On the structure of take-over models, and insider-outsider conflicts in negotiated take-overs

Journal of Banking & Finance 19 (1995) 11-44

On the structure of take-over models, and insider-outsider conflicts in negotiated take-overs P. Sercu *, C. Van Hulle Catholic Uniuersity Leuuen, Naamsestraat

69, 3000 Leuuen Belgium

Received October 1992; final version received June 1993

Abstract We model a takeover game where the players can bid or bargain without the traditional exogenous constraints on the order, length, and number of alternating stages. In our (‘European’) setting, dominant shareholders can appoint and dismiss management, implying that we have an insider-outsider conflict rather than a management-shareholder agency problem and that the distribution of (sizeable) private benefits is a crucial issue. The bargaining solution determines the price even if no explicit negotiations are observed, while bargaining strength and scope for exclusion determine the type of takeover (pre-negotiated or not, discriminatory or not). Keywords:

Take-over

JEL classification:

bids; Bargaining

G34

1. Introduction In many corporations, especially in Europe or Japan, between large and small owners (the insider/outsider Meckling, 1976) supersedes the agency problem between agement. Such a situation arises when there are large industrial and holding companies, shareholder syndicates,

* Corresponding

the conflict of interest problem of Jensen and shareholders and manshareholders (families, and, in e.g. Germany

author. Tel. ( + 32) (0) 16 326734; Fax ( + 32) (0) 16 326732.

0378-4266/95/$09.50 0 1995 Elsevier Science B.V. All rights reserved SSDI 0378-4266(94)00043-3

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and France, also banks) that can appoint or dismiss the corporation’s management without any need for proxy fights etc. Equally crucial, these dominant shareholders tend to control more than one firm, and there are important crossholdings among firms or agreements between their shareholders. ’ In a context where disclosure requirements are limited and the information released is less transparent than in e.g. the US, these inter-company links create substantial incentives and opportunities to transfer cash flows between companies. In one recent case, blocks of shares were traded between SociCtC G&t&ale de Belgique, a conglomerate holding company, and its controlling shareholder, the French Compagnie de Suez, at prices generally considered to be advantageous for Suez. Similar deals, sometimes amounting to up to BEF 12 billion (USD 400m), also occurred between SociCtt G&&ale and several publicly traded firms under its control. ’ In short, corporations with its dominant-shareholder networks offer plenty of scope for exclusion or private benefits of control. Press reports also stress the importance of the agreement of the large shareholders in take-overs. Empirical evidence indicates that, on the Continent, proportionally less contested and multiple bids occur than in the UK and the US (Franks and Mayer, 1990) 3 - although, according to John Pound in the WSJ (19921, also in the US “the market based approach [to transferring corporate control] of the 1980s is being replaced by a political model, involving quiet negotiation, diplomacy and limited voting challenges.” At first sight, the comparative scarcity of contested bids in Europe is puzzling. Contested bids are associated with higher prices, and especially large target shareholders have much to gain from a higher bid price; so one would expect these owners to actively seek alternative bidders. Why then the low occurrence of contested takeovers? We argue that it is the very combination of sufficiently concentrated ownership and benefits of control that curbs bidding contests. The way this argument works depends on the type of game that is being played. First consider a non-discriminatory game, where the incumbent management receives the same price per share as the small shareholders. In this setting, the sole role of private benefits is that they leave room to buy out the small shareholders at a price below the total value of the target under the bidder’s management. Unfortunately for the bidder, though, the current management, being an important shareholder, has an incentive to drive up the takeover price by counterbids; and, as Harris and Raviv (1988, p. 213) remark, an incumbent group with sufficient

t See Vincent and Martens (1991) for an overview of European groups. * See Financieel Economische Tijd (1992b). 3 Franks and Mayer (1990) offer an interesting comparison of modes of control changes and regulatory differences in France, Germany and the U.K. In Section 5 we discuss reasons why companies make use of restrictions on the transfer of shares and voting rights discussed by Franks and Mayer.

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financial resources can even drive up the price to the level of the bidder’s total valuation (including private benefits). We argue that the possibility of bargaining provides a limit to such counterbidding: the rival can always start a bidding war, then withdraw and leave the incumbent management in full control, and finally negotiate a takeover. If the target’s total value to the bidder exceeds the value to the current owners, both parties gain by agreeing upon a price somewhere in between the two values; thus, the bidder can buy the company at a price below its total valuation of the target. During the initial bidding contest, both contestants are aware of this possible strategy. It follows that the price will never be bid up to the target’s total value to the bidder. This role of (potential) bargaining is not recognized in the literature, perhaps because the incumbent management is not at all a willing party in such negotiations. Rather, the bidder’s optimal strategy, if played explicitly, is to force the current management to take private the firm, leaving the latter no choice but to negotiate a subsequent takeover in order to limit the damage. Thus, in a no-discrimination game, bargaining is not a conspiracy between two large shareholders who rip off the third shareholders in their mutual interest. In fact, the controlling group is hurt by the bidder’s option to bargain, because this curtails its potential to bid up the price. Second, consider a discriminatory game. The incumbent management can always be convinced not to drive up the price if it is offered more, per share, than the outside shareholders - with the savings being divided between the contestants. But in the EU, discrimination has to be hidden: any transfer of a controlling block at a premium relative to the market price has to be followed by a public offer, at the same high price, to all shareholders. Private benefits now play an additional role: the bidder can discriminate on the sly by offering the current dominant shareholders a slice of the benefits of control. Thus. friendly arrangements between the bidder and controlling shareholders offer scope for circumventing laws that intend to protect the small shareholders. This view seems to be shared by The Economist [1992], which in fact ascribes the 1992 European takeover binge partly to the prospect of tighter no-discrimination rules to be enacted in the near future. In a situation like this, the incumbent management is not at all a reluctant party to the negotiations. The situation is now a bilateral exchange, where the bidder brings in the increase in the assets’ value, and the current management brings in a promise not to drive up the price. This, in other words, is a situation where the role of bargaining is more conform with conventional notions. Also the role of shareholder syndicates differs depending on whether the game is discriminatory or not. We argue that, in a non-discriminatory game, syndicates (i) lend credibility to the threat of a counterbid, and (ii) strengthen the incumbent’s bargaining position by providing ‘soft’ financing. In a non-discriminatory game, one purpose of syndicates is to reduce the risk that outside bidders upset the conspiracy against the small shareholders: a syndicate ensures that the large stakeholders, who are also the most obvious potential rival bidders, automatically take part in the negotiations. Second, bidders or potential bidders can be invited to

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join the syndicate and share the existing private benefits rather than take over and reorganize the firm. A crucial trait in our way of modelling these takeovers is the endogenized sequencing of the stages of the game. Setting up a bidding/bargaining game is much more involved than simply adding, at an arbitrarily predetermined stage, some bargaining round to the bidding model. The reason is that the outcome of bargaining/bidding models heavily depends not just upon the details of the rules for each stage, but also upon the order in which bidding and bargaining takes place and the number of times game participants are allowed to move back and forth between bidding and bargaining. Inevitably, we have to exogenously impose the rules that apply to each stage; and, in doing so, we try to follow EU regulation. But the sequence and the number of moves are not regulated. It follows that realistic bargaining/bidding models should allow participants to determine themselves the type of opening and closing stage (bidding versus bargaining), as well as the number of bidding and bargaining stages and the number of rounds within each stage. 4 This necessity to endogenize the structure of the problem has not always been fully recognized. Using such an approach, we show that if market participants can choose between several control transfer mechanisms, then the bargaining mechanism determines the price. Actual bargaining will be observed only if the time value lost during a bargaining round is small. So as soon as time value matters, explicit bargaining is dropped; but the bidding price still reflects the anticipated outcome of potential bargaining: bidding merely serves as a device through which small shareholders transfer their shares to the bidder. From an economic perspective, this finding is important for at least two reasons. First, within a bidding stage the behavior of the small shareholders generally affects the outcome; bargaining, in contrast, involves only large shareholders so that the contestants generally have more manoeuvring space. Second, takeover regulation is concerned mainly with public bidding, while bargaining happens behind the scenes without being subject to formal legal rules. Since our findings suggest that the unregulated bargaining process dominates, legislation will be effective only if it affects the bargaining situation. Our paper differs from the seminal article by Shleifer and Vishny (1986a) on

4

One could object that multi-stage games, with participants moving back and forth between bidding and bargaining many times, are rarely observed. But this should be explained by the fact that, already from the beginning of the control contest, the participants’ decisions take into account the implicit option of additional bidding and/or bargaining stages. As a result, most stages are played implicitly. Therefore each of the following alternative scenarios is a plausible outcome of our model: the acquirer opens with a preemptive offer price, upon which everybody tenders; there are no observed negotiations nor defensive actions by the target; or a bidder wins after a control contest with a white knight; no negotiations are observed; or a bidder launches a bid after successful negotiations with the target’s management; the latter supports the bid.

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large shareholders in that our ‘European-type management cannot steer its own course and the large shareholder does not need a takeover bid or proxy fight to impose its views on management. Dewatripont (1990) discusses a model with large shareholders and a white knight defence; but his pure bidding setup precludes an analysis of the interaction between bidding and bargaining which is a key ingredient of our work. The articles by Nyborg (1989) and Berkovitch and Khanna (1991) do consider bidding and bargaining, but exogenously impose the order in which bidding and bargaining may take place. They endogenize the choice between an uncontested and a contested change in control, but they focus on the shareholder/management agency problem rather than on the magnitude and sharing of private benefits and the credibility of the threat of a white-knight counterbid. Harris and Raviv (1988) discuss bidding and voting as control allocation devices, not bidding and bargaining. The present model does not explicitly consider voting, but voting can be incorporated without affecting the results. The paper is organized as follows. Section 2 describes the setting, including the exogenous assumptions about beliefs, objectives, and the rules of the bargaining and bidding stages. In Sections 3-5, we consider no-discrimination games. Section 3 analyses how, in a two-stage game, the order in which bidding and bargaining takes place affects the solution. Section 4 presents and solves the model in which participants choose themselves the type of opening and closing strategy (bidding vs bargaining) as well as the number of stages they wish to play (explicitly or implicitly). Section 5 extends the model to multiple bidders. Section 6 introduces the possibility of discrimination. Section 7 considers some testable implications. Section 8 contains the conclusions.

2. The setting 2.1. Certainty We use a standard Grossman and Hart (1980)-type setting. All parties concerned are informed about and agree on the effects of a change in control, and have perfect foresight. One implication of the perfect foresight assumption is that only pure strategies are used. 2.2. The players

and the stakes

The target firm is governed by simple majority rule (one share, one vote). It is initially controlled by its largest shareholder C, “current management”, which owns a minority block (~c < 0.5. (Games where C is well-entrenched, for instance because of an ownership exceeding 50% or because of protection by the law or the company statutes, are not discussed in this paper.) Until section 4 we consider

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only one rival, the firm or group B that bids for the target’s control. B holds a proportion CY~2 0 of the shares. We assume that cq + on < 0.5, so that B cannot gain a majority by simply striking a deal with C. The other shareholders are atomistic, implying that they either tender all their shares, or none. The present value of all benefits produced by the target company if C has control, V,, consists of the discounted value 5, of security benefits that accrue to all shareholders, plus the value 2, of private benefits pocketed by C: V, = S, + Z,. So, before a change in control takes place, the present value of C’s benefits amounts to +Sc + Zc while B’s benefits are worth (~a$. Similarly, V, = S, + Z, denotes the total value of all target benefits if company B is in control. 5 Because we are primarily interested in a genuine takeover situation rather than greenmail, for most of the paper we assume V, < V,.; still, we can also apply our logic to greenmail (Section 4.3). In principle, the controlling stakeholder receives the private benefits; however it may decide to share them with another large shareholder. We consider such sharing as of Section 6. 2.3. The bid procedure,

availability

of credit and feasible bid prices

For simplicity, we only consider full buyout bids conditional on obtaining a majority, and relegate the discussion of partial buyouts to Appendix 4. Full buyout offers are important in practice; in several EU countries partial bids are even forbidden. 6,7 The incumbent group C is an active control contestant as it can launch counteroffers. We allow control contestants to revise their offer as many times as they wish. Any offer price pB or pC is expressed as the price per share times the total number of shares outstanding. For simplicity, we assume that bidding takes no time. ’ To ensure a finite length of any bidding contest, we assume that every such offer has to be strictly better than the preceding one or than the currently outstanding bids. 9 (An alternative set of assumptions without this stepping-up

’ For simplicity we fix the size of private benefits exogenously. In practice this is not so. However we would not expect the large owners to reduce security benefits below a certain level because of reputation (they may wish to tap securities markets in the future) and possible backlash from supervising bodies. 6 Also in Anglosaxon countries full buyouts are important. See for example Bagnoli and Lipman (1988). Hirschleifer and Titman (1990) illustrate how formally unconditional offers are usually hedged with escape clauses so that they are, for practical purposes, close to conditional bids. ‘See Maeijer and Geens (1990) for an overview of takeover regulation in several E.U. countries. Art. 4 of the Draft Thirteenth E.U. Directive implies an obligation to purchase all shares in a takeover bid. * Similar results are obtained if there is discounting between offers (see appendix 4). 9 Rules like this are common in continental E.U. countries; with this assumption we also want to avoid equivalent bids, which would require arbitrary endogenous assumptions like: “if B’s and C’s offer price are equal, small shareholders tender to C”.

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1-i

requirement but leading to similar conclusions is given in Appendix 4.) Realistically we assume that a strictly better offer implies an improvement with minimally one unit. This unit is equal to the smallest monetary unit in the capital market (e.g. cents) times the number of shares outstanding. V,, V,, S,, S,, Z,, Z, are all expressed in terms of this unit. To avoid a tedious discussion of uninteresting marginal cases, we assume that the benefits are non-trivial: Z,>l,(V,-Vc)>l

(1)

The bid procedure we impose is consistent with stylized EU regulation. The crucial traits, summarized in Fig. 6 in Appendix 1, are as follows. B starts with an opening bid. C can always counterbid: because of symmetric information, C can always borrow against its net wealth and make a public counteroffer. Thus, if B opens the public bidding contest, C may respond with a counterbid or abstain from doing so. If C abstains, the tendering procedure with one outstanding offer begins (Appendix 1, Fig. 4). All parties can tender, except of course B whose offer is outstanding. If B’s bid succeeds, the current bidding stage ends. If B’s bid does not attract sufficient tendering, B may revise its offer; in the latter case a new tendering round is organized. lo A counteroffer by C may trigger a chain of revisions by B and C and lead to the tendering procedure with two outstanding offers (Appendix 1, Fig. 5). Any contestant can withdraw (and possibly tender its shares) if and only if the other’s outstanding offer is better. bidding round ends when one contestant has withdrawn and the remaining bidder sticks to its most recent offer, or when both contestants stick to their most recent offer. The subsequent tendering round may or may not fail to produce a majority.

2.4. The bargaining process

Fig. 1 summarizes the sequence of events within an explicit bargaining stage. li The contestants may make alternating offers to which the other party can respond by accepting (in which case the bargaining ends), by rejecting and formulating a counterproposal, or by walking away from the negotiations and start bidding. Obviously the third option is only useful as long as the small shareholders have

” This assumption reflects the idea that, if a bidder believes at some point during the contest that an insufficient number of shares will be tendered, it may wish to revise its bid. In our certainty model, this idea is already captured by the assumption of perfect knowledge about the outcome; any undesirable outcome can then be set right by a revision of the offer and a new tendering round. I1 The game might be played implicitly too; see below.

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B makes an offer I C rejects

c acclepts and sells out

I

C fP$C--+m

[B offers same price to T] *

counteroffer

bidding

Wppendk

I

Graph la-c)] **

(newperiod)-----

---------C makes counteroffer

I B rejects

B accejts and buys out C

I

1

I

[B offers same price to TJ *

B prepares counteroffer

E,sk$ (Appendix 1, Graph la-c)] **

I

(new

peri&)

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

-

B makes new offer, etc. * A tenderfor Ts sharesis not necessaryif the thirdshareholdershave already sold out. ** This option is not open if bargaining is (exogenously) constmined lo be tbe last stage. Fig. 1. Sequence of events within an explicit bargaining stage.

not yet sold out in some previous bidding stage. If C has in fact bought out the third shareholders before negotiations start, the bargaining is about the terms of a transfer of C’s total block to B; otherwise, bargaining is about the terms of an agreement under which B organizes a public tendering round, uncontested by C, and offering all small shareholders as well as C the agreed-upon price. I2 To ensure that bargaining does not last forever, we adopt the standard assumption that the process of (re-Idrafting a bargaining offer takes one period. The discount factor l/(1 + R) between successive offers is the same for all participants, and can be arbitrarily small. There is no need to assume that also bidding takes time: the minimal improvement clause already ensures that bidding will be

12

This implies that the negotiated price is an integer number. If C holds all shares initially owned by third players, no post-negotiations bid is necessary anymore, and the integer constraint drops.

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over in a finite number of moves. The solution when bidding takes time, presented in Appendix 4, just complicates matters without adding any insight. 2.5. Objectives All participants in the game maximize expected wealth. In accordance with Selten’s perfectness concept, all players take into account the possibility that others may, with an infinitesimally small probability, make a mistake in their next move but play the remainder of the game rationally. In our atomistic shareholder model, this possibility of “trembling” eliminates weakly dominated strategies. One crucial example of such a weakly dominated strategy is the strategy under which the third shareholders do not tender as long as B retains any surplus. This would be in the small shareholders’ best interest; but if B conditionally offers pe 2 S, + 1, every single shareholder will realize that not tendering is a dominated strategy and will tender, so that the hold-out strategy cannot be an equilibrium. This is, in fact, the familiar prisoner’s dilemma. Even after eliminating weakly dominated strategies, many Nash equilibria may remain, especially when two competing bids are outstanding. To sort these out, we assume that all small shareholders behave according to a “no panic” rule like in Constantinides (1984). In our framework, this rule says that, in the public bidding stage, the atomistic shareholders expect that the others will never go for a bid that is manifestly worse than another available ‘perfect’ equilibrium. In particular, if at the end of a bidding stage two offers are outstanding, shareholders T expect all other small owners to go for the higher of the two. The “trembling” rule still assures that “no panic” equilibria generated by weakly dominated strategies disintegrate. 2.6. Types of takeovers A bid is said to be pre-negotiated if there is a prior agreement that B’s bid will not be contested by C. A deal is called discriminatory if C gets more, per share, than the third shareholders. Whereas U.S. legislation allows B to pay a ‘control premium’ for a large block, in Europe such discrimination is ruled out by the 13th EU directive. However, an agreement can still be discriminatory de facto if C receives a side-payment, for instance by obtaining a share in the private benefits Z, after the takeover. Until Section 6, we only consider bids that are non-discriminatory and not pre-negotiated.

3. The two-stage game As pointed out in the introduction, a bidding/bargaining model should let the players determine themselves how they start and end the allocation of control

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process and how many bidding and bargaining stages are played. This section shows how the solution of a no-discrimination game is affected by changing the order of bidding and bargaining if maximally one bidding and one bargaining stage is considered. The results are crucial for the complete game to be discussed in Section 4.

3.1. Bargaining

followed

by bidding

Takeover games are sometimes modeled as follows: l3 the bidder B either launches a bid right away, or first approaches C with negotiations. During the negotiations, either party can walk away from the talks and start bidding. Once bidding has started, it is impossible to return to negotiations. We now show that with the above ordering, the solution of a pure bidding model obtains: B immediately opts for bidding and offers a price pB = V, - 1. - Suppose that (~a > 0 and that B initially opts for negotiations, and offers less than V, - 1. C can then choose between continuing to bargain (accepting or rejecting B’s offer) or starting the bidding process immediately by launching a bid on the target’s shares. If C chooses to stop bargaining, and publicly offers pc = V, - 1, B can only respond by a better counterbid, i.e. offer at least VB. I4 B will actually make such a counteroffer rather than selling out to C: selling out yields onpc = a,(V, - 11, which is marginally less than the value from counterbidding with pB = VB. l5 Note that pc = V, - 1 is the highest offer C can safely make: if C bids more than V, - 1, a profit-maximizing B calls C’s bluff and sells out. In short, if B starts with a negotiation offer below VB - 1, C can walk out and bid V, - 1, forcing B to pay V,. It also follows that, during the time-0 negotiations, C will never settle for less than Va. - Still assuming that that (~a > 0, if instead firm B skips negotiations and immediately opts for bidding, it can offer pB = V, - 1. B knows that C will never bluff with pc > V, - 1. So when (~a > 0 the maximal price that can be forced out of B is pB = V, - 1. - If (~a = 0, finally, B has no gain on an initial toehold. This means that B will never be prepared to pay more than V,. Again, B’s best strategy is to open with pB = V, - 1, because this prevents a counterbid pc = V,. The one-unit difference between the two outcomes is marginal, but the first mover advantage becomes non-trivial if, like in Belgium or France, the difference between two subsequent bids has to be at least 5%. So B immediately goes for

I3 See for example Berkovitch and Khanna (1991). l4 As Za > 1, pa = Va exceeds S, + 1 so that the free rider bound is satisfied. ” i.e. V, -Cl - asIps = Va -(l - ~y~)Va = (Y~V, > @I, - 1)

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bidding, and offers V, - 1. At this price, all small shareholders tender to B as trembling creates a prisoners’ dilemma. l6 This outcome, which has also been obtained under rather different assumptions in Grossman and Perry (1986)‘s concession game, differs from the standard English auction or sealed-bid auction result where B would get control at V, + 1. The main reason is that, here, C has a stake in the target and hence an incentive to drive up the price at which B obtains the target. Note that even when (~a > 0 (i.e. when B’s reservation price exceeds V,, because of B’s capital gain on the toehold), C cannot go too far: B can always sell out to C, which is decidedly not C’s purpose. So B’s option to sell out ensures that B can always keep the capital gain on the initial toehold (~a, implying that even at pB = V, - 1 the NPV to B remains non-trivial. 3.2. Bidding followed

by bargaining:

general discussion

This alternative ordering of the two stages may emerge quite naturally in a game. To see this, let us consider B’s first offer to all target shareholders. The purpose of this opening shot may just be to provoke C to counterbid and win (that is, C takes the firm private). Indeed, unlike in a bargaining + bidding game, the bidding firm B no longer has to outbid C if it wishes to achieve control: when C holds all the shares, B now has the opportunity to purchase the target during the bargaining stage following the bidding, and knows that mutual benefits of trade surely exist (as B’s valuation of the target is higher than C’s). Let us denote the anticipated outcome of these (explicit) negotiations by p,,. Since the value of the company, in C’s hands, is V,, while B can extract a higher value V,, the For instance, with equal negotiated price pne will be somewhere in-between. bargaining strengths and a short negotiating time, pne will approach the split-thedifference solution pne = V, + (V, - V,)/2. Thus, B prefers such a negotiated takeover over a pure bidding process, where the price would have been (close to) V, (Section 3.1). This anticipated bargaining outcome will of course have its implications for the players’ bidding behavior in the first stage accordingly. To understand the logic,

16

This solution implicitly assumes that payoffs of off-equilibrium paths are finite, so that e-probabilities of trembling do not upset the outcome. For example, suppose B makes the mistake (with some infinitesimal probability) to open with bargaining. A rational C then immediately walks out, and opens bidding with pr = V, - 1, on the basis of borrowed money (or commitments from banks). After that, B may again make a mistake (with some infinitesimal probability) and sell out rather than counterbid. We need to specify the payoffs for such paths too. There are many ways to complete the model without upsetting the proposed equilibrium. As long as no infinite payoffs come up, infinitesimally small trembling probabilities do not affect our argument. For example, we could assume that if C wins control with borrowed money and then defaults, the total valuation of the firm remains at V, and all cash flows are paid out to C’s creditors. In fact, it would be hard to imagine infinite payoffs in off-equilibrium situations.

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suppose for a moment that drafting a bargaining offer takes no time, that B holds no shares, and that the integer constraint on offer prices is absent. C will never stop counterbidding and sell out as long as B’s offer is below pne. But, unlike in a game that ends with bidding, C can no longer drive up the price beyond p,,, because then B would call C’s bluff, let C purchase all shares, and afterwards buy back the entire company at pne. From this it will already be obvious that the negotiations stage needs not even be played explicitly: if bargaining takes no time, both B and C are as well off if B immediately takes over the company at p,, during a public offer. The only wrinkle to be added is that B’s offer also has to satisfy the free-riding bound: if pne < S,, B has to offer S, + E, otherwise the small shareholders will not tender. In short, if bargaining takes no time, B immediately bids pB = Max(p,,, S, + E), and succeeds. Note that both pne and S, are below V,, implying that B wins relative to a pure-bidding solution. C, of course, would prefer the pure bidding solution, but has no choice. Sutton (1986) argues that bargaining should take some time, however minimal, otherwise there is no incentive to come to an agreement. If drafting a bargaining offer takes time, and B has some shares, and prices are not continuous, B still calculates a maximal offer price p * which (i) cannot be topped by C, and (ii) takes into account the discounted negotiation price pne and the advantage of an immediate takeover (i.e. the cashflows B can generate during the first period, in excess of the dividend B would receive if C runs the company for one more period). The precise outcome depends on the one-period interest rate, B’s initial stake (us, and the one-period cashflows under C and B’s management. As before, B will offer no more than p * if this is sufficient to attract the small shareholders; otherwise, B has to increase the offer to S, + 1. ”

Proposition 1: If there is maximally maximally one bargaining stage, constrained bargaining price p,,, p, =m=(&

one bidding stage possibly followed by control is allocated to the bidder B at the

+ l,p*)

(2)

where p ’ is the highest time-0 counteroffer C can safely make taking into account the discounted explicit negotiations price p,, and the benefits of an immediate takeover (in the sense that, if C offers pc L p * + 1, B will call C’s blufj sell out, and resort to an explicit, time-l negotiated takeover at p,,).

To obtain a closed-form solution for this bidding + bargaining scenario, we need to specify payoffs when the game is played explicitly. In the next subsection, we illustrate proposition 1 by one possible completion of the model.

I7 Unity takes over the role of E if the integer constraint

is imposed.

P. Sercu, C. Van Hulle /Journal

Dividends; private benefits Bidding , COT ,

Dividends; private benefits (Interest); , B’s yffer ,

1 Tie

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i

0

Time 1

23

Dividends; private benefits (Interest), etc. , C’s,offer , i

Tie

2

etc.

Fig. 2. Time scenario.

3.3. An illustrative

completion

of the model

The completion discussed here is chosen for its simplicity. We assume that S,, Z,, S,, Z, are the present values of constant perpetuities. In particular, the controlling group derives private benefits under the form of a constant perpetuity R.Z, per period, for example via transfer pricing with a company fully owned by the controlling group. Similarly Sx represents the present value of a perpetual stream of dividends R.S, shared proportionally among all stockholders. The time scenario is illustrated in Fig. 2. At time zero, the dividends and private benefits from the preceding period are paid out. A bidding contest follows immediately. If nobody wins, B lost its one and only chance to obtain full control, and the game is over with C remaining the dominant shareholder. If company B wins, it immediately pays for the shares, and the game is also over. If C wins, it pays for the shares, possibly after taking out a loan; C then runs the company throughout the first period so that the next (time-l) dividend is R.S, (plus Z, for 0; B drafts a negotiation offer. At time I the preceding period’s dividends and private benefits are distributed, and C pays interest on its loans (if any). Then a first bargaining round starts, with B making its offer. If C accepts, shares are delivered and paid for immediately, and the game ends with B in control. If C rejects, C remains in control for another period so that the time-2 dividend still remains R.S, (plus Z, for C>; also, C prepares a counter to proposal. The game continues until agreement is reached. The above illustrative setting is chosen because of its simplicity. Nevertheless it still opens many interesting sidelines on, for example, the role of initial toeholds and the role of C’s “financial strength” or “borrowing capacity”. Even if the incumbent’s only wealth consists of its initial shareholdings in the target, C is always able to issue at least VC worth of perpetual debt and offer a price pc = Vc/(l - (~c) for all other shares during the bidding. Indeed, even if C gains control and negotiations last forever, the profits R.V, generated by the firm suffice to service the interest payments. C’s bank may allow C to borrow more if it anticipates an agreement in a finite number of periods and expects a sufficiently high bargaining price; but then C may turn out to be unable to service the debt. So

24

P. Sercu, C. Van Hulle / Journal of Banking & Finance 19 (1995) 1 I-44

if C’s only marketable wealth is its block ocS,, C may not be able to fund an offer that exceeds V,/(l - ac>. B may then use this against C. The ultimate impact on the negotiated price depends on the behavior of C’s bank (is it prepared to capitalize the interest, or will it trigger bankruptcy?) and on the bankruptcy legislation. It follows that C’s “financial strength” matters. We shall return to this issue later on, in Section 4.3. Until then, we assume for the remainder that C’s total resources are sufficient to sustain the interest payments on any loan needed within the logic of the game. So we are considering a game that starts with bidding, and that might continue into a negotiated takeover, one period later. Clearly, bid prices announced by B or C will take into account the (known) outcome of the bargaining if C would win the preceding bidding contest. If the time value of speeding up the transfer of control is nontrivial, there exists an integer bid price which settles the whole matter at once, and this consideration should lead to a preemptive, uncontested bid from B. We also know that any such successful bid price has to satisfy a no-free-riding bound px 2 S, + 1 if it is to sway the small shareholders. l8 The details of this line of reasoning are found in Appendix 2, and lead to p* = INT

Pne

+

RVB

l+R

while in an explicit, equal-bargaining-strength the first offer, the outcome is P”, =

negotiations

game where B makes

VEI- vc vc+ ____ 2-i-R

Notice that the takeover price in such a game depends only very marginally on the bidder’s initial toehold: (mu can change p * by at most 1 unit. rg Also, pn is independent of the incumbent’s initial stake ac. The reason is that, if bargaining ever actually occurs, C will already have been manoeuvred into a lOO%-ownership situation by the end of the bidding round. Also notice that in contrast to the game ending in bidding, B normally keeps part of the private benefits, since p,, is below V, - 1. If B is better off relative to the pure-bidding solution, C (and the small shareholders) must be worse off. This fact means that our bargaining solution is certainly no conspiracy between two major players who join forces to rip off the third players. Rather, it is the result of B’s unilateral strategy. We have shown in Section 3.1 that a non-discriminatory bargaining + bidding game is in fact a bidding-only game, while in the non-discriminatory bidding + bargaining game we just solved the bid price is determined by the negotiations

‘* The small shareholders correctly anticipate that B will become the ultimate owner of the firm, and hence understand that their shares will be worth S, if they are withheld. I9 Since aa < a, 5 (Ye + (~c < 0.5, in most cases (in will not make any difference at all.

P. Sercu, C. Van Hulle / Journal of Banking & Finance I9 (1995) 11-44

25

stage (subject to the free riding constraint) even though no bargaining is observed. In the next section we show that if the players in such a non-discriminatory contest can freely choose whether to begin by bidding and by bargaining, and can subsequently switch back and forth between bidding and bargaining as many times as they wish, then (i) B has no incentive to start by bargaining, and (ii) B still immediately succeeds by offering Max(p * , S, + 1) for all shares. That is, a non-discriminatory takeover game with an endogenously chosen sequence of stages will turn out to be identical to the two-stage bidding + bargaining game we just discussed.

4. The complete takeover game We now discuss a more complete game, where the number of stages is not a priori limited to two and where B is allowed to decide whether to start the game with bidding or with negotiations. We first explore the implications of B opening with a bidding round, which may then be followed by an infinite series of bargaining-bidding alternations. 4.1. B starts with bidding This sequence is similar to the two stage game of Section 3.2, except for the addition of a potential tail of alternating stages. We now show that this addition does not affect the solution. Consider the following two cases: a> the initial bidding stage ends with some bid pB I S,; b) the initial bidding stage ends with some bid px 2 S, + 1. We first explore case a>. If pB I S,, the small shareholders will free-ride rather than tender during the initial bidding stage, and also C’s optimal decision is to stay put (see Appendix 2, case 2). So once this pointless bidding stage is over, the game has become equivalent to a game that starts with bargaining rather than with negotiations-except for the loss of takeover benefits for one period. This waste of time and money makes an opening bid pB I S, irrational. In case b), px 2 S, + 1 ensures that all small shareholders will tender to the highest bidder, even though better offers can be expected if the current offer fails (prisoner’s dilemma). So either B or C obtains a majority. - If B is the winner, the game ends: as B is firmly in control and has the highest valuation of the target, there is no point in continuing. - If C wins, the game moves on to the first negotiations stage. But because all small shareholders have sold out, there is no point in re-starting a bidding war. So the addition of a later bidding stage is irrelevant. Therefore this sequence is de facto a bidding + bargaining game, with the known outcome: B opens with a successful offer pe = pn = Max& + 1 ,p * 1.

26

P. Sercu, C. Van Hulle / Journal of Banking & Finance 19 (1995) I I-44

4.2. B starts with bargaining

It is easy to prove that opening with bargaining hurts B. Simply note that a game opening with (non-discriminatory) negotiations is identical to the one just discussed, except that now a bargaining stage has been added in front. 2o Under this scenario, B opens with some bargaining offer. - If C accepts it, this amount is immediately paid out by B to C and also to the third shareholders (via a tender that takes no time), and B ends as the sole owner. C only accepts if B’s offer is no worse than what C can secure by rejecting the offer. - If C rejects the offer, it can walk away and start bidding; and then the contestants are back in the game we discussed in Section 4.1. So all we need to find out is how and when C prefers to walk away. This depends on whether S, + 1 exceeds p* or not. - Suppose the (potentially infinite-stage) game starting with bidding has as its outcome pB =s,+1>p*. We consider C’s possible responses. a) If C refuses to negotiate, B’s subsequent public bid secures C a price pB = S, + 1. To see this, recall that B has to bid at least p* in order to bar C from driving up the price. But, as by assumption p * < S, + 1, offering p * is not enough to prevent free-riding on behalf of the atomistic shareholders. So if S, + 1 > p * and the game is in a bidding stage, B settles the affair immediately via an uncontested public offer pB = S, + 1, the lowest price that prevents free-riding. C will not outbid B, because p * ( < S, + 1, here) is the highest rational bid C can make in light of the later negotiations. b) If, on the other hand, C negotiates, the takeover is finalized one period later, at p,,, . But p * > p,,/(l + R) since p * also takes into account the added period-O benefit of an immediate takeover by the better manager, B. We conclude that if S, + 1 >p * , C will prefer the outcome of bidding (pB = S, + 1) over a negotiated deal (with discounted outcome p,,/(l + R)

S, + 1, B normally opens with pB =p * in order to bar C from making the highest “safe” counteroffer pc = p * . If C rather than B now obtains the initiative, C’s opening offer is pc =p * , forcing B to reply with pB = p * + 1. Again, the one-unit difference is marginal, but the first mover advantage becomes non-trivial if, like in Belgium of France, the difference between two subsequent bids has to be at

2o The flowchart representation bargaining process of exhibit 1.

is similar

to the one in appendix

1, except that it starts with the

P. Sercu. C. Van Hulle / Journal of Banking & Finance 19 (1995) I1 -44

21

least 5%. To sum up: if B opens with bidding, control is transferred at a price Pa, while the price would have to be at least p * + 1 if B opens with negotiations. So B does not open with negotiations. Proposition 2: If the contestants can freely use the bargaining and bidding mechanism to allocate corporate control, all non-discriminatory takeover prices are essentially constrained bargaining prices, even if only public bidding is observed.

4.3. Shareholder

syndicates,

and greenmail

In this section we discuss some corollaries of the results obtained so far. We shall first discuss the role of shareholder syndicates, and then interpret greenmail. It is enlightening to consider the (largely European) phenomenon of shareholder syndicates in these games. 21 A shareholders’ syndicate contract is concluded among the company’s major shareholders. It specifies rules with respect to the sharing of control, and contains commitments in case of an attempted takeover. A systematic study of these contracts is difficult, because they are not publicly disclosed. But they are generally considered to be widespread in Europe, and are frequently referred to in the press. Syndicates have even been recognized in corporate or securities law, in the sense that, in most EU countries, separate legal rules have been developed as a part of the takeover legislation (see Maeijer and Geens (1990) for an overview). The recent lobbying, in Belgium, to lift the current 5-year cap on the duration of a syndicate contract likewise suggests that syndicates are considered important by real-world players. Syndicates may play a major role in pre-negotiated, discriminatory games, as we shall argue in Section 6. In the non-discriminatory game discussed so far, syndicates firstly lend credibility to the threat of a white knight defense if the bid was not pre-negotiated. For instance, related companies can help the incumbent C in quickly raising amounts beyond what commercial banks would consider prudent; in this respect syndicates are even a substitute for a junk bond market. Obviously, these allies can also play the white-knight role hitherto assigned to C itself. Secondly, if financing of the counterbids is done within the group rather than via unrelated parties (e.g. commercial banks), the beleaguered C will also be under less time pressure to come to an agreement. Thus, membership of a syndicate increases C’s financial strength, improves its bargaining position, and hence leads to better conditions for C. We can also apply our arguments to greenmail situations. If V, < V, rather than the other way around and if Z, is sufficiently high, B can make a profit by launching a public bid. Suppose B makes such a public offer. C may then either

21 The shareholder syndicates is one class of the limitations shares and to which Franks and Mayer (1990) refer.

companies

can place on the transfer of

28

P. Sercu, C. Van Hulle / Journal of Banking & Finance 19 (1995) I1 -44

launch a counterbid or let B win. Under the latter alternative C then repurchases the target in private negotiations at some price rr,,‘ne.By analogy with the preceding analysis, C’s optimal course in fact is to launch a counterbid and immediately take private the firm at a price r * which derives from T”, in the same way as p * relates to pDe in our takeover model. This will be profitable to B if 7~ * > SC. This potential for greenmail imposes bounds on the degree of exclusion by the controlling group: if Sc is too low, a raider has the incentive to scare C into taking private the firm and eliminate the insider-outsider conflict. Let us now return to our main analysis. We have shown that in a non-discriminatory takeover with an endogenously determined sequence of stages, it suffices to consider only the truncated game bidding + bargaining. Before considering discriminatory games, we first discuss the impact that additional bidders may have on such a takeover.

5. Adding more bidders We add to our bidding + bargaining game a second candidate bidder B, with Vc < V,, < VB. We suppose that B, arrives simultaneously with B, or at least immediately after B has started bidding. Since company B is the best potential acquirer, it will ultimately take over the target firm; indeed, as long as B is not in control the game cannot be over, since negotiations would still offer opportunities of mutually beneficial trade. The existence of B, implies a new bound on B’s takeover price: not only must this price exceed S, + 1, but also it must offer no incentive for B, to contest the outcome. If B’s offer is too low, B, will counterbid with a slightly better price, take over the firm, and sell out afterwards to B at a negotiated price pne(B,,B). Using the same logic as before, it is not hard to show that B, can take over the role of C, and bid up the public offer price to the level indicated by Eq. (2). 22 As before, the takeover price is still based on the negotiations outcome, this time between B and its strongest rival B,. Proposition 3: In the absence of discrimination, the successful takeover price is affected by competition, in the sense that the outcome is bounded below by the (potential) negotiations between the strongest and the next strongest possible bidder. This reasonable outcome is in stark contrast with a pure bidding game, where, as we argued in Section 3.1, the outcome is pe = V, - 1 irrespective of the presence of other bidders.

z Of course, the negotiations

price behind p*

now is pne(B,,

B), not the pne hehveen B and C.

P. Sercu, C. Van Hulle / Journal of Banking & Finance 19 (1995) 1 I-44

29

6. Discriminatory takeovers 6.1. Hidden discrimination. European takeover regulation is heavily concerned with the protection of the small shareholders. Generally the rulebook intends to impose the non-discriminatory game discussed so far, by insisting that all shareholders be paid the same price per share. However, in practice it is often possible to circumvent this requirement, especially if both B and C own several firms, For example, in return for accepting a lower public bid price, some other firm controlled by C may obtain a favourable contract with one of B’s firms. 23 One example was the deal under which France’s Elf Aquitaine obtained a 9.2% block of shares in another French oil company, SPEP. The price originally agreed upon, end 1992, was FRF 250 per share of SPEP, but this agreement was upset by a sudden rise of SPEP’s market price to about FRF 350. Early 1993, Elf agreed to raise the purchase price to FRF 390. As a quid pro quo, SPEP was to bid for the remaining shares Cofibel, a Belgian company already 58% owned by SPEP, and then sell Cofibel to Elf at a zero profit. Cofibel’s minority shareholders argued that the low price offered by Elf for Cofibel (and hence the price publicly offered by SPEP for the remaining Cofibel shares) was, in fact, part of a deal to compensate Elf for the FRF 140 rise in the price of the 9.2% block of SPEP shares. 24 Not surprisingly, the discriminatory outcome of takeovers in EU countries is a matter of concern for the supervising authorities. 25 It is straightforward to show that discriminatory arrangements made after public bidding are useless (Appendix 3). In terms of modelling, a discriminatory arrangement therefore requires that a bargaining stage be added before bidding so that B and C have the opportunity to pre-contract and collude during the bidding stage. One can then use arguments similar to Section 4 to conclude that, when the number of bidding and bargaining stages is endogenized and side payments are allowed, it is sufficient to consider the truncated game bargaining + bidding + bargaining. In principle B and C could agree to set the stage-l public offer price as low as the no-free-riding hurdle, S, + 1, and somehow split the gain. This suggests that, in the interest of B and C, a pre-negotiated deal should be the predominant type of takeover, and that it should lead to substantially lower takeover prices than non-discriminatory buyouts. Conversely, the issue is why takeovers are ever of the non-discriminatory type. We shall argue that such conspiracies are not always possible.

-z----Legally

the payment of side benefits to C is not allowed either. In practice it is very hard to find out about such a payment, especially if it takes the form of some business contract. 24 Financieel Economische Tijd (1993). 25 See for example Financieel Economische Tijd (1991d).

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P. Sercu, C. Van HuNe/ Journal of Banking & Finance 19 (1995) I1 -44

One force that limits the potential for ripping off the small shareholders is the arrival of a (potential) competing bidder who may upset a discriminatory deal. As argued before, if B and C’s joint offer to the public is below the (time value adjusted) price a third bidder can obtain in subsequent negotiated takeover with B, this third bidder will bid up the price. Thus, competition protects the third shareholders. One way for B and C to prevent this is inviting the potential outside bidders to join the conspiracy. We shall discuss this below. Another aspect is that there is scope for a pre-negotiated deal iff p * > S, + 1. To see this, recall that the non-discriminatory solution p * is the time-0 bid price obtained by correcting the explicit, non-discriminatory negotiations price p,,, for time value. If p * is below S, + 1, the only possible price that attracts the third shareholders is S, + 1, and collusion between B and C cannot help to lower the price. To simplify the discussion, assume that R is small, so that p* is close to p,,. Then there is scope for pre-negotiation if p,, > S, + 1. Whether this is true depends on the bargaining strengths, and the values obtained by the rivals. - Suppose there are equal bargaining strengths, and sufficient private benefits for B for p,, to exceed S,. Then p,,, = V, + (V, - Vc)/2, and there is scope for pre-negotiation if

va- v,

P,e = Vc + ~>s,+l=v,-z,+1 2 that is, if

ZB’

vE3 - v,

p-1

2 Thus, with equal bargaining strengths and negligible time value there is scope for pre-negotiation only if B’s private benefits are at least half of the value gain. - The second force that leads to pne I S, (and thus to no discriminatory takeovers) is a low “bargaining strength” for C relative to B. For example, C may lack the financial strength to make the threat of a counterbid credible, or may be under pressure by its banks to swiftly finish a negotiated takeover. Conversely, discriminatory deals are more likely if C has a strong bargaining position and if B can extract a substantial part of the value gain. Proposition 4: Pre-negotiated takeovers lead to lower prices than buyouts starting with a bidding contest. when B expects important benefits of control and C can credibly threaten with a counterbid, the contestants have a strong incentive to engage in a pre-negotiated deal. 6.2. Roles of shareholder

syndicates

in discriminatory

games

We have described syndicate contracts in Section 4.3, and discussed their roles in non-discriminatory games. One additional role for a syndicate contract is that it facilitates discriminatory deals. The contract ensures that all large shareholders automatically participate in takeover talks. This is important, as major sharehold-

P. Sercu, C. Van Hulle /Journal

of Banking & Finance 19 (1995) I I-44

31

ers are potential bidders. Thus, setting up a syndicate reduces the chance of a disgruntled co-owner upsetting a discriminatory agreement. One example is a Belgian syndicate contract, signed in 1989 and aptly nicknamed the “Energy-Yalta’, imposing a standstill on the major shareholders’s stakes in Petrofina (an oil company) and Tractebel (an electric power holding-company). 26 Thus, the contract bars any large shareholder from making a bid without the consent of the others. Another well-publicized example illustrating the role of syndicates in facilitating discriminatory deals is the case of Wagons-Lits, a services firm incorporated in Belgium but dominated by French shareholders. Early 1992, a dissatisfied minority owner Sodexho was left out of a pre-agreement and upset the discriminatory takeover of Wagon-Lits by Actor, a large hotel company. Sodexho convinced the Brussels commercial court that to compensate for the advantages other large shareholders received through separate contracts, it should be paid BEF 12,500 BF rather the BEF 8,650 public offer price agreed upon by Wagon-Lit’s other large shareholders. This type of quarrel is precisely what syndicate contracts intend to avoid. A similar quarrel arose during the 1992 fight between Swiss Nestle and the Italian Agnelli-family for control over Exor, a French food holding-company that controls e.g. Perrier. The press interpreted the help of Compagnie de Suez to Nestle as the action of a dissatisfied minority owner wishing to maximise the price for its 10% minority stake in Exor. 27 Syndicates may also be used to stave off hostile bids and reorganizations by outsiders: C can simply invite the bidder B to join the board and share in the existing private benefits. This is possible if the leak of benefits to the minority shareholders in case of a public bid is important, and if C can extract more private benefits than B. Formally, B will agree to accept a fraction @ of C’s private benefits rather than starting a public bid at pn if VI3 - (I - ‘YF3)P” < ‘y&J + M, while C prefers to share the benefits with B if ‘YcPn
(7) (8) using V, = S, + Z,, we find

(P,-~c)(~-~,-~c)>Va-Vc (91 The LHS is the capital gain paid out to the small shareholders if B bids for the shares. If B and C, taken together, do not hold a lot of shares, and C has ample private benefits, the leakage may exceed the total value gain, and it is in B and C’s

26

The contract specifies that the two largest Belgian holdings, i.e. G.B.L. and Socidtt GMrale, may each own 26% and 39%, respectively, in Tractebel, and 25% and 12..5%, respectively, in Petrofina. See e.g. Financieel Economische Tijd (1992~). Other examples of pre-contracting are mentioned in Financieel Ekonomische Tijd (1991a), Financieel Economische Tijd (1991b), and Financieel Economische Tijd (1991~). ” Financieel Economische Tijd (1992a).

P. Sercy C. Van Hulle / Journal of Banking &LFinance 19 (I 995) 11-44

32

joint interest not to fight. To show the role of C’s private benefits, consider two possible solutions for pn: - If pn = S, + 1 (that is, B has little scope for exclusion), the condition becomes (S, + 1 -S,)(l

-era

- crc) 7 v, - v,

or zc7z,+((Y,+(Yc)(sa+1-sc)-1

(10)

Recall that p, = S, + 1 corresponds to the case where pre-contracting does not help (Section 6.1). If, in addition, C’s private benefits exceed those of B grossed up with the joint capital gain on the securities, it is not in B and C’s joint interest to buy out the third shareholders at S, + 1 and reorganize the firm. B is better off demanding a slice of C’s benefits. - If, ignoring subtleties about time value etc., p, = V, + (V, - V,)/2, we can rearrange condition (9) as Vu - Vc

Pn = v, + p>>c+

2

VE?- vc 1-+-a,’

or Va - v,

Zc 7

--=-Vu - Vc 1 - (Ya - (Yc 2

vn - V-c 1+ (Ya + (Yc 2

1 - on - ffc

(11)

Recall from Section 6.1 that, in an equal bargaining strength game with negligible time value, Z, 7 (V, - Vc)/2 is necessary to create room for pre-contracting. But if C’s private benefits are sufficiently higher, it is again in B and C’s joint interest not to buy out the third shareholders and reorganize the firm. The RHS of condition (10) or (11) is a positive function of ((~a + a,); so the larger the joint shareholdings, the more C’s private benefits have to exceed B’s to be able to buy off an outside bidder.

7. Implications Our arguments have several (testable) implications. - Contested us uncontested bids. We should observe a low frequency of white knight action in case of a pre-negotiated bid on a target with a syndicate. In the absence of a syndicate contract we should observe a lower frequency of pre-negotiated bidding on firms with a management that cannot credibly threaten with a counterbid defence. Examples are a controlling group that only owns a small fraction of the shares (so that borrowing from commercial banks is difficult), is not a large company, nor part of a group of companies.

P. Sercu, C. Van Hulle / Journal

of Banking & Finance I9 (1995) 11-44

33

- Pre-negotiated versus other takeovers or minority block transfers. The existence of syndicates should increase the frequency of pre-negotiated deals, and could even lead to trading in minority blocks (in which case no public bid is necessary, and the small shareholders do not receive any takeover premium at all). Trading minority blocks is especially interesting (for B and Cl if C can extract much more private benefits than B. ” - The level of the takeover price. If, as we argue, private benefits are shared by way of side-payments to lower the overt takeover price, we should observe higher public offer prices if the minority owner that sells out does not own any other company: in that case it would be harder to pay the incumbent partially in private benefits. Furthermore, apparent overpaying (as evidenced by negative abnormal returns to bidders) should be relatively more frequent if the bidder is a publicly quoted company belonging to a group: then it may be rational to ‘overpay’ if several companies of the group receive control benefits from the acquisition while the small shareholders of the bidder co-pay for the purchase of the target. Finally, factors that affect the bargaining position of the contenders should influence the takeover price, at least as long as no discriminatory deal is struck. Regulatory changes that should increase prices include an increase in the minimal time period a bid should remain open (which facilitates a reaction from competing bidders and improves the incumbent’s implicit bargaining position), or imposing more disclosure regarding the bidder’s intentions (a better knowledge of the bidder’s valuation improves the effectiveness of the white knight threat). Also changes in the financial system, like the emergence of swift junk-bond financing, would drive up prices in not pre-negotiated takeovers (there would be more potential bidders, and the defensive counterbid threat becomes more credible).

8. Conclusions

This paper develops a model of bargaining and bidding in which control contestants freely choose the type of opening stage (bargaining or bidding), the type of ending stage, and the number of stages played. In our setting, the focus is on the conflict of interests between large and small shareholders rather than on the standard management-versus-shareholder agency problem. Private benefits make it possible to successfully offer a price below the total value V,. In such a context, B

*’ Maeijer and Geens (1990) review some legal restrictions bid rather than trading controlling blocks.

that can force bidders to resort to a public

34

P. Sercy

C. Van Hulle / Journal of Banking & Finance I9 (1995) 1 I-44

can always start a bidding war and force C to take private the firm, thus leaving C no choice but to sell out afterwards to the bidder at a price below V,, the takeover price that would have been the outcome of a pure bidding process. Since both players anticipate this, there is no need to play the game explicitly; still, bargaining determines the price at which control changes hands even if no explicit negotiations are observed. As B acquires control at a lower price than in a pure bidding contest, the bidder prefers (possibly implicit) bargaining, and generally emerges with nonzero private benefits of control rather than with just the capital gain on the initial toehold. Due to the possibility of pre-bargaining, discriminatory deals are even more attractive to the bidder than non-discriminatory buyouts. With such discriminatory negotiations, small shareholders receive less than large shareholders. There may not always be scope for such arrangements however: if the target’s management has low bargaining strength (e.g. cannot credibly threaten with a white knight counterbid) and/or if there is little scope for exclusion (a high post bid security value means that a large fraction of the synergy cake is passed on to the third shareholders), a non-discriminatory bid is more likely. Pre-bargaining can also be used to avoid buying out the third shareholders, especially if the incumbent management can obtain more private benefits than the rival. As a final remark, we have assumed away uncertainty and asymmetric information. Yet our bidding + bargaining structure is equally relevant for the takeover literature that stresses uncertainty and asymmetric information. Critical for the present bidding + bargaining structural solution are (i) the existence of a sufficiently large stakeholder who has an incentive to bid up the take over price, (ii) the possibility of bidding and bargaining and (iii) the existence of private benefits, so that bids below Vu become feasible. If these elements are added to, for instance, the model of Fishman (1988), the threat of a white knight counterbid potentially followed by negotiations will also affect the choice of the initial offer price by the first bidder. Similarly, if one adds to Leach (1992)‘s setting substantial private benefits and a large target shareholder, the option to bargain would again become relevant and would lead to a bidding + bargaining game structure.

Acknowledgements The authors thank Dan Kovenock, Barton Lipman, Jerry Hass, Werner De Bondt, Henri Servaes, Christian Rydquist, Arnoud Boot, Kjell Nyborg and other participants at the Athens EFA Conference, the EIASM Finance Workshop at Den Haan, the Catholic University Leuven Finance Workshop, the Western Management Association Conference at Leuven, and the CEPR Summer Institute at Gerzensee, and anonymous referees whose constructive criticisms have substantially improved the paper. All remaining errors are the authors’.

P. Sercu, C. Van Hulle / Journal ofBanking & Finance 19 (1995) 11-44

Appendix 1

Bidding / counterbidding procedures See Figs. 3-5.

B bids 1 C tops B’s bid

I

No counterbid by C I all, except B may tender

I TENDER (lb) I

I

[Al

B does n&revise

B’s bid

I

[Go to nodeA]

C wit&s I

all except B may tender

I TENDER (lb)

not withdraw

I

all except B and C may tender

I TEMlER (lc)

B withdraws

I all except C may tender

I TENDER (IcJ Fig. 3. Bidding/counterbidding procedure.

I

B does not withdraw

I all except B and C may tender

I TENDER (ICI

35

P. Sercu, C. Van Hulle / Journal of Banking & Finance 19 (1995) 11-44

36

tender procedure lb TENDER, everyone observes outcome before closing game

I

outstanding offer

outstanding offer

offer

I hand back the tendered shas

I

tender (lb)

offer

_

I

tender (lb)

I

I

---------------------(new period)

I

END’of new period and bargaining*

I BARGAINING

* If the game is constrained to 1 biddingkounterbiddingstage (as in section 2.2.) followed by one batgaining stage the game simply ends if no bid succeeds and no offer is revised; otherwise it passes into a new period and bargaining.

Fig. 4. Tendering procedure: 1 bidder.

I

P. Sexy

C. Van Hulle /Journal

of Banking & Finance 19 (1995) 11-44

tender procedure lc ns everyone observes outcome before closin game

I

I

Sufficient tendering: one bid succeeds

no bid succeeds

no rev&n outstanding offer

of outstanding offer

tendered shares are handed back

’

..,L+ lowest offer: withdraws, hands the tendered shares

END of new

I

tender (lb)

no contestant withdraws

I

tender (lc)

period and no revision;l

losing party hands back the tendered shares

bargaining*

revision outstanding offer

I

tender (lc) ----------------------(new period)

I

BARGAINING * If the game is constrainedto 1 biddingkounterbiddingstage (as in section2.2.) followed by one bargaining stagethe game simply ends if no bid succeedsand no offer is revised;otherwise it passesinto a new period and bargaining. Fig. 5. Tendering

procedure: 2 bidders.

31

38

P. Sercy C. Van Hulle / Journal of Banking & Finance I9 (1995) I I-44

Appendix 2

Analysis of the bargaining game Suppose the game proceeds into the bargaining stage. This means that C has won the bidding contest and we are situated at time 1 in Fig. 2. B’s and C’s situation can be represented by a Rubinstein game as described in Sutton (1986). As C has won the bidding contest it has bought out all small shareholders; 29 even B may have sold some or all of its shares to C. Let crk denote the fraction of the equity maintained by B throughout the bidding contest. So when negotiations start, B holds (Y; (0 I (~ij < a,), and C holds (1 - (Y;). At the beginning of every period, the value of cash flows obtained by B and C are as shown in Fig. 6. We see that B and C have to distribute a “cake” equal to V, - V,. Denote by m the fraction of the cake V, - V, that C can pocket; that is, by definition (1 - a;>p,, -(V-c - a;&) = m(V, - Vc>. The solution is B immediately offering C a share

(AlI followed by immediate acceptance of C. Hence p,, is equal to 3o 1 Pne = Vc + ___

1 - ar, I

VI3- v, 2+R+4P-c-S,)

I

(Ml

It follows that pne strictly exceeds V,. To prove proposition 1, two cases must be discussed, depending on whether or not the free-riding-bound px 2 S, + 1 is binding. The free-riding bound is not binding B can open the bidding contest with a price that cannot be rationally topped by C; or B can start at a lowish price (albeit 2 S, + 1) and leave C some room to counterbid. We first explore the implications of the latter strategy.

” This follows from the fact that all small shareholders T are atomistic and only pure strategies are considered, Then if tendering is the preferred strategy for some small shareholder, it is preferred by all. We do not consider the case where small shareholders form a coalition and get actively involved in the bargaining. This situation is realistic in Germany, where small shareholders generally deposit their voting proxies with the commercial banks. It is well known that the latter are major players in the market for corporate control (see e.g. Franks and Mayer [1990]). Also the situation described in Pound [1992] presumes active “small” shareholders. 3o Because all small shareholders have sold out, the offer no longer has to be a multiple of a (discrete-scale) price per share.

P. Sercy C. VanHulle/ Journalof Banking& Finance19 (1995) I1 -44

if negotiations fail

if negotiations work

(C stays in control forever)

(C sells out at p&

to c

V, - atB S,

(l - a’,) p,,e

to B

VB

Total

- t1 -

a’B)

39

he

“B

%2

VC

VB

Fig. 6. Values of cash flows obtained by B and C.

In counterbidding, C’s purpose can either be to bid up B’s price to some maximum level before letting B win, or to take over the company and resort to negotiations. We denote by p* the maximum price that C can offer during the bidding contest, in the sense that if C would offer pc 2 p * + 1, it would be more profitable for company B to withdraw and sell the portion ((.w, - ok) of its shares to C. That is, we look for an offer p * by C, which leaves B a positive but minimal incentive to come back with pB = p * + 1 rather than to sell out at pc = p * ). This critical price level p* is the largest integer satisfying VB + d&R (ffn-

4)P’

+

-

p,,(

1 - @Z)

l+R

I v, - (1 - (Yn)( p* + 1)

or v, - cw&

1

1 - ffu

- 1-

1 _ a, B

ff’B

(A41

The right hand side of (A31 shows the net value of company B’s position if it buys out the other shareholders at p * -I- 1; the left hand side shows the proceeds of B’s possible partial sale at pc =p * , plus the discounted value of taking over the company later (at p,) after cashing in the next dividend on the retained shares. Since p * is the largest integer satisfying (A4), the solution is 1

p* =INT

( [ 1+R

1

-

Lyi Pne +R v, 1 - “#c

CX’B I -- 1 --cya 1

(A9

As will become clear later on, B takes over the company at p * . So it is in B’s interest to choose an c& that minimizes p*. The argument inside the INT(.) operator (including the part p,,) is a positive function of c&. Hence the optimal ff;3 is zero, implying P ‘=INT

“-,‘,T

-(l-aB))withp”c=Vc+s

(Ah)

40

P. Sercq C. VanHulle/Jourml ofBanking& Finance19 (1995) 11-44

We return to the bidding-counterbidding contest. From the above analysis B already knows that a bid pB = p * will not be topped by C if the intent is to force B’s price further up; indeed, a counterbid pc = p * + 1 would lead to a sell-out by B rather than to a revised bid, which is contrary to C’s assumed purpose. However, C could conceivably make such a counterbid pc =p * + 1 with the objective to take the firm private and then sell out at pn, in negotiations. But this is rational only if the time value on the “cake” is trivial, which is assumed not to be the case. To see this, assume that B offers ps = p *, and compute C’s net gain of selling out to B at this pB = p * (the first term in (A7), below) as compared to taking private the firm at pc = p * + 1 and delivering the entire firm at pne (the bracketed term in (A7)): C’s net gain from selling immediately = cu,p*

-

p-,t+RRv,

-(p*

+1)(1-a,) I

=p*+1-a,-

Pm +

RVC

(w

l+R

or, using (A4) and denoting by r (0 5 I < 1) the term needed to turn the expression in the INT brackets into an integer, = Pm + RVB + (YB - cYc - Pm + RVC l+R l+R -’

= NVEl- v,) l+R

+(cY+-cQ)-r

This will be positive if the time value is non-trivial, i.e. if R(VB - Vc)/(l + R) > 1. 31 From here on it is sim ple to show that: - if B opens with p *, C rationally withdraws; - B is worse off if it opens with another price (e.g. if B opens with p * - 1, C has the opportunity to rationally counterbid and force a price of p * + 1 from B; if B opens with p * + 1, this price is unnecessary expensive). The free-rider

bound is binding

This case occurs when p * is below S, + 1. The best C can do is abstain from any action: the free-rider mechanism forces B to pay out S, + 1, which is more than C could obtain (in terms of present value) by counterbidding, winning the bidding contest and afterwards selling out to B during negotiations, i.e. pB = S, + 1 if p*
31 For lower time values, C will be prepared to go one unit higher than p explicitly negotiate.

l

, take the firm private, and

P. Sercy C. Van Hulle / Journal of Banking & Finance 19 (199.5) 11-44

Appendix

Friendly

41

3

arrangements

after public bidding

We consider a full buyout bidding + bargaining model where B and C try to improve their payoff by letting C keep some of his ownership in the target and by sharing the control benefits. As before, we first consider the explicit version of the game. That is, we assume that B has actually let C acquire control at some uncontested price pc(> S, + 1); B may even have sold part or all of its shares to C. Afterwards there is a modified negotiation round, in which C may keep a stake (r;1 in the company, and where the total value is shared by the two remaining shareholders B and C on the basis of their share holdings. We denote by p,*, the price paid to C for the shares sold during these negotiations. The role of this negotiated price is different from the previous model. Whereas, before, C got pne for all its shares, C’s control is now transferred against a “payment” partly in shares worth V, - not S,, as C shares the private benefits and partly in cash (at p,*,>. On average C receives: +&I%+

(l-&-)P;e=Pa”e

Once B and C are in the negotiations stage, the stakes are as shown in Fig. 7. Now compare these payoffs to the ones in Fig. 6. C can always refuse a discriminatory deal and insist on a full buyout at p,, . That is, C requires pa,, > p,,. B considers a friendly deal only if pa,, p,,) and partly in cash (at p,: < p,,). Since the bargaining outcome is the same, the pre-bargaining bid stage is also unaffected, and (2) still holds.

if negotiations immediately to c

ateVa + (1 - alB-a’c)pne* = hd

to B

Total

work

if negotiations forever

V, -alBSC

1 -a’,)

(1 - a’c)VB

- (1 - a’B - a’&&*

= vB - Pad

1 - “B)

vB

Fig. 7. The stakes in the negotiations

“B

VC

stage.

sC

fail

42

P. Sercy C. Van Hulle / Journal of Banking & Finance 19 (I 995) I I-44

Proposition IA: if after the bidding stage also discriminatory

deals are possible,

no gain is implied to any of the parties.

Appendix 4

Alternative bidding assumptions and partial buyouts Alternative bidding assumptions Several alternative sets are possible. We wish to show that the bidding assumptions that may seem to be the most restrictive are not critical; they are there only to simplify the main arguments. The bidding assumptions that may seem most restrictive are the improvement requirement and the timelessness of the bidding. Denote by l/(1 + Rbid) the discount factor between successive offers; R,, could differ from the rate R for a bargaining round because of a different time length. While some party is drafting a new offer, this party’s previous offer and all competing offers remain outstanding. We replace the improvement requirement by the assumption that in case of a tie the small shareholders tender to C. Also assume that when B (C> is indifferent between bidding and selling out, it opts for bidding. We also drop the integer constraint. Then if the arguments of Section 2 are applied to a bargaining + bidding model, it is easy to show that B immediately offers p = V,/(l + R,,)’ + E with E some arbitrary small positive number. If the time span between successive offers is small (say 1 day), then Rbi, is small and this solution again expresses that in a bargaining + bidding game the bidder basically pays out its valuation V,. In a bidding + bargaining model, a small Rbi, implies a solution close to split-the-difference. Partial buyouts The ‘no panic’ assumption (Section 2.5) guarantees that in a conditional partial buyout small shareholders tender to the bidder with the highest average price. We revert back to the bidding rules of the main text, except for the partial buyout assumption. The control contestants wish to obtain a fraction @ (say 51%) of all shares. By analogy to Appendix 2 we denote by pi the maximal upfront price that C can offer during the bidding contest, in the sense that if C would offer pc up,’ + 1, it would be more profitable for B to withdraw. This critical price level p,* is the largest integer satisfying: @S, +Z, (%3 - cq I m,

.p; + +z,

- (@-

+ c&R

- (CD- a;)~,,,

l+R (YB).(Pp* + 1)

(9

with Ppne the negotiation price in case of a partial buyout. One factor influencing ppne is the existence of a requirement to buy out all shareholders proportionately.

P. Sercy C. Van Hulle / Journal of Banking & Finance 19 (1995) II-44

The correspondence between (A8) and (A3) from Appendix 2 is obvious. here on it is easy to redo the arguments of Appendix 2 for partial buyouts.

43

From

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