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Module 5
Bid Tactics
Introduction ........................................................................................................ 5/2
Bidding and Resisting as a Game .................................................................... 5/10
Offensive and Defensive Tactics ..................................................................... 5/14
Northern Electric Case Study ......................................................................... 5/34
Learning Summary ...................................................................................................... 5/42
Bibliography ................................................................................................................. 5/44
Review Questions......................................................................................................... 5/45
Learning Objectives
This module examines the merger process from the initiation of the bid through to its
conclusion. When seeking to acquire another business, acquiring firms must proceed
through a bidding process that involves convincing the target firm’s shareholders that it is in
their interests to accept the offer. In this process the management of the target company
plays an important role. In many instances, even if the management in the target company is
broadly in agreement, there are many potential areas of conflict that can derail the transaction. These conflicts are multiplied many times over when the bid is hostile and the target is
adamantly against the proposal.
At the same time, a bidder will have not only to negotiate and deal with a possibly recalcitrant management in the target but also to address issues raised in connection with
competition policy and the conduct of the bidding process.
Firms under threat may seek to make themselves less vulnerable by putting in place a
range of takeover defences that make the target less desirable or harder for an acquirer to
By the time you have completed this module you should understand:
• the need by an acquirer for a disciplined approach to the bidding process, particularly
with respect to setting the maximum price for the target;
• the nature of the conflicts of interest between the acquirer’s and the target’s management
and shareholders and their effect upon the merger process;
• the role of management in the bidding process and in particular how the takeover
negotiation can be modelled as an economic game;
• how regulators, who are concerned with issues of public policy and the competitiveness
of markets and industries, evaluate and identify acceptable and unacceptable mergers;
• the role and effect of market process regulation governing how target company shareholders should be treated and how the management in the target firm should act to
minimise conflicts of interest;
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Module 5 / Bid Tactics
• why takeover defences are instituted by firms as a means of deterring an aggressor and
entrenching management;
• how the takeover process worked in practice in the case of Northern Electric plc.
You’ve reviewed the strategy, analysed the potential acquisition and run over the valuation
using all the financial and business tools at your disposal. At the same time you’ve warmed
up your financial and other advisors and everyone is now eager for the fray. You’re now
ready to make a bid for the target company. What do you do?
The objective now seems simple: buy the business. But to do so you’re going to have to
persuade the target company’s shareholders and management that selling to you (or merging)
is the right decision. They may have other intentions or not quite see the attractions of the
deal. We already know that we’re going to have to pay a premium for corporate control.
What we also have to figure out is how to manage the negotiation or auction process to
obtain ownership of the target. Even in friendly acquisitions the target’s management will
want to ensure they get the best possible terms. In addition, there are regulatory and
procedural hurdles to overcome. This module is about the process of mounting a bid and
seeing it through to a conclusion.
Takeovers and mergers are some of the most high-profile transactions in business. Nothing excites the business press more than the sight of a company engaged in an acquisition,
especially if the target resists. Hostile takeovers lead to critical articles and a load of mudslinging by both sides. They generate a lot of passion, and managers can be carried away by
the excitement of the chase. It is therefore important to set ground rules about how to
proceed and limits on price and other factors. Some firms, for instance, state they will not
engage in hostile acquisitions. So, if a deal turns hostile, they will walk away. Such binding
behaviour is necessary as, once a bid is mounted, events can move very fast, and in the heat
of the moment good intentions can get lost.
In addition, the proposed combination may raise regulatory concerns that will have to be
addressed about the impact on competition. At the same time, the bidder will have to
navigate the legal issues surrounding the acquisition of another business, not least the market
process involved in making a tender for another company’s shares.
Setting the Reserve Price
An immediate critical decision has to be made about the absolute maximum price to be paid
for the acquisition at the start of the takeover process. As mentioned in the previous
module, the price encapsulates all the benefits and costs associated with the creation of the
enlarged firm. A sensible price leaves a positive net advantage of merging (NAM) to the
acquiring firm. Figure 5.1 provides an intuitive understanding of the issues involved. The
value a buyer will be prepared to pay is based upon realising benefits against the costs of the
acquisition. Although the costs are well known, there is less certainty as to the value of (and
the ability to realise) the benefits.
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Increasing risk
Value enhancements
Cost reductions
Figure 5.1
Total price
Cost and valuation benefits
The value of the acquisition will be a combination of relatively safe existing asset value
(tangible and intangible assets) together with an element derived from these assets of future
predictable cash flows. In order to realise a positive NAM, the acquirer will need to realise
value enhancements. These will include the private benefits that the acquiring firm may be
able to make from scale and scope economies, synergies and market power. Recall that, in
the previous module, these are categorised as: level 1, tactical synergies; level 2, strategic
synergies and level 3, transformation. These value benefits depend ultimately on correctly
identifying and pricing the strategic logic of the acquisition. In the previous module,
methods to estimate these were described. Obviously, some of these will be relatively low
risk. For instance, enhancements 1–3 are, as detailed in the previous module, cost reductions
or value extraction from making use of the target’s surplus cash or borrowing capacity. As
we move up the list, there is greater risk in achieving the realisable value enhancements. For
instance, those from 4 to 7 are synergies requiring considerable business transformation to
exploit economies of scale and scope. At the extreme (enhancements 7 and 8 and beyond)
will be new strategies whose attainment is very speculative. Note that any enhancements
from the acquisition will be specific to the acquirer and might or might not be realisable if
another firm were to acquire the target.
So the more the bidder has to pay away the value enhancements, the riskier the takeover
strategy. In terms of the bid process, managers should be very concerned about the price of
the acquisition as there is a significant danger of paying away the value enhancements they
have identified as a bid premium. In order for the bid to enhance shareholder wealth, it is
therefore necessary to ensure that the acquisition price is less than the realised benefits.
Mergers and Acquisitions Edinburgh Business School
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To put it simply, the maximum price a rationale bidder would pay is the one for which
the NAM is zero. This is the point at which all the expected benefits are given away in the
price. We can now define the area of variability within which the negotiation will take place.
At the bottom end will be the market value prior to the announcement of the bid. Although
in theory there is no upper limit to the price, rational bidders will not knowingly pay beyond
the point where the NAM falls to zero. That said, bidders often get carried away and – in the
heat of the action – abandon their initial valuation. For instance, they often reconsider the
potential benefits and may revise upwards their estimate of the NAM during the auction
process in order to justify paying a higher price. This is probably dangerous as under the
pressure to succeed these revisions are often overly optimistic. Richard Roll (1985) described
the tendency of managers to overbid, having overvalued the potential benefits of an
acquisition, as a manifestation of the ‘winner’s curse’ problem. So correctly identifying what
the target is worth and the maximum price to be paid is important.
Taking a disciplined approach is particularly essential when the situation develops where
an initial bid leads to another company also entering the bidding and a contest develops
between them for the target firm. It is possible that the target is worth more to the other
bidder. In such a situation a cool head is required. Managers should be cautious about
getting into a bidding contest where winning becomes the objective rather than value
creation. They are likely to end up paying more for the target than it is worth to the acquirer.
Lloyds TSB, a major money centre bank in the UK, has developed a reputation as a disciplined bidder. When seeking to buy up competing or related businesses, it has been very
careful to ensure that, whatever the outcome, the price it is willing to pay allows the bank to
retain a positive NAM. In a number of cases of a contested takeover it has allowed itself to
be outbid rather than raise the price just in order to win. As a result, Lloyds TSB shareholders have applauded the management’s disciplined approach to the merger process, for
instance when bidding against the Hong Kong & Shanghai Bank for the Midland Bank in 1991.
In the subsequent £7 billion acquisition of Scottish Widows, the bank was less astute and
overpaid for the life company. Thus even a disciplined bidder can easily come unstuck in its
Time Out _______________________________________________________
Think about it: Bidding wars
Often acquisitions are contested, which leads to two companies bidding against each
other to take over the target. The correct identification of the synergies and other
benefits of the acquisition should help managers avoid the risk of getting into an auction
with the other acquirer. The danger is that incorrectly valuing the benefits will lead
managers to pay away all the net benefits, or more, in order to succeed.
In December 2001 ENI, the Italian energy company, made an unsolicited offer to acquire
Enterprise Oil, an independent UK oil and gas producer with major interests in the North
Sea, Italy, the US and Brazil, pumping about 250 000 barrels of oil per day. ENI’s private
approach to Enterprise was rumoured to be at a price of around 600 pence/share.
The strategic background was that ENI was keen to add Enterprise to its other acquisitions of independent companies in the UK, having previously acquired two other oil
firms, British Borneo acquired in March 2000 and Lasmo in December 2000. In making the
bid, ENI was benefiting from a combination of rising oil and gas output, from a €4.5
billion ($4 billion) programme of disposals up to 2005, and from the €2.2 billion
proceeds of the recent sale of a 40 per cent stake in a gas pipeline. It had publicly
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announced a strategy of growth by acquisition in the oil and gas sector and, in addition
to the €24 billion of capital expenditure planned for the period 2002–05 to boost
existing businesses, had set itself a €7.1 billion acquisition budget for the period 2001–
2004, of which slightly over half went on buying Lasmo.
Enterprise had been the subject of speculation since being spun off from its then parent
British Gas in the early 1980s. Under Sam Laidlaw, its recently installed chief executive
officer who had taken up his post in October 2000 just prior to ENI’s bid, Enterprise set
out a strategy to try and remain independent by taking steps to increase shareholder
value. The problem for the company was that it was too small to compete effectively
with the major oil companies such as BP and ExxonMobil and too large to offer investors
the excitement of smaller oil companies with their greater exposure to the exploration
end of the business. Laidlaw’s strategy entailed lifting production by 7 per cent a year
and cutting costs by over £30 million a year. This was grudgingly endorsed by shareholders as the preferred alternative as they did not see the ENI bid as delivering full
value for the company. ENI meanwhile waited to see how the market would react to
the restructuring before making another decisive bid.
However, matters took an unexpected turn on 2 April 2002 when Royal Dutch/Shell
announced an offer for Enterprise of 725 pence/share (a 45 per cent premium to the
share price pre the ENI bid in December) valuing the company at £3.5 billion (plus £800
million of assumed debt).
The question was whether ENI could and should raise its bid. In justifying the purchase,
Shell indicated it would wring out $300 million per annum of synergies from the
acquisition. Although in some quarters it was expected that ENI might raise its bid in
response, and the Enterprise share price momentarily rose above 725 pence, ENI
indicated that it could not match the level of synergies that Shell was expecting to make
and was not prepared to make a counter offer.
However, should ENI have reconsidered and increased its initial offer?
As an aside, the competition for Enterprise raises some interesting issues about the
nature of the synergies involved. If both contenders could extract the same value, then,
subject to the reserve they considered prudent, they would both be able to pay the
same price for the target. The question is whether ENI could match the synergies being
offered by Shell. It would require an understanding of where the synergies were to be
created. Were they common to the industry or unique to the two companies? In
mounting its bid, Shell implied that many of the benefits were firm specific rather than
generic to the industry. This requires a very good understanding of both the acquirer’s
own operations and sources of value-added and those for the target.
Time Out _______________________________________________________
Setting the price so as to obtain a positive net advantage to merging (NAM) seems a
sensible thing to do prior to proceeding with an acquisition. But maybe there are
takeover situations where such prior commitment can work against the bidder? So,
while setting a reserve price is the right thing to do, this can – and should – be revised if
circumstances change in the case, for instance, where another bidder makes an appearance.
What do you think?
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Setting Objectives
The basic mechanics of acquiring a firm are simple. The bidder makes an offer for all (or
part, as is allowed in some jurisdictions) of the target firm’s equity. In a few cases, the offer
will be for a specific package of assets or a subsidiary where the sales proceeds are then paid
to the selling company. In seeking to acquire the shares of the target, the bidder needs to
convince a majority of existing shareholders to sell. At the same time, there is an ongoing
negotiation with the target firm’s managers. It greatly helps the acquisition process if the
board of directors of the target recommends the transaction. Directors are stewards of the
company acting on behalf of the shareholders. As they are appointed by the shareholders, it
is logical for shareholders to accept their advice on key matters.
The process is an auction. Different parties will have different views as to what constitutes
the value of the target firm. The selling shareholders will realise that the bidder can extract
value from the combination and will want to be compensated for surrendering ownership of
the target’s future prospects. Managers in the target may be concerned at losing their jobs
and hence will seek to place obstacles in the way of the bidder. Managers in the acquirer may
be driven by ambitions as to firm size and hence, since there is a strong relationship between
firm size and pay, in their remuneration. There is also the prospect of success fees. Christopher Gent, chief executive of Vodafone, was awarded £10 million by the company for
engineering the takeover of Mannesmann in 1999/2000. If such performance-related bonuses
are offered before an acquisition is mounted, there may be strong personal reasons for
managers to conclude the transaction – at any price. Finally, it may be the bidder management’s view that a successful acquisition is required to deliver on the long-term strategy
which led to the decision to take over the target in the first place. That is, there is a high
strategic price attached to the failure to win.
An example of the problems of losing arises with Lafarge SA, the French buildingmaterials group, as a result of its £3.80 billion bid for the UK cement maker Blue Circle plc in
May 2000. Advised by its investment bank Dresdner Kleinwort Benson, the French company bid
450 pence/share for Blue Circle. However, shareholder resistance meant that it ended up
owning 22.6 per cent of Blue Circle shares while Dresdner held a further 9.7 per cent (which
increased to 44.5 per cent when acceptances were included) when its bid was rejected.
Lafarge was left with the cost of holding its 30 per cent plus stake in the group. Net financial
expenses, which had been €337 million in 1999, rose to €489 million in the financial year
2000. A major element of this related to the cost of financing its holding of Blue Circle
In the event, the large minority position made life difficult for Blue Circle, and the following year its board of directors agreed to a cash offer at 495 pence/share. This represented
a premium of 10 per cent to the bid price of the previous year. The cost to Lafarge was a
£2.4 billion price for the 67 per cent of Blue Circle shares in third party hands. Lafarge
would also assume £1.8 billion in debt.
Time Out _______________________________________________________
Think about it: Bid talks at Jefferson Smurfit
Shares in the Irish packaging company Jefferson Smurfit rose 15 per cent, adding 24.5
pence to close at 191 pence on the news that it had ‘received an approach from a third
party’. Michael Smurfit, founder and chairman and chief executive of the company,
declined to comment or name the interested party. Under his leadership, Jefferson
Smurfit had been turned into a global business worth more than £2 billion. With the
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packaging industry in a period of consolidation and facing a poor outlook, analysts
considered that Michael Smurfit might be considering an exit.
An interesting twist was that about 40 per cent of the capitalisation of the company
represented a strategic stake of 29.4 per cent held in Smurfit-Stone Container, its US
associate. Some commentators considered that an astute buyer could dispose of the
Smurfit-Stone stake and gain control of the rest at a discount.
The bidder was understood to be a financial buyer, though there were rumours that the
deal could involve the existing management. However, commentators also felt that
trade buyers could be interested, anxious to participate in the consolidation of the
paper industry. Some suggested that major industry names such as International Paper,
Weyerhauser, Stora and Mondi (part of the Anglo-American Group) would jump at the
chance of picking up the business. However, European firms might face regulatory
difficulties with the European Commission, and US firms already had stretched balance
Market Reaction to Takeover Moves
When a takeover attempt becomes public, there is an initial reaction in the share price of
both the acquirer company and the target. One way of analysing the market’s reaction
around the announcement date is to separate the returns on a share into its two components:
the market-related return and the stock-specific return. Takeovers affect the stock-specific
returns of both companies as the costs and benefits relate to the two companies and not the
wider economy. A simple model, known as the market model, predicts the following
relationship between the share return
and market return
. The market’s return is
measured by an index. The equation is
where alpha
and beta
are coefficients and ε is an error term. The model parameters
α and β are calibrated such that the expected value of ε is zero. The alpha and beta coefficients are normally computed using historical data. The importance of the model is that we
know that the expected return, conditional on the market’s return, will be
where the alpha and beta terms are estimated from historical data. The return on the market
is that observed at time t. Consequently, the stock-specific return will be that component of
the total return observed at time t less the market-predicted return:
where the tilded , is the return observed from market prices. The difference between the
expected return and the actual return is known as the abnormal return (AR). These are
often added together over an event period (say a few days, a month, or even longer) to create
cumulative abnormal returns (CARs). If an event such as a takeover announcement is
made, then we would expect to observe a price reaction independent of general market
changes. This is in fact what is observed. Graphing the cumulative abnormal returns (which
can be either positive or negative) gives a picture similar to that shown in Figure 5.2. This
graphs the CARs for bidders and targets prior to the announcement of a takeover and in the
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immediate post-announcement period. Typically such graphs run for 30 to 50 days prior to
the announcement (event) date to capture any leakage of intent that might affect the share
price, and are carried over until after the bid outcome is known, typically 80 days or so,
although long-run post-acquisition studies have also been done.
Using the market model, and computing CARs from the market reaction to merger
announcements, academic researchers have established that, on average, the initial movement in share price is a reliable predictor of the subsequent performance of the takeover.
This movement is the sum of the changes in market capitalisation of both the acquirer and
target. As there is normally a rise in the target company share price (as the implicit premium
for corporate control crystallises), a good indicator as to whether there is the potential for
value destruction is the change in the bidder company’s share price. If the share price rises,
the market is taking a positive view of the potential for the acquisition; if it falls it is
expecting value destruction from the resulting combination. A weakness of the model is that
it does not give the underlying reason for the market’s reaction. But studies of merger
announcements and particular types of bid, such as contested takeovers, the reactions of
industry rivals, and failed bids, can help to determine the causation.
Target cumulative
abnormal returns
Bidder cumulative
abnormal returns
Period before
Figure 5.2
Period after
Typical cumulative abnormal return patterns for bidder and target
For those involved, observing how the market reacts to the announcement – and subsequently – provides a useful reality check on the merits of the proposed takeover. Bidders
therefore need to watch how their share price reacts to the takeover announcement and
The academic evidence can be summarised as follows. Virtually all studies are unanimous
that target shareholders gain from acquisitions. The evidence for acquirers is mixed. Early
studies suggested on the basis of short-term price behaviour around the announcement date
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that bidders also gain. On the other hand, longer-term studies over several years suggest that
bidders’ share prices underperform. These are not without their problems, especially in
terms of model error, which is probably not material in the short-term studies, but the
weight of evidence suggests, as does other research, that the majority of acquisitions are
disappointing from a valuation perspective. Figure 5.3 summarises the evidence.
Event period
Post-event performance
tend to underperform
tend to outperform
Figure 5.3
Event period
significant outperformance
neutral or slightly negative
Post-event performance
large fall, if not acquired
negative performance
Summary of academic evidence on merger performance
Time Out _______________________________________________________
Think about it: Not two, but three
Sometimes the announcement of a bid creates the situation where other firms decide
they would like to acquire the same company. With multiple bidders the different
parties are engaged in a competitive auction. In this case, the seller has more opportunity to extract value from the bidders by setting them against each other. Every seller
wants to set up the transaction to maximise value by having more than one bidder.
Financial advisors will therefore seek to design the selling process so as to attract the
maximum amount of interest, and the best price for the vendors.
In the sale of National Car Parks, better known to UK motorists by its initials NCP, by its
parent company Cendant, the US direct marketing and franchising group, over 20
bidders were submitted to the vendor’s financial advisors in the first round. After
vetting, the list was reduced to six serious contestants. As the prospect of a bidding war
loomed, a number of potential buyers dropped out, leaving three serious bidders for the
final round. What price can the vendor therefore expect to get and what will be left for
the buyers?
Richard Roll (1985) in a study of merger activity warned that the disappointing outcome
for most acquirers was the result of a problem known as the winner’s curse. This
arose because the company which paid the highest price was the most optimistic and
(probably) the one to overestimate most the benefits of the combination. In the above
auction it is likely that Cendant would get a very ‘full price’ from the successful bidder,
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who would have paid away most of the potential gains from the acquisition to the
vendor. Thus the seller gains, but the winner loses.
However, even with the disappointing empirical evidence on the success of acquisitions,
some of which dates back to the 1960s, firms have continued to buy up each other.
There is more at work than ‘enhancing shareholder value’. The evidence, as Richard Roll
pointed out, indicates severe management hubris: the belief among managers that
they can succeed where others have failed. Or, they are driven by considerations other
than value enhancement: that is, self-aggrandisement, empire building, and the like. That
is, managerial motives determine the decision, not value-maximising ones.
Time Out _______________________________________________________
Going all out to win seems the natural thing to do once you’ve started the process of
acquiring another firm. The price of failure can be high. Failing managers are often
dismissed from office by ungrateful shareholders. So losing isn’t going to endear
management to shareholders. But pressing on regardless of cost – as seems to happen
all too frequently – probably means overpaying. How can shareholders reconcile the
need for managers to take risks (by initiating takeovers) but prevent them pursuing
these in the face of value destruction? Can you think of an example?
What do you think?
Bidding and Resisting as a Game
There are a number of different players in a takeover. We can easily identify the following
parties who have an interest in the outcome:
Bidding firm
Other stakeholders
Target firm
Other stakeholders
General public
The state
Local government and municipalities
The list seems forbidding. The principal actors, in the absence of public policy issues
such as anti-trust or national interest, are the shareholders and managers in the bidding and
target firms. Generally, although the other stakeholders have an interest in the outcome, they
lack the power to influence events directly. Also, as managers are the shareholders’ agents (in
the absence of special factors), there is a general tendency for shareholders to support the
existing management. Given this, we can essentially reduce the complexity of the different
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interests to two: the managers in the bidding firm (acting on behalf of the acquiring firm’s
shareholders) and the managers in the target firm (acting for the target firm’s shareholders).
This is not to ignore potential conflicts of interest that might exist between managers and
shareholders. These are well documented in the economic and finance literature and are
known as the agent–principal problem. There will be times in the acquisition process
when it is in the self-interest of managers to go against the wishes of shareholders. At this
point it is important for shareholders to have in place, or be able to provide, incentives for
managers to act in shareholders’ best interests. See Jensen and Meckling (1976). See Finance
textbook, Modules 9 and 12.
Time Out _______________________________________________________
Think about it: Why managers in the target firm oppose takeover bids
Managers in a target often choose not to roll over and accept the inevitable, but fight
the acquisition. This applies even if there is a sound reason for the transaction. Success
comes at a price, as the losing managers face an uncertain future. One reason for
fighting back is that they believe their jobs are at risk if the acquisition proceeds. Hence
they pursue tactics designed to frustrate the deal, thus preserving their jobs. Another
reason is that they want to extract a higher price from the bidder. The argument here is
that by demonstrating their management ability, they can raise their perceived worth in
the executive job market. That is, they are seeking to signal the worth of their ‘human
capital’ as they are likely to be dismissed or downgraded in the combined firm and will
be looking to be hired by other firms. They may also feel – rightly or wrongly – that the
company will do best under their stewardship and therefore will have an emotional
objection to giving it up.
So even if the target shareholders approve of the takeover, the management is likely to
resist. How can shareholders ensure that good takeovers proceed without being
derailed by recalcitrant managers? Some firms seek to reduce such conflict of interest by
offering managers golden parachutes. These are generous payoffs if managers lose
their jobs as a result of a takeover. In some cases acquiring firms negotiate such payoffs
directly with the managers of the target as a way of lessening their hostility to the bid.
Managers of acquiring firms have strong incentives to bring a takeover bid to a successful
conclusion. Executives who successfully mount takeovers tend to receive additional rewards
from doing so. This may be in the form of either performance-related bonuses or higher
remuneration from taking on increased responsibilities for the integration and development
of the enlarged post-acquisition firm. In undertaking the transaction, the acquiring firm
managers have a strong incentive to end up with the best and most remunerative management positions at the expense of those in the target. They are also part of the management
team that developed the strategy and successfully carried out the acquisition.
Managers in targeted firms have equally strong incentives to resist. One of the problems
of using professional managers is that, in order to be effective, they need to invest in firmspecific skills. Much of their personal wealth, including their future earning power, is tied up
in the firms they manage. In addition, it may be possible for managers to earn rents from
their position. By being taken over, they stand to lose much of what they have from their
position in the firm. Everything that the acquiring firm managers seek to gain in the enlarged
entity is at the expense of managers in the target.
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There is a branch of economics known as game theory that deals with situations of conflict where both sides have choices as to the strategy to pursue. In the simple game model we
shall examine, each set of managers has two strategies, which are shown in Table 5.1. This is a
version of the prisoner’s dilemma game where the benefits of cooperation outweigh the
alternative strategy of fighting one’s corner. The bidding firm’s managers can either share the
benefits or seek to exploit the situation. Likewise, the target’s managers can either share or
exploit. In the case of the acquirer sharing and the target sharing, they can split the benefits
equally, thus gaining +4 each. Note the numbers are arbitrary ones to illustrate who gains and
loses from the different strategies in the acquisition. One can consider these values as the
additional gains (in income, wealth, economic rents and/or status) from successfully acquiring
or resisting the takeover. If the bidding managers exploit, they stand to gain +6 whereas the
target managers, if they share, end up with −2. If the bidder shares but the target exploits, then
the acquirer managers end up with −2 and the target managers with +6. If the bidder exploits
and the target exploits, then both sides suffer a penalty of −1.
Table 5.1
Payoffs matrix for bidder and target managers
4, 4
−2, 6
6, −2
−1, −1
To identify what each side will do it is necessary to compare the outcomes for each strategy. Taking the bidder’s management first, to exploit provides a gain of +6 if the target
shares and of −1 if the target management also seeks to exploit. The alternative strategy of
sharing gives +4 if the target shares and −2 if the target exploits. Comparing the two choices
from the bidding management’s perspective it is the case that exploiting is better if the target
managers share and it is also better (albeit unpalatable) if they exploit. Thus no matter what
the target managers agree to do in this situation, it is better for the acquiring managers to
exploit. This fact makes exploiting the dominant strategy for the bidder.
Using the same logic to consider the target firm’s managers, we see that they do better if
they also exploit. Thus their dominant strategy is also to exploit.
This type of game has three essential features. First, each party has two strategies: to
cooperate with one’s rival or to defect from cooperation. Second, each player has a dominant strategy. Third, the dominant solution equilibrium has a worse outcome for both parties
than the non-equilibrium solution in which each party follows the dominated strategy (in our
case, to share/share). That is, they would be better off from following a cooperative
strategy. But this requires trust between the two sides.
The issues raised by the problem of a dominant strategy that leads to a worse outcome
than cooperation have been extensively researched in a variety of situations. The solutions to
the prisoner’s dilemma game depend on the type of game involved. One way round is for
trust to be established as the game is repeated. In this case an acquisition is a one-off game
between the two sides so that there is no prior opportunity to build up trust. Games that are
repeated allow trust to be built up through cooperative behaviour whenever the game is
played. This ability to signal good intentions is absent from the once-only situation of a
takeover. One possibility is to penalise managers who adopt the sub-optimal exploit stance
so as to direct them to share with the other side. The problem here is that there is little that
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the acquiring managers can do to change the incentives for the target managers. One
possibility often seen in many M&A situations is for the acquiring firm to agree the
combination’s management structure with the target so as to reduce the incentive to exploit.
In game terms, this is equivalent to raising the cost of exploiting. This would happen, for
instance, if the cost of exploiting given in the bottom right cell was raised to 3. A third
strategy is known in the literature as leadership. Table 5.1 assumes that both sides are likely
to suffer equally in the process. This is not untypical of most takeovers, where the bidder
tends to be significantly larger than the target. In this case the gains and losses are likely to
be on a different scale. In this situation the bidder, given the potential losses from exploitive
behaviour, may prefer to share even though it is likely the target will nevertheless exploit. In
Table 5.2 it now becomes the bidder’s dominant strategy where share has the payoff +8 −4
compared to exploit with +6 −8. Thus the dominant solution is bidder share/target exploit.
Table 5.2
Payoffs matrix for large bidder and small target managers
8, 4
−4, 6
6, −2
−8, −1
Reviewing Table 5.1, one can see that the bidder will be better off if it can persuade the
target to share the benefits. If the players in the game can make side payments and/or credible
promises to each other, there is a better solution for everyone in getting a share/share
outcome. To get to this stage, the bidder might want to transfer some of the benefit it would
gain from the share/share outcome to the target. For instance, transferring just over +2 to the
target would ensure their cooperation as they would then have a better payoff than following
the exploit strategy. How can this be done? Well, shareholders in firms provide payment
mechanisms known colloquially as golden parachutes, which compensate managers for the
loss of the benefits from selling the firm to a bidder. Note that as these are paid out after the
acquisition proceeds, they effectively come from the bidding firm. The bidding firm itself can
offer (financial) incentives, such as pension enhancements or ex gratia payments for loss of
office, or guaranteed positions in the new firm or other benefits to compensate the losers. For
instance, the Chief Executive of cosmetics group Revlon received a $35 million payoff when the
company was acquired. In the tough takeover battle between the UK’s Vodafone and the
German Mannesmann group, after the bid was eventually successful, Mannesman’s chief
executive Klaus Esser received DM29.4 million ($14.15 million) payment for early termination
of his contract. This sum included a payment for termination worth DM25.5 million in June
2000 and a ‘lifetime benefits final settlement’ payment of €2 million, made in January 2001. The
size and nature of these payments attracted considerable controversy in Germany, where such
large payoffs were hitherto unknown.
Time Out _______________________________________________________
The analysis of the choices in an acquisition characterised the two sides as being in
conflict. Is this a natural outcome of the acquisition process or have the incentives given
to managers something to do with the tendency of the management in a target to resist?
What do you think?
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Offensive and Defensive Tactics
Whereas the previous section has characterised a takeover in the form of a game, the
decision to acquire another company does involve the parties in deciding how to mount the
bid and, for the target, how to defend itself. This section takes a look at the basic offensive
and defensive tactics.
In a bid situation, there are many different possible scenarios for the acquirer and the
target. First, the bid can be either friendly, where the two sides negotiate on the terms and
price, or unfriendly, where the bidder makes a hostile grab for the target. Second, a number
of different mechanisms for taking control of the target exist. A general framework for
understanding the choices is given in Figure 5.4. Note that the range of choice is likely to be
jurisdiction specific. For instance, in the US it is possible to mount a partial tender, whereas
that is illegal in the UK. In many continental European countries specific minority provisions make the use of proxy contests problematic.
Is acquirer
willing to forgo Yes
Is acquirer
willing to go
(bear hug)
Abandon bid
Select bid
Move to
Figure 5.4
Buy up
in market
Decision framework for acquiring another firm
The key element for an acquirer is whether to seek a negotiated acquisition or to go
hostile and forgo the possibility of negotiating an agreement. This is matched by the
possible reactions of the target: whether to agree to a negotiated settlement or whether to be
hostile to the approach. If the target’s board is hostile, then a bidder can try to force
negotiation through a bear hug. That is, the bidder makes an offer designed to force the
target’s managers into having to consider the offer rather than simply turn it down out of
hand – and hence they are forced to discuss the merits of the bid. Or a bidder can simply
opt for a hostile approach right from the start.
In practice, many mergers are agreed by both sides. Given the issues raised in the previous
section, it makes sense for an acquirer to get the target management on their side. If they
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recommend the takeover, then the target firm’s shareholders are likely to endorse the
proposal. If, on the other hand, for some reason the target managers are hostile to the bid,
the acquirer can go over the management’s head and appeal directly to the target firm’s
shareholders. This can be done in two ways. First, the acquirer can seek the support of target
firm’s shareholders at the next annual general meeting (AGM) to replace the management.
This approach involves mobilising shareholders to vote in favour of the acquiring company
in a process known as a proxy fight. That is, they obtain the right to vote someone else’s
shares. The evidence suggests that holding a block of between 20 and 30 per cent of the
votes would give effective control. Such battles are expensive and, in the past, have proved
difficult to win. But where the company is protected by takeover defences, getting shareholders’ cooperation may be the only way forward. The types of defences firms create are
discussed in a later section.
The second way of bypassing the target firm’s managers is to bring the takeover offer
directly to the target’s shareholders. In this case, the management of the target firm may
either advise its shareholders to accept the offer or they may elect to fight the bid. Note that,
in fighting, the target managers may not be acting in the best interests of shareholders who
might stand to gain more from the deal going through than by its being rejected.
The three-way €30.8 billion tie up, announced on 8 March 8 2000, between Deutsche Bank,
Dresdner Bank and the Allianz Insurance company provides an example of the difficulties
involved. The key information for the two banks, which were to merge while at the same
time divesting their retail banking operations to the Allianz Group, is given in Table 5.3. The
combination would be a colossus, with a market capitalisation of around €85 billion, and
would have been Europe’s second largest bank by market capitalisation. On a pro forma
accounting basis, the new entity would have had assets of 1.251 trillion, making it the largest
commercial bank in the world.
Table 5.3
Key data on Deutsche–Dresdner 2000 merger proposal
Total assets
Pre-tax income
Market capitalisation
€840 billion
€5.0 billion
€53.4 billion
€410 billion
€2.1 billion
€24.6 billion
75 306
48 948
The intention for the merged entity was to spin off the less profitable retail banking
operations in order to concentrate on commercial, investment and Internet banking. The
retail banking elements would be merged into a new company to be called Bank 24, in which
Allianz would hold a minority stake. The reaction of the financial markets to this ambitious
three-way merger is given in Table 5.4.
Table 5.4
Market reaction to announcement of Deutsche–Dresdner merger
(March 8 2000)
Closing share price on
Per cent change
day of announcement
on day
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Note the favourable share price reaction for the three parties. From this point on things
began to unravel. Disagreements arose over the fate of Dresdner Bank’s profitable investment
banking business in London. As Deutsche already owned a similar unit, the implication of
merging the two businesses was that the smaller business should be either sold or closed. This
met with substantial resistance from the banking unit, which was in a strong position within
Dresdner as it contributed significantly to the group’s profitability. On 6 April the agreed
merger collapsed, and Dresdner chairman Bernhard Walter resigned while at the same time
refusing to accept any blame for the failure of the merger negotiations. In the aftermath
Dresdner and Deutsche exchanged mutual recriminations and insults over the deal. The share
price of all the parties involved ended up lower than before the merger was announced,
although both banks saw increases on the day (Deutsche’s share price rose +7.5 per cent, and
Dresdner’s was up 4.26 per cent). The share price of Allianz, the third party in the reorganisation, tumbled 13.86 per cent on the day to end up back at the level it stood at when the threeway link-up was originally announced. The result is that shareholders in the two banks ended
up worse off than if the transaction had never been initiated (see Table 5.5).
Table 5.5
Market reaction to announcement of collapse of Deutsche–Dresdner
merger (April 6 2000)
Closing share price
Closing share price
Per cent change in
on day of merger
on day of collapse of
share price
There is a coda to the aborted merger between the two banks. A year later, on 2 April
2001, Allianz and Dresdner announced a €23.4 billion agreement to merge. Interestingly, the
Allianz share price fell 2.5 per cent on the announcement whereas that for Dresdner went
down 1.2 per cent. The market gave the thumbs down to the value-creating potential of such
a diversified financial conglomerate.
Time Out _______________________________________________________
Think about it: Radar alert
Managers in firms continually examine the possibility that their firm might be the subject
of a takeover attempt. Unusual buying activity in the firm’s shares might indicate that a
predator is quietly acquiring a strategic stake in the company prior to going public with a
bid. Keeping a watch on such activity, known as a radar alert, may give the target early
indication that something is brewing.
At the same time, other factors in the competitive environment may make firms more
likely to be targets. Managers will want to take into account factors such as current and
anticipated developments in the industry and their own estimates as to potential M&A
activity (in terms of both the threats it poses and the opportunities it presents). It is
likely that, if managers are seeking to add or extend critical capabilities to participate in
attractive growth areas, other firms might be thinking likewise. Or if consolidation is the
key to the industry’s future, others might be eyeing the opportunity for rolling up
fragmented elements of the industry into larger and stronger combinations. In considering this, managers will be alert to the possibility that the company might be targeted.
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Other factors that tend to trigger consolidation in industry relate to the industry’s
economics, such as whether sales in relation to capacity are improving or deteriorating
and how consolidating mergers are affecting (or have affected) the industry’s capacity
and/or its cost structure. In addition, as a result of past acquisitions in the industry,
competitors with enhanced capabilities who would be seeking to dominate the industry
might be on the acquisition trail.
If the industry is under threat of consolidation, then firms can undertake simple preemptive moves to lower their attractiveness to acquirers. One of the simplest is to use
up any excess cash in the firm, either to acquire other firms or by paying it back to
shareholders. In addition, management should consider divesting poorly performing lowprofit subsidiaries that can be eliminated without significantly impairing cash flows.
Potentially to avoid large cash inflows, these business can be spun off to existing
shareholders. Other undervalued assets should be sold. Finally, value should be increased via restructuring. For instance, if cash flows are stable, the company might be
able to support more debt and a higher rate of dividend payments.
In essence, managers should be proactive in undertaking the necessary restructuring of
the business in response to the changing business environment to extract maximum
value rather than leave this to the acquirer.
Time Out _______________________________________________________
Takeovers have major implications for firms. They are disruptive, often entailing job
losses as duplicate elements are eliminated and value is realised. Are they truly value
creative? Empirical evidence suggests most mergers destroy value. Therefore, should the
management of target firms be given weapons to protect themselves against bidders?
On the other hand, as managers should act in the best interests of shareholders, should
they be required to conduct an auction to obtain the highest price for the owners?
What about bidders? Should they be forced to reveal their intentions at an early stage?
Disclosure rules in the UK require any individual shareholder with more than 3 per cent
of a company’s shares to declare the fact. But, of course, this wouldn’t stop an aggressive bidder who might build up a commanding stake by buying in the market, thus preempting any competition. If bidders must signal their intentions well in advance, might
this not allow other firms to take advantage of their ideas?
What do you think?
Financial Advisors
One of the characteristics in any takeover is that both sides will use investment banks,
brokers, accountants, public relations specialists and other professional firms to advise and
assist their aims. They will be employed in helping speed the transaction. For instance,
investment banks often prepare the bid documents on behalf of the acquiring firm. They will
also be involved in advising on pricing, in terms of both the offer terms and the value of the
target as an acquisition. As mergers and acquisitions involve complex legal, regulatory and
compliance issues, firms will also seek guidance in these matters. As the bid process is
dynamic, and requires strategies to achieve the desired result, advisors will be intimately
involved in the strategies and tactics. Ultimately, they may be called upon to help finance the
deal, if successful.
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Duty of Directors
Directors are the stewards of the company and accordingly are required to act in the best
interests of the shareholders. This can be difficult, as there may exist conflicts of interest
between the two groups. Agency theory predicts the likely behaviour of managers (agents)
when such conflicts of interest exist. In addition, in some countries such as the United
States, directors’ judgements can be subject to legal review in the court. This has led to the
concept of the business judgement rule. Directors must be able to demonstrate to a court
of law that they have acted in the best interest of shareholders during the transaction. They
would therefore need to show that, in the event of rejecting a bid, they had sound business
reasons for doing so. The business judgement rule also requires directors to affirm that the
transaction is fair to shareholders and that it is the best transaction available. This means that
it is not possible for directors to exclude another bidder from the proceedings. Therefore
they need to analyse and evaluate fully all the different competitive bids with a view to
obtaining the best offer. Such legally constrained decision-making sets the boundary to any
managerialist behaviour.
Although litigation curbs the worst excesses in countries such as the US, other jurisdictions give more leeway to directors to entrench themselves and favour particular bidders and
thus (potentially) to fail to maximise value for shareholders.
In the spring of 2002, Northrop Grumman, the US defence contractor, made an all-share
offer for TRW, another defence contractor with significant interests in the automotive
sector. In response to Northrop’s offer, which was dismissed as ‘financially inadequate’,
TRW’s board of directors invited BAE Systems of the UK, General Dynamics and Raytheon to
propose offers for all or part of TRW’s business. In doing so, TRW’s board was acting to
promote the interests of its shareholders. The result was that Northrop Grumman faced the
prospect of either increasing its bid or losing out to competitors.
Role of Regulation
Regulation of takeovers takes two forms. There is the effect on competition or anti-trust,
which is a public policy issue. Most countries have laws that prevent firms simply establishing monopolies through acquiring competitor firms. The other area is merger process
regulation, which governs how bids can be mounted – and defended. This is the domain of
securities regulation and company law.
Overview of the UK Regulation Process
The UK provides an interesting illustration of the public policy issues raised by mergers
and acquisitions. One of the rationales for acquiring another company, particularly in a
horizontal merger, is to reduce competition. Prior to the Enterprise Act 2002, however,
decisions regarding the acceptability of takeovers were based on ‘public interest’ grounds. In
the highly politicised process – which is evident in the Northern Electric case study given later
– the final arbiter was an elected politician, the Secretary of State for Trade and Industry.
The reforms in the Enterprise Act remove political discretion and provide a clear focus on
competition issues. This brings the focus of UK regulation into line with that within the
European Union.
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Figure 5.5 shows how the UK regulatory process operated prior to the Enterprise Act
2002. As the chart shows, the public policy issues were divided between the Department of
Trade and Industry (DTI), that part of government that is concerned with industrial policy,
including competition policy, and the Director General of Fair Trading, which has
responsibility as an agency for policing competition within the UK. Investigation of anticompetitive practices is devolved to a separate entity, the Competition Commission, which
provides reports on cases sent to it by the OFT. (Note that the Competition Commission
was formerly known as the Monopolies and Mergers Commission (MMC).) As the UK is a
member state of the European Union, competition issues that meet European-wide criteria
(these relate to the transaction’s size and whether it involves more than one member state)
may be referred to or assumed by the European Commission for investigation.
UK Regulation (pre-2002)
Competition policy
Aims to prohibit anti-competitive
practices and abuse
of market power
Secretary of State for Trade and Industry
Size and EU
criteria allows
for vetting
Ultimate arbiter
public interest test
Director General
of Fair Trading
Makes recommendations
based on competition issues
Market conduct
Referrals for
provides a
Financial Services
Takeover Panel
Competition Commission
Determines whether a merger
‘operates against the public interest’
Figure 5.5
Conduct of bids and
market practices.
Applies principles of:
City Code on
Takeovers and Mergers
Regulation of UK takeovers and mergers prior to the Enterprise Act
The key determinant in the UK has been the public interest criteria governing the decision to allow mergers. One of the salient features of the process in the past has been the
degree of political discretion exercised by the final arbiter of the process, namely the
Secretary of State for Trade and Industry. The Enterprise Act now substitutes a competitiveness test as the deciding factor as to whether a merger can proceed, the political
discretion of ministers having been largely removed.
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The new competition framework is shown in Figure 5.6. First the Director General of
Fair Trading has been replaced by a new statutory body, the Office of Fair Trading (OFT)
including, in line with corporate governance best practice, a largely non-executive supervisory board. Second, the decisions will now reside with independent competition bodies against
a competition-based test within a more transparent and predictable framework. The new
structure also allows for appeals against decisions to be reviewed by the Competition
Appeals Tribunals and the law establishes the maximum length of time allowed for
investigations. The Competition Commission, tasked with carrying out the investigation
under the new competitive test, will also provide (as is the case with merger investigations at
the European level) a more transparent remedies-seeking stage before the publication of its
provisional findings. It is obliged to consult on mergers it investigates and provide reasons
for all significant decisions. Under this structure, transactions that raise competition issues
may be permitted if certain criteria are met. These remedies may include actions by the
bidder involving elements such as divestitures of divisions or other actions in order to
prevent the creation of monopolies.
UK Regulation (post-2002)
Competition policy
Aims to prohibit anti-competitive
practices and abuse
of market power
Size and EU
criteria allows
for vetting
of Fair Trading
Makes decisions based
on competitive-test criteria
Appeals Tribunals
Handles objections to
OFT rulings
Market conduct
Referrals for
CC provides a
Financial Services
Takeover Panel
Competition Commission
Determines whether a merger
is ‘anti-competitive’
Figure 5.6
Conduct of bids and
market practices.
Applies principles of:
City Code on
Takeovers and Mergers
Regulation of UK takeovers and mergers subsequent to the Enterprise
Act 2002
It is expected that this change will remove many of the ambiguities in the process and the
criticism that decisions are motivated more by political concerns than an objective reading of
the public interest.
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The other element of UK regulation relates to market conduct: that is, what is permitted
in a takeover and how matters should be conducted. The key regulatory entity here is a selfregulatory organisation set up by the financial services industry called the Panel on Takeovers and Mergers (Takeover Panel), now under the auspices of the UK’s Financial
Services Authority, the financial sector regulator. As with competition policy, there is an
increasing European Union-wide dimension to this process as the European Commission
seeks to craft common standards for member countries. Thus, in the future, there may be a
more statutory-based regime than exists at present.
Defenders of the UK system have argued that the present self-regulatory approach is
both rapid and flexible and, with its system of hearings, responsive to the dynamics of the
takeover market. In their view, the principles that govern the market process have served the
UK well, and the adoption of a legal framework is likely to inhibit takeovers and raise the
spectre of frivolous legal challenges by incumbent management seeking to entrench
Time Out _______________________________________________________
Think about it: Avoiding the premium for control
Deep-Sea Leisure (DSL), the Scottish-based aquarium management company quoted on
the London Stock Exchange’s Alternative Investment Market (AIM), saw a change of
control in June 2002 without the bidder paying the normal premium for control.
The buyer was Aspro, which was already a major investor in DSL with a strategic holding
of 29.9 per cent, and was able to buy a further 9.2 per cent from one of DSL’s founder
shareholders at 38.6 pence, a discount to the then market price of 42.5 pence. Aspro
operates water parks, animal parks and aquariums in Continental Europe, and its chief
executive, Richard Golding, was also a director at DSL and would have inside knowledge
of the company’s performance.
The offer represented a 9.2 per cent discount to the closing price, but a 16 per cent
premium to the average of 33.3 pence over the previous 12 months. DSL had had a
troubled history as a public company. The initial public offering in 1996 priced the shares
at 160 pence, but the performance had disappointed, and a loss of £719 000 in the
previous year had helped to depress the share price. However, DSL’s broker Bell
Lawrie White was predicting a turnaround with profits of about £1.1 million for the
financial year to February 2002.
At the same time as buying up a founder’s stake, Aspro obtained letters of intent from
other shareholders for a further 2.1 per cent of shares. Acting in this way, Aspro
converted its significant minority holding into a majority stake of 51.9 per cent without
paying a premium for control.
In response to the purchases, DSL’s board argued that the transactions significantly
undervalued the business and recommended to shareholders not to sell at the offer
price. In a statement the board said that: ‘The board of Deep-Sea Leisure plc believes
that it (the bid) significantly undervalues the company and urges shareholders to take no
Under UK takeover regulations, remaining shareholders had to be offered the same
terms. Following the announcement, shares in DSL fell by 3 pence to 39.5 pence, just
above Aspro’s offer price.
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Market Regulation
A key issue likely to arise in any takeover is the role of the competition authorities in
approving the transaction. Anti-trust policy, as public policy decisions concerning M&A
transactions that threaten to create anti-competitive markets or industries are known in the
US, developed out of the nineteenth century wave of consolidations and, in particular, the
monopoly practices of firms such as Standard Oil, which obtained a position of dominance in
the oil industry through mergers. A more recent example is Microsoft, makers of the ubiquitous Windows software. Although the case against Microsoft did not arise from any takeovers,
the issues raised were the same: the exploitation of monopoly power.
Competition policy reflects two opposing views as to the underlying economic process:
that mergers are anti-competitive, and that merger activity is an expression of the competitive process. These divergent views also account for some of the paradoxes in the decisions
made by such entities as the US Department of Justice (the federal government department charged with enforcing the anti trust laws), the Federal Trade Commission, and the
UK’s Department of Trade and Industry (which is the guardian of the public interest in
takeovers). Generally, the criteria for rejecting a takeover are when it is deemed to be against
the public interest, or when the result is to lessen competition substantially, or when it is
likely to create a monopoly. The approach to determining the acceptability of takeovers is
slightly different at the European Union level, where a merger can be prohibited only if it
creates or strengthens a dominant position.
Regulatory authorities have been concerned with measuring the effect of an industry’s
concentration on competitiveness. A full discussion of the question is beyond the scope of
this module, but a bidder will need to take into account the public policy issues raised by
such reduction in competition. Recall also that one of the reasons for bidding in the first
place is possibly to exploit market power. This can be achieved by ‘taking out’ a competitor
in the industry. Different regulators use different means to determine the impact on
competition. However, the Federal Trade Commission and the Justice Department in the US
established criteria for measuring market concentration (a proxy for monopoly power). This
is through the HHI or H index, named after the two economists Herfindahl and Hirshman,
who developed it. See Clark and Moore (2000). The index works as follows. It is simply the
sum of the squares of the market shares of the firms in an industry. So if there are eight
firms with equal market shares of 12.5 per cent, then the index value will be: 8 12.5
1250. If another industry has ten firms with shares of 30 per cent, 20 per cent, 15 per cent
and the remainder 5 per cent, the index value will be: 30 2 20 2 15 2 7 5 2
The index takes into account the relative size and distribution of the firms in a market,
and in the case where the index approaches zero, then the market consists of a large number
of firms of relatively equal size. On the other hand, the index increases both as the number
of firms in the market decreases and as the disparity in size between the firms increases.
The guidelines on investigating a merger as potentially against the public interest are that
in industries where the index is below 1000 prior to a merger, then the transaction will not
be investigated for its concentration effects. If the index is between 1000 and 1800 and the
resultant merger increases the index value by 100, then this requires investigation for antitrust issues. If the index prior to a merger was above 1800, then any takeover that increased
the concentration by 50 would be investigated. If, for instance in the above example, one of
the smaller firms with 5 per cent was bid for by the third largest firm (with the 15 per cent
market share), then the index, post acquisition would be: 30 2 20 2 20 2 6 5 2
1850. That is, the concentration index would rise by 150 and the merger would be investigated. If two of the smaller firms had merged, however, the index value would have risen to
only 1775, and no investigation would be called for.
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An alternative approach is known as the concentration ratio, which measures the percentage of the market share owned by the largest m firms in an industry or sector, where m is a
specified number of firms. The ratio is often based on the four largest firms in an industry.
If the concentration ratio for the these top firms is close to zero, then this would indicate an
extremely competitive industry as even the largest firms would not have any significant
market share. As a rule, if the concentration ratio for the four largest firms is less than about
40 (indicating that the four largest firms have less than a 40 per cent combined market
share), then the industry is considered to be very competitive. By looking at different values
of m it is possible to get a picture of how competition shapes the industry. For instance, if m
is 1 and the concentration ratio is around 90, then the largest firm in the industry controls
nine-tenths of the market and is effectively a monopoly.
If we take our earlier example, setting m to be 3, we would have a concentration ratio preacquisition of 55 and post-acquisition of 70. This would certainly trigger concerns about a
reduction in competitiveness. On the other hand, with m at 1, the merger would leave the
concentration ratio unchanged at 30.
There are key empirical issues that policymakers and analysts have to determine in any
analysis of the anti-competitive effects from a merger. These relate to determining the
boundaries of the industry and firms’ market shares. Regulators, such as the European
Union, also advocate investigating anti-competitive practices such as collective dominance.
For example, General Electric of the US found itself in difficulties with the European
Commission in its attempt to take over Honeywell on exactly these grounds. In the event, the
merger was aborted as the remedies demanded were too onerous.
In practice, whether the competition authorities clear a bid will be an empirical issue as to
whether it imposes an unacceptable reduction in competition. As the later case study on
the Northern Electric takeover makes plain, determining in advance whether a particular
takeover will be given the green light or not, is not straightforward. The authorities can
demand one of three outcomes:
• The takeover is rejected as constituting an unacceptable increase in concentration (or
decrease in the competitiveness of the market).
• The takeover is allowed to proceed on the grounds that it does not involve any competition issues.
• The takeover is allowed to proceed subject to meeting agreed remedies. Typically, these
may involve divestitures of certain business units (to maintain competition in a market
segment) or undertakings that govern future firm behaviour and actions.
Time Out _______________________________________________________
Think about it: Battle for the Love Boat
The Love Boat is the name irreverent public officials at the European Commission’s
competition division gave to P&O Princess Cruises, the target of a two-way takeover bid
involving Carnival Corporation, the owner of the Cunard brand, and Royal Caribbean
Cruises. Because of the takeover’s international ramifications, the European Commission
opted to examine the competition issues in the two proposals. Carnival’s bid, while the
higher of the two at $6.4 billion, as against Royal Caribbean’s $3.7 billion merger
proposal, faced a major scrutiny on competition grounds.
Carnival faced an uphill stance in response to concerns about an undesirable concentration in the cruise business. The first issue the anti-trust investigators had to define was
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what constituted the market. After a two-month long study, in May in a preliminary
judgement, the Commission concluded that cruise holidays did not compete with other
types of holiday, such as safaris or exotic trips. Indeed, the Commission’s analysis
suggested that the premium cruises offered by the three companies to the wealthy
constituted a separate segment even to the more modest cruises sold by package tour
operators. The implications were clear. Given a Carnival/P&O combination, then
regulators indicated that Carnival would be required to make significant disposals in the
UK and Germany to win approval on competition grounds.
This presented some unpalatable choices to Carnival’s management. Apart from arguing
down the interpretation of the market’s boundaries, the required disposals put a dent in
the logic of the acquisition. In disposing of parts of P&O to meet regulatory concerns,
Carnival was in danger of diluting the benefits of the takeover. In addition, the remedies
proposed by the Commission in which cruise operating companies Aida (based in
Germany) and either Cunard or Princess (in the UK) were sold, meant disposing of the
best elements in the target.
So even though the Carnival bid offered greater value to P&O’s shareholders, the tough
conditions set out by the Commission meant that, if these could not be negotiated
down, Carnival was likely to walk away from the deal. And what did the market think
about the deal’s prospects?
The market’s view was that the regulatory obstacles facing Carnival were such that, in
the end, the corporation would fail or they would walk away having decided the
conditions set by the anti-trust authorities were too onerous. P&O’s share price
stubbornly stuck around the 442 pence level as shown in Figure 5.7, a price reflecting
the value of the Royal Caribbean bid.
Figure 5.7
P&O share price during the bid
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An aggressive regulator, a tough definition of the market; either one seemed enough to
sink Carnival’s chances. But in July the Commission engaged in an extraordinary U-turn.
In a remarkable about-face decision, Mario Monti, European Commissioner for competition, approved Carnival’s hostile bid.
Three factors may have led the Commission to abandon its earlier stance. The first was
the European Court’s strong criticism of the Commission’s merger procedures. This arose
out of a review of an earlier decision by the Commission to veto the merger between two
tour operators, Airtours and First Choice, in 1999. The Court reversed the Commission’s
decision while at the same time severely questioning the analysis and procedures used in
reaching the decision. The second factor was the decision by the UK’s Competition
Commission in June to pass the rival merger between Princess and Royal Caribbean. This
effectively undercut the Commission’s argument. As Micky Arison, Carnival’s chairman,
was quick to point out to the Commission, how could Brussels reject their bid given that
the UK anti-trust authorities were allowing the merger given that Carnival had a similar
share of the UK’s cruise market as Royal Caribbean? Third, a review of the regulatory
process by the Commission’s legal experts, designed in Monti’s words to ‘assess the
theories of competitive harm and check them against newly emerged evidence’, may have
led to the conclusion that the original analysis was at fault. But it is impossible to be
certain exactly why the Commission reversed its earlier stance as it failed to provide a
complete explanation for the about-face. There was also the veiled threat from Carnival to
take legal action if the bid was blocked possibly leading to another humiliation from the
European Court, which may have tipped the decision to reverse the earlier preliminary
findings. Whatever contributed to the decision, it represented one of the most remarkable
regulatory climbdowns in history.
Naturally this reversal led to angry words from Richard Fain, chairman and chief
executive of Royal Caribbean, accusing the Commission of short cuts and undermining
the transparency of the whole regulatory process. He stated that: ‘The concerns of
Royal Caribbean and many other third parties over the Carnival bid have been set aside.
No explanations have been given nor reactions sought.’
The case raises important issues about competition policy process, and in particular the
need for predictability and transparency. It also highlights the fact that the competition
authorities add one further element of unpredictability to an already complicated and
uncertain process.
Merger Process Regulation
In addition to competition issues, firms involved in acquisitions or defending themselves
against bidders are bound by market process regulations. These differ across the globe
although, in principle, they attempt to do the same thing. For the UK, there is a voluntary
code of practice (the City Code on Takeovers and Mergers, which is administered by the
Panel on Takeovers and Mergers (Takeover Panel)), which binds the actions of
acquirers, target firms, and their advisors, as well as the Rules Governing the Substantial
Acquisition of Shares. The key elements of the Takeover Code are as follows:
• All shareholders in a given class (for instance, ordinary shares or common stocks) should
be treated equally.
• Shareholders should be given sufficient information to allow them to form a proper
judgement about the transaction.
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• High standards of care by firms and their advisors are required in the wording of
documents and advertisements.
• The board of directors of the target company must act in the best interests of its
• The creation of a ‘false market’ in the target company’s shares should be avoided.
When disputes or differences arise, it is the function of the Takeover Panel to interpret
and set binding decisions on the issues by reference to the above criteria. It also provides a
framework under which advisors can develop strategies to frustrate the intentions of a
In seeking to acquire a company, bidders have to overcome various hurdles as regards the
level of ownership of the target company (as shown in Figure 5.8). At the lowest level, any
shareholder holding in excess of 3 per cent of the outstanding shares has to disclose its
identity to the target company. If a predator starts to accumulate a shareholding in excess of
the disclosure level, this steady increase in ownership will alert the target to the aggressor’s
intentions. This means that bidders need to acquire shares rapidly before announcing their
intentions. They do this is in a process known as a dawn raid, when the bidder’s agent buys
up all the available free float of shares within a single trading session.
The next critical shareholding level is when a bidder holds 25 per cent of the company.
This gives the right of the holder to block changes to the articles and memorandum of
association (known as the corporation’s charter in the United States). These are the rules
governing how the firm operates, the appointment of directors and other such issues. Also, a
shareholder with such a block can seek to have a representative on the board of directors of
the company. This is a backdoor method for obtaining influence if not control of a target
firm. Obviously, if the bidder’s intentions are hostile, the incumbent management will resist
having directors whose allegiance is with the acquiring firm.
3%, must disclose
interest in company
90%+ can force
remaining shareholders
to sell (mop-up provision)
25%+ can block
any changes to
articles and
memorandum of
75%+ can make
changes to
articles and
memorandum of
30% ownership triggers
requirement to make a
full bid for the company
50.1% gives
Figure 5.8
Ownership clock for the UK market
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Beyond the 25 per cent blocking minority, any bidder who obtains in excess of 30 per
cent of the outstanding shares is obliged, under the UK market process takeover rules, to
mount a full takeover bid for the company. Note that, under UK accounting rules, firms that
control 30 per cent of the shares are deemed to have an associated interest. In the case
where the remainder of the shares are widely held, the company is also deemed to have a
controlling interest. That is, it can effectively control the direction of the company.
However, in seeking to acquire another firm, the key ownership level is just beyond the
50 per cent level. With a majority of shares – and votes – a bidder is in effective control of
the target. It will have a majority of the votes on key issues, and will be able to appoint a
majority of directors to the board, regardless of what other shareholders wish. In this
situation, the remaining shareholders become minority shareholders and will, in the absence
of any special circumstances, sell out their holdings. The reason for selling is that they lose
any possibility of blocking the decisions of the majority shareholder, and the shares are likely
to be an illiquid investment. In an acquisition, once the tendered acceptances reach the 50
per cent level, then non-assenting shareholders tend to accept the inevitable change of
control and, not willing to remain as minority shareholders in the company, tender their
shares to the bidder.
Once the acquiring firm reaches the 75 per cent ownership level, it has the power to
change the articles and memorandum of the company. That is, it can change the firm’s
constitution to favour its controlling interest. As its ownership level increases, when it
reaches 90 per cent the bidder has the right to force acceptance on the small minority of
(presumably recalcitrant) non-accepting shareholders. This ‘clean-up provision’ means that
any shareholders either adamantly opposed or too lazy to act can be forced to accept the
takeover terms.
Takeover Defences
A firm being targeted for takeover will seek, for a variety of reasons, to put obstacles in the
way of the bidder. A number of reasons have been advanced to account for this:
• The management of the target resists in order to get a better price for shareholders.
• Managers in the target company judge that the business will perform better as a standalone entity.
• Management is seeking to preserve the benefits it derives from control.
How can managers protect themselves from the attentions of a predator? One simple
solution is to run the firm efficiently. This means that an acquirer will have few opportunities
to make gains from the acquisition. The corollary to this is that the firm will have a high
market value (market-to-book), making it expensive to acquire.
Various characteristics are likely to make a firm vulnerable to takeover; managers can
address them by pursuing the appropriate strategies. These include:
• a low stock price in relation to the replacement cost of assets or potential earning power
(namely a low market-to-book ratio);
• large amounts of excess cash, and/or securities, and significant unused debt capacity;
• good and steady cash flow relative to the current share price;
• a price-earnings multiple (PE multiple) that is low relative to the market or sector;
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• business units or assets, in particular property, which could be disposed of without
significantly impairing cash flow;
• few shares under the control of the incumbent management;
• dissatisfied institutional investors
In addition a number of firm-specific factors will make it easier for an acquirer to purchase the target. These include situations where:
• the target has assets that can be used as collateral for borrowing to finance the acquisition;
• the target’s cash flows from operations and divestitures can be used to repay loans.
To defend a firm against being an appetising target, one approach is to pursue policies
that make the company less attractive. This is known as self-uglification. In the light of
what makes for an attractive acquisition, then the incumbent management should pre-empt
any predator and restructure to make the company less of a target. Therefore managers can
pursue strategies such as to:
• increase indebtedness and use the borrowed funds to repurchase equity (via a share
buyback programme);
• increase the percentage of shares under management’s discretion. A favoured approach
used extensively in the US is the employee stock ownership plan (ESOP), where the
issued shares are effectively under management’s control;
• raise the payout ratio through increased dividends;
• borrow with a change of control clause that obliges repayment in the event of a takeover,
thus forcing the acquirer to refinance existing debt;
• dispose of securities and pay back excessive cash in the balance sheet to shareholders
(either through a special dividend or via a share buyback programme);
• invest in new value-enhancing projects (positive net present value projects).
In addition to developing financial and business strategies to make a firm a less attractive
target, many managers will seek to put in place special defences raising the cost and
complexity of the acquisition process prior to any takeover attempt being announced. These
go by the generic name of poison pills and shark repellents. They involve managers in
persuading shareholders that such devices are in their best interests, despite the fact that they
are likely to entrench the management and give them considerable power in any takeover.
Typical shark repellent provisions include such mechanisms as the granting of contingent
rights to existing shareholders allowing them to purchase additional shares in the company if
an individual shareholder builds up a significant stake in the company. Or it may involve
disenfranchising voting rights beyond a certain percentage, regardless of the number of
shares owned unless approved by the company’s board of directors. This has been sometimes seen as a way of protecting minorities, for example in Germany, where such provisions
prevented Pirelli, the Italian tyre maker, from acquiring Continental, despite the fact that it
held a majority of the shares. Another favoured device is to set up a staggered board of
directors by splitting it into three equal groups. The constitution of the company is then
amended so that only one group can be elected each year. As a result, even if the bidder
should acquire a controlling interest, it cannot gain immediate control of the company.
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However, such defensive devices are not generally in the interests of shareholders for the
obvious reason that, as discussed earlier, they stand to gain from the takeover. On the other
hand, they are desirable from the management’s perspective as they entrench their position
and make it difficult for a bidder to take control and remove them. For this reason, the
desire to put in place such defences raises conflicts of interest between management and
shareholders. Agency theory predicts that, unless checked, managers will seek to put in place
such defences as it will allow them to continue to enjoy the rents they derive from the firm.
Deterrence and Poison Pills as a Game
As with the incentives problem in Section 5.2, we can model the deterrence problem as a
game. Whereas a friendly bid, where the two management groups agree on terms for the
merger or takeover, allows for the two sides to agree on the result, in a hostile takeover the
target management would want to fight off the aggressor. The decision to put in place some
form of anti-takeover defence must be made before the existence of a bid is known. Equally,
a bidder must proceed knowing that the target has such a defence in place, though it can be
overcome in some situations.
Typical poison pill provisions might include:
• costly severance payments to target managers in the event of an unfriendly takeover;
• conditions in the firm’s constitution allowing the board of directors to issue new shares
in the event of an offer by a rival firm;
• rules prohibiting the board from considering any offer deemed ‘not to be in the longterm interests of shareholders’ (as certified by the board);
• prohibitions on the board of directors entertaining certain competitors’ offers or counter
offers (exclusion clause).
The key issue of a poison pill is that it acts as a commitment device. If a takeover is made,
the poison pill comes into play and the target firm’s management (or its shareholders) are
committed to carrying it through. Poison pills will thus act to discourage an acquirer or may
change the terms of the eventual takeover.
Suppose company A has entered into negotiations with firm B to acquire it and another
firm C also considers entering the fray. In negotiating the merger, A and B decide to put in
place a poison pill to deter any third party such as C from counter-bidding. C has to decide
whether or not to contest the proposed merger between A and B. In entering the contest, A
and B can either play tough by refusing to negotiate (R) or they may accommodate (A) and
reach agreement among the three parties. With a poison pill in place, A and B are committed
to fight (R). There is also an additional choice for A and B, namely whether to put in place a
poison pill or not.
We can characterise this as a game. Unlike the game in Section 5.2, this cannot be expressed as a table, but can be shown in the form of a decision tree. The initial step in the
game is the decision whether A and B put in place a poison pill. Then C has to decide
whether to enter the bidding or stay out. The decision tree with the outcomes is given in
Figure 5.9.
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2, –2
poison pill
Stay out
6, 0
0, –2
No poison
4, 2
Stay out
Figure 5.9
6, 0
Decision tree for the deterrence game
Without the presence of the poison pill, A and B will accommodate, firm C will enter the
contest, and A and B’s gain will be 4. With the poison pill in place, C will choose to stay out
of the contest, and hence A and B’s gain will be +6. To determine what will be the best
strategy, we carry out a process of backward induction to determine what the optimal
outcome from the tree will be. In this situation, firms A and B would clearly prefer to adopt
the poison pill, and this commitment nets them the extra reward reflecting the difference
between the two strategies 6 4 2 .
But what if firm C knows it can gain something even in the situation where A and B
decide to put in place a poison pill? Let us assume that C knows it can get at least a positive
payoff of +1. Then we now have the tree in Figure 5.10. Now, despite the existence of the
poison pill, C finds it profitable (although much less so than if there is no pill in place) to put
in a counter-bid. That is, firm C still manages to extract some of the gains from bidding,
although not as much as would be available if it could negotiate fairly with the combining
firms A and B. Firms A and B end up with a gain of +5, which is a better result than not
adopting – so they will adopt.
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5, 1
poison pill
Stay out
6, 0
0, –2
No poison
4, 2
Stay out
6, 0
Figure 5.10 Situation when C mounts a counter-offer
The above analysis helps to explain the attractions of poison pills – and the reasons why
counter-bidders try to have them set aside. Ideally firm C would have liked to enter the
contest without a poison pill being in place, hence forcing the other firms into accommodating with it and gaining +2. Given this, one might expect to see firms in C’s position seeking
to have poison pills set aside by shareholders or the commercial court. And that is exactly
what happens.
Time Out _______________________________________________________
Think about it: M&A colour
The takeover process is rife with wonderful terminology to describe the strategies and
moves by the various players in the market for corporate control. What follows are
some of the more common terms you may come across.
Break fees. An agreement between the two parties in merger negotiations that if, for
whatever reason, one of the parties should not continue to complete the merger then
compensation will be paid by the non-performing party to the other. This applied when
American Hospital Products (AHP) sought to merge with Warner Lambert. However, Pfizer
expressed an interest in and eventually won control of Warner Lambert. Under the
terms of the break fee agreement, Pfizer had to pay $1.5 billion to AHP.
Dawn raid. Aggressive buying by a bidder of available shares in the market to build up
a strategic stake in a target firm prior to launching a takeover. The purpose is to acquire
enough shares to initiate a dialogue or takeover attempt of the target and at the same
time avoid alerting the target or competitors to the bidder’s intentions. By implication, a
dawn raid signals hostile intentions towards the target, although white knights might also
engage in this activity. For instance, in December 2000 Scottish Radio Holdings (SRH) was
the subject of a dawn stock market raid by rival Scottish Media Group, which owns
Scottish and Grampian Television, with a view to ultimately acquiring the company. This
intensive purchase of shares was designed to force SRH into negotiating with Scottish
Media Group.
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Pacman defence. Named after a popular computer game, this is a retaliatory strategy
where the target seeks in turn to acquire the bidding firm. As such it embodies the
principle that the best form of defence is the counter attack. The key element here is
whether the target firm has sufficient credibility to mount a bid of its own. A recent
instance of this was the defensive bid in July 1999 by Elf Aquitaine, the French oil
company, which bid $53 billion for TotalFina to thwart the latter’s hostile bid for Elf.
Bear hug. A takeover tactic used principally in the USA is designed to force the
management of the target company into negotiations with the acquirer. This involves
the predator company making an attractive formal offer for the target, which is attractive to shareholders and, if rejected, might lead to shareholder litigation such that the
directors would need to defend the decision to reject the offer under the business
judgement rule. It is widely believed that in 2001 in order to initiate discussions towards
a deal, Comcast offered more than $40 billion in stock for AT&T’s cable business.
White knight. A friendly third-party company that, with the agreement of the target
management, agrees to bid against the initial acquirer. White knights appear in hostile
bids where the target wants to be saved from the embrace of the unfriendly acquirer.
The logic here is that the target prefers to be taken over by the white knight with which
it has negotiated a preferred solution. This usually means that the management of the
target company is promised a significant role in the combination rather than facing the
prospect of being dismissed by the hostile acquirer.
In 1997 under takeover threat by H.F. Ahmanson, in which the raider planned to
savagely reduce the payroll of its intended target, Great Western Financial Corporation, a
savings and loan association (or thrift), the latter responded to a friendly approach by
Washington Mutual Inc. – another thrift – and agreed to a stock swap valued at $6.6
Grey knight. Similar to a white knight but where the good intentions of the competing
bidder towards the target firm’s management are less clear.
Black knight. Third-party contender in a takeover with definite hostile intentions
towards the target firm’s management.
Crown jewels. A defence tactic sometimes used in hostile takeovers is to sell certain
high-valued assets or businesses, known colloquially as the firm’s crown jewels. The
intention is to render the target firm less attractive (and is one of the possible tactics of
self-uglification). If outright sale is not immediately possible, then the target firm can
indicate that, if the bid fails, the company will sell the assets in the future.
Lady Macbeth. A third-party contender in a takeover bid that initially portrays its
intentions as friendly and hence comes dressed as a white knight before revealing its
true colours by siding with the original hostile bidder.
Poison pill. Used in a general sense, it is the series of contingent defences put in place
by a potential target management to make it difficult for the company to be acquired in
a hostile takeover. It can also describe a specific contingent financial transaction
designed to make it virtually impossible for a bidder to acquire the company against the
wishes of the incumbent management. These include anti-takeover defences such as the
contingent right of existing shareholders to be given significant new shares, thus diluting
any bidder’s stake while at the same time leaving them with losses.
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An example of the kinds of defences that firms put in place is given by the online
electronic brokerage firm E*Trade. In putting in place a so-called shareholder rights plan,
E*Trade’s protection plan would allow shareholders to buy from E*Trade Group 0.001
shares of a new series of participating preferred stock at an initial purchase price of
US$50 if certain events occurred. The shareholder rights plan would be triggered if a
person or group acquired beneficial ownership of 10 percent or more of E*Trade’s
outstanding common stock (ordinary shares). It would also be triggered if a person or
group began a tender or exchange offer allowing it beneficial ownership of 10 percent
or more of E*Trade common stock.
Put into play. The situation of raising the knowledge that a particular company may be
available for acquisition by making takeover overtures, whether formal or not, to the
firm. The information that a particular company might be available to be acquired starts
the takeover auction process by alerting other potential acquirers to the opportunity. In
some cases firms that deliberately seek to be taken over put themselves into play.
In March 2002 DataMirror, the software company in the HA and clustering software
market, made a hostile bid for Ideon Technology Holdings, a rival software group that
included Vision Solutions, widely seen as DataMirror’s real target. By making a bid,
analysts commented, it could be seen as an attempt to put the group into play by
pointing out what a bargain Ideon represented and signalling to any third party its
willingness to participate in the dismemberment of Ideon.
Self-uglification. Any of a range of operational and financial transactions designed to
render a potential target less attractive to a bidder. These may include disposing of
surplus cash, refinancing and increasing debt, increasing financial leverage (gearing) by
buying back equity by borrowing, and disposing of certain business assets.
Shark repellent. Any of a range of anti-takeover defences designed to make it difficult
or frustrate a bidder’s attempt to take control of the target. Usually, such takeover
defences are put in place prior to any bid being mounted, although it is not impossible
for managers to get these agreed after a bid is announced.
Supermajority. A condition entered in the firm’s constitution (known in the UK as
the articles and memorandum of association, or in the US as the charter) which specifies
that certain actions (including accepting a takeover) require the agreement of more than
half the shareholders. Typical conditions require anywhere between two thirds and 90
per cent acceptance to pass. The effect of such voting conditions is to entrench the
management of firms, as it is difficult to get shareholders to vote the same way.
Tender offer (USA). An offer made by a bidder, known as a raider in the US, to
purchase the common stock (or ordinary shares) of a corporation. US securities laws
allow bidders to make a partial tender offer where some fraction (usually enough to give
the raider effective control) is tendered for. Shares not tendered to the partial offer
may be subsequently offered for at a lower price. The logic of the partial tender offer is
to force shareholders into tendering their stock.
Greenmail. Not a takeover tactic as such, but used in the United States as a way of
extracting cash (hence the green element, the colour of US dollar notes) from a potential
target company. In greenmail, the predator buys a strategic stake in a target and then
implies that it will tender for the rest of the company. The target’s management is then
pressurised into buying out the greenmailer at a significant premium to the price at which
it built up its stake, thus allowing the greenmailer to walk away with a tidy profit.
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When Sir James Goldsmith, the UK financier and entrepreneur, acquired an 8.6 per cent
stake in St Regis Paper Company and sought board representation, the company agreed
to repurchase the shares at a premium. Having acquired the stake at an average price of
around $35.50/share, the company agreed to pay $52/share netting the greenmailer $51
Northern Electric Case Study
‘It staggers me how difficult people find it to answer the question: how much is your
company worth, and why?’
– Northern Electric shareholder
This case study brings together the elements of the merger tactics for the takeover of a
publicly listed company. Northern Electric plc (NE) is a UK-based regional electricity company
(REC) operating in the north of England. It was created as a result of the privatisation of the
UK electricity industry under the Thatcher government in the 1980s. Taking the electricity
industry out of state ownership was seen as a necessary prelude to increasing its efficiency
and reducing prices. The various elements of the industry were to be sold to investors with
the companies being listed on the Stock Exchange. In doing so, the intention was, as
possible, to remove the monopoly element and allow competition to increase efficiency and
drive out costs. To do so, in England and Wales (but not Scotland) electricity generation was
split from supply and distribution. Two competing generating companies were created out of
the old Central Electricity Generating Board, and the National Grid ownership was split up
between the generators and the 12 RECs created for the privatisation process. The generators competed nationally, but the RECs were local monopolies. An electricity regulator, the
Office of Electricity Regulation (OFFER), was set up to police the industry and set a cap on
prices (using a formula based on the Retail Prices Index plus or minus a margin (RPI ± x)).
As there was a group of RECs in different parts of the country, through regulation it was
hoped to ensure some elements of a competitive market as, in time, consumers would be
allowed to switch suppliers. In addition, to foster competition, new entrants were encouraged to move into the industry.
The First Bid
Towards the end of 1994, Trafalgar House, part owned by Hong Kong Land, a conglomerate
based in the Far East, announced the intention to acquire NE for 1050 pence per share. This
was the first bid for a REC by a firm outside the industry. Trafalgar House was a conglomerate with major interests in real estate construction, shipping and leisure cruises. At the time
of the bid it was capitalised at about £900 million. The bid was mounted despite the fact that
the UK government held a golden share in NE, which gave it a veto on any takeover,
although this was due to expire at the end of March 1995. At the time of the bid, NE was a
profitable company with no debt and plenty of advance corporation tax (ACT) headroom.
Advance corporation tax is paid by companies that make a dividend distribution to shareholders. Under the corporation tax rules, only UK profits can be offset against ACT. Hence
a company that is highly profitable but has little UK profit and is paying dividends may find
itself unable to offset the ACT against its profits. This pushed a number of companies to
seek out profitable UK acquisitions in order to create ACT headroom. The ability to make
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use of ACT to offset tax losses at Trafalgar House was seen as a major attraction of the
takeover. That is, the main synergy identified by Trafalgar House was financial. Another
motivation for the bidder was the need by its controlling shareholder Hong Kong Land to
repatriate funds to the UK in advance of the return of Hong Kong to Chinese control. In
addition, the management at NE at the time, mostly ex-employees of the state-run local
electricity board, was not seen as particularly aggressive or impressive.
The chronology of the takeover attempt was as follows:
19 December 1994
January 1995
14 February 1995
23 February 1995
7 March 1995
Bid terms announced – £10.50 in cash or cash and preference
shares worth about £10.60. Northern share price at £10.
Department of Trade and Industry (DTI) asked to review bid.
Bid cleared by DTI; Northern share price rises to £11 (market
expects Trafalgar House to raise its offer).
Trafalgar House announces increased and final offer of £11 cash.
Northern share price moves to £11.25, but subsequently falls to
Office of Electricity Regulation (OFFER) announces a further
price review, on top of the one recently concluded, as a result of
the apparently rich prices being offered in the takeover. In light of
this announcement, and in accord with the terms of its offer,
Trafalgar House withdraws its offer and bid lapses. Northern
share price falls to £8.00.
While Trafalgar House was trying to acquire NE, NE’s management had not been inactive. It adopted a scorched earth approach, promising to undertake the restructuring that
Trafalgar House would have done if it had been successful. First it offered a special dividend
of 150 pence/share. It then offered a bonus preference share worth about 100 pence/share.
It agreed to pass on to shareholders the proceeds from selling its stake in the National Grid,
which was worth around 287 pence/share. The dividend was increased by one third to 33
pence/share, and the board of directors announced that NE would increase dividends by
about 13 per cent in the subsequent two years.
NE board argued that its restructuring programme meant that any bid below £13 should
be rejected by NE’s shareholders. Although financial leverage was going to rise to 225 per
cent, it would subsequently fall to around 100 per cent by March 2000. Interest cover would
remain above 2.5 times, which given the stable nature of earnings was satisfactory, while
dividend cover would fall to around 2.2 times for 1996/7.
Their assessment of the value of the shares post restructuring was:
Immediate value
Residual equity (on basis of 4% dividend yield)
Total value of equity
Value (pence)
In the event, the intervention of the regulatory review meant that NE’s shareholders were
not given the opportunity to decide upon the merits of NE’s defensive restructuring.
Mergers and Acquisitions Edinburgh Business School
Module 5 / Bid Tactics
Key issues arise for both sides from this takeover attempt:
• First, the market took the view that Trafalgar House was in a position to raise the bid
when it first offered 1050 pence/share in December 1994.
• Second, when NE’s management offered to restructure the company, this was seen as
the favoured alternative given the preference of shareholders to support the existing
management. We shall see that the failure to deliver on its promises is one reason why
shareholders defected when the second bid for NE emerged in 1996.
• Third, the part played by the regulators: first the acceptance of the bid by the DTI which
held a veto through its golden share, and second, as this was a regulated industry, the
part played by the electricity regulator in forcing Trafalgar House to abandon its takeover
attempt. Thus external parties can have a key role to play in furthering or frustrating a
bid. This will become evident from the part played by the competition authorities in the
second takeover attempt.
The Second Bid
The second bid arrived in October 1996 when the US utility CalEnergy entered the market
and bought up 13 per cent of NE’s shares in a dawn raid while at the same time making an
offer at 630 pence/share to value the company at £766 million. This was inherently hostile,
as NE’s management was not consulted on the desirability of the takeover. It seemed that
CalEnergy was capitalising on the weakness in NE’s share price to buy a presence in the UK
electricity market. NE provided a quick route to a significant presence. CalEnergy, along
with a number of other US utilities, had been eyeing up the UK market for potential
investment, both to take advantage of the favourable regulatory regime and to learn about
how to operate in a competitive market. The US energy market was at this time being
deregulated, and utilities such as CalEnergy would have to face competition in their own
geographical area. Buying into the UK market would both diversify their earnings and
provide much-needed expertise in operating in a competitive energy market.
The timetable of the takeover is given below as Table 5.6. The bid followed the standard
approach in the London market where, under Takeover Panel rules, two rounds of bids (and
counter defences) were allowed to each party. Under takeover rules, the timetable is that the
bidding must close 60 days from the posting of the initial offer document. The final day for
a revised bid is 46 days prior to the closing of the offer.
Table 5.6
28 Oct
End Oct
5 Nov
8 Nov
17 Nov
18 Nov
20 Nov
22 Nov
29 Nov
Chronology of second bid for Northern Electric
Initial bid at 630p/share (£766m), CalEnergy takes 13% stake
Office of Fair Trading recommends referral of bid by DTI
CalEnergy publishes offer document
CalEnergy lifts holding to 29.5% as price below offer as market fears a referral on
competition grounds
NE dismisses 630p as too low; postpones interim results
DTI decision on referring bid due on 25 Nov
DTI announces delay of decision until 13 Dec
NE repeats offer of special dividend of 56.5p
NE delivers better than expected interim results; reveals discussion with a ‘white
Edinburgh Business School Mergers and Acquisitions
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6 Dec
10 Dec
13 Dec
16 Dec
18 Dec
20 Dec
24 Dec
30 Dec
Final bid at 650p /share (£782m), closing 20 Dec
[Note: Takeover rules allowed for a maximum of 60 days]
NE unveils plans to raise dividends and merge its electricity and gas supply
businesses with another regional electricity company
DTI waves merger through, saying there are no competition issues involved
CalEnergy accuses NE of ‘misleading and incorrect’ statements about value of bid
Takeover Panel approves BZW and Schroders buying controversial 2.3% stake in
London Electricity agrees to £1.3 billion takeover by Entergy.
Valuing NE on a similar basis would indicate a price of around 700p for NE
Bid officially closes, but Takeover Panel extends, bid to 24 December owing
to alleged irregularities between BZW and NE
Extended deadline closes; CalEnergy has 50.3% of NE’s shares
NE’s board recommends acceptance of the offer by remaining shareholders
CalEnergy published its first offer document on 5 November. At the same time, weakness in the NE’s share price (due to concerns that the deal would be referred to the
Monopoly and Mergers Commission and hence lapse) allowed CalEnergy to build up a 29.5
per cent stake in the target, thus virtually precluding any third party from coming to NE’s
rescue. As events would show, this was fortunate as CalEnergy and its financial advisors
then struggled to get a majority of the shares as the bid unfolded.
At this time, the market (shareholders) tried to anticipate the outcome of the bid. In the
initial period, CalEnergy was able to build up its commanding stake in Northern shares
because there was a significant risk that the bid would be referred to the competition
authorities and hence lapse. As the Financial Times reported on 9 November, Northern’s
shareholders were behaving as though they believed that ‘substantial downside [risk] exists’.
This negative view on the outlook for the shares was reached despite optimism about
Northern’s half-year results and ‘hidden asset values.’
Advised by Schroders, the investment bank, and using its stockbrokers Barclays de Zoete
Webb (BZW) to drum up support, Northern’s defence was first to argue that the initial bid
was too low at 630 pence and to encourage shareholders to reject the offer by announcing
an offer of a special dividend of 56.5 pence. At the same time the company decided to delay
the announcement of its interim results. The implication was that NE would examine how
best to present its results so as to ‘talk up’ the share price and potentially raise the price for a
successful acquisition. At the end of November NE finally unveiled its interim results, which
were better than expected, while at the same time announcing it had entered talks with a
third party about a friendly acquisition. NE was seeking to avoid the clutches of CalEnergy
by selling itself to a ‘white knight’: that is, a third party with which the existing NE management could negotiate more acceptable takeover terms.
At this point, matters became more complicated. Not only was the Department of Trade
and Industry reviewing the proposed acquisition with a view to referring it on competition
grounds, but the Office of Electricity Regulation (OFFER), the oversight body tasked with
regulating prices in the electricity industry, also had a say in approving – or rejecting – the
deal. After deliberating on the issue, OFFER announced that it did not oppose the bid. Two
factors impacting on the decision were the information about prices derived from NE’s
share price through being a listed company, and the fact that CalEnergy had a subMergers and Acquisitions Edinburgh Business School
Module 5 / Bid Tactics
investment grade credit rating. Rating categories issued by credit-rating agencies are divided
into investment grade – that is, relatively safe investments – and sub-investment grade (or
speculative grade), which have a significant element of risk. OFFER objected to the junk
credit status implied by NE adopting a sub-investment grade financial structure implied by
the CalEnergy acquisition. OFFER announced that while ‘The loss of the listing is important; it is useful to have it, but not enough on its own to advise against a merger.’ The
question of NE’s credit standing if taken over was addressed by CalEnergy’s undertaking to
maintain an investment grade rating for NE, if successfully acquired by ‘maintaining an
appropriate financial separation and financial independence’.
On 6 December CalEnergy made its second and final bid for NE, valuing each share at
650 pence, or £782 million for the company. This represented a none-too-generous 31.6 per
cent premium on the pre-bid share price. Although the offer can be open under the takeover
rules for a maximum of 60 days, CalEnergy, advised by investment bank Credit Suisse-First
Boston (CSFB), went for a short 15-day period with acceptances (of the bid) due by 20
December. Under the takeover rules, CalEnergy could have sought to close the deal 60 days
from 6 December. Instead, it chose to go for a short and aggressive closing two weeks later,
just before Christmas. This was designed to put an element of pressure on fund managers to
accept, as a failed bid would adversely affect their final quarter’s portfolio returns.
In response, on 10 December NE announced plans to raise dividends and merge its
business with another electricity supply business. The benefits of this merger were given as
efficiencies in the back office operations of the combined firms.
Unexpectedly, the then minister at the Department of Trade and Industry (DTI) Ian
Lang, the person responsible for the decision, ruled against a referral to the Monopolies and
Mergers Commission. This was unexpected by the market as it went counter to earlier
decisions in the electricity sector. (The NE share price had initially dropped below the first
offer price on well-grounded fears of just such a referral, allowing CalEnergy to build up a
near 30 per cent holding.) In fact, one of the problems any bidder had at the time seeking to
buy in the electricity industry was the inconsistent effect of competition policy. When
ScottishPower (an electricity producer and distributor operating in Scotland) had sought to buy
Manweb (one of the many RECs that existed post-privatisation) the Monopolies and Mergers
Commission (MMC) had ruled against the bid, but had been overruled by the then minister at
the DTI. Later when PowerGen (one of the electricity generator companies) had sought to
buy Midlands Electricity (another of the many RECs) and National Power (again a generator)
had sought to buy Southern Electric (yet another REC), these had been referred on competition grounds and given the go ahead by the MMC only to have the recommendation
reversed by the DTI. So competition policy for the electricity sector was totally unpredictable. The boundaries of the UK government’s competition policy were unclear at this point in
time, and this was particularly apparent in the energy sector. The Financial Times of 7
November reported the view of one advisor in UK mergers and acquisition as stating that,
‘If there’s one thing that’s always consistent about [Ian Lang], it’s that he’s totally inconsistent.’ Lang was the President of the Board of Trade at the DTI at the time.
Following the second offer document, each side tried to discredit the other and gain
support from NE’s shareholders. CalEnergy via its advisors CSFB accused NE of making
‘misleading and incorrect statements’ about the value of the bid. On the other side, the
Takeover Panel gave the go-ahead to a controversial plan by NE’s financial advisors to buy
2.3 per cent of NE’s shares in the market.
Edinburgh Business School Mergers and Acquisitions
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On 18 December, two days before CalEnergy’s offer was due to close, London Electricity
(another REC serving the capital) agreed a friendly takeover by Entergy. The takeover valued
the company at 6.8 times cash flow (that is, profit before interest, tax and depreciation), a
common multiple in use for electricity distribution companies at the time. Applying the same
valuation basis to NE would have indicated a price of around 700 pence/share. East
Midlands, the other REC taken-over around this time, was sold for 6.5 × cash flow.
The offer closed on 20 December. The approximate state of play when the deadline
expired is given in Table 5.7.
Table 5.7
Position of two sides at 20 December
Northern Electric
Acquired 29.9% of NE’s shares in
market operations below initial bid
price of 630 pence/share
Received, prior to Friday deadline,
acceptances of the offer for about 5% of
Therefore controlled: approximately
of shares
A number of institutions, including the
Prudential Insurance, M&G, Foreign &
Colonial Investment Trust holding about
17% of the shares, publicly indicated
they considered the offer too low
Shareholders in NE England and also
loyal to the company held another 17%
of shares
Therefore for the defence: approximately 40% of shares
Balance: held by non-committed institutions and individuals
Of which, institutions engaged in risk arbitrage about 7%
Result of acceptances
Total acceptances or owned after deadline gave CalEnergy 49.77%
Bid had failed
As Table 5.7 indicates, the two sides were evenly matched in terms of committed shares.
BZW, taking soundings of investors in NE, would have been fairly well aware of the
situation in the days before the deadline. As a result, BZW, in consultation with Schroders
(advisors to NE), came up with an innovative scheme to buy up uncommitted and arbitrage
stakes in the market to prevent these being voted in favour of the acquisition. After getting
clearance from the Takeover Panel as to the acceptability of the scheme, BZW bought a 2.3
per cent stake on 18 December. This proved controversial, as NE had given an indemnity
against loss to BZW (since it was likely the share price would fall if the bid failed) This was
because the plan breached the Takeover Code guidelines preventing target firms from
buying shares in themselves. However, the plan helped NE just to retain its independence,
since at the close of the 20 December tender CalEnergy ended up just short of the 50 per
cent needed to gain control, with a tantalisingly close position in shares held or acceptances
of 49.77 per cent. The bid had failed.
However, that was not the end of it. As a result of the controversy surrounding BZW’s
buying up of NE’s shares, both parties had to return to the Takeover Panel. First CSFB, as
CalEnergy’s financial adviser, complained about the scheme on the grounds that it involved
the target repurchasing shares without consent. The Panel rejected this argument. However,
there was a second complaint about a discretionary fee to BZW of £250 000 from NE (on
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top of the £1.5 million fee agreed for the share purchases), which had not been disclosed to
the Panel. Given this revelation, the Panel decided to allow this information to be brought to
the attention of shareholders and to extend the original deadline by four days. The bid was
now back on.
As a result, one investment institution, now realising that the bid had failed and facing the
potential prospect of a subsequent price decline, decided to tender its 930 000 shares, the
bulk of the 1.17 million shares required to nudge CalEnergy’s bid above the 50 per cent
As if these developments were not enough, on December 23 the Prudential Insurance Company (affectionately known as the Pru), one of the most vocal shareholders to oppose the bid
and support NE’s management, announced it would offer 650 pence per share to any
holders prepared to revoke their acceptances. In earlier comments a spokesman for the Pru
had stated that: ‘We don’t think that 650 pence reflects an appropriate premium for control
of a company whose management has sought to deliver value for shareholders.’ The idea
was that successfully buying up even a small fraction of the acceptances would reverse the
outcome of the bid and preserve NE’s independence.
However, there was a problem for those shareholders who were not ‘in the loop’. Shareholders who were not in a position to sell shares to the Pru would be seriously disadvantaged
as – if the acquisition failed – the share price was likely to drop. Also, it seemed a perverse
action by the insurance company. Was buying highly priced shares that, in the event of the
bid being frustrated, were likely to fall in value in the best interests of policy holders?
In the event, the Pru’s intervention came to naught. NE’s board accepted the inevitable
and recommended acceptance of the offer.
However, even as CalEnergy and CSFB were celebrating victory, another problem
loomed. Siding with the Pru (which held a hefty 12.27 per cent of the shares) a number of
institutions such as Foreign & Colonial Investment Trust and M&G Fund Managers, dissatisfied
with the offer price, threatened to remain as minority shareholders in the hope of a ‘special
dividend’ rather than accept the inevitable and tender their shares. They reasoned that:
‘There is a strong argument that, in a heavily regulated business like Northern’s, our position
will be protected because CalEnergy will take value out by paying dividends.’
However, many smaller institutions considered this strategy of remaining minority shareholders ‘too risky’ and would follow NE’s board in accepting the offer. Within weeks
CalEnergy was able to take control of Northern and institute changes. All Northern’s
executive directors were dismissed, as were the non-executive directors. They paid the price
for opposing the bid. They were replaced with a new board of directors appointed by
CalEnergy. Reflecting on the outcome, one City participant in the takeover commented that:
‘The management (of Northern) have been penalised for something that was not their fault.
It leaves a very uneasy feeling in one’s stomach.’ Schroders, who had mounted a strong
defence, announced that: ‘We are obviously disappointed that the success of our powerful
defence has been reversed on a technicality.’
Some Conclusions
The Northern Electric case is interesting as an example of some of the issues that arise from
a takeover. It is noteworthy for the fact that there were two distinctly separate bids, the first
– as the case makes clear – being unsuccessful as the bidder abandoned the attempt in the
face of resistance and changes to the competitive environment. The second bid, although it
Edinburgh Business School Mergers and Acquisitions
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does not seem motivated by the fact that Trafalgar House put Northern ‘into play’ – that is,
the bid raised the profile of NE as a takeover candidate – certainly reflected the attractiveness of the electricity sector. The bid processes themselves raise some interesting issues that
impact on firms’ ability to carry out takeovers in a regulated environment.
A key issue is the role played by the competition authorities in a regulated industry. As
the case shows, those charged with regulating competition in the UK at the time did not lay
down clear guidelines as to what constituted acceptable or unacceptable market concentration and ownership. In addition to this problem, a bidder faced not just the competition
authorities (in the shape of the inconsistent President of the Board of Trade) but also the
industry regulator (OFFER). However, this takeover did escape the scrutiny of the European Commission. If there had been cross-border elements in the deal, then there might have
been additional vetting of the takeover at the European Union level. Such public policy
oversight added greatly to the uncertainty surrounding the transaction, and contributed
directly to the ease with which CalEnergy managed to raise its stake in NE to a commanding
29.45 per cent. This block stake proved vital in the final analysis to give it victory, as the
bidder was able to obtain only just over 4 per cent acceptances prior to the (original)
In deciding on the price, it is clear that the valuations attached to Northern were very
inexact. A Northern Electric shareholder was moved to state that: ‘It still staggers me how
difficult people find it to answer the question: how much is your company worth, and why?’
Clearly, at different stages of the takeover different people held very different views as to the
target’s value.
In addition, there seemed to be a stance that, in buying control, CalEnergy needed to pay
a certain premium to the pre-acquisition share price. It is obvious that the Pru and other
like-minded institutions felt that the offer price was too low, given the potential benefits to
be derived. In a takeover situation, shareholders will usually support the incumbent management – as they did during the first bid and to a certain extent in the second. What
normally happens is that a consensus develops for and against acceptance. It is highly
unusual to have the dead heat finish that characterised the first deadline.
The process itself can be very messy. There were a great many parties involved, some
with murky motives (for example, the Prudential’s last-minute intervention). Although the
investment bank advisors were creatively seeking mechanisms to help deliver the result they
wanted, it led to considerable argument. Both sides, at various times, appealed to the
Takeover Panel, the entity that policed the market. Its decision to extend the deadline
allowed CalEnergy and its advisors to snatch victory from the jaws of defeat. It suggests that
the outcome, in the circumstances, was quite arbitrary. Also, neither side’s advisors seem to
come out of it untarnished. One wonders why the additional £250 000 discretionary fee (a
small element in the overall context of the remuneration being paid) was not disclosed to the
Takeover Panel at the onset. One could also question the advisability of the share-buying
activity by NE’s broker BZW.
What is not at issue is the high drama involved, and the way the actions of the different
participants at various times changed the course of the takeover attempt. It would be nice to
report that, following the drama of the takeover, Northern Electric found a stable home
within the CalEnergy stable. But this has not proved to be the case: changes in the North
American and UK energy markets have meant that NE has since been resold as a result of
CalEnergy’s decision to disvest itself of its UK operations in distribution.
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Module 5 / Bid Tactics
Learning Summary
This module has addressed the steps involved in buying another business. The bidding phase
of the acquisition process is when the intentions of the acquiring firm’s management collide
with the separate wishes of the target’s management. In addition, there are competition and
market process regulatory hurdles to overcome before the transaction can be completed. In
promoting and resisting a bid, firms will employ a variety of tactics to secure their position.
The candidate should now understand:
• The requirement for a disciplined approach to the acquisition process and the key
requirments in mounting the offer.
• In particular, the importance of the bidder setting a maximum price to be paid for the
• The conflicts of interest that exist between the interests of the acquirer’s and the target’s
management and also the shareholders in both companies and how these conflicts affect
the results of the bidding process.
• The key role of the managements in both the acquirer and the target companies in the
bidding process and specifically how negotiations leading up to the acquisition can be
modelled using game theory.
• How regulators who evaluate the impact of mergers on the competitiveness of industries
and firms identify acceptable and unacceptable mergers. That merger regulation is both
based on competitive criteria and issues of public policy. Merger regulation also differs
significantly depending on the jurisdiction of the regulating authority.
• The purpose and rationale for regulating the process by which firms tender in the
market. In particular how target company shareholders should be treated, and how market process regulation seeks to minimise conflicts of interest between the target
company’s shareholders and its management by setting standards of behaviour to prevent managers acting in their own self interest. These regulations also affect how a
bidding firm can act.
• The rationale for takeover defences by firms in order to deter an aggressor and to
entrench the existing management in the target.
• How the takeover process in the United Kingdom affected Northern Electric plc in two
separate bids situations.
The candidate should now be able to evaluate the difficulties a bidder will face in its
attempt to acquire a target, and whether it succeeds or fails. Many factors ranging from how
the target’s shareholders and managers behave to the actions of regulators and the presence
of takeover defences will impact on the success – or otherwise – of the process.
• The bidder needs to set the maximum price it is willing to pay such that it preserves
a positive net advantage of merging for its shareholders.
• There is a real danger that as the bid develops, the auction process will compete
away the benefits of the acquisition to the target shareholders. The historical evidence suggests that firms tend to overpay.
• To acquire another firm, a bidder makes an offer (or tenders) for the shares of the
target firm.
Edinburgh Business School Mergers and Acquisitions
Module 5 / Bid Tactics
• Bidding for another firm is in effect an auction. For this to succeed, a majority of
shareholders have to accept the terms of the transaction. This typically results in the
buyer paying a premium for control. This is a mark-up to the pre-announcement
price. It is rare that a bidder can acquire a company without paying away some of
the identified value benefits to the seller shareholders.
• Studies of share price behaviour around announcement dates show that, on average,
the share price of target firms appreciates significantly as sellers are able to extract a
significant proportion of the merger benefits from the acquirer. For buyers, the way
the share price behaves is an indicator of how the market perceives the chances of
the combination enhancing shareholder value. If the share price weakens on announcement then the market is of the view that the bidder firm’s management has
overestimated the potential benefits.
Bidding and Resisting as a Game
• The management teams in both bidder and target are intimately involved in the
success, or otherwise, of the bid.
• The managers of the target firm have a strong incentive to resist the acquisition in
order to preserve the economic rents they derive from the firm, to demonstrate
their market value to other potential employers, and to extract greater value on
behalf of their shareholders.
• The conflicts of interest between the bidding firm and the target can be modelled as
a game where there are dominant strategies that will predict how managers will act.
• A common form of game, known as the prisoner’s dilemma, involves strategies on
both sides that can lead to gains or losses. If both sides persist in their dominant
strategies, they are worse off. Only by co-operating can both sides gain advantage.
This simple game mirrors the predicament confronting the managements of both
firms in a takeover situation.
• To overcome resistance bidders need to build up trust with the target’s management or change the economic incentives involved.
Offensive and Defensive Tactics
• The bidding process can be seen as a fight where the aggressor will seek to overcome the hurdles to a successful outcome while the target will seek to impede the
process through the clever application of defensive tactics.
• Both sides will be assisted in the bidding process by financial advisors.
• To ensure ethical behaviour and a due process, many aspects of the bidding process
are subject to regulation. Directors are usually constrained to act in the interests of
shareholders by facilitating the auction process and hence the best price regardless
of their preferences.
• Nevertheless, by actions such as encouraging an intervention by a friendly company,
or white knight, the management of the target company can seek to influence the
result to their own advantage.
• Many different tactics and stratagems have been tried in the past and often go by
various colourful names, such as Pacman defence or poison pill.
Mergers and Acquisitions Edinburgh Business School
Module 5 / Bid Tactics
Role of Regulation
• Since acquisitions involve changes to an industry’s structure they raise issues of
antitrust or competition policy.
• Not only do mergers need to satisfy the interests of the different parties’ shareholders and management, they also have to clear the hurdles set by regulators. Mergers
that increase industry concentration or market power are likely to be especially
• Regulators, for instance the US Justice Department or the European Commission,
use various measures, such as the H index or the concentration ratio, to determine
whether mergers are against the public interest or create monopoly or market
power. Mergers that fail the test of competition are likely to be rejected. Acquirers
therefore need to know the probable effects of the combination on competition and
the likely response of regulators prior to mounting the bid.
• The bidding process, even though governed by a well known set of rules, can be a
messy affair with the different elements, public policy, shareholders and managers
interacting in complex and unanticipated ways. Therefore even the simplest of takeovers can have unexpected elements. The Northern Electric case study illustrated in
detail the various elements (shareholders, managers, regulators and others) that
interacted during the bidding process.
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York: McGraw-Hill.
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• Fama, Eugene F. (1980) Agency problems and the theory of the firm, Journal of Political
Economy, 88, April: 288–307.
• Jensen, Michael C (1986) Agency costs of free cash flow, corporate finance and takeovers, American Economic Review, 76, May: 323–9.
• Jensen, Michael C. and William H. Meckling (1976) Theory of the firm: managerial
behavior, agency costs, and ownership structure, Journal of Financial Economics, vol. 3, No
4, October: 305–60.
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scientific evidence, Journal of Financial Economics, 11, April: 5–50.
• Hay, Donald A. and Derek Morris (1994) 2e Industrial Economics and Organization, Oxford:
Oxford University Press.
• Moles, Peter and Nicholas Terry (1997) Handbook of International Financial Terms, Oxford:
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April: 197–216.
• Weston, J. Fred, Juan A. Siu and Brian A Johnson (2001) Takeovers, Restructuring, and
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Edinburgh Business School Mergers and Acquisitions
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