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Discussion Notes for Presentation at

Yale UniversityOctober 4, 2001

The Effect of Takeovers on Shareholder Value

Sanjai Bhagat

University of Colorado,

David Hirshleifer

Ohio State University,

Robert NoahAnalysis Group (Cambridge, MA)

http://bus.colorado.edu/faculty/bhagat

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The QuestionThe Question

Do takeovers improve target and bidder Do takeovers improve target and bidder firm value?firm value?

Other stakeholders Other stakeholders notnot considered: considered:EmployeesEmployees

Customers/SuppliersCustomers/Suppliers

BondholdersBondholders

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Two important challenges to estimating Two important challenges to estimating

value effects of takeoversvalue effects of takeovers

I: I: Truncation Dilemma (of Window Length)Truncation Dilemma (of Window Length)» Short return windowShort return window: Since not all bids succeed, : Since not all bids succeed,

return is only a fraction of the value effects of successful return is only a fraction of the value effects of successful takeovers.takeovers.

» Long return windowLong return window: Can capture full value effects. : Can capture full value effects. But, return includes greater noise, and raises questions But, return includes greater noise, and raises questions of benchmark specification.of benchmark specification.

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Two important challenges to estimating Two important challenges to estimating

value effects of takeoversvalue effects of takeovers

II: II: Revelation BiasRevelation Bias» Bidder’s return at the time of bid gives a wrong Bidder’s return at the time of bid gives a wrong

estimate of the market’s valuation of the estimate of the market’s valuation of the bidder’s gain from takeover, because bidder’s gain from takeover, because

Some bidders deliberately time bid announcement Some bidders deliberately time bid announcement with unrelated negative announcements. Wall with unrelated negative announcements. Wall Street’s version of Street’s version of Wag the DogWag the Dog ( (WSJWSJ 12/18/98). 12/18/98).

The form of the offer and the very fact of an offer The form of the offer and the very fact of an offer may convey information about the bidder’s stand-may convey information about the bidder’s stand-alone value.alone value.

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““It's Wall Street's version of `Wag the Dog.’ ”It's Wall Street's version of `Wag the Dog.’ ”

““Over the past week, both Mattel and Coca-Over the past week, both Mattel and Coca-Cola have announced acquisitions on the same Cola have announced acquisitions on the same day they also issued warnings about day they also issued warnings about disappointing earnings. ... No one is disappointing earnings. ... No one is suggesting that either company unveiled its suggesting that either company unveiled its acquisition solely to divert attention from its acquisition solely to divert attention from its problems... But it is also clear that the problems... But it is also clear that the acquisitions, like the [Iraq] bombings, helped acquisitions, like the [Iraq] bombings, helped shift attention away from other less favorable shift attention away from other less favorable developments.'' developments.''

» WSJWSJ, `Heard on the Street', 12/18/98, p. C1, `Heard on the Street', 12/18/98, p. C1

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Revelation ExamplesRevelation Examples

Returns to bidding firm shareholdersReturns to bidding firm shareholders..Fact of an OfferFact of an Offer

» Good newsGood news Bidder expects high cash flow.Bidder expects high cash flow.

» Bad newsBad news Poor internal investment opportunities.Poor internal investment opportunities. Bidder management with empire-building propensities.Bidder management with empire-building propensities.

Cash vs. Exchange OfferCash vs. Exchange Offer» Stock Offer: Bad news, lemons problem with equity Stock Offer: Bad news, lemons problem with equity

issuanceissuance» Cash offer: Good news that not issuing equity.Cash offer: Good news that not issuing equity.

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Goals of the Paper

Document stock returns associated with Document stock returns associated with tender offers in a comprehensive dataset tender offers in a comprehensive dataset (1962-97; soon to be through 2000).(1962-97; soon to be through 2000).

Develop and apply a method to address the Develop and apply a method to address the truncation dilemma. truncation dilemma.

Develop and apply a method to disentangle Develop and apply a method to disentangle shareholder value improvements from shareholder value improvements from revelation about stand‑alone value. revelation about stand‑alone value.

Examine several economic hypotheses about Examine several economic hypotheses about takeover contests.takeover contests.

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SolutionSolution to to Dilemma of Window LengthDilemma of Window Length problem problem

Probability Scaling MethodProbability Scaling Method

»Like traditional methods, uses short Like traditional methods, uses short return window.return window.

»Method adjusts return from short window Method adjusts return from short window upward to reflect the probability of upward to reflect the probability of success of bid.success of bid.

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SolutionSolution to to Dilemma of Window LengthDilemma of Window Length and and Revelation BiasRevelation Bias problems problems

Intervention MethodIntervention Method

»Focuses on the returns to the bidder Focuses on the returns to the bidder when something happens (while the bid when something happens (while the bid is outstanding) that changes the is outstanding) that changes the probability of success of the bidderprobability of success of the bidder..

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What might change the probability of success of a bidder?

Litigation by target firm.Litigation by target firm.

Arrival of other bidders.Arrival of other bidders.

Objection by a government regulatory Objection by a government regulatory agency (FTC, Dept. of Justice).agency (FTC, Dept. of Justice).

Defensive measures by target (poison pill, Defensive measures by target (poison pill, lock-up provision).lock-up provision).

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Arrival of a second bidderArrival of a second bidder::

Decreases probability of success of the first Decreases probability of success of the first bidder.bidder.If takeover If takeover isis in the interest of the first bidder, the in the interest of the first bidder, the

first bidder’s stock price first bidder’s stock price declinesdeclines at the arrival of at the arrival of the second bidder.the second bidder.

If takeover If takeover is notis not in the interest of the first bidder, the in the interest of the first bidder, the first bidder’s stock pricefirst bidder’s stock price rises rises at the arrival of the at the arrival of the second bidder.second bidder.

Note: Decline/rise in the first bidder’s stock price is Note: Decline/rise in the first bidder’s stock price is not related to the stand-alone value of the first not related to the stand-alone value of the first bidder, but only reflects value from the takeover.bidder, but only reflects value from the takeover.

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FindingsFindings

Value improvements from tender offers are Value improvements from tender offers are positivepositive in in 95% of the sample using the Intervention Method 95% of the sample using the Intervention Method (89% using the Probability Scaling Method), and are (89% using the Probability Scaling Method), and are on average on average 50% of target value50% of target value using either method. using either method.Sample average revelation effect is zero. But time Sample average revelation effect is zero. But time

variation in revelation effects.variation in revelation effects.

Average perceived value improvement larger than Average perceived value improvement larger than estimates based on short-window returns.estimates based on short-window returns.Bradley-Desai-Kim (1988): 30% of target value.Bradley-Desai-Kim (1988): 30% of target value.Intervention and Probability Scaling Methods: 40% Intervention and Probability Scaling Methods: 40%

of target value.of target value.

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FindingsFindings

Bidders do not profit from buying targets: Average Bidders do not profit from buying targets: Average premia about the same as the value improvement.premia about the same as the value improvement.

Similar value improvements pre- and post-Williams Similar value improvements pre- and post-Williams Act.Act.

Takeover by a large bidder of a small target creates a Takeover by a large bidder of a small target creates a greater value improvement. (=> ‘Cultural’ clashes greater value improvement. (=> ‘Cultural’ clashes more severe in marriage of equals.)more severe in marriage of equals.)

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FindingsFindings

Value improvements as a Value improvements as a fractionfraction of target value not of target value not especially high during merger boom of 1992-1997. especially high during merger boom of 1992-1997. However, these takeovers have created large However, these takeovers have created large dollar dollar increases in value because of their large scale!increases in value because of their large scale!

Larger value improvements for friendly (business Larger value improvements for friendly (business complementarities) takeovers compared to hostile complementarities) takeovers compared to hostile (discipline of bad managers) takeovers. (discipline of bad managers) takeovers.

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Illustration of the Truncation Dilemma

Target Stand‑Alone Value: Target Stand‑Alone Value: $ 100 $ 100

Target Post‑Takeover Value: Target Post‑Takeover Value: $ 140$ 140

Bidder Stand‑Alone Value: Bidder Stand‑Alone Value: $ 200$ 200

Prior probability of successful bid:Prior probability of successful bid: 0 0

Post-offer probability of success:Post-offer probability of success: 0.60.6

Combined pre-bid expected value: Combined pre-bid expected value: 100 + 200 = 300.100 + 200 = 300.

Just after the initial bid: Just after the initial bid: 100 + 200 + .6(40) = 324.100 + 200 + .6(40) = 324.

Combined equity return: Combined equity return: (324/300) - 1 = 8.0%.(324/300) - 1 = 8.0%.

True percentage value improvement: (40/300) = 13.33%True percentage value improvement: (40/300) = 13.33%

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Illustration of the Truncation Dilemma (2)

Stock market’s prior perception of bidder + Stock market’s prior perception of bidder + target discounted value:target discounted value:

100 + 200 = 300.100 + 200 = 300.

Stock market’s post-bid combined valuation:Stock market’s post-bid combined valuation:

100 + 250 = 350.100 + 250 = 350.

Combined bidder/target equity return:Combined bidder/target equity return:

(350 - 300)/300 = approx. 16.7%(350 - 300)/300 = approx. 16.7%

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Illustration of the Intervention Method

Case 1: Large Improvement from Takeover

Target Stand‑Alone Value: $ 100

Target Post‑Takeover Value: $ 140

FB Stand‑Alone Value: $ 250

E[Price FB Pays|FB Succeeds]: $ 120

E[Price FB Pays|Competing Bid, FB Succeeds]: $ 130

Pr(FB Succeeds) .6

Pr(FB Succeeds|Competing Bid) .4

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Stock Price Reaction of FB to Competing Bid

Stock price when FB announces offer: 250 + .6(140 ‑ 120) = 262.

When competitor appears: 250 + .4(140 ‑ 130) = 254.

FB's stock return:

(254 ‑ 262)/262 = ‑ 3%.

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Sources of FB’s Return

FB’s price reaction to the competing bid reflects:FB’s price reaction to the competing bid reflects:

(1) FB pays more if he succeeds. (1) FB pays more if he succeeds.

(2) FB has a lower probability of succeeding. (2) FB has a lower probability of succeeding.

(2) ==> FB return decreases with improvement.(2) ==> FB return decreases with improvement.

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Case 2: Zero Improvement from Takeover

Post‑takeover value of target = $100.

Stock price when FB announces offer:

250 + .6(100 ‑ 120) = 238.

When competitor appears:

250 + .4(100 ‑ 130) = 238.

Stock return = 0%.

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One-to-One Mapping of Value One-to-One Mapping of Value Improvement to Stock ReturnsImprovement to Stock Returns

Improvement Stock Return40% -3%0% 0%

Given the other parameters, 1:1 mapping.

Can infer improvement without revelation bias.

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Specifics of the Intervention Method

4 dates4 dates

t = 0: Time prior to first bid.t = 0: Time prior to first bid.t = 1: Arrival of first bid.t = 1: Arrival of first bid.t = 2: Time prior to arrival of t = 2: Time prior to arrival of

competing bid.competing bid.t = 3: Arrival of competing bid.t = 3: Arrival of competing bid.

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y : Market value of bidder not related with takeover.

t : Bidder's profit from takeover conditional on t.

Pt : Bidder's price at t.

Hence,

P1 = y + 1 ,

P3 = y + 3 . (11)

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V0 : Non-takeover target value.

V1 , V3 : Post-takeover target value reflecting takeover gains.

B1 , B3 : Price ultimately paid by a successful first bidder.

: Fraction of target held by first bidder prior to first bid.Hence,

1 = Pr(S|V1 - V0] + (1-)[V1 - B1]},

3 = Pr(S|V3 - V0] + (1-)[V3 - B3]}. (12)

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Assume, V3 = V1 = V . [See footnotes 16, 17]

Also, R3 = P3 / P1 - 1.

(V/V0) - 1 = {[R3(P1/V0)] / [Pr(S|Pr(S|V) + (1 - V

- 1where, Pr(S| [Pr(S|Pr(S|

Strong Agency / Hubris Hypothesis: (V / V0 ) - 1 = 0.

(V / V0 ) - 1 > 0. Implies joint value improvement.

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The Probability Scaling Method of Estimating Value Changes

Value Improvement = [Combined Initial Bidder and Target Return] /

[(Probability a First Bidder arrives and wins) +

(Probability a First Bidder arrives but a Later Bidder wins)] (9)

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DATA

MERC and SDC datasets.Table 1: 794 tender offers during 1962-1997.

Figure 2 : Percentage of•Successful takeovers,•Multiple (two) bidder takeovers,•Hostile takeovers,•All cash offers.

Figure 7 : Median dollar shareholder returns to•Bidders,•Targets,•Combined entity,over various sub-periods during 1962-1997.

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Table 4, Model B: Entry of second bidder Table 4, Model B: Entry of second bidder significantly lowers probability of success of significantly lowers probability of success of first bidder.first bidder.

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ESTIMATES OF VALUE IMPROVEMENTS

(V/V0) - 1 = {[R3(P1/V0)] / [Pr(S|Pr(S|V) + (1 - V

- 1where, Pr(S| [Pr(S|Pr(S|

(V/V0) - 1: IRATIO : Joint value improvement brought by takeover.

R3 : Bidder abnormal return at entry of second bidder = -.3% (median = -.3%).

P1/V0 : Relative size of bidder versus target = 4.68 (1.80).

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Pr(S|1) : Unconditional probability of success of first bidder = 530/794 =.6675.

Pr(S|3) : Probability of success of first bidder given arrival of competing bid = 35/137 =.2555.

: Fraction of target's equity owned by first bidder = .025 (median = .000).

B1/V0 : Average price at which first bidder wins in full sample = 1.435 (1.384).

B3/V0 : Average price at which first bidder wins given arrival of competing bid = 1.440 (1.421).

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Table 3

IRATIO = 49.6% (median = 43.4%).

95% of IRATIO estimates are positive.

Histogram of IRATIO: Figure 8.

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SENSITIVITY ANALYSIS

1. Use transaction-specific probabilities of success using the logit models of Table 4. Last four rows in Table 3. 2. Sensitivity of mean of estimated IRATIO to simultaneous variation in each of the estimated parameters in the direction of lower IRATIO: Mean IRATIO remains positive with simultaneous 12% shift in all four estimate parameters.

3. Table 3: Parameter estimates from Bhagat-Shleifer-Vishny (1990). IRATIO= 36.7% (21.2%)

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SENSITIVITY ANALYSIS4. Table 3: Parameter estimates from Betton-Eckbo (1998). IRATIO= 52.2% (47.0%)

5. Parametric derivation of distribution of mean IRATIO.

6. Model Specification: Table 10•If the arrival of a competing bid causes an upward revision in the expected post-takeover value of the target to the first bidder => K > 1.•If the first bidder fails to acquire the target, the first bidder will successfully acquire another similar target at a similar premium=> •An unsuccessful first bidder can sometimes profit by selling its holdings to a successful competing bidder=> Pr(S2|

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Comparison of the Intervention Method, and Probability Scaling Method to

Traditional MethodsTable 5 Traditional Method combined return (CIBR) = 28.3% Intervention Method combined return (IRATIO) = 43.4%Probability Scaling Method combined return = 41.1%

Work to be doneEstimate revelation effects in different classes of transactions.

•Is revelation more adverse when pay with equity than when pay cash?• Different revelation in hostile versus friendly transactions?