
§ Changes in taxation
§ Changes in foreign investment laws
o Quasi-‐commercial risk
Risks that arise when project contends with state-‐owned suppliers or
customers à ability or willingness to fulfill contractual obligations
towards project is questionable
• PR comprises broad range of risks with different attributes:
o Some are easy to identify ex post (changes in transferability) some are
not (changes in tax law)
o Some are closely related to individual business (expropriation, regulatory
changes) some apply to whole society but have impact on business
(corruption)
è Investment related PR, General PR

How to deal with political risk?
• Project finance structure
o Financial flows become highly transparent for loans

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o Cash flows become verifiable, government interventions become visible

à This applies to investment related PR. General PR cannot be mitigated
through project finance structure.
• Participation of DBs
o Help mitigate both investment related and general political risk
o Provide political umbrella since they interact frequently with different
government bodies
o If government wants to intervene in project (negatively), participation of
DB can
• use special status to mitigate problems
• influence government’s decision as the government thinks about
its reputation at DB after intervening in project and may therefore
not intervene

• ICRG (International Country risk guide) provides various measures of political
risk:
bureaucracy quality, corruption, democratic accountability, ethnic tensions,
external conflict, government stability, internal conflict, investment profile, law
and order, military in politics, religious tensions, socioeconomic conditions

Law and Institutions
Legal and institutional risks (LIR) are highlighted as important risks for loan contract
designing, which can be managed by two characteristics of project finance:
• high transparency of cash flows
• limited recourse

Therefore
• Through separate legal entity and the fact that it is heavily financed by debt
management commits itself to monitoring
• Transparent financial flows influence managers behavior

è project finance can influence incentives if legal and institutional environment are
not able to shape them

In contrast to mitigating political risk DBs have difficulties addressing problem in legal
and institutional environments. Legal provisions in corporate law can not be easily
changed; implementation of law is often difficult and very hard to address for DBs

In their analysis they capture two different aspects of law and institutions:
• The country’s corporate governance system (legal protection of shareholder
minorities etc.)
• The country’s creditor rights (in case of default)


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Other country level control variables

Next to the risks mentioned above other factors can be included to model e.g.:
• Legal enforcement
• country risk
• corruption
• financial or economic development

3. Data and Methodology
Data is retrieved from Dealscan Database. Methodology is simple regression. No new
formulas etc...
4. Results
4.1. The use of Project Finance and the Participation of DBs
• PF most important in Africa and Middle East
• PF loans fund assets in countries that are politically riskier, have weaker
corporate governance systems, stronger creditor rights and are of equal
economic performance
• DBs invest in countries with high political risk, weaker corporate governance,
similar creditor rights and poorer economic performance.
• Full recourse loans without DBs fund investments in countries that are politically
safer, strong corporate governance, strong economic perf. and similar creditor
rights.
• DBs have no preference to project finance and full recourse loans

4.2. Relevance of Political Risk and Law & Institutions
• Higher political risk à PF is correlated to corporate governance and creditor
rights, unrelated to economic performance and legal origin (French/German)
• Better Corporate Governance à PF correlated to political risk and corporate
governance, less related to creditor rights
• Lower Corporate Governance à PF is more likely since framework of project
finance can substitute weak legal environments (2.2)
• PF is used for riskier investments with longer life

• Higher political risk à probability of DB participation is increased. Indicates that
DBs provide political umbrella

• PF is used to manage investment related PR
• Multinational DB participation is used to manage general PR
• National DB participation is used to manage investment related PR

5. Conclusion
From the study authors derive following suggestions:
• If investment related PR is high, project finance structure as well as DB
participation can reduce the risk

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• If general PR is high, best way to deal with it is to have DB in syndicate
• The study contributes that not only law and institutions influence the loan
contract but also political risk. In their variables PR is actually even more
important
• With respect to law and institutions the use of project finance decreases for
better corporate governance provisions and increases for better creditor rights.
In contrast participation of development banks is not correlated with the legal
and institutional environment.

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Project Finance as a driver of economic growth in low-‐income countries Kleimeier & Versteeg
Hypothesis that project finance (PF) is beneficial to the least developed economies as it is able to compensate
for a lack of domestic financial development. The contractual structure unique to PF improves investment
management and governance. Results show that PF fosters economic growth and that its effect is strongest in
low-‐income countries, where financial development and governance is weakest (and transaction costs are high)
(investigation of 90 countries between 1991 and 2005).
Introduction
• Financial development leads not only to an increase in the quantity of capital but – more importantly –
also to an improvement in the quality of capital. It is through the quality of capital that finance
contributes to growth
• PF with its contractual structure can substitute for underdeveloped financial markets and thus the
authors perceive PF as a high-‐quality financial instrument that leads to better investment
management and governance and, ultimately, to more economic growth
• PF is designed to reduce transaction costs, especially those arising from a lack of information on
possible investments and capital allocation, insufficient monitoring and enforcement of corporate
governance, risk management etc.
• Increase in annual growth by 0.67 percentage points in low-‐income countries can be observed
Financial development, project finance and economic growth
Theory and Evidence on the finance-‐growth nexus
• Generally, financial markets can stimulate the quality of capital in several ways [Levine]:
a. Well-‐developed markets improve resource allocation and allow easier access to capital for
entrepreneurs, thus lowering their financial constraints and financing costs
è Ex-‐ante information production and the efficient allocation of capital
b. Financial markets play a vital role in CG by dealing with agency costs and informational
asymmetries
è Ex-‐post monitoring of investments and enforcing CG
c. Markets facilitate the pooling and sharing of risks (diversification)
è The facilitation of diversification and the management of risk
d. Markets mobilize and pool savings
è The mobilization and pooling of savings
e. They ease the exchange of goods and services – empirical evidence supports the view that
financial markets stimulate economic growth
è The facilitation of transactions
• Guidelines on how to develop financial markets when they are still nascent:
a. Import capital from abroad
a. It can supplement low levels of domestic capital stocks, lower the cost of capital and
increase the scope of risk diversification
b. The quality matters – not the quantity – an economy should first focus on relatively safe
capital flows before benefiting from riskier types of capital
Which types of ‘safe’ capital are suitable for emerging markets?
a) Portfolio equity investments: they are known to reduce the cost of capital for domestic firms,
increase risk sharing and stimulate the improvement of CG – BUT a country can only receive equity
inflows if the domestic stock market is well developed – as this is seldom true for emerging markets,
this puts sever limitations on the use of international equity financing
b) Foreign Direct Investment (FDI): it is a long-‐term investment which minimizes currency-‐ and maturity-‐
mismatches; it is further beneficial in terms of transfers of technology, managerial skills etc.
Importantly, FDI does not rely on the existence of a well-‐developed domestic financial market and
firms can in part substitute the domestic financial market through FDI – a firm exerts direct control
over operations, reduces information asymmetries and can thus alleviate some of the problems
connected with inadequate contract enforcement etc.

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è FDI has been found to have a positive effect on economic growth – however, it is only beneficial if a
certain threshold of development in the country has been reached; in an environment with a lack of
human capital, lack of institutions etc. these positive effects can all be hampered
è FDI only has a positive impact on high-‐income countries; positive effects in developing countries do
not materialize
The Growth-‐enhancing properties of project finance
• Project Finance defined as “the creation of a legally independent project company financed with equity
from one or more sponsoring firms and non-‐recourse debt for the purpose of investing in a capital
asset” [Esty]
o Generally used for new, stand-‐alone, complex projects with large risks and massive
informational asymmetries
• The lead banks become project insiders through working with the project sponsors during the initial
screening and structuring phase, and are responsible for funding the loan in the global syndicated loan
market by attracting other banks to become members of a loan syndicate
• These loans are non-‐recourse (they finance the project company with no or limited support from the
sponsors) and thus the syndicate bears much of the project’s business risk (given the project’s high
leverage, business risk must be reduced to a feasible level)
o This is the main advantage of PF – the ability to allocate specific risks to those parties best
able to manage them – besides the financial arrangements, a large set of contractual
arrangements is aimed at risk management
è Allows PF to substitute underdeveloped financial markets hence, functioning relatively well in the least
developed countries (LDCs)
• ADVANTAGES:
I. Improved Resource Allocation and decreased cost of capital
o PF reduces transaction costs as a syndicate of banks provides the majority of the funds
and delegates the major screening and arranging tasks to the syndicate’s lead banks
o PF can improve the efficiency of capital allocation as it targets sectors that are
bottlenecks in LDCs
o Generally, funds for large capital investments in developing countries are often only
available from the public sector – BUT they lack the managerial expertise
§ PF can overcome this by explicitly taking these financing needs into account and
by transferring the management to the private sector and can thus lead to a
more effective allocation of capital
o Also does PF reduce the agency cost of underinvestment caused by risky debt while
increasing the value of the tax shield of debt
o The separation of the project from the sponsor improves the transparency of the
investment thereby making it easier to screen
o Also are the lead banks expected to have superior screening skills due to their standing as
sophisticated multinational banks and in some cases their regional specialization
II. Monitoring and CG:
o Separation of the project from the sponsoring firm improves CG as management is
decentralized and project-‐specific incentives are created for managers
o The waste of FCFs during operation is reduced due to high leverage and the inclusion of a
cash-‐waterfall as part of the contractual structure
o The extensive contractual structure reduces project risk, controls agency cost and
increases transparency about the project, thereby improving CG
o Legally, if local legal systems are not well developed, it is possible to choose for example
US or UK law for the finance and project agreements to circumvent problems
o With regards to political risk, PF cannot fully mitigate this risk but there is some evidence
that it may at least reduce it – development banks are especially effective in reducing
political risk since they are acting as political umbrellas when included in the loan
syndicate [PF is the preferred financing tool in countries with high political risk and poor
CG]
III. Cross-‐Sectional Diversification:
o If investors cannot diversify cross-‐sectional risk, then savings will not flow towards high-‐
return investments which can boost growth – PF will not alter the risk appetite of local

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investors, but as international capital it is not limited by the same constraints and thus
more likely than domestic capital to flow to the above-‐mentioned growth-‐enhancing
projects
IV. Inability to mobilize and pool savings and to facilitate transactions:
o PF is designed to deal with large investments and syndicates normally consist of large
(international) banks – it should not be hindered much by an inability to pool savings nor
by an inability to facilitate transactions
o PF can do little to help improve the market’s ability to pool domestic savings and
facilitate domestic transactions – it can only help in meeting the need for large sums of
money for single investments which cannot be met by domestically pooled savings
Summary
• PF is very flexible and can easily be adopted to different economic and political environments
• Its structure enhances ex-‐ante screening and ex-‐post corporate governance
• PF is well suited to deal with political risk and suffers only minimally from the market’s inability to
manage risk, pool savings or facilitate transactions

Data and Methodology
• Approach of using a neo-‐classical growth framework: these models presume that the GDP per capita
of each country converges towards equilibrium (assuming that a country is not at its steady state –
hence, transitional dynamics such as financial development are important determinants for economic
growth)
• The Starting Model:
𝐺𝑅𝑂𝑊𝑇𝐻! = 𝛽! + 𝛽! ln 𝐼𝑁𝐼𝑇𝐼𝐴𝐿 𝐺𝐷𝑃! + 𝛽! 𝑃𝐹! + 𝛽! +! 𝑋!" + 𝜀!
!
è Model is based on this empirical specification mentioned above and visualizes growth in country I as a
function of initial GDP, project Finance PF and a set of further control variables X
è The selected control variables X include schooling, population growth, and government consumption
è A dummy is included for the sub-‐Saharan countries in the sample to account for the stylized finding
that growth rates are systematically lower in this region
in the extended specification, a larger set of control variables will be used, measuring also economic,
population-‐related and institutional characteristics
• The chosen variables are: FDI and thus measure its effect on growth with that of PF; further
investigate the effect of PF on growth dependent on economic development of the recipient countries
è The starting equation is estimated as an OLS regression for a panel of three 5-‐year periods; to control
for possible endogeneity we also estimate a 3SLS instrumental variable model
Results (Growth and PF)
• When comparing the annual volume of newly signed PF deals in real US$ (2005), it becomes clear that
the use of PF has increased over time from $16bn in 1991 to just ca. $69bn in 2005
• While the total numbers are substantial, PF is relatively small in comparison to the GDP of the
recipient country (size of new PF deals in most years less than 0.01% of GDP, in countries with the
highest use PF deals amount to 0.2% of GDP)
• FDI inflows are normally in the range of 1% and 5% of GDP – table 1 shows a remarkable trend
o High growth countries raise substantially more funds in form of PF than low-‐growth
countries; also do these countries have more PF inflows than both low-‐growth countries and
the average country in the sample
è More PF is associated with higher growth

• Although total PF flows are substantial and large growth notwithstanding, flows of PF remain rather
small relative to the GDP of the recipient country
• OLS estimation of Equation 1 – sample of 90 countries with selected control variables (schooling,
population growth, government consumption, and a dummy for the SSA countries) – extended

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regressions are added institutional quality (law), the black market premium, inflation and the trade
volume (openness)
• Generally, initial income has a significant negative impact on growth, indicating that (conditional)
convergence is present; sub-‐Saharan countries and countries with high inflation or high population
growth face lower GDP growth, while more schooling and a better rule of law have significant positive
effects on economic growth
• With respect to PF, the main results show that PF is not unambiguously correlated with economic
growth – although positive, PF is not significantly correlated with growth
• PF will be most beneficial in LDCs with a weak domestic financial system – PF is only significant
contingent on the host country’s economic development (income level)
è PF has a positive impact on growth, but the effect is only significant for the low-‐income countries and
not in the middle-‐ and high-‐income countries
These growth effects of PF might be driven by benefits unique to PF – or as well by more general
spillovers of PF as foreign capital à Include a measure of FDI in order to control for these effects
o While a high-‐income country might well be financed by a syndicate of domestic banks, in low-‐
income countries the syndicate will likely be dominated by foreign banks
è FDI is highly significant for all income levels and PF remains significant for low-‐income countries
è This indicates that in low-‐income countries it is indeed PF with its unique features that is beneficial to
the country’s growth
Robustness Check
• Results are robust even when considering for endogeneity

• When excluding all observations which belong to the top 5% in terms of PF relative to GDP, the
findings confirm that PF is a driver of economic growth (results are even stronger)
Conclusion
• The results show that PF promotes growth in particular in low-‐income countries
• These countries gain an up to 0.67% point increase in annual economic growth, when increasing their
th th
level of PF from the 25 percentile to the 75
• Given the relatively low volume of PF as a percentage of GDP, such growth effect seems very
substantial
• Another possible explanation can be sought in the industry distribution of PF in low-‐income countries:
38% of PF is invested in infrastructure projects, a sector which is clearly important in these countries
• The structure of PF leads to extensive and effective screening and PF is also likely to flow to growth
enhancing industries
• With regard to CG, PF creates transparency combined with strong monitoring incentives for the
investment
• Overall, PF is an effective tool to deal with high-‐risk environments

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The economic Motivations for Using Project Finance – Benjamin C. Esty

Introduction
Modigliani and Miller’ “irrelevance” proposition
• Key assumption: financing and investment decisions are separable and independent activities
Ø corporate financing decisions do not affect firm value

Rise of project finance provides evidence that financing structures DO matter.

Project finance solves two financing problems
• PF reduces costs of agency conflicts inside project companies
• PF reduces opportunity costs of underinvestment due to leverage and incremental distress
costs in sponsoring firms

Why project finance?
Project finance involves both an investment decision involving a capital asset and a financing decision

Important assumption
• Decision for PF reflects attempt to reduce total financing costs, simultaneously increasing
firm value
• The need to raise external capital makes it significantly more difficult to find negative NPV
projects (because bankers need to be convinced first)

Three motivations for using project finance:
1) Agency cost motivation
• Certain assets (large, tangible assets generating high free cash flows) are susceptible to costly
agency conflicts
• asset-‐specific governance system (contracts, concentrated ownership, board of directors,
separate incorporation, high leverage) to address conflicts between ownership and control
when few other disciplining methods are present or effective (manager’s discretion)
o e.g. high leverage counters manager’s discretion as project managers are forced to
use FCF for repayment of debt which is totally dependent upon the project’s CF; no
safety net like with corporate debt (corporate balance sheet = safety net)
• Joint ownership and high leverage to discourage costly agency conflicts between owners and
related parties (opportunistic behavior, “hold-‐up”; strategic behavior of suppliers of critical
inputs or expropriation of host governments)
• only two classes/sources of capital (with three types of capital: senior bank loans,
subordinated debt, equity) reduce conflicts between debt holders and equity holders

2) Debt overhang motivation
• Allocating project returns to new capital providers in a way that can’t be replicated using
corporate debt: solves leverage-‐induced underinvestment
• Also: project finance allows firms with moderate leverage to raise funds and invest without
becoming highly leveraged, thus avoiding the opportunity cost of underinvestment

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• PF eliminates all recourse to sponsor’s balance sheet as well as the possibility that new
capital will subsidize pre-‐existing claims with higher seniority/reduce value of junior claims
• Risk averse managers do not invest as investment would require company’s CF to be used for
repayment of debt, also raising the leverage ratio; project finance typically for timely limited
assets → no need to consider future investment, re-‐investment

3) Risk management
• Investing in risky assets can generate incremental distress costs
• Isolating asset in a standalone project reduces possibility of risk contamination (failing asset
drags an otherwise healthy sponsor into distress), and …
o … the possibility that a risky asset imposes indirect distress costs (e.g. negative
influence on investment decisions of sponsor’s other divisions) on a sponsor even
short of actual default, and …
o … the need for co-‐insurance by sponsoring firm
• Maximum loss equals equity commitment (which is comparably low due to high leverage)
• Risk management via organizational form where financial instruments do not exist/are
expensive or where a possibility of a total loss exists, contrary to traditional risk
management’s use of financial instrument or derivatives
• value-‐enhancing
• particularly effective in case of binary risk (e.g. negative event happened or not, with
potential to render project virtually worthless)
• diversification (financing via joint incorporation or corporate finance) versus specialization
(separate incorporation or project finance)
• motivation for risk management can also be seen as motivation of a risk averse manager
trying to minimize threats to his/her poorly diversified (as he is only involved in this project)
human capital
• mitigation of political risk might be limited when (exemplary) host country seizes collaterals

Defining project finance
Project companies have evolved as institutional structures that reduce the cost of performing
important financial functions:
• pooling resources
• managing risk
• transferring resources through time and space

Structural attributes of project companies
• Organizational structure: separate incorporation – legally independent from sponsor(s)
• Capital structure: very high leverage similar to LBOs (average ratio of 70%)
• Ownership structure: highly concentrated debt (nonrecourse; mostly syndicated bank loans)
and equity (1-‐3 sponsors; almost always privately held) ownership structures
• Board structure: boards comprised of affiliated (“gray”) directors from sponsors
• Contractual structure: high amount of contracts for supply of inputs, purchase of outputs
(off-‐take or purchase agreement), construction, operation


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[Framework for analysis]

Deadweight costs (DWC) resulting from capital market imperfections and/or frictions
• Transaction costs
• Agency costs
• Distress costs
• Information costs
• Taxes

Investment value = (Present value of project CF) – (DWC of project) – (DWC of sponsor)
Assumption: project NPV is positive and does not change with financing structure

→ use project finance whenever total DWC are lower than total costs under corporate-‐financed
alternatives

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An overview of Project Finance and Infrastructure finance -‐ Benjamin C. Esty, Aldo Sesia

Introduction
• financing of capital expenditures has declined after economic crisis in 2007
• in 2007: most used financing mechanism for new or start-‐up companies
• project finance historically used by private companies for industrial projects (mines, pipelines,
oil fields)
• early 1990s: financing of infrastructure projects like toll roads, power plants,
telecommunication systems via project financing
• 2000s: financing of social infrastructure projects like schools, hospitals, prisons
• infrastructure investment linked to GDP growth by one-‐for-‐one percentage (newer studies
indicate a 1-‐to-‐1.59 relationship)
• project structure typically used for financing assets with limited life = few valuable growth
options

Definition
"Project finance involves the creation of a legally independent project company financed with
nonrecourse debt (and equity from one or more corporate entities known as sponsoring firms) for
the purpose of financing investment in a single-‐purpose capital asset, usually with a limited life."

nonrecourse debt: dept repayment comes from the project company only rather than from any other
source (simply terms: debt is repaid using revenues of the project company); no recourse to the
sponsors

stock-‐type investment: firms extract resources and sell output
flow-‐type investment: use of asset to generate cash flows

legally independent entity that owns assets: form of off-‐balance-‐sheet finance, i.e. project assets and
liabilities do not appear on sponsor's balance sheet; this assumption does not always hold as
assets/liabilities can and do appear in the sponsor's balance sheet (e.g. only one sponsor with 100%
ownership; around 60% of all projects)

Comparison with ABS, other financing mechanisms
ABS (portfolio of financial assets) versus single-‐purpose capital asset

portfolio has greater statistical regularity (more predictable cash flows and default rates)
→ can support more debt

industrial assets: require active management
financial assets (e.g. receivables): requires few, if any, day-‐to-‐day operating decisions

Are following mechanisms forms of project finance?
• Secured debt: NO; secured debt typically has recourse to corporate assets and CF, in addition
to the secured assets or assets

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• Covered bonds: NO; debt securities have recourse to corporate assets, CF; backed by
financial assets (e.g. mortgages) rather than single-‐purpose capital asset
• Subsidiary debt: NO; has recourse to corporate assets, CF
• ABS or real estate investment trusts (REITs): NO; ABS or REITs hold financial assets rather
than single-‐purpose capital asset
• Commercial real estate development: YES; if developed as single property
• Joint ventures: NO; unless JV is funded with nonrecourse debt
NOTE: many projects are structured as incorporated joint ventures
• Vendor or trade finance: NO; recourse to corporate assets (Vendor finance similar to
secured debt in which manufacturer of the good provides financing)
• Leases: NO; obligation has recourse to lessor; no asset ownership by lessor
• Privatizations or municipal development projects: No; no corporate sponsor
• Leveraged and management buyouts (LBOs, MBOs): No; no corporate sponsor
• Project holding companies: Maybe; with increase of projects, holding company begins to
look more like a corporation with cross-‐collateralized debt obligations

Example:
Independent power producer (IPP): owns power plants and finances them with nonrecourse debt
In order to create IPP, developer needs to sign four primary contracts:
(1) construction and equipment contract: fixed-‐price, date-‐certain, turnkey with experienced
contractor
(2) long-‐term fuel supply contract
(3) long-‐term power purchase agreement (PPA) with creditworthy public utility
(4) operating and maintenance contract

Project finance: extensive use of contracts → contractual finance

Public-‐private partnerships (PPP)
• Use of private financial institutions and private companies to construct and operate project
assets like roads, prisons, schools
• governments use PPP to expand pool of available funds, shift construction and operating
risks to private sector in order to improve efficiency
• governments and municipalities are better able to bear large, long-‐term risks
(macroeconomic risks)

Private finance initiative (PFI)
• private sector provides asset, public service, financing
• public sector maintains ownership of asset

Factors that led to increased use of project finance:
• Privatization: former state-‐owned companies used PF to fund growth, investment
• Deregulation: created new opportunities for investment by private sector

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• Globalization: increased minimum efficient scale for many industries while depletion of
existing natural resources forced firms to search in increasingly remote and risky locations
for new reserves
• Global economic recession: prompted governments to pass large stimulus packages
emphasizing infrastructure investment to spur economic growth

Current and Future Trends
1) Rise of infrastructure finance
• typically transportation, telecommunications, power/water/sewage/natural gas projects;
recently schools, hospitals, prisons, government buildings
• forecasts of infrastructure spending are enormous
• danger of overestimation and excessive leverage: classic symptoms of asset bubble

2) Impact of regulatory and environmental policies
• changes in international banking regulations (Basel II/III)
• policy changes around management of environmental and social risks (EP II, Equator
Principles)
• growing interest in renewable energy sources

3) Changing nature of deal structures
• return to more structured deals, which in extreme means fixed-‐price and fixed-‐quantity
contracts on both input/output side of deal
• hybrid structure: combine project and corporate finance
• club deals: group of banks commits to provide entire amount
• increased demand for funds from international development financial institutions (IDFIs)

4) Rise (and fall) of expropriation risk
• with fall of commodity prices have fallen, incentive to expropriate projects or renegotiate
contract terms have diminished, yet not entirely disappeared
• projects with large up-‐front capital costs and low ongoing costs are particularly vulnerable
• challenge to design sustainable long-‐term contracts

5) Role of China in project finance
• important destination for investment (infrastructure, industrial), though with many
challenges: navigating extensive government involvement, adapt an emerging legal system
to handle complexity of contractual finance (deal structuring, contractual enforcement,
litigation)
• importer of raw materials
• Chinese government, Chinese financial institutions are important as project financiers for
outward investment

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Corporate Governance and Restructuring 23.10.2012

Privatization Session 5
Hypothesis Explanation
2.1 The impact of privatization depends on the Welfare theory argues that privatization tends to have the greatest positive impact in those
degree of market failures cases where the role for the government is lessening a market failure is the weakest, i.e., for
SOE’s in competitive markets, or markets that become rapidly competitive.
2.2 Contracting ability impacts the efficiency of state Governments may not be able to credibly formulate objectives. Although changing
and private ownership governments every legislation may lead to inefficiencies. Government goals may be
inconsistent with efficiency and inconsistent with maximizing social welfare.
2.3 Ownership Structure affects the ease with which Government’s transaction costs of intervening in production arrangements and other decisions
government can intervene in firm operations of the firm are greater when firms are privately owned.
2.4 A major source of inefficiency in public firms The state is unlikely to let a SOE go bankrupt. This safety leaves room for inefficiencies.
stems from less-prosperous firms being allowed to Putting harder budget constraints on SOE is not effective in that case.
rely on the government for funding, leading to
‘soft’ budget constraints
2.5 Privatization can impact efficiency through its There is evidence that sales of SOEs showed increased efficiencies on government spending.
effect on government fiscal conditions In some favourable cases, governments used money from SOE sales as savings rather than
spending it to increase government spending.
2.6 At a macroeconomic level, privatization can help Privatizations help to develop factor, product and security markets as they increase
develop product and security markets and competition in the market and thereby raising efficiency.
institutions

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Corporate Governance and Restructuring 23.

Privatization Se
2.3 Policy Alternatives to Privatization
Academic discussions have argued for more competition and deregulation instead of privatization. In
the evidence on the benefits of reform without privatization comes primarily from individual co
where country-specific factors may play an important but unidentified role. However, especially Pol
China noted significant performance improvements of SOEs after implementing enterprise restructurin
Poland: ‘Big Bang’ reform in 1990. This reform deregulated prices, introducing foreign competition
industries, and signalled that tight monetary and fiscal policies would be pursued (e.g. tighter
constraints, tighter bank lending behaviour, etc.). Significant performance improvements on the part
manufacturing companies have been found.
China: The managerial labour market in China underwent an economic reform in the 1980s. Manager
given incentive contracts and were selected by auctions. This initiative resulted in market improvem
the marginal and total factor productivity of 272 Chinese SOEs in the period between 1980 and 1989.
3. Methods of Selling State-Owned Assets
There are several factors influencing the method through which the state-owned asset should be tran
to private ownership:
a) The history of the asset’s ownership

b) The financial and competitive position of the SOE
c) The government’s ideological view of markets and regulation
d) The need to pay off important interest groups in the privatization
e) The government’s ability to credibly commit itself to respect investor’s property rights after divest
f) The capital market conditions and existing institutional framework for corporate governance in the
g) The sophistication of potential investors
h) The government’s willingness to let foreigners own divested assets
3.1 Methods of Privatization
Brada (1996) presents four principal divestment methods, being:
1) Privatization through restitution*

2) Privatization through Sale of State Property**
3) Mass or Voucher Privatization***
4) Privatization from below****
According to empirical studies, the choice of the method of sale is influenced by the country’s
market, its political and firm-specific characteristics. Studies have shown that SIP is the preferred me
sale when capital markets are less developed, SOEs are highly profitable and the offer size is large.
One of the most important questions for governments prior to the sale of a SOE is whether to restruct
SOE prior to the sale or to leave this to the new owners or to sell an asset at once or in stages. The
clear evidence on the benefits or restructuring before the sale. According to studies, restructuring
sale does not improve the net price received for the company.
There is some empirical evidence that small and medium-sized SOEs should be sold ‘as is’ at the be
possible, as quickly as possible.
* Mainly in Eastern European countries where land has been expropriated

** Government trades its ownership claim for an explicit cash payment. First form: Direct sales, second form: SIP, in which so
of a government’s stake in a SOE is sold to investors through a public share offering.
*** Vouchers are distributed to eligible citizens fo bid for stakes in SOEs (esp. in Eastern European Countries). In order to
voucher holders trade their shares after the purchase, post-sale trading of stock is usually prohibited.
**** To finance startup SOEs
3

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3.3 Pricing and allocation of Control and Ownership in SOE sales
1) Pricing Decisions in Asset Sales

One way of selling SOEs is through competitive auctions. Studies have shown that the maximizing the number
of bidders in an open auction is usually the best way to maximize revenues.
2) Pricing and Share and Control Allocation Decisions in SIPs

Control Transfer Decision: Whether to sell the SOE all at once or through a series of partial sales.
Pricing Decision: Whether the offer price should be set by a tender offer, a book-building exercise
or at a fixed price.
Share Allocation Decision: Whether one group of investors is preferable over another.
An empirical study (cf. Table 2) by the authors showed that SIPs are on average 34% underpriced (using the
one-day return at the first day of public offer). Seasoned offers are on average only 10% underpriced.
Furthermore, although governments usually pass on day-to-day operating control of the SOEs to private
owners in the SIP, they usually retain a ‘golden share’ which gives it power to veto certain actions, such as
foreign takeovers.
3.4 The structure of Voucher Privatizations
Voucher privatization is the most controversial method of divesting state-owned assets. The largest problem
arises when the proportion of ownership resulting from a given voucher bid is unknown but the post-
privatization performance largely depends on the skills of the new owners and their stakes in the company.
There are different philosophical approaches to voucher privatization. E.g. in the Czech Republic, post-sale
trading is prohibited, whereas Russia issues only small stakes in firms and allows unrestricted trading of
vouchers afterwards. The performance of firms in Russia that have been privatized through vouchers has
been especially poor.
4. Has privatization improved the financial and operating performance of divested firms?
Many methodological problems arise in empirical studies: Data availability and information. Reporting
standards differ across countries, so comparability is not always given. Using accounting information in order
to compare the operating performance is difficult.
4.1 Empirical Studies employing data from non-transition economics
In most cases, net welfare gains were noticed. Workers on average were better off after privatization.
However, although productivity increased significantly, the level of investment spending dropped, sales force
in many cases was cut by more than half after the privatization.
The summary of empirical studies (cf. Table 4) on average finds

Significant increases in: Output (real sales), operating efficiency, profitability, dividend payments
Significant decreases in: Firm directors
Ambiguous effects on: Capital Spending, leverage, employment declines
Table 5 (below) examines the three-year average operating and financial performance of a combined sample
of 211 newly-privatized firms with the average performance of those same firms during their last three years
as SOEs. All studies at least show limited support for the proposition that privatization leads to significant
improvements in the operating and financial performance of SOEs privatized through public share offering.

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4.2 Empirical Tests of Privatization in Transition Economics
Two classifications of privatizations: Central and Eastern Europe and former Soviet-Union countries. The
major difficulty of analyzing cause and effect of performance improvements in in-transition countries is that
these countries at the time of the privatization undergo massive economic and political changes. Therefore,
data from transition economies is much more problematic and often not available at all.
4.2.1 Central and Eastern Europe
Private ownership and ownership led to greater post-privatization performance and firm restructuring,
especially when new managers were brought into the firm. Employment levels drop for almost all observed
firms.
4.2.2 Former Soviet-Union
Collecting data to evaluate post-privatization performance for the former soviet-union countries is especially
difficult. For Russia, only survey data or anecdotal evidence was available. Furthermore, nation-wide
changes were greater than elsewhere, making it difficult to measure performance improvements.
All studies found a positive association with performance improvements in firms that were divested during
the mass privatization program of the early 90s. However, various factors impact the success of the
privatization. Changing management and allowing foreign investors to own shares in an SOE was crucial to
initiate firm restructuring and to break up old oligarch management structures.

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4.3 Privatization and Economic Reform in China
Even though China launched a market liberalization and privatization program in the late 1970s that raised
labour and factor productivity and privatized all but the largest 300 SOEs, there are still too many
governmental restrictions ban SOEs from being owned by private investors. Only one-third of the stock in
publicly listed SOEs can be owned by individuals; the remaining two-thirds of a company’s shares must be
owned by the state and by domestic (financial) institutions, which are state-owned. The long-term
performance of former SOEs in China has been, consequently, quite poor. The largest barrier to
privatizations though probably is the country’s social safety net that burdens SOEs with many social welfare
responsibilities.
5. Initial and Long-Run Investor Returns from Privatizations
Investors purchasing privatization public offering offerings (PIPO) at the offering price and then sell these
shares on the first day of open market trading, earn significantly high returns (cf. Table 8). This shows that
almost all PIPOs are underpriced, ranging from 39% to 940%. PIPOs are significantly more underpriced than
IPOs.
Multi-national studies showed persuasive evidence on long term excess, market-adjusted return earned by SIP
investors (cf. Table 9). However, there is hardly explanation of precisely why SIP issues out-perform over
time.
6. Privatization’s Impact on Financial Market Development
Global capital markets grew tremendously since the early 1980s. Total world market capitalization increased
by more than 10x between 1983 and 1999. Trading volume raised almost 40x in the same period. In 1999,
companies that were privatized made up approximately 10% of total market capitalization of non-U.S. capital
markets (cf. Table 11).
Privatized firms account for sizeable fractions of the total capitalization of national stock markets: Mexico
(23.6%), Spain (15.4%), Germany (13.1%), Italy (11.8%)…
Besides accounting for large parts of national market capitalization, privatizations have promoted stock
market developments through new share offerings, attracting foreign investors and have played a large role
in bond market development.
7. Privatization’s Impact on International Corporate Governance Practices
OECD countries have established a code of conduct and principles of good corporate governance practices.
Corporate governance impact the interpretation of the effects of privatization. There is empirical evidence
that corporate governance generally and corporate legal systems specifically, influence capital market size,
ownership structure and efficiency. A country’s legal system impacts the operation of financial markets and
corporate governance in that country. Similarly, the structure and operation of a country’s legal system will
affect the impact of privatization. Privatization means a large change in the governance structure of a firm.

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Readings:
• From State to Market: A Survey of Empirical Studies on Privatization, by: Megginson, Netter, 2000
1. The impact of privatization to date
Historically, the most important denationalizations have been actively initiated by the Thatcher government
in 1979. The government agreed that it should at least own the telecommunications and postal services,
electric and gas utilities, and most forms of non-road transportation (esp. airlines and railroads). Some
politicians even argued that governments should be in possession of important ‘strategic’ manufacturing
industries, such as steel and defence production.
The Adenauer government launched the first large- scale ideologically motivated privatization program of the
post-war era. In 1961, the German government sold a majority stake in Volkswagen in a public share offering
heavily weighted in favour of small investors.
Some other huge privatizations have been the 1984 IPO of British Telecom, the 1987 privatization of NTT
(Japan, transaction value of $40 billion) and the IPO of France Telecom in 1997 ($7.1 billion). Especially
during the 90s, most of the world’s countries launched large privatization programs that usually relied on
public share offerings.
The last region to adopt privatization programs were the former Soviet-bloc countries of Central and Eastern
Europe.
Although China launched a major economic reform and liberalization program in the late 1970s, the overall
number of privatizations has been limited due to existing Chinese social welfare responsibilities that make a
privatization difficult.
2. Why have governments embraced privatization programs?
2.1 The Efficiency of State vs. Private Ownership Theory
Theoretically, the motivations for governments to privatize state-owned enterprises are to:
a) Raise revenue for the state*
b) Promote economic efficiency**
c) Reduce government interference in the economy
d) Promote wider share ownership
e) Provide the opportunity to introduce competition
f) Subject SOE’s to market discipline
g) Develop national capital markets
The various hypotheses for and against the need for privatization are stated in the table below (page 2).
2.2 Empirical Evidence on the Efficiency of State vs. Private Ownership Theory
Diverse empirical studies have examined the performance of private ownership firms and state-owned firms.
Consent on better performance of privately owned enterprises with respect to the following measures of
performance (cf. Table 1: Summary of Recent Empirical Studies comparing Public Versus Private Ownership):
- Profitability
- Efficiency
- Returns
* Cumulative profit during the second half of the 90s was more than $1 trillion, which filled governmental households and eliminated the
need for raising taxes or cutting government services. Privatization proceeds were an average of one and three-quarters percent of GDP.
** Governments perceive the need to regulate/own (natural) monopolies, intervene in the case of e.g. pollution and help provide national
services (education, information, national defence).

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The Effects of Changes in Corporate Governance and Restructurings on Operating Performance:

Evidence from Privatizations
• Paper offers evidence of how restructuring and CG changes affect the firm’s post-‐P
performance
• Prior to P, governments may choose to restructure firms through governance changes and/or
restructurings
• The results suggest that both restructuring and changes in CG are important determinants of
post-‐P performance
Introduction
• Privatization: the sale of previously state-‐owned enterprises to private owners
• P improves the financial and operating efficiency of divested firms
• Evidence that pre-‐P restructuring leads to stronger post-‐P efficiency gains – evidence of
stronger profitability gains for firms with lower post-‐P employee ownership and higher state
ownership – stronger output gains for firms in competitive (unregulated) industries and for
firms in developing countries
Potential Sources of Post-‐Privatization Performance Improvements
• P involves changes in in CG due to changes in ownership – the act of P reduces state

ownership and some P further re-‐shuffle governance structures by providing ownership to
employees and foreigners
• The ownership changes from P should help redefine the firm’s objectives and the manager’s
incentives – this should impact post-‐P performance
• Transferring the firm from government control provides greater entrepreneurial
opportunities – like restructuring
Corporate Governance: Changes in Ownership
• Privatized firms are more focused on profit maximization

• Since state owned enterprises (SOEs) pursue objectives that frequently conflict with profit-‐
maximization, the level of post-‐privatization ownership retained by the state should affect
the newly privatized firm’s efficiency improvements
o If the state maintains majority ownership, the firm is likely to delay restructuring and
maintain high levels of employment – selling only a small stake increases the
likelihood of continuing government interference and possible re-‐nationalization –
larger efficiency improvements following sales in which the government no longer
maintained majority control
• The presence of foreign investors may also affect the degree of post-‐P performance
improvement
o Return on equity or revenue per employee is significantly higher for the firms with
foreign investors
• The amount of employee share ownership does not spur performance improvements after P
o We expect employee ownership to negatively affect post-‐P performance
Corporate Governance: Changes in upper Management
• We expect that CG changes (brought on by different upper management) will positively

impact the degree of post-‐P performance

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Restructuring
• P is often an initial step in a transformation process whereby the state-‐owned firm becomes
reconfigured to compete as a private enterprise – restructuring is a common part in this
process
Reasons for Restructuring
a) Response to external shocks

• Restructuring generally seen as response to significant shocks – ownership and institutional
transformation brought about by P seen as such a shock
• Restructuring may also be triggered by economic conditions (recession etc) or by market
pressure – newly privatized firm faces larger threats from these forces since P frequently
involves the weakening of regulatory protection and the reduction of state subsidies à this
heightened sensitivity to external shocks may contribute to greater restructuring activity by
newly privatized firms
b) Desire for efficiency improvements
• Restructuring generally increases efficiency by transferring assets to firms that can put the
resources to a better use – restructuring involves the elimination of negative synergies –
since state-‐owned firms are seen as economically inefficient, they are prime candidates for
such restructuring targeted for P
c) Pursuit of new opportunities
• New growth opportunities may motivate companies to restructure – thus newly privatized
firms should engage in restructuring
d) Change in corporate strategy
• P creates growth opportunities and thus the newly privatized company may engage in an
expansion strategy to pursue this potential
Forms of Restructuring
• 3 forms of restructuring activities:

1. Organizational/Operational Restructuring (Org/Op) [most frequent means in their sample]
-‐ The reorganization of the firm’s production methods and/or management structure
-‐ It may also involve changes in management structure
2. Acquisitions and Divestments (A&D)
-‐ Acquisitions cause expansion and may represent an effort to take advantage of opportunities
-‐ Divestments cause contraction – shed up unprofitable units and downsizing
-‐ In asset sell-‐offs, the firm sells a division or major facility to an outside party
3. Financial Restructuring
-‐ Involves a reduction in the leverage level – done through debt payoffs, debt write-‐offs, and
leverage-‐reducing recapitalizations (debt-‐equity swaps etc.)
-‐ May also include a major refinancing or restructuring of a loan
Other factors: Macroeconomic and institutional environments
• It is expected that firms whose shares trade in more sophisticated and active equity markets
should display the strongest performance improvements
• For managers to feel the full disciplining pressure of the capital market, the rights of the
individual shareholder (particularly voting rights) must be enforced by the country’s legal
system
• It is expected that the degree of shareholder rights protection within the country should be
positively related to performance improvements following privatization

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• Whether a divesting government is “committed” (to P and economic reform) or “populist”

(selling SOEs just to raise money) should significantly influence the performance of privatized
firms
• Does the level of development of a nation’s economy significantly affect post-‐P efficiency
improvements?
• Having to compete with other firms for customers and market share may provide the
pressure required to stimulate greater efficiency and profitability
• It is tested for post-‐P performance differences between competitive and regulated firms
Empirical proxies and testable predictions
Corporate Governance:
• Newly privatized firms in all industries engage in restructuring

• The largest number of restructuring is by manufacturing firms, majority of the sample is from
the manufacturing sector, telecommunications industry exhibit much greater frequency
• Most restructuring occurs in Italy and England
• The type of restructuring varies by location – Organization/Operational restructurings
occurred in 22 countries, while financial restructurings took place in 8 countries
• The legal origin does not appear to affect the overall frequency of restructuring –
nevertheless is can be said that in common law countries, the stronger financial market
orientation may contribute to a greater likelihood of financial restructuring by newly
privatized firms
• Majority of the sample’s restructurings were from OECD countries – there appears to be no
immediate evidence that the country’s level of economic development impacts the likelihood
of restructuring
Empirical Results
• Following P, firms experience significant increases in profitability, efficiency, and real output
in the 3-‐year post-‐P period, compared to average values from the 3-‐year pre-‐P period
• Changes in a newly privatized firm’s upper management may also contribute to
improvements in financial performance
• Upon P, firms restructure to reduce employment and to reduce leverage
o The transfer to private ownership may lead to adjustments in employment
o P should trigger a decrease in leverage since SEOs frequently received loans from
state agencies and benefited from governmental guarantees of creditworthiness à
such state support should be reduced following P – firms may seek to move to a
more optimal capital structure
Conclusion
• Results show that restructurings are important determinants of post-‐P performance –

restructuring leads to stronger efficiency improvements
• Changes in CG (especially ownership changes) brought on by P may also contribute to the
performance improvements
• Higher amounts of foreign ownership lead to larger gains in post-‐P efficiency and lower levels
of employment
• Real output significantly increases as state ownership declines
• Profitability decreases as employee ownership increases

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The Long-‐Run Return to Investors in Share Issue Privatization
• Statistically significant positive net returns for the 158 unseasoned SIPs for all holding periods and
compared with all benchmarks
• Findings contrast with the patterns reported in previous research for equity offerings of private firms in
the US and other countries!
• since the early 1960s, internationally more than $700 billion have been raised through the sale of SOEs
to private investors à these P programs have profound effect on the liquidity and total capitalization
of world security markets (21 largest common stock offerings in financial history have been share issue
privatization (SIPs))
• studies find significant performance improvements as result of P
• the paper examines the long-‐run stock price performance for privatized firms
o systematic evidence of large, average, positive abnormal performance for the SIPs is found
o the findings of positive long-‐run returns for SIPs contrast with the return patterns many other
researchers have found for equity offerings of private firms in the US and other countries à
SIPs and private equity offerings are different in many ways
Data and Methodology
• the most frequent SIP issuer in the sample and the country with the largest total value of all offers is
the UK with 27 issues worth $52.6 billion in November 1997
• the second largest total value of SIPs is Japan
• the second most frequent SIP issuer is Hong Kong
• to compute one-‐, three-‐, and/or five-‐year buy-‐and-‐hold returns for each issue, the return index (RI)
datatype from Datastream is used
• the RI represents the theoretical aggregate growth in the value of a share over a given period,
assuming that dividends are re-‐invested to purchase additional shares at the closing price applicable
on the ex-‐dividend date:
𝑅𝐼! = 𝑅𝐼! ×𝑃𝐼! ÷ 𝑃𝐼!!! × 1 + 𝐷𝑌! ÷ 100𝑁
where
RIt = return on index on day t

RIt-‐1 = return on index on previous day
PIt = price on index on day t
PIt-‐1 = price on index on previous day
DYt = dividend yield, in %, on day t
N = number of working days in the year (taken to be 260)

Results
• local, international and US investors receive significantly better one-‐year returns from purchasing
unseasoned SIP offerings than they could over the same period by investing in the national market
index (in local currency) or in either the world or US market index or in a US firm in the same industry
Summary
• SIP investors earn higher returns than do investors who buy the local, world, or US market, or who buy
a portfolio of industry-‐matched firms
• The SIP investors do well
o The SIPs in the sample consistently outperform their reference indexes and matching firm
portfolios over one-‐, three-‐ and five-‐year horizons
o How these investors have fares is significant because SIPs are almost always the largest
equity offerings in the histories of most nations’ capital markets, and usually generate a
substantial increase in the number of shareholders

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A Century of corporate takeovers: What have we learned and there do we stand?
• We find that patterns of takeover activity and their profitability vary significantly across
takeover waves
• All waves still have some common factors: they are preceded by technological or industrial
shocks, and occur in a positive economic and political environment, amidst rapid credit
expansion and stock market booms
• Takeovers towards the end of each wave are usually driven by non-‐rational, frequently self-‐
interested managerial decision-‐making
Introduction
• 5 takeover waves have been examined in recent literature: those of the early 1900s, the
1920s, the 1960s and the 1990s
o Five American takeover waves, three UK waves and 2 recent European waves
• Takeover activity is usually disrupted by a steep decline in stock markets and a subsequent
economic recession, while considerable heterogeneity in the triggers of takeover activity are
observed
• Takeovers usually occur in periods of economic recovery – they coincide with rapid credit
expansion, which in turn results from burgeoning external capital markets accompanied by
stock market booms
• The takeover market is also often fuelled by regulatory changes
• Takeover waves are frequently driven by industrial and technological shocks
• Managers’ personal objectives can also significantly influence takeover activity, to the extent
that managerial hubris and herding behavior increases during takeover waves which often
leads to poor acquisitions
The overview of takeover waves
1. The 1st wave: the Great Merger Wave – late 1890s to 1903/05
-‐ Period of radical changes in technology, economic expansion and innovation in industrial
processes
-‐ The wave is characterized by horizontal consolidation of industrial production
2. The 2nd wave: late 1910s – 1929 (the great depression)
-‐ A move towards oligopolies because by the end of the wave industries were no longer
dominated by one giant firm but by two ore mot corporations
-‐ Companies intended to achieve economies of scale and build strength to compete with the
dominant firm in their industries
3. The 3rd wave: late 1950s – 1973 (oil crisis) with a peak in 1968
-‐ Very high number of diversifying takeovers that led to the development of large
conglomerates
4. The 4th wave: 1981 – 1987 (stock market crash)
-‐ With changes in anti-‐trust policy, the deregulation of the financial services sector, the
creation of new financial instruments and markets an the technological process
-‐ Conglomerate structures created during 1960s had become inefficient by the 1980s such that
companies were forced to reorganize their businesses
5. The 5th wave: 1993 –
-‐ Surged along with the increasing globalization, technological innovation, deregulation and
privatization
-‐ Takeovers feature a very international nature – cross border transactions as a means to
survive the tough international competition created by global markets
-‐ Main motive was growth to participate in globalized markets
SUMMARY

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• Waves occur in periods of economic recovery

• Waves coincide with periods of rapid credit expansion and booming stock markets
• Takeover waves are preceded by industrial and technological shocks often in form of
technological and financial motivations, supply shocks, deregulation, and increased foreign
completion
• Takeovers often occur in periods when regulatory changes take place
Takeover Profitability across the decades
1. Target-‐firm stockholder return

-‐ Share prices of target firms significantly increase at and around the announcement
-‐ The size of the announcement effects is similar for the 4th and the 5th takeover waves
-‐ The price-‐run up is substantial and often even exceeds the announcement effect itself (a
period of one month prior to the bid) à the bids are anticipated, and result from rumors,
information leakages or insider trading
-‐ Target shareholders in successful but initially hostile M&As are offered higher premiums than
those in friendly M&As – when a hostile bid is made, the target share price immediately
incorporates the expectation that opposition to the bid may lead to upward revisions of the
offer price
-‐ Target shareholders earn substantially higher premiums in tender offers – as the means of
payment in mergers is usually equity whereas cash bids prevail in tender offers, they also
find that all-‐cash bids are more profitable tor target shareholders than are all-‐equity ones
-‐ All-‐equity bids trigger lower target returns than all-‐cash bids
-‐ Shareholders of target firms accumulate significant positive CAARs in the period around the
bid announcement – these CAARs can be dissected into those realized prior to the bid
announcement, the announcement returns, and those realized after the announcement
-‐ The pre-‐announcements are returns are significantly different
-‐ Returns to the target firm shareholders have been increasing over the takeover waves
2. Bidding firm stockholder returns
-‐ Bidder shareholders realized announcement abnormal returns, which are statistically
indistinguishable from zero
-‐ The one-‐month share-‐price run-‐up prior to a takeover announcement is mostly insignificant
for bidder shareholders
-‐ When one considers the wealth effects over somewhat longer time windows of one or two
months surrounding the announcement, the bidders’ CAARs are significantly positive
-‐ The bidders’ CAARs measured over a wide time window surrounding the takeover
announcements largely depend on the type of acquisition, the means of payment, the
acquisition strategy:
o The CAARs of friendly takeovers are generally significantly higher than those of
mergers, which in turn are significantly larger than those of hostile bids
-‐ Gains to the bidders depend on the status (private or publicly listed) of the target firm, with a
bid on a private target resulting in substantially higher CAARs to the bidders
-‐ The means of payment also determines the bidders’ CAARs
o The announcement of all equity-‐financed acquisitions are associated with
significantly negative abnormal returns on the bidders’ shares, and that these
takeovers substantially underperform the all-‐cash bids
o Equity-‐financed bids result in positive and sometimes significant returns to the
bidder
è Shareholders of the bidding firm earn significant CAARs prior to and at the announcement of
a takeover
è There are no significant differences in the pre-‐announcement and announcement bidder
CAARs across waves
è The differences emerge when post-‐announcement and the total returns are scrutinized

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3. Total Gains from Takeovers

-‐ Takeovers are expected to increase the combined market value of the merging firms’ assets
-‐ Wealth effects of M&As occurring in periods outside the surging takeover waves are always
significantly lower than the gains earned during upward moving takeover waves
-‐ The highest combined M&A gains are realized at the beginning of takeover waves
4. Long-‐term wealth effects
-‐ Takeovers lead to a decline in share prices over several years subsequent to the transaction,
while the previous section has given evidence of significantly positive total gains around the
announcement dates of M&As
-‐ Possible reason may lay in other events occurring after the takeover on the long run which
might influence the measurement of the firm’s performance
Operating Performance
• Studies showing a decline in post-‐merger profitability employ earnings-‐based measures while
studies showing merger gains are based on cash flow performance measures
Summary of the evidence on takeover profitability
• The conclusions do no entirely converge as to whether takeovers create or destroy company

value
• At their announcement, takeovers trigger substantial value increases. But most of these
gains are captured by the targets’ shareholders which is not surprising as they hold most of
the negotiation power
• A substantial decline in the acquiring firms’ share prices is observed over the first five years
subsequent to the event – this suggests that the anticipated gains from takeovers are on
average non-‐existent or overstated
Theoretical Explanations for M&A clustering and empirical evidence
• 4 groups of takeover theories:

1. Business Environment shocks
2. Agency problems and corporate governance
3. Managerial hubris and herding
4. Market timing
Summary
• Takeover activity occurs as a result of external economic, technological, financial, regulatory
and political shocks
• When takeovers are a response to such shocks and managers take the shareholders’ interest
at heart, M&A activity is expected to lead to profit optimization and shareholder value
creation
• In contrast, models, which explicitly include herding, managerial hubris, and other agency
costs allow for the possibility that value-‐destroying takeovers follow M&A which create value
• No single theory is able to explain takeover activity and M&A waves
• Takeovers occurring early in the wave are triggered by industry shocks – these takeovers
generate substantial (short-‐term) wealth to target shareholders and the combined
companies are expected to create synergetic gains
• The majority of value-‐destroying acquisitions occur in the second half of the takeover wave
• Unprofitable takeovers are a result of both managerial hubris and agency problems
Changing characteristics of takeover waves
Explaining the rise and decline in diversification activity

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• The improved efficiency of the external capital markets in the 1980s is considered the
foremost cause for the decline in diversifying takeovers – as the cost of external finance had
fallen, internal capital markets became an unnecessary and costly configuration
Explaining the rise and decline in hostile takeovers
• Hostile takeovers were considered as an alternative corporate governance mechanism that

corrects for opportunistic managerial behavior
• With regulatory changes in the late 1980s hostile takeover activity decreased – they were no
longer needed as a CG device, given that there are sufficient number of alternative
governance mechanisms
Conclusion
• Takeovers usually occur in periods of economic recovery

• They coincide with rapid credit expansion, which in turn results from burgeoning external
capital markets accompanied by stock market booms
• The takeover market is also often fuelled by regulatory changes, such as anti-‐trust legislation
or deregulation
• Takeover waves are frequently driven by industrial and technological shocks
• Managers’ personal objectives can further influence takeover activity: managerial hubris and
herding behavior increase during takeover waves, often leading to poor acquisitions
• Takeover activity is usually disrupted by a steep decline in stock markets and a subsequent
period of economic recession
• The bulk of M&As are expected to improve efficiency and trigger substantial share price
increases at the announcement, most of which are captured by the target firm shareholders
• Takeovers occurring at a later stage of the takeover wave trigger lower gains to shareholders
than those at the beginning of the wave – this indicates that waves tend to pass their optimal
stopping point and that unprofitable takeovers occurring later in the wave result from
limited information processing, hubris, and managerial self-‐interest

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Chapter for M&A
Reasons for M&A:
1. Economies of scale

2. Creation of Synergies
3. Specialization à firms of larger scale organize production into specialist groups
4. Economies of scope à produce related products at lower cost because of experience with
existing products
Value increasing theories:
Coase:
1. Weigh transaction cost of separate vs. merged entities

2. Transaction cost efficiency
Bradley, Desai, Kim,
1. Mergers create synergies (economies of scale, effective management, improved production,
Alchian, Demsetz:
1. Disciplinary à replace a poorly functioning management team
Value Reducing theories:
Jenson:
1. Agency costs due to high amounts of free cash flows
Schleifer and Vishny:
1. Managerial entrenchment à managers make investments that increase the manager’s position
and are not directly aligned with the interests of shareholder
Value Neutral theories:
Roll:
1. Managerial hubris à prone to over self-‐confidence, winner curse in bidding situations
2. Mergers can occur even if they don’t have an impact on the value

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The merger Process:
Theory Combined Gaines Gains Target Gains bidder

Efficiency /Synergy + + Non-‐negative
Agency -‐ + More negative
cost/entrenchment
Hubris 0 + -‐

Takeover Bidding Process:
The winners curse:
-‐ The bidder in a takeover attempt might face the winners curse (due to asymmetric info)
-‐ If a bidder is concerned about the real value the bidder can offer stock rather than cash.
-‐ Both bidder and target bar the cost of overbidding at the time of merger
Bidders Costs:
-‐ Bidding costs cost can reduce the potential payoff from inviting to many people to compete in
the bidding process
-‐ one counteractive measure can be a already signed termination fee à more likely to choose the
first bid
-‐ the question is also whether to obtain a toehold (initial stake) à can help recoup bidding costs
Seller Decision:
-‐ An initial toehold in the company might deter competition for the bidding à lesson gain to seller
-‐ Seller firm bears the costs borne by the bidders in the auction à reduce nr. of bidders
Appendix:
Event studies:
-‐ Measuring the effect of an event on the stock price
-‐ Choosing an event period (if no other events -‐40; +40)
-‐ Calculate the predicted return if no event would have taken place
-‐ Next calculated the residual = actual return minus the predicted return
For the three methods see chapter:

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Takeover Defenses and Bargaining Power (Guhan Subramanian)
The “bargaining power hypothesis”: a target with strong takeover defenses will extract
more in a deal than a target with weak takeover defenses.
The modern arsenal of takeover defenses:

• Poison pill: gives the shareholders the right to buy shares of the target (“flip-in”)
the acquirer (“flip-over”) or both at a substantially discounted price in the event
that the acquirer acquires more than a specified percentage of the company’s
shares.
o Vary in potency (specific provision & state corporate law)
o Vulnerable to Proxy-contest (bidder gain control of target’s board)
§ Can be slowed down by staggered boards (staggered boards with
either 2 or 3 year terms of directors)
§ Can be slowed down by “dead hand” pill (pill can be redeemed
only by continuing directors or their approved successors) or “slow
hand” pill (delayed redemption)
o Endorsed in Virginia, Pensylvania and, Georgia and Maryland
o California has not validated any version of a poison pill
Bargaining Power Hypothesis

• Targets with pills achieve higher premiums than targets without pills (provide
managers with greater power to negotiate with outside bidders and therefore get
higher premiums for the target firm shareholders)
o BUT since a poison pill can be introduced at any point in time friendly
takeovers are also negotiated in the “shadow” of a poison pill
o Non-EBS targets achieved on average a 1.8% greater increase from the
initial bid than EBS targets.
o Largest increase in hostile takeover was achieved without the benefit of an
EBS (PeopleSoft’s $26.50 per share as opposed to initial $16.00 per share
from Oracle)
A Model of Bargaining with Defenses

• Baseline model involving bilateral
o Bilateral monopoly between acquirer and target
o no incremental costs of a hostile bid
o complete information
o loyal shareholder target board
• Each of the constraints will be relaxed individually and then analysed
Baseline Case
• Target worth $100 stand-alone $200 to acquirer
o With no takeover defenses → acquiring company offers $101 target
accepts

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o With complete takeover defenses → (target knows that acquirer willing to

pay $199; acquirer knows target would accept a small amount of $101)
using the Nash bargaining game expected outcome is $150
Alternative away from tables
• Buy side alternative: Existence of walk-away alternative puts constraint on the
target’s use of defenses
o If T2 with identical assets has no defenses price of this acquisition would
be $101. if price of T1 goes up acquirer buys T2
o Strategic need, management attention and financing constraints cause the
buy-side alternative to put a constraint to the bargaining power
• Sell-side alternative: (1990; 50 companies) contacted on average 63.2 potential
buyers, 28.7 signed confidentiality agreement, 6.3 due diligence or preliminary
proposals, 2.6 submitted binding written offers
o Revlon duties: target and buyer must leave deal unprotected to permit
higher-value offers
• Extent of constraints of alternatives depends on market thickness
o thin market: defenses may provide bargaining power in the takeover
negotiation
o thick market: defenses are less effective (other potential buyer and sellers
contrain bargaining range)
Hostile Bid costs
• introduction of hostile bid costs further reduces the influence of defenses
o target gains bargaining power because bidder is no longer indifferent
between a negotiated acquisition and a hostile bid, holding deal price
constant.
o Hostile bid costs pushes the predicted outcome against a target with no
defenses towards the outcome against a target with complete defenses
o Three categories of hostile bid costs (all reduce the influence of takeover
defenses on the negotiated outcome):
§ Bidder out of pocket costs: additional out-of-pocket expenses: eg.
Financing costs, tender offer information agents, proxy solicitors,
printing and advertising costs, lawyer and banker fees
§ Bidder reputational costs: future targets are less willing to initiate
negotiations with a bidder that has previously made a hostile
takeover bid
§ Costs imposed on target: (makes the target less attractive for the
bidder to acquire) hostile bid causes operational disruption and
make post-deal integration more difficult
o If fixed hostile costs are greater than the width of the bargaining range,
then a hostile bid is structurally precluded → target’s defenses are
irrelevant for the takeover negotiation
o more potent defenses do not necessarily give additional bargaining power
Information disparities

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• a “blind bid” is subject to the well-known “lemons problem” (bidder has likely
overpaid when target accepts offer)
• “standstill agreement”: under such terms the acquirer agrees (for typically 6-12
months) to
o not increase its stake in the target firm
o not conduct a proxy contest
o not make a tender offer for the target’s stock
in exchange the acquirer gains access to target’s internal documents
• if the standstill agreement is the standard quid pro quo for access to confidential
books and records → then takeover defenses are irrelevant in determining the
final price received by the target shareholders
Agency Costs
• if the target board is not loyal to its shareholders it might use bargaining power
provided by takeover defenses to extract private benefits for itself
• any deal that provides a premium to target shareholders can be improved for both
the target and acquirer managers with a deal that provides less value to the
shareholders and some value to the target managers.
• Defenses may allow target managers to extract private benefits for themselves
rather than a higher premium for shareholders
Summary
• Once
o alternatives away from the table
o hostile bid costs
o asymmetric information
o agency costs
• are introduced in the standard bargaining model it becomes clear that takeover
defenses are a potent weapon against a hostile takeover bid BUT are not
important in most negotiated acquistions
Conclusion
• in the base case takeover defenses increase premiums for targets
• when introducing the 4 real-world factors (alternative walk-away, hostile bid
costs, information disparities, agency costs) → only a fraction of acquisitions are
negotiated in the shadow of a hostile takeover threat
• bargaining power benefits of takeover defenses in negotiated acquisitions recede
and the costs of takeover defenses in the from of higher agency costs of
management come to the fore

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Where M&A pays and where it strays (Robert F. Bruner)
Conventional wisdom on M&A Failure: still hazy after all these years
Problems that occure when making inferences about the profitability of M&As:
• Conventional wisdom generalizes too readily the findings of a single study
• Theres is a tendency to exaggerate the extent of failure
o One-in-a-life-time study periods shouldn’t be generalised opver other time
periods
o Difficulties for M&As can also be due to changes in certain industry
segments (eg. Price collapse in the technology-media-telecommunication
sector tgat strated in 2000)
o There are differences in the type of deals (eg. Stock-for-stock deals are
worse than cash deals)
o Size can matter as well (eg. big deals tend to have more intergration and
regulatory problems)
o There are differences between deals two of public companies and deals of
two private company, where the latter seem to be more profitable for the
buyer
An informed “view” of M&As depends on mastering the scientific findings on the

profitability of M&A and on understanding how profitability varies by type of deals and
companies.
Measurements of M&A Profitability: Better than what?
The benchmark for measuring performance is investor’s required returns. There are 3
possible outcomes
• Value destroyed: investment returns are worse than those required by investors
• Value created: investment returns higher than required
• Value is conserved: normal returns (investment earns its required rate of return)
→ in economic terms an investment is “successful” if it does anything other than destroy
value
3 measure to test whether M&A has been profitable:

• Weak form: did the share price rise? This is a before-and-after comparison (are
shareholders better off after the deal than they were before)
o Weak because it fails to control for other unrelated factors that my have
caused price changes
• Semi-strong form: did the firm’s returns exceed a benchmark? Uses a
benchmark like the return in the S&P500 Index, or sample of peers that did not
merge.
o Control for factors in the industry/entire economy that may have triggered
returns
o Only semi-strong because benchmarks are imperfect

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• Strong from: “golden standard” of comparison. Are shareholders better off after
the deal than they would have been if the deal had not taken place?
o True test of the cost of lost opportunity
The following studies summarised below are classified as semi-strong
Event studies: examines abnormal returns to shareholders in the period surrounding the
announcement of a transaction.
• Raw return for one day = (change in share price + any dividends paid)/closing
share price the day before
• Abnormal return = raw return – a benchmark of what investors required that day
o Benchmark here is either CAPM or return on large market index
(S&P500)
• Based on the assumption that stock markets are forward looking and that share
prices are simply the present value of expected future cash flows to shareholders
Accounting studies: examine reported financial results (accouting statements) of

acquirers before and after the acquisitions to see how the financial perfomrnace changed
• Study focuses on variables such as net income, return on equity or assets, EPS,
leverage and liquidity
• Matched comparison of acquirers performance against performance of non-
acquirers with similar size in the same industry
Broad finding: M&A Pays
• Abnormal returns to target firm’s shareholder: 25 studies → M&A

transaction delivers a premium return to target firm shareholders (despite time-
period variations, type of deal, and observation periods)
• Abnormal return’s to buyer firm’s shareholders: 50 studies → 40% negative
returns; 60% positive returns
o 16 studies → (returns to buyers in the years over a multi-year period after
the consummation of the transaction). 11 negative and significant returns
o contaminating events, overvalued stock and industry shocks could all
easily mislead into believing that M&A is unprofitable
o buyers are typically larger than targets (impact of smaller deals is difficult
to measure)
o author’s general conclusion from event studies buyers essentially
break even
• abnormal returns to buyer and target firms combined (net economic gain
from M&A deal):
o large %gain to seller can be offset by small% loss to buyer
o almost all of 24 studies report positive returns (14 report significant
positive returns)
• Reported financial performance of buyers: market’s reaction to the
announcement of a given deal tended to be a reasonably reliable predictor of
future operating improvements with more positive reactions anticipating larger
increases in operating cash flows

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• Surveys of executives: both practitioners and scholarly studies seem consistent

with the view that although M&A does not produce abnormal returns, investments
in acquisitions tend at least to cover their cost of capital.
• Conclusion about profitability of M&A:
o M&A does pay on average.
o M&A pays for shareholders target firms
o Most studies of target and buyer firms combined indicate that M&A
transactions create net value
o For bidders alone – 2/3 of the studies conclude that value is at least
conserved if not created
All M&A is local
• Joseph Schumpeter: M&A is one way of capitalizing on turbulence

o 1984-1904: industries characterised by capital-intensive, mass production
manufacturing processes. M&A involved with removing older and less
efficient excess capacitiy from these industries
o 1890-1930: M&A associated with the diffusion of electricity and the
internal combustion engine
o 1971-2001: M&A involved the diffusion of information technology
• Micheal Jensen: creation of new markets (eg. High-yield debt market) stimulated
wave of hostile takeover and leveraged buyouts
• Bruce Wasserstein: 5 main forces driving the merger process:
o Regulatory and political reform
o Technological change
o Fluctuations in financial markets
o Role of leadership
o Tension between scale and focus
Where M&A Pays and where it Strays

(buyer’s perspective)
Neighbourhood map 1: Strategy
Focus versus diversification
• Focus versus diversification: “focusing acquisition” pays better than

diversification.
o Opportunity for cost savings
o Asset reduction
o Other efficiencies
• Diversification may pay if
o a single entity facilitates knowledge transfer among different business
divisions
o reduces financing cost
o creates a critical mass for competitiors
o exploits monitoring thorugh internal capital markets

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• diversification may pay when the buyer and the target are in information intensive
industries
• IN sum
o All else equal focus and relatedness pays better than does unrelated
diversification
o Strategy of unrelated diversification can pay where there are unusual skills
such as running an LBO association or value investing (special managerial
skill could trump the need for strategic linkage)
o Acquisition strategy of relatedness and focus warrants critical scrutiny too;
industries are dynamic
Strategic restructuring pays:
• Divestiture create value for shareholders of sellers (results for buyers are mixed)
• Redeployment of underperforming businesses is greeted positively by investors
• Carve-outs, spin-offs and tracking stock are neutral to beneficial for shareholders
with generally consistent abnormal returns
• Continually reshaping the business to respond to changes in the competitive
environment pays
Initiation of M&A programs
• Market’s systematic positive response to M&A announcements
Strategic synergies
• Include cost savings, revenue enhancements, financial synergies

• M&A pays where synergies are more credible
Grabs for market power
• Horizontal mergers are typically motivated by the prospect of cost savings and
other synergies → more efficient is better (bigger is not necessarily better)
Value acquiring pays, glamour acquiring does not
• Glamour acquiring: companies with high book to market value ratios

• Value acquiring: low book to value ratios
Mergers to use excess cash generally destroys value except when redeployed
profitably
• Value destruction associated with the announcemtn of M&A transactions by firms
with access cash
• Transactions pairing “slack-poor” and “slack-rich” companies tend to be value
increasing

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Neighbourhood map 2: Investment Opportunities
Targets that can be restructured

Mixed evidence
• Targets of hostile tender offers are underperformers with relatively low share
price → bidders expect to earn profits form improving the targets performance
• Targets are healthy but fit very well with the buyer’s strategy
Privately owned assets
• Sizable positive announcement-day return to bidders when they buy private firms
opposed to public firms
Crossing borders
• Targets earn large returns, buyers essentially break-even; on a combined basis

shareholders gain
• Foreign bidders appear to pay more than domestic bidders
o Premium represents payment for the special local knowledge and market
access that the target provides the foreign buyer
Hot and cold M&A markets: misevaluation of buyer firms
• Market “windows of opportunity” close and open over time

o Due to changes in regulation and ..
o ..the appearance of market bubbles
• the more highly valued the buyer the more negative is the investor response to the
acquisition announcement
• Hot M&A market poses a major dilemma to CEO of an overvalued company:
o If you acquire or not, shares will drop
o M&A offers chance to transfer part of prospective losses to target firm
shareholders
Neighbourhood map 3: Deal Design:
From of payment: cash versus stock
• Stock based deals are associated negative returns to the buyer’s shareholders at
deal announcements, whereas cash deals are zero or slightly positive
• Announcement of the payment with share, like the announcement of an offering
of seasoned stock, could be taken as a sign that managers believe the firm’s are
overpriced
• Tender offers amplify the cash-versus-stock effect (cash effect even higher; stock
effect even lower)
• Stock deals also tend to be used
o In friendly deals

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o Buyer’s stock price is relatively high

o Ownership pf buyer is not concentrated
o Deals are larger in size
o Buyer has less cash
LBOs
• Shareholders of target companies earn large abnormal returns

• LBOs transactions are followed by large increases of operating Cash Flow
relative to sales and decreases in capital expenditure
Use of earnouts
• Eranouts and other contingent payment structures can be viewed as providing

stronger performance incentives for selling managers as well as risk management
device for the buyer
Use of collars
• Collar = another risk management device, used in stock-for-stock transactions to

hedge uncertainty about the value of the buyer.
o Changes payments if buyer’s payment rises or falls
Social issues: the merger of equals
• Combined partners of equal influence without a premium payment by one party to

the other (usually mergers by an exchange of shares with a low or zero implied
acquisition premium)
• Targets earn positive abnormal returns that are also smaller than those in other
deals
• Absence of dominance from one side over the other helps to reduce resistance of
target company
Tax exposure
• Half of all acquisitions (study in 1989) are designed to be tax-free or only partly
taxable
• In taxable deals the acquisition premium is more than twice as high
o In taxable deals target company shareholders’ taxes are due immediately
rather than deferred → creates demand for higher payment
o In taxable deals, the buyer is allows to “step up” the tax basis of the
acquired assets (affording a larger depreciation tax shield)
Neighbourhood map 4: Governance:
Governance:

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• Firms with stronger governance practices are more highly valued
Activism by institutional investors
• = (seeking influence in the board of directors and management) LBOs,

replacement of executives underperforming firms, corporate restructuring
• is associated with creation of shareholder value
What managers have at stake
• return to buyer firm’s shareholder is associated with larger equity interests by

managers and employees (transactions under management control influenced
ultimate payoffs from takeover)
• In LBOs managers tend to commit a large portion of their own net worth to the
success of the transaction
Approaching the target: friendly versus hostile
• Larger return to bidders in tender offers than in friendly negotiated transactions

• Higher acquisition premiums for target shareholders in hostile deals
• Unsuccessful takeover attempts often lead to restructurings that unlock value for
shareholders
Use of anti-takeover defenses
• Can help to extract higher prices (only in well-governed compaies)

• Can harm shareholders in purely run firms by entrenching mangers who disregard
their duty to shareholders
Conclusion
• All M&A is local

• You are more likely to fail in M&A when:
o Your organisation enters a fundamentally unprofitable industry or refuses
to exit from one
o Your organisation steps away from what it knows
§ Diversification versus relatedness (but more relevant is knowledge,
mastery and competencies)
o Economic benefits of the deal are improbable or not incremental to the
deal (eg. synergies)
o You fail to seek economic advantage (eg. Paying a premium for a target in
a foreign country)
o There is no creativity in deal-structuring
o Your organisation has poor checks, balances and incentives
• LAST PAGE of the article summarises it in a list of bullet points) J

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Leveraged Buyouts and Private Equity

Kaplan and Strömberg

Leveraged Buyout -‐ Definition
• firm is acquired by specialized investment firm using small portion of equity and high
leverage
• investment firms commonly referred to as private equity firms
• typically majority control of existing/mature firm is acquired

History/Development
• emerged in 1980s, first wave
• highlight of first boom: buyout of RJR Nabisco in 1988
• Jensen (1989) predicts that LBO/PE firms would become dominant corporate organizational
form
o PE firms combine concentrated ownership stakes, high-‐powered incentives for own
professionals, and lean, efficient organization with minimal overhead costs
o applying performance-‐based managerial compensation, high-‐leverage capital
structures (often relying on junk bonds,) active governance to invested firm
o superior structure compared to typical public corporation with dispersed
shareholders, low leverage, weak corporate governance
• crash of junk bond market led to large number of defaults and bankruptcies of high-‐profile
Buyouts
• LBOs of public companies virtually non-‐existent in early 1990 to early 2000s
• PE firms focus on purchasing private companies
• third LBO boom in mid-‐2000s, including public-‐to-‐private buyouts
• decline in 2008 after subprime-‐crisis

PE Firms
• typically organized as partnership or limited liability corporation (LLC)
• most prominent: Blackstone, Carlyle, KKR
• in 1980s, rather small number of professionals in PE firms (13)
• these days, PE firms have more than 100 investment professionals

PE funds
• PE firms raise equity through PE funds
• PE funds typically "closed-‐end", i.e. fixed number of shares
• investors commit to provide equity for investments and management fees of PE firm
• Legal: PE funds are limited partnerships
o general partner (the PE firm) manages fund, provides at least 1% of capital
o limited partners provide most of the capital
o limited partners: institutional investors, corporate/public pension funds,
endowments, insurance companies, wealthy individuals
• usually fixed life (common are 10 years), but possible extension of up to 3 years
• PE firm has up to 5 years to invest the funds capital and 5-‐8 years to return capital to
investors

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• limited partners have little say as long as basic covenants are followed
• common covenants: limited investment in one company, types of securities, restriction of
debt at the fund level
• compensation of general partner (PE firm)
o annual management fee: percentage of capital committed and after realization of
investments a percentage of capital employed
o share of the profits of the fund (carried interests), typically 20 %
o deal and monitoring fees (sometimes paid by portfolio companies, i.e. firms that the
fund invested in)

PE transaction/LBO procedure
• after buy-‐decision, PE firms typically pay premium of 15-‐50% over current stock price for
public companies
• 60-‐90% of debt financing (-‐> Leveraged BO)
• debt structure
o senior and secure debt -‐ arranged by bank or investment bank; in 1980s and 1990s
often provided by banks; recently, institutional investors purchase large fraction of
senior and secured loans
o junior and unsecured debt -‐ financed via high-‐yield bonds or "mezzanine debt" (debt
subordinated to senior debt)
• capital from limited partners used as equity to cover the remaining 10-‐40%
• new management team of purchased company (can be identical to pre-‐buyout management,
but does not necessarily have to be) typically contributes small fraction to equity

Commitments to PE funds (US)
• 200 million USD in 1980
• 200 billion USD in 2007 (1% of US stock market value)
• PE commitments appear to be cyclical
o first wave 1980s to early 1990s, peak in 1988
o second wave mid 1990s to early 2000s, peak in 1998
o "third wave" mid 2000s to present, peak in 2007/8
• Commitment outside the US have also grown substantially (3 non-‐US PE firms among top 12
firms in terms of assets under management)

Number of PE transactions
• 17,171 transaction between 1/1/19970 and 6/30/2007
• seems to be cyclical like commitments to PE funds (logical!)
• huge fraction of activity within last few years
• first wave almost exclusively in US, Canada, UK: relatively large transaction in mature
industries (manufacturing, retail), public-‐to-‐private
• after first wave, growth in "middle-‐market" buyouts of non-‐publicly traded firms (private
companies/divisions of larger corporations) and spread to new industries (IT, media, telecom,
financial services, health care)
• during and after second wave
o return of public-‐to-‐private buyouts (though not as prominent as before)

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o increasing fraction of secondary buyouts (i.e. PE firms exiting old investments and
selling portfolio companies to other PE firms)
o spread to Europe
• third wave magnified many of these trends, also spread to Asia (modest levels compared to
Western Europe and N. America)

Manner and Timing of Exit
• investment exit important due to limited contractual lifetime of PE funds
• types of exits (in order of occurrence):
o sale to strategic (nonfinancial) buyer
o secondary buyout, i.e. sale to other PE firm
o IPO
o other/unknown (could be any of the mentioned types)
o bankruptcy
o sale to management
• holding periods roughly stable, median is around 6 years
• keep in mind that secondary buyouts mean that portfolio companies are still held by PE
funds

PE as superior organizational form?

Financial, governance, and operational engineering
• PE firms pay attention to management incentives
o typically large equity upside through stock and options
o management ownership increased by factor 4 from going from public to private
(Kaplan 1989b)
o PE firms require management to make meaningful investment in the company
o stocks (equity)and options given to management are illiquid as company is private,
i.e. management can't sell equity or exercise options until value is proved by exit
transaction → reduces incentive to manipulate short-‐term performance
• leverage
o pressure on managers not to waste money as they have to pay interest and principal,
i.e. reduction of FCF problem
o provides discipline to acquiring PE fund which has to persuade third-‐party investors
(debt providers) to co-‐invest in deals
o leverage potentially increases firm value through tax deductibility of interest
o flipside: inflexibility of required debt payments (in contrast to flexibility of payments
to equity) increases chance of costly financial distress
• governance
o PE firms control boards of their portfolio companies and are more actively involved
in governance then public company boards
o boards of portfolio companies are smaller and meet more frequently
o PE firm do not hesitate to replace poorly performing management

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• operational engineering
o PE firms often focused on certain industries
o PE firms use their industry and operating knowledge to identify attractive
investments, develop and implement value creation plans (add value to portfolio
companies)
o make use of internal or external consulting groups (or individuals)

Operating performance
• empirical evidence on operating performance of companies purchased by PE firms is largely
positive
• Cumming, Siegel, and Wright (2007) summarizes: "LBOs and especially MBOs enhance
performance and have a salient effect on work practices"
• exception: more recent public-‐to-‐private buyouts only show modest increase in performance
• possible sources for misinterpretation: selection bias, LBOs might increase current cash flow
but hurt future cash flow
• however, empirical evidence largely consistent with existence of operating and productivity
improvements after LBOs
• no research on latest PE (third or fourth) wave

Employment
• Critics: LBOs benefit PE investors at the expense of employees (job and wage cuts)
• empirical evidence shows that employment increases post-‐buyout, yet by less compared to
other firms in the industry
• evidence largely consistent with view that economic value is created in portfolio companies
by operating more efficiently (due to buyout)

Taxes
• tax deductions are difficult to value accurately
• can explain between 4% (debt is repaid in 8 years and personal taxes offset benefit of
corporate tax deductions) and 40% (permanent debt and no offset due to personal taxes) of
a firm's value
• true value probably lies in between; reasonable estimate seems to be 10 to 20% (1980s),
lower for more recent buyouts

Asymmetric Information
• PE firms potentially have superior information on future performance of portfolio companies
• Critics: possible source of inside information is the incumbent management
o incumbent management works "better" under new owners (PE firm) due to higher
incentives
• empirical evidence suggests that operating improvements are unlikely a result of PE firms
taking advantage of private information
o actual performance of portfolio companies lags the forecasts by the PE firm
o PE firms frequently bring new management: incumbent management can't be sure
that it will be in a position to receive high-‐powered incentives from new owners

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o boom-‐and-‐bust cycle: at times, PE firms overpaid in LBOs and experienced losses

(inside information by incumbent management wasn't enough to avoid periods of
poor returns)
• instead: large financial returns to PE funds because PE firms are able to buy low and sell high
o PE firms identify undervalued companies/industries (taking advantage of market
timing and mispricing)
o PE firms are good negotiators and/or target boards and management do not get best
possible price in these acquisitions

PE fund returns
• value creation by PE firms through LBOs does not imply that PE firms generate superior
returns for limited partners
o portfolio companies are purchased in competitive auctions or by paying premium to
public shareholders
o limited partners pay meaningful (considerable amount of) management fees
o net return for limited partners lower than return of portfolio company for PE fund
• Kaplan and Schoar (2005)
o limited partners (investors in PE funds) earn slightly less than SP500, net of fees; this
suggests that, gross of fees, they outperform the benchmark
o their research has two flaws: selection bias, no risk adjustment
o persistence in performance: performance of PE firm in one fund predicts
performance of subsequent funds

Boom and Bust Cycles in PE
• Boom when there is systematic mispricing in debt and equity markets
o cost of debt is relatively low compared to cost of equity
o PE firms can arbitrage or benefit from difference
o this argument relies on existence of market frictions that enable debt/equity markets
to become segmented
• overly favorable terms for debt during first wave led to high leverage (only 10-‐15% equity)
• less favorable terms for debt during second wave lead to higher equity share (30%)
• cyclicality can also be explained by looking at interest rates
• debt in LBOs may be driven more by credit market conditions than by relative benefits of
leverage for portfolio firm
• PE funds accelerate investment pace when interest rates are low
• question: why do borrowings of public firms not follow credit market cycles like LBOs?
possible explanations
o public firms are unwilling to take advantage of debt pricing because managers dislike
debt or public market investors worry about high debt levels
o PE funds have better access to credit markets because they are repeated borrowers
(reputation building=cheaper loans and looser covenants)
o compensation structures of PE funds provide incentives to take on more debt than
optimal for individual firm
• PE fund returns decline when more capital is committed to this asset class (Boom),
commitments to PE funds decline when realized returns decline (Bust) → cycle pattern

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When managers bypass shareholder approval of board appointments:
Evidence from the security market
By Matteo Arena and Stephen Ferri, 15th May 2007
Abstract:
Examine influence of managerial entrenchment to appoint board members without shareholder (sh)
approval. The bigger entrenchment the more likely is shareholder bypassing and the less likely is
announcement of independent director. Aim of bypassing: Perpetuate managerial entrenchment.
Introduction:
• Private placements in which representatives of private investors are appointed to the Board go
hand in hand with lower announcement return
• Why do managers bypass approval? 3 Hypothesis:
• Entrenchment hypothesis: Entrenched manager appoints friendly investor, who is aligned with
current management and who is unlikely to provide tough monitoring to board, the more likely it
is that shareholders oppose his candidate
• Approval irrelevance hypothesis: Managers do not need to bypass approval; shareholders almost
always vote for managers candidates due to proxy committee is appointed by management board
• Monitoring Hypothesis: Private investor wants board position when he should provide more
capital; based on poor corporate governance
Role of shareholder voting in Corporate Governance
• Connection between ownership and control

• Voting rights are alternative to contracts, since in contracts not every part can be foreseen; Voting
rights can be used to ratify decision ex-post
• The more diffuse ownership is the less likely is shareholders incentive to vote or influence
corporate decision; The more routine proposal is classified the more likely is sh’s approval
How do firms appoint directors without sh approval?
Private security issuance without sh approval
• Number of authorized shares in certificate of corporation is larger than outstanding shares

• Blank checked preferred stock provision (Directors can issue preferred stock)
• Issuing convertible notes
But if new issuance in larger than 20% of common stock or is sold at an discount, approval is needed!
Board appointment without sh approval
1. Bylaw does require only range for directors’ amount (e.g. between 5 to 10 directors’). Current
directors can appoint new director till upper limit of range (e.g. if there only 5 directors, additional
5 directors can be appointed). If upper limit range is reached, directors can easily change bylaw
2. Replacement for fired director

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3. Issuance of Blank Checked Preferred Securities to new investors to elect new director; if the
already exist in charter no extra sh approval is needed
4. If director is already elected, sh can ratify decisions. If board is not staggered election within
12months/if board is staggered - sh might have to wait up to 3 years to ratify director.
Relation between approval of security issuance and approval of board appointments
If company does not have Blank Checked Preferred Stock provision, directors have to as sh for approval
of issuance. Simultaneously sh permit board to appoint new director.
Data
185 private placements of US firms associated with Private Announcments
• Firms that issue convertible preferred shares and appoint more directors are more likely to ask for
sh approval
• On average 1,89 directors are appointed within a Private Placement: 25% change of board
composition
• Firms that don’t ask for approval a smaller, younger and distribute less equity to investors
• Entrenched managers are more likely to bypass sh approval
Determinants of sh approval
• Results are consistent with Entrenchment Hypothesis and Monitoring Hypothesis

è Firms are more likely to bypass sh approval, a) the higher free Cash Flow and b) whether
board chairman is a company manager
Monitoring quality of appointed directors
Entrenchment hypothesis: Managers tend to appoint directors who won’t provide effective monitoring
Approval irrelevance hypothesis: Quality of newly elected directors does not depend on sh approval
Monitoring Hypothesis: Firms that bypass sh approval, will increase board’s monitoring quality
How to test quality of directors? Monitoring effectiveness depends on how many appointed directors are
independent (Number of independent directors is positively related to likelihood of removal of poorly
performing CEO)
Results are confirm with Entrenchment Hypothesis
Market reaction at the time of announcement
Entrenchment hypothesis: Announcement should show less entrenchmentà positive market reaction
Approval irrelevance hypothesis: No effect in market return, since approval is irrelevant
Monitoring Hypothesis: Not very positive market reaction
The analysis adjusts abnormal returns, since usually Private Equity is sold at discount (purchaser should
contribute positively to target firm or should maintain managerial entrenchment)

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Results: Market strongly rewards director announcement for sh approval. Consistent with Entrenchment
hypothesis.
Does sh approval impact performance?
Entrenchment hypothesis: predicts firms asking for sh approval, perform better
Approval irrelevance hypothesis: predicts, approval does not affect firm’s performance
Monitoring Hypothesis: predicts: firms asking for approval (to give new investor board position)
underperform firms bypassing sh approval
Operating Performance: Firms seeking for sh approval perform better within 3 years than bypassing firms
(Entrenchment Hypothesis)
Stock Performance: Firms seeking for sh approval outperform bypassing firms
Conclusion, bitches:
1. The greater managerial entrenchment the more likely bypassing sh approval

2. Positive market reaction after seeking sh approval
3. In general, entrenchment has more influence on Private Placement than previously believed
4. Entrenched managers are more likely to nominate directors who are aligned
5. But: Managers can still easily avoid sh approval and neutralize sh monitoring. Sh still do not have
enough power (although sh can replace directors) to secure “Value-increasing governments
arrangements that management disfavors”.

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Private Placements and Managerial Entrenchment -‐ Micheal J. Barclay, Clifford G. Holderness, Dennis
P. Shehan
Private Placements: The sale of securities to a rather small number of selected investors.
è Private placements more favorable than public stock offerings

è Two hypothesizes explaining the positive assessment:
Monitoring Hypothesis Certification Hypothesis

Private placements are purchased by large Private placements are purchased by informed
investors who are willing and able to: investors who certify the value of the entity by
1. monitor the management purchasing large blocks of stock
2. ensure efficient use of resources
3. increase likelihood of value enhancing
takeovers

è One Hypothesis against the favorable outlook:
Entrenchment Hypothesis
Managers sell stock to selected friendly investors
who might not act in the best interest of the
shareholders à do not “rock the boat”

Three Types of Placement:
Private Placements separated into three groups:
1. Placement in which the purchaser is active in the firms
2. Placement in which the purchase is top manager of the firm
3. Placement were purchaser plays a passive role in the firm à no active role in the company
Results:
Empirical Results in line with the Monitoring and Certification Hypothesis:
-‐ Short run discount à to compensate for the monitoring cost and certification of firm value

-‐ Positive short run return after the announcement à investors perceive the placement to be
favorable
Empirical Results in line with the Entrenchment Hypothesis:
-‐ Most private placements acquired by passive investors
-‐ Magnitude of Discount à price discount is higher for passive than for active purchasers


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-‐ Discounts increase with the fraction placed and purchased by aforementioned passive investors
à monitoring and certification costs are fixed, thus discount should decline with size

-‐ Decline in long run returns à for passive and active investors
o However, positive long run return for managerial placements à entrenchment theory
states that managers issue stock to themselves when the stock price is undervalued

-‐ Returns decrease with higher fraction placed

-‐ Return decreases with increase in discount

-‐ Purchaser rarely becomes director or CEO à evidence against monitoring hypothesis

-‐ Probability of takeover decrease with placement à in conflict with the monitoring hypothesis

-‐ No public reports on monitoring à no reason to hide monitoring reports

-‐ Comparison to block trades : negotiated purchases of shares from other shareholders
o Block trades presage monitoring
o On average shareholder favor block trades over private placements à (lower discount,
short and long-‐run abnormal return)
Conclusion:
-‐ Total cost of private placements (include discount + out of the pocket costs: transaction costs) is
two times higher than for Seasoned Equity Offerings à nevertheless, no control of who
purchases the shares
-‐ Positive announcement effect à however, neither the monitoring nor the certification
hypothesis can explain the negative long run returns
In Summary:
-‐ Support for monitoring and certification hypothesis much weaker
-‐ Strong and significant evidence for the entrenchment hypothesis

è All in all, theories regarding agency problems (agency explanations) should be incorporated more
strongly and carefully into capital structure decisions

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The impact of corporate governance mechanisms on value increase in

leveraged buyouts
By Erkki Nikoskelainen, Mike Wright
Topic: Value increase of buyout targets and realized value increase in exited leveraged
buyouts
Prior studies:
• Gains in productivity and operating performance

• Buyout markets outside the US
• Free cash flow theory
o Leveraged buyouts à corporate governance mechanisms à reduce agency
costs à increase firm value through improved operating efficiency
• Bankruptcy threat motivates improved operating efficiency
• Leverage and realignment of incentives à positive effect on operating
performance
• Concentrated ownership à ability to monitor and control
Three contributions of the paper:
1) Adds to limited previous research on investor returns in buyouts

2) Extension of several studies on the staying power and survival of buyouts by
providing empirical evidence concerning the relation between corporate governance
structure and a positive return at investment realization.
3) Adds to studies on buyout success examining that return characteristics are different
for buyouts and buyins.
The type of buyout can impact buyout performance:
Buyouts by definition are transactions initiated and led by the incumbent management team of
the target whereas buyins are leveraged buyout transactions initiated and led by private equity
investors together with partially or completely new management team
è Informational asymmetry between buyouts and buyins.

o Buyins involve outsiders with potential consequences for performance
Internal rate of return:
• Return on enterprise value and equity investments is measured by an index-adjusted

IRR.
• Index adjusted EV IRR 22.2% vs. index adjusted EQ IRR 70.5%; correlation of 0.62
showing much variation between these two measures.
• Exit strategies (a way of cashing out):

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o Under favorable economic conditions, exit opportunities are better due to

active IPO and M&A markets
o IPO (going public)
o Trade sale (sale to strategic investor)
o Secondary offering (selling own stake on the market)
o Receivership (recoup as much of the unpaid loans as possible, liquidation)
Variables for corporate governance mechanisms
1. Gearing (leverage) = D/E ratio

2. The less equity is invested, the greater the equity ownership the management receives
(stronger incentives)
3. Several control variables like size, divestments, acquisitions etc.
Empirical results:
• The return earned on a buyout investment at exit depends to a large extent on exit type
à exit type and decision depend on the need for investment realization and capital
market situations
• For buyouts, size and acquisitions are important drives of returns.
Robustness
• Private equity investors who invest in a large number of small LBOs often invest in
buyouts that go bankrupted.
• Overleveraging of the target companies leads to lower returns.
Conclusion:
• IPO exits outperform trade sale and secondary buyout exits.

o Larger size, highest returns
• Buyouts generate value creation and equity value.
• Managerial equity stake is more related to enterprise value based measures than to
equity based measures.
o Especially in smaller firms
• Governance mechanism are not necessarily the drivers for LBO returns
o For large/successful LBOs management’s equity stake is a driver for LBO
returns
• Size is positively related to value increase
• Acquisitions during the holding period are main drivers for LBO returns
• Larger buyouts perform better à higher investors returns
o Due to higher bankruptcy risk for small LBOs
o Small firms are vulnerable to industry cycles and short term disturbances
o Larger companies have better buffers
o Larger companies have more than one business line à absorb negative shocks
o Investing institutions provide more assistance to large corporations since they
have more equity at risk

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§ Supporting through more equity injections for operations and fulfilling

covenants
• Acquisitions increase the buyout value and enterprise value.
o Buy-and-build strategies are common
o Acquisitions are used as mechanism to increase scale à lower risk
o Acquisitions as sign of industry consolidation à lower competition à
economies of scale
• Buyout vs buyin returns
o Buyout returns are driven by acquisitions
o Buyout equity returns are negatively affected by divestments
o Buyin equity returns are positively affected by divestments
è Private equity firms applying institutional buyins can drive their returns through
streamlining of target company operations
Realize growth opportunities rather than focus on downsizing.

Summary A Survey of Corporate Governance by Shleifer Vishny

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Summary A Survey of Corporate Governance by Shleifer Vishny

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Summary A Survey of Corporate Governance by Shleifer

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A survey of Corporate Governance -­‐ Shleifer & Vishny

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III. Legal protection

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3) Cooperatives and state ownership

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Project Finance as a Response to Agency Problems

Ownership, Capital Structure, and Incentives

The Impact of PF in an M&M World

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Political Risk, Development Banks and the Choice of Recourse in

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Participation of development banks

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o Cash flows become verifiable, government interventions become visible

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Other country level control variables

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Financial development, project finance and economic growth

Theory and Evidence on the finance-­‐growth nexus

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The Growth-­‐enhancing properties of project finance

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Data and Methodology

Results (Growth and PF)

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• Results are robust even when considering for endogeneity

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[Framework for analysis]

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Corporate Governance and Restructuring 23.10.2012

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Corporate Governance and Restructuring 23.

2.3 Policy Alternatives to Privatization

3. Methods of Selling State-Owned Assets

a) The history of the asset’s ownership

3.1 Methods of Privatization

Brada (1996) presents four principal divestment methods, being:

1) Privatization through restitution*

* Mainly in Eastern European countries where land has been expropriated

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Corporate Governance and Restructuring 23.10.2012

3.3 Pricing and allocation of Control and Ownership in SOE sales

1) Pricing Decisions in Asset Sales

2) Pricing and Share and Control Allocation Decisions in SIPs

3.4 The structure of Voucher Privatizations

4.1 Empirical Studies employing data from non-transition economics

The summary of empirical studies (cf. Table 4) on average finds

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Corporate Governance and Restructuring 23.10.2012

4.2 Empirical Tests of Privatization in Transition Economics

A survey of Corporate Governance -‐ Shleifer & Vishny

Theory and Evidence on the finance-‐growth nexus

The Growth-‐enhancing properties of project finance

Potential Sources of Post-‐Privatization Performance Improvements

• Results show that restructurings are important determinants of post-‐P performance –

The Long-‐Run Return to Investors in Share Issue Privatization

1. Target-‐firm stockholder return