strategic issues of m & a transactions (takeovers) · strategic issues of m & a...

Strategic Issues of

M & A Transactions (Takeovers)

Preliminary version. Please,don’t cite without permis-sion. May 19, 2002Manfred Jager∗,∗∗, Frauke Schuster

Martin-Luther-University Halle-Wittenberg

Abstract

This essay provides a primer on the economic analysis of takeovers. Itdraws the major attention to theory, however the theme is motivated ina casual style in the first section. This section shows that takeovers haveattracted a huge interest of the general public and this interest is far frombeing calm. In the second section we describe the setup, introduce somebasic terminology and provide an empirical synopsis. Section 3 discussestender offers of one bidder whereas section 4 considers takeover auctions.Section 5 sketches topics that are not extensively discussed in this paperand section 6 summarizes.

Key Words: Merger, Acquisition, Hostile Takeover, Tender Offer.JEL Classification: G30, G34, G38

∗Corresponding author: Comments are gratefully appreciated: Department of Eco-nomics (Wiwi), Martin-Luther-University Halle-Wittenberg, D-06099 Halle, Germany, Tel.:0049/345/5523323, Fax: 0049/345/5527188, Email: [email protected]. My web-pagehttp://www.mathfred.de provides several links related to corporate governance.∗∗We thank Christian Block, Michael Hopfe, Anja Laue and Ulrike Neyer for comments and

suggestions. The paper was partly written while the corresponding author benefited from ascholarship at the Technical University Vienna granted by the OAD. I thank the OAD forgrants and Gustav Feichtinger for hospitality. The paper is part of a research project financedby the state Sachsen-Anhalt.

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Contents

1 A Starter 31.1 Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31.2 The “Evolution” of the German Takeover Law . . . . . . . . . . 6

2 Context, Terminology & Empirical Synopsis 102.1 The Context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102.2 Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122.3 An Empirical Synopsis . . . . . . . . . . . . . . . . . . . . . . . . 13

3 Tender Offers with a Single Bidder 193.1 The Free-Rider Problem . . . . . . . . . . . . . . . . . . . . . . . 193.2 Dilution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203.3 Cost of Bidding . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213.4 Dilution is Useful . . . . . . . . . . . . . . . . . . . . . . . . . . 213.5 Toehold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223.6 Two Tier Offers . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223.7 Value Decreasing Bids . . . . . . . . . . . . . . . . . . . . . . . . 253.8 Voting and the Market for Corporate Control . . . . . . . . . . . 273.9 Post Takeover Moral Hazard . . . . . . . . . . . . . . . . . . . . 293.10 Asymmetric Information . . . . . . . . . . . . . . . . . . . . . . . 313.11 Private Benefits for the Bidder . . . . . . . . . . . . . . . . . . . 33

4 Multiple Bidders 344.1 Preemptive and Sequential Bidding . . . . . . . . . . . . . . . . . 344.2 Toeholds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 384.3 Strategies of the Target . . . . . . . . . . . . . . . . . . . . . . . 404.4 Efficiency Aspects . . . . . . . . . . . . . . . . . . . . . . . . . . 41

5 Omitted topics 43

6 Summary 45

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1 A Starter

1.1 Motivation

Warning: This section is written to motivate the reader. It uses a casual styleand we do not try to be impartial. It may be perceived as the view of a personwho has collected shapes of a jigsaw puzzle, but who has not yet put the piecestogether. The succeeding sections will try to solve the puzzle.

In February 2000 we saw the finish of the largest hostile takeover so far:Vodafone/Mannesmann. Preceding the termination of about 200 bn. $ dealwe observed a happening that many characterized as a battle. The flood ofad’s was impressive and the combination of the fierce statements in the massmedia, the reaction of angry workers and the comments from high-ranking politi-cians gave the deal an enormous publicity1: The Bild-Zeitung led its front pagewith the headline “Englishman’s knock-out offer. Will greed for money winMannesmann?” A picture in the Financial Times (Nov/20/1999) showed Man-nesmann workers with banners: “Wir pfeifen Gent zuruck!” and “Wir lassenuns nicht verhokern!”. The german chancellor Gerhard Schroder noticed that ahostile bid destroys “the culture” of the target company. That Vodafone’s bidwas a cross country bid gave it a further nuance. The fight was quite severeas both parties aggressively advertised for their strategy, sometimes – as theBorsensachverstandigenkommission argues – ignoring objectivity.2 This spe-cial transaction has intensified the discussion about hostile takeovers, corporategovernance and especially about the necessity of a german takeover code.

At least one takeover battle – the auction of RJR Nabisco in 1989 – was soexciting that it provided the stuff for a movie and a bestseller (see Burrough andHelyar (1990)). Until the mid 90’s this 25 bn. $ Leveraged Buy Out was thelargest hostile takeover. It attracted fierce comments and for many it was andis a perfect example for the ugly face of capitalism where greed and envy seemto play a major role. Burrough and Helyar (1990, 400ff.) provide an impressionof public perception. A cartoon shows the chart of the share price of RJRNabisco with a picture of CEO Ross Johnson accompanied by the sentence: “Itall started with a small lemonade stand in Manitoba. The next thing I knewI had sold my mother. The rest was easy.” The magazine TIME had a coverwith a picture of Ross Johnson and the headline was: “A Game of Greed.”

1Financial Times (Nov/20/1999).2The statement of the Takeover commission is available via Internet (www.kodex.de, click

on New/Aktuelles). Hopner and Jackson (2001) offer an extensive case study of the Vodafone-Mannesmann takeover.

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The “legend” of Jay Gould is the most extreme case of public hate of hostileraids. Maury Klein has collected plenty of insults, where the following is arepresentative example.

Gould was impeached as one of the most audacious and successful caneersof modern times. Without doubt he was so; a freebooter who, if he couldnot appropriate millions, would filch thousands; a pitiless human carni-vore, glutting on the blood of his numberless victims; a gambler destituteof the usual gambler’s code of fairness in abiding by the rules; an incar-nate fiend of a Machiavelli in his calculations, his schemes and ambushes,his plots are counterplots.

Gustavus Myers (1909) cited inMaury Klein (1986, page 1)

Obviously, hostile takeovers are a disputed subject. The language alone soundsexciting: There exists a pacman defence. A white knight may help against thebarbarians at the gate. You have to mind poison pills. Maybe the threatenedmanagement can use a sharp-repellent device in the company’s charter to defendthemselves against the mercenaries. In the case of a defeat, the managementcan enjoy golden parachutes.3

Hostile takeover bids aren’t new phenomena. For instance in 1953 CharlesClore bid for J. Sears & Co and “had thrown a large stone into calm watersand sent many ripples through the boardrooms across the country, ...” (seeLittlewood (1998, 86)). The government came to the aid of the target with the(curious?) argument: “takeover bids lead to encouragement of higher dividends,dissipation and abandonment of conservative financial policies” (see Littlewood(1998, 86)). The description of these early hostile bids, especially the reactionof the affected management and the reception of the general public, combinedwith the analysis of managerial mis-behavior – e.g. slack – is very similar toreports of contemporary takeovers (Compare Littlewood (1998) and Burroughand Helyar (1990)).

Obviously – the language indicates this observation – a hostile takeoveris not a harmonic meeting of CEOs discussing their joint strategy. Yet thisunfriendly environment is not necessarily a disadvantage. Some argue that the(threat of) a hostile takeover is an important tool of corporate governance. TheEconomist asserts: “Vodafone’s hostile, and successful, bid for Mannesmannis the biggest and most visible example of the growth of shareholder powerthat promises to remake European capitalism” (The Economist Feb/12/2000).

3All these terms are explained in Brealey and Myers (2000, 959 – 963). Herzel and Shepro(1992) provide interesting comments on the language of takeovers.

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Other commentators assume (or hope) that the success of this bid was a majorstep away from the so called Deutschland AG (Financial Times DeutschlandFeb/20/2000) or more concise: “Rheinish finished” (Economist Feb/20/2000).

Some observers are more sceptical. For example Charkham comments: “Torequire a take-over to change a CEO is like needing a revolution or foreignconquest to change a government.” Several sound and even more unsound ar-guments can be found. Jensen and Chew (1998) remark that they know “ofno area in economics today where the divergence between popular belief andthe evidence from scholarly research is so great”. To get an impression of thesound arguments we sketch some. Firstly, a supposed gain for the shareholdersmay not necessarily be the result of the removal of a misbehaving management,the consequence of economies of scale or synergies but the exploitation of otherstakeholders (the tax authority, the bond holders, the customers, the employ-ees) and actually “breach of trust” (Shleifer and Summers (1988)). Secondly,the threat of a takeover may induce managerial myopia (Stein (1988)). Thirdly,a takeover may be the result of an agency problem of the bidder rather thanan attempt to solve one of the target (Jensen (1986 [1998])). And fourthly, thedevice “takeover” may be redundant if the competition in the output market issufficiently severe to erase managerial slack (Allen and Gale (2000)).

Another reason for skepticism is hubris. A very often cited statement4 ofWarren Buffet makes the point crystal clear.5

Many managements apparently were overexposed in impressionable child-hood years to the story in which the imprisoned handsome prince is re-leased from a toad’s body by a kiss from a beautiful princess. Conse-quently, they are certain their managerial kiss will do wonders for theprofitability of the Company T[arget] ... Investors can always buy toadsat the going price for toads. If investors instead bankroll princesses whowish to pay double for the right to kiss the toad, those kisses had betterpack some real dynamite. We’ve observed many kisses but very few mira-cles. Nevertheless, many managerial princesses remain serenely confidentabout the future potency of their kisses – even after their corporate back-yards are knee–deep in unresponsive toads ...

We have tried occasionally to buy toads at bargain prices with resultsthat have been chronicled in past reports. Clearly our kisses fell flat. Wehave done well with a couple of princes – but they were princes when pur-chased. At least our kisses didn’t turn them into toads. And, finally, wehave occasionally been quite successful in purchasing fractional interestsin easily identifiable princes at toadlike prices.

Warren Buffet (1981) cited inWeston et. al. (2001, page 5)

4For instance in Brealey and Myers (2000, page 946), Foster (1983) and Weston et. al.(2001).

5A scientific foundation for hubris of bidders was presented by Richard Roll (1986).

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We hope that these brief remarks awake curiosity. Takeovers are an excitingsubject. Before entering the scientific part of the paper we discuss some currentaspects of the takeover regulation in Europe and specifically Germany.

1.2 The “Evolution” of the German Takeover Law

Triggered by the takeover of Mannesmann a discussion of a takeover law tookplace. Indeed, Germany had until recently no law regulating takeovers. The onlyregulatory device was a voluntary takeover code (the Kodex6). However – asthe commission responsable for the Kodex conceded – this voluntary institutionfailed due to an insufficient participation (e.g. Loehr (1999)). For exampleBMW, VW and VIAG did not subscribe the Kodex (Picot (2000, 143)). Onlyabout 73 % of the corporation registered at the stock market have acceptedthe Kodex (Loehr (1999, 159)). Additionally, the sanctions laid down in theKodex for breaking a rule are not severe. It is curios that a nation that dislikeshostility in economic transactions – the Rheinish model – did not have atakeover law. The absence of a takeover code had significant influence on theconduct of the three hostile bids that took place before Vodafone-Mannesmann.7

Whereas the latter transaction seems to be essentially in accordance with fairrules of conduct, the three older bids must be considered as very critical (Franksand Mayer (1998)). Especially the minority shareholders were not treated inaccordance with e.g. the Kodex or the City Code. Meanwhile the germangovernment has enacted a takeover law.8

The evolution of this law is exciting. It demonstrates the effectiveness ofthe lobbyism. The first proposal of the ministry of finance was published viaInternet in June 2000. This proposal and its successor in March 2001 were veryclose to the kodex and the City Code, especially concerning the neutrality ofthe management of the target. Furthermore the law was in accordance with theproposal of the EU commission (EU Proposal)9. Thus, all signs indicated thatGermany would have a takeover law and more or less simultaneously Europe adirective. Consider the following citation from the comment to the March 2001proposal of the German ministry of public finance.10

6The code and information about it as well as general comments can be found on the webpage www.kodex.de.

7Flick ↪→ Feldmuhle Nobel, Krupp ↪→ Hoesch and Pirelli ↪→ Continetal (Franks and Mayer(1998, pages 645 – 652)).

8See references.9Monti (2000) discusses this proposal.

10We chose to give the original German version of the text to provide unbiased evidence.A translation is available on the web page www.finomix.de. Meanwhile, the old proposals areno longer available via Internet but upon request from the corresponding author.

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6. Verhalten des Vorstands und des Aufsichtsrats der Zielge-sellschaft und Abwehrmaßnahmen

Durch die gesetzlichen Regelungen soll den Empfangern eines Ubernahme-angebots, d.h. den Aktionaren, ermoglicht werden, in voller Kenntnisder Sachlage eigenstandig uber ein Ubernahmeangebot zu entscheiden.Diese Entscheidungsfreiheit wurde eingeschrankt, wenn der Vorstand oderder Aufsichtsrat der Zielgesellschaft ohne weiteres durch eigenstandigeEntscheidungen den Erfolg eines Ubernahmeangebots durch Abwehrmaß-nahmen vereiteln konnten. Der Vorstand und der Aufsichtsrat der Zielge-sellschaft werden daher in Ubereinstimmung mit den Vorgaben der Uber-nahmerichtlinie dazu verpflichtet, grundsatzlich wahrend des Ubernahme-angebots Handlungen zu unterlassen, die geeignet sind, den Erfolg desUbernahmeangebots zu verhindern.

Vorstand und Aufsichtsrat der Zielgesellschaft sind jedoch nicht wehrlos;sie konnen vielmehr unter bestimmten Voraussetzungen auch aktiv beider Abwehr eines Bieters tatig werden. Erlaubt ist zum einen die Suchenach einem konkurrierenden Ubernahmeangebot (”white knight”). Hier-durch wird Vorstand und Aufsichtsrat ermoglicht, durch Einbeziehungeines weiteren Bewerbers im Interesse aller Aktionare fur moglichst at-traktive Angebotskonditionen zu sorgen.

Zulassig sind ferner samtliche Handlungen, die auf Grund eines Beschlussesder Hauptversammlung der Zielgesellschaft erfolgen, der nach Veroffent-lichung der Angebotsunterlage des Bieters getroffen wurde. In diesem Fallbasiert das Handeln auf einer Entscheidung der Aktionare der Gesellschaft,die diese Entscheidung eigenstandig vor dem Hintergrund der konkretenUbernahme getroffen haben. Durch verkurzte Ladungsfristen, eine freieWahl des Versammlungsortes und die gleichzeitige Festlegung einer An-nahmefrist von zehn Wochen fur Ubernahmeangebote bei Einberufungentsprechender Hauptversammlungen wird in diesen Fallen die Durch-fuhrung entsprechender Abwehrmaßnahmen ermoglicht.

Zulassig ist daruber hinaus auch die Ausgabe von Aktien unter Wahrungdes Bezugsrechts der Aktionare, sofern der zugrunde liegende Beschlussder Hauptversammlung der Zielgesellschaft nicht fruher als 18 Monate vorVeroffentlichung der Angebotsunterlage erfolgt ist.

March Proposal of the Ministry of Finance

This proposal demands strict neutrality of the target’s management, but allowsdefence measures contingent on a corresponding decision of the shareholder as-sembly held after the takeover bid arrived. This is in accordance with the(meanwhile failed) EU Directive Proposal, which forbids a decision about de-fence of the shareholder assembly in advance of a bid (Monti (1999, page 25)).However, by vehement lobbyism of the trade unions, managers and the BDI thegerman government obviously went weak on the knees. The July proposal offersthe target’s management more defence weapons. The corresponding part of thenew proposal reads as follows:

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6. Handlungen des Vorstands und Aufsichtsrats der Zielge-sellschaft wahrend des Angebotsverfahrens

Durch die gesetzlichen Regelungen soll den Adressaten eines Ubernahme-angebots, d.h. den Aktionaren, ermoglicht werden, in Kenntnis der Sach-lage eigenstandig uber das Ubernahmeangebot zu entscheiden. DieseEntscheidungsfreiheit wurde eingeschrankt, wenn Vorstand oder Aufsichts-rat der Zielgesellschaft ohne weiteres durch eigenstandige Entscheidungenden Erfolg eines Ubernahmeangebots verhindern konnten. Vorstand undAufsichtsrat der Zielgesellschaft bedurfen daher fur Handlungen, durchdie der Erfolg des Angebots verhindert werden konnte, grundsatzlich einerErmachtigung der Hauptversammlung. Dies gilt jedoch nicht fur solcheHandlungen, die auch ein ordentlicher und gewissenhafter Geschaftsleitereiner Gesellschaft vorgenommen hatte, die nicht von einem Ubernahme-angebot betroffen ist. Hierdurch wird sichergestellt, dass die Zielgesell-schaft wahrend des Angebots nicht unangemessen in ihrer Geschaftsta-tigkeit behindert wird. Die Suche nach einem konkurrierenden Angebotbedarf ebenfalls keiner Ermachtigung der Hauptversammlung.

Die Hauptversammlung kann den Vorstand zur Durchfuhrung von Ab-wehrmaßnahmen ermachtigen. Erfolgt eine solche Ermachtigung ”aufVorrat”, d.h. ohne dass ein offentliches Angebot vorliegt, gelten auf Grundder sehr weitgehenden Folgen besondere Erfordernisse. Zum einen sind”Blankettermachtigungen” unzulassig. Zum anderen bedarf der Beschlusseiner Mehrheit von des bei der Beschlussfassung vertretenen Grundkap-itals. Die Ermachtigung kann fur hochstens 18 Monate erteilt werden.Handlungen des Vorstands auf Grund der auf Vorrat erteilten Ermachtig-ung bedurfen stets der Zustimmung des Aufsichtsrats.

July proposal of the Ministry of Finance

The major change is the possibility of a “Vorratsbeschluss”, which gives thetarget management considerably more freedom to defend.11 However at the topof all is the actual law. Paragraph 33 states

x33 Handlungen des Vorstands der Zielgesellschaft

(1) Nach Veroffentlichung der Entscheidung zur Abgabe eines Angebotsbis zur Veroffentlichung des Ergebnisses nach 23 Abs. 1 Satz 1 Nr. 2 darfder Vorstand der Zielgesellschaft keine Handlungen vornehmen, durch dieder Erfolg des Angebots verhindert werden konnte. Dies gilt nicht furHandlungen, die auch ein ordentlicher und gewissenhafter Geschaftsleitereiner Gesellschaft, die nicht von einem Ubernahmeangebot betroffen ist,vorgenommen hatte, fur die Suche nach einem konkurrierenden Angebotsowie fur Handlungen, denen der Aufsichtsrat der Zielgesellschaft zuges-timmt hat.

(2) Ermachtigt die Hauptversammlung den Vorstand vor dem in Ab-satz 1 Satz 1 genannten Zeitraum zur Vornahme von Handlungen, diein die Zustandigkeit der Hauptversammlung fallen, um den Erfolg vonUbernahmeangeboten zu verhindern, sind diese Handlungen in der Ermach-tigung der Art nach zu bestimmen. Die Ermachtigung kann fur hochstens

11The word “Vorratsbeschluss” does not appear anywhere in the March Proposal.

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18 Monate erteilt werden. Der Beschluss der Hauptversammlung bedarfeiner Mehrheit, die mindestens drei Viertel des bei der Beschlussfassungvertretenen Grundkapitals umfasst; die Satzung kann eine großere Kapi-talmehrheit und weitere Erfordernisse bestimmen. Handlungen des Vor-stands auf Grund einer Ermachtigung nach Satz 1 bedurfen der Zustim-mung des Aufsichtsrats.

Gesetz zur Regelung von offentlichen Angeboten zum Erwerb vonWertpapieren und Unternehmensubernahmen

This law gives the target’s managers considerable leeway if they obtain thesupervisory board’s approval. Since often the supervisory board restrains theactivities of the management only marginally, this amounts to a complete ab-sence of the duty of neutrality.

Parallel to the “weakening of the standards” in the German law proposals theGerman opposition against the EU directive got stronger. Eventually the EUproposal failed in July 2001 after twelve years of preparation and presumablyGermany played an important role. In 2000 it seemed that the passing of thedirective depended only on the “marginal” question of the status of Gibraltar.But in spring 2001 the climate changed. The opponents argued that the dutyof neutrality of the target management generated a disadvantage for Germancorporations. They pointed to the fact that German corporations do not havecertain weapons at their disposal that other European corporations – especiallyFrench – have; viz Hochststimmrechte and golden shares. For the time beingthere is a standstill on the EU level.

A major aspect of a EU Regulation is the degree of freedom it leaves forthe member countries. If one interprets the principle of subsidiarity very far,then a regulatory competition may evolve. Loosely speaking the subsidiaryprinciple makes the competition between legislators the rule and harmonizationthe exception. The American conditions shed light on this subject. In the USthe federal states have some freedom with respect to corporate law and thereexists a well developed discussion about this aspect, the so called “incorporationdebate” (Easterbrook and Fischel (1992, chapter 8), Romano (1985, 2001)),Bebchuk and Farrell (2001), Daines (2001). Two theses have crystalized: “Raceto the bottom” vs. “Race to the top”. May the best rule win!

Race to the bottom This theory claims that the preferences of the managerdecide about the place of incorporation and that the interest of sharehold-ers will be ignored. Therefore the place with the most manager friendlylaw will attract corporations. In the end there will be a race to the worstlaw for the shareholders.

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Race to the top This theory claims that the law that offers good conditionsfor shareholders has a competitive advantage since the costs of capital arelower under this law.12 Places with more shareholder attractive law willattract more capital. In the end the competition in the capital marketswill trigger an efficient law.

The importance of the debate is underlined by the Centrus verdict (Heine andKerber (2000)). This verdict strengthens the permissiveness within Europeby ruling that a corporation mainly acting in one country may incorporate inaccordance with the law of another European nation.

2 Context, Terminology & Empirical Synopsis

2.1 The Context

This essay is a primer on takeovers. It will draw the major attention to the-oretical analysis (models) rather than to empirical findings and institutionalaspects.13 This section will describe the “context” of hostile bids and takeovers.It will provide a common motto and the next subsection introduces terminology.

To analyse the takeover process as such we need to clarify the economicand legal environment of the transaction. We need to name and characterizethe players, define their strategies as well as the informational assumptions ofthe game. Weston et. al. (2001, page 137) give a table with 25 variables inmodels of takeovers. Additionally, to analyse the function of takeovers – e.g. asa corporate governance device – we have to embed the takeover process in theoverall economy. Well, given this enormous degree of freedom, it is obvious thatthere is a host of possible theoretical approaches. These approaches highlightsome specific aspects and ignore others. Due to this heterogeneity an essay ontakeover is at risk to be heterogeneous and look like a collection of singularresults, i.e. a rag rug.

We will try to avoid a totally disconnected picture by interpreting – fol-12“Moreover, rational corporations would not incorporate in a state that provided no pro-

tection to creditors or shareholders. For if they did they would have to pay very high interestrates to creditors (or else have to agree in their loan agreements to elaborate protective pro-visions), and they would find it difficult to interest investors in their shares” Posner (1998,458).

13Weston et. al. (2001) deliver an extensive textbook treatment, that is complementary tothis essay as it merely briefly discusses models. A survey not short of models is Hirshleifer(1995). De Matos (2001) discusses some basic models.

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lowing Jensen (1986 [1998]) – hostile takeovers as an aspect of the manageriallabor market. Under this common motto the specific aspects are related toeach other. The idea of this interpretation of hostile takeovers runs as follows:Shareholders as the principles of the corporation delegate the right to managethe businesses. The incumbent management team constitutes the agent of thisrelationship. However the specific management team is no datum, but open tocompetition from other management teams or professional restructuring com-panies14. A hostile takeover is expression of this aspect of the managerial labormarket (Jensen (1986 [1998], page 353)). We formulate the situation within theframework of the standard Principal-Agent terminology, however opportunisticbehavior is no necessary ingredient of the later analysis. Even if managers donot behave opportunistically, their jobs are and should be objects of competitionand of efficiency considerations.

Even though not a necessary component of the job market of managers theiropportunistic behavior has received a large degree of interest. Many commen-tators view the market for corporate control, i.e. competition for the right tomanage the assets of the corporation, as a major device of corporate governance.The aspect that received the major attention is the problem arising from thedelegation relation between the shareholders and the management, where it isassumed that the management should strive exclusively to carry out the will ofthe shareholders (Fama and Jensen (1983a, b), Shleifer and Vishny (1997)). Theproblem that results from the separation of day-to-day decisions from ownershipwas already recognized by Adam Smith:

The directors of such companies, however, being the managers rather ofother people’s money than of their own, it cannot well be expected, thatthey should watch over it with the same anxious vigilance with which thepartners in a private copartnery frequently watch over their own.

Adam Smith (1776, 700)

Berle and Means (1932) extensively studied the problem highlighting the ratio-nal passivity of the shareholder:

... investors with small holdings or who hold stocks for a very short periodand face low transactions costs for getting out of a position have very littleincentive to learn about the business they invest in or to monitor the

14The ”repair shops of capitalism“ (Baker and Smith (1998, page 204)). These reconstruc-tion firms “buy, fix and sell” corporations and are paid for this restruction service. The mostfamous example is the LBO firm Kohlberg, Kravis and Roberts. Usually their encounter witha company starts with an enormous redesign of the incentive structure and eventually thefirm is deliberated into the market. Concerning KKR it is necessary to note that they avoidhostility. Their preferred strategy are MBOs. Baker and Smith (1998) extensively documentthe strategy of KKR.

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operational and business performance of the companies’ executives. Fromthe narrow point of view of any one investor, liquidity is good becauseit gives investor options and thus reduces that investor’s risk. But, thisargument continues, liquidity for individual investors may not be good forthe economy as a whole because investors, in general, are less likely to beknowledgeable about or committed to specific investments.

Blair (1995, 136)

Manne (1965) introduced the idea that hostile takeovers – or the threat of them– could work as a check of the opportunistic behavior. The raiders, the argumentgoes, are fighting on behalf of the shareholders for a higher shareholder value.This intention e.g. was explicitly offered by T. B. Pickens, when he tried to raidGulf Oil Co.: “I am fighting as an investor to create value for Gulf shareholders,and I am shocked at the hostile reaction from Gulf” (T.B.Pickens (1983) citedin Blair (1995, p.102)).

2.2 Terminology

Finally, before discussing specific issues several terms will be introduced. Amerger is a transaction where two firms become one. An acquisition is thepurchase of a firm by another firm, an individual or a group of individuals.Here a purchase of a firm should be understood as achieving the control ofthe target, e.g. through a controlling fraction of all votes. Both, mergers andacquisitions, are takeovers. Takeovers may be friendly or hostile. A takeover ishostile if – at least at the beginning – the management of the target opposesthe transaction. A hostile takeover is typically connected with a tender offerdirectly addressed to the shareholders without consent of the board(s).

A tender offer may be restricted or unrestricted and conditional or uncondi-tional. A conditional tender offer isn’t binding unless a pre-specified number ofshares is actually tendered. When the offer is unrestricted then the bidder will– maybe contingent on the success of the bid – buy all shares that are tendered.

The legal environment plays a crucial role since it determines the strategiesthat are permitted. We will discuss only a few legal aspects without presuminga specific regulation; a more extensive treatment is e.g. given in von Rosenand Seifert (1999) and Burkart (1999). It may be stipulated that the bidderhas to offer the same condition to all shareholders. This rule is called theEqual Opportunity Rule. In the case of oversubscription a pro rata allocationis usually used. Alternatively the bidder may have the right to offer everyshareholder specific conditions. This rule is called the Market Rule. The FairPrice Rule regulates the price paid in a follow-up merger. This rule restrains

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two-tiered offers by enforcing that the price of the second tier is equal to the firsttier price. Another regulation which is likely to be an element of European lawsis the so called Mandatory Bid Rule (Monti (1999)). This rule stipulates thatafter obtaining control the bidder has to offer a fair parachute for the minorityshareholders. Law regulates the conditions of this offer as well as it defines, whena control change happens. Usually the price is related to relatively recent shareprices. Note, that these regulations consider the targets in need of protection;especially their minority shareholders. This is a puzzle since empirical evidence(e.g. Jensen and Ruback (1983)) indicates that shareholders of the bidder aremore likely to be in need of protection.15

2.3 An Empirical Synopsis

The empirical studies usually use event studies to measure the effects of tenderoffers.16 The date of the announcement is designated as day 0. The purpose ofthe event study is to capture the effect of the event (e.g. tender offer) on thestock price. The consequence of the tender offer is measured by the abnormalcumulative return to be explained now. In a first step an event window isdefined, e.g. 40 days before and after the event. In the second step a normalreturn Rn

jt at time t for all firms j in the sample is estimated.17 Next the residualrjt = Rjt − Rn

jt is calculated, where Rjt denotes the actual return of firm j at

time t. Since individual datas are very “noisy” the average ARt =P

j rjt

N isusually taken, where N denotes the number of firms in the sample. Finally weobtain the cumulative abnormal return (CAR) as a measure of the effect of theevent:

CAR =40∑

t=−40

ARt.

There exists a host of empirical studies that demand an extra survey. Jensenand Ruback (1983) summarize 13 empirical studies and they suggest some styl-ized facts. The most “famous” stylized fact is that in tender offers target’sshareholders earn excess returns of 30 % on average while the bidder’s earn only4 % (Jensen and Ruback (1983, 7)).

15Admittedly the minority shareholders of the targets Feldmuhle Nobel and Krupp neededprotection (Franks and Mayer (1998)).

16For the methodology of event studies see Campbell et al. (1999), MacKinley (1997) orWeston et al. (2001).

17This sounds innocent but it is the most difficult point. The normal return is the returnthe stock would have had in absence of the tender offer. One must rely on a model and anestimate both of which are never unproblematic.

13

Sample Sample Size Runup Markup CAR

All (Main) 1523 13.3 % 10.5 % 23.8 %successful 1174 14.3 % 15.8 % 30.1 %

unsuccessful 349 10.0 % -7.4 % 2.6 %Poison Pill 229 11.9 % 17.6 % 29.5 %Auction 312 12.7 % 18.2 % 30.9 %

No Auction 1211 13.4 % 8.5 % 21.5 %Tender Offer 564 15.6 % 20.1 % 35.6 %

Cash 931 14.1 % 14.2 % 28.3 %Equity 254 9.2 % 7.7 % 16.9 %

A more recent and quite extensive study of takeover premia is Schwert (1996).The above table shows some of his results. It refers to the “Main” sampleof Schwert (1996, 163) and subsamples of this sample. This sample containsmerger and tender offers in the period 1975 - 91. “Runup” denotes the abnormalcumulative return for t = −42 ... − 1 and “Markup” the abnormal cumulativereturn for t = 0 ... min[126, delisting]. There exist several other similar studies,e.g. Bradley et al. (1988) and Jerall et al. (1988). Weston et al. (2001, 199ff)offer a survey.

The results shown in the table demonstrate that the “strategic environment”of the transaction determines the premium. It certainly matters whether thereare several bidders or poison pills (defence weapons explained later). An em-pirical study by Strassburg (2002) analyzes whether the performance of theindustry relative to the market is an explanatory factor of the premium andfinds no evidence. This result is supported by the observations of Andrade etal. (2001, 110) that “premia are fairly similar across different types of mergertransactions”. Thus there is some evidence that the major determinant of thepremia is the strategic environment and not “fundamentals”.

In addition to the analysis of announcement-period event studies there arestudies about long run abnormal returns, e.g. Franks, Harris and Titman (1991)and Loughram and Vijh (1997). Loughram and Vijh distinguish between themode of the acquisition (cash vs. stocks). For stock offers they report large neg-ative and for cash offers large positive returns. However, Andrade et al. (2001,113f.) point to the methodological concerns with these studies and recommendto leave the priors from the announcement-period event studies unaltered.

The empirical studies commented so far relate to the verdict of the capitalmarket. Alternatively one may study the post-merger performance of corpora-tions that were involved in mergers and takeovers. Healy et al. (1992), Raven-scraft and Scherer (1988) and Agrawal et al. (1992) offer such studies. Healy

14

et al. report that merged firms have higher operating cash-flows in comparisonto their industry. They find no evidence that this increase has been achieved atthe expense of long-run viability (measured by capital expenditures and R & Drates). A very important finding of Healy et al. (1992, 156 ff.) is that the after-merger performance is positively correlated with the event returns discussedabove. This result supports the view that event returns on average correctlyforecast future performance.

However there is a high variance in the results of empirical studies of post-merger performance. Ravenscraft and Scherer (1987) for example find deterio-rating operating performance after mergers, where there their sample consistedof 5000 mergers between 1950 and 1975. Results are very sensitive to sampleselection and measurement methodology. For an accurate picture, a rather dif-ferentiated approach is necessary.18 See Weston et al. (2001, 209 f.) and theliterature cited therein.

Merger activity comes in waves. Consider figure 1 and figure 2 showing datafor the US since 1968. In figure 1 the volume of M & As is shown relative to theGNP and in figure 2 relative to the DOW Jones 65 (the level of the last waveis mitigated in this case, presumably stock prices were exaggerated implying an“exaggerated” M & A Volume). The first wave19 ended in the late 60’s, the sec-ond wave took place in the 80’s and the current wave started in 1995 (see figure1). Andrade and Mitchell (1999) report industry clustering of mergers wherethe industry affected varied. A well-known hypothesis is that industries reactvia merger to exogenous shocks (Jensen (1993)). For the 90’s, “deregulation”seems to be the driver of the merger wave (Andrade et al. (2001)). For otherwaves, supply shocks (oil prices) and technical change are the suspects.

Andrade and Mitchell (1999) suggest and test a useful classification. Merg-ers may be triggered by the “necessity” of growth or decline (expansionary vs.consolidating mergers). As noted above, at a certain point of time mergers areconcentrated in certain sectors, since mergers are a device for sectoral adjust-ment. Sectors may be hit by favorable or unfavorable shocks.20 If a sectoris a growth sector then mergers have the role to increase capacity and thesemergers are called expansionary mergers. If the sector needs consolidation thenagain mergers are used – but to downsize aggregate production. Andrade andMitchell empirically demonstrate the usefulness of this characterization. Sup-pose, excess capacity – induces a shock – drives mergers. In this case capacity

18However, a differentiated approach has the disadvantage that it is idiosyncratic.19The first wave shown in the figure is not the first M & A wave in the US. There have been

two earlier waves, viz. around 1900 and in the twenties (Wasserstein (2000)).20Wasserstein (2000) gives an extensive verbal account of the industrial logic behind the

specific takeover waves beginning with the takeover wave of the beginning of this century.

15

utilization in a sector should be negatively related to merger activity in thissector. Andrade and Mitchell show that such a relationship holds for mergeractivity in the mid-70’s and the 80’s and these findings are consistent with thearguments of Jensen (1993). Furthermore, the sign of the relationship betweencapacity utilization and merger activity should invert if merger activities aremainly of the expansionary type. Indeed, Andrade and Mitchell demonstratesuch a relationship for the mergers of the 90’s. However, Andrade et al. (2001,104) remark:

Of course, in the end, knowing that industry shocks can explain a largeportion of merger activity does not really help clarify the mechanism in-volved, which brings us to the issues we know least about: namely, whatare the long-term effects of mergers, and what makes some successful andothers not. Here, empirical economists, and we include ourselves in thisgroup, have had very little to say.

figure 1 about here

16

Figure 1: Volume of M & A per GNP (USA)Data: Mergerstat (M & A), OECD (GNP)

02468

1012141618

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

figure 2 about here

Is the higher Shareholder Value a result of Redistributions?

In the empirical synopsis we claimed that at the bottom line mergers increaseshareholder value. Do shareholders merely profit at the expense of others?Several potential loosers come to mind: Taxpayers, bondholders, customers andworkers.

Taxpayers: The empirical study of Auerbach and Reishus (1988) finds no evi-dence that tax benefits are a significant factor in the M & As they studied. Lehnand Poulsen (1988) find in their sample of LBOs that premiums are dependenton the tax advantage. Jarrell et al. (1988, 56) conclude that even though taxconsiderations had some impact much takeover activity was not motivated bythem (similarly Weston (2001, 149)).

Bondholders: Most studies find no evidence that shareholders benefit at theexpense of bondholders (Asquith and Kim (1986), Denis and McConnell (1986),Weston et al. (2001, 149)). However, for LBOs resulting in a high leveragethere is some evidence of a negative impact for bondholders (McDaniel (1986),Warga and Welch (1993)). But, even for LBOs the evidence is not unanimous.

17

Figure 2: Volume of M & A relative to Dow J. 65 Data: M & A (Mergerstat), Dow Jones Datastream)

0

10

20

30

40

50

196819701972197419761978198019821984198619881990199219941996199820002002

Lehn and Poulsen (1987) study LBOs and find no evidence for the redistributiontheory.

Customers: Maybe mergers increase market power? The findings of Stillman(1983) and Eckbo (1983) are inconsistent with the market power hypothesis.The evidence comes from the analysis of the stock prices of firms that competein product markets with the merging firms. The idea is that the merger leads tohigher concentration which implies higher prices and the competing firms wouldbenefit.

Workers: Maybe shareholders benefit from a breach of contract workers hadwith their pre-merger employer? In a seminal contribution Shleifer and Sum-mers (1988) argued that the bidders after obtaining control of a target cutsalaries to the benefit of the shareholders and at the expense of the employees.Furthermore, they argued that the salary cuts were a breach of trust. The highwages paid before the takeover include payments made for firm specific invest-ment of the employees. Latter had – trusting on implicit contracts – investedin skills that cannot be transferred to other employers. The reduction of pay-ments represented breach of trust. As a consequence if takeovers are taken intoaccount by employees they make implicit contracts impossible and an efficiencyloss results.

This interpretation is however not undisputed. Shleifer and Summers basetheir argument on the takeover of TWA by Icahn where indeed salaries of em-ployees declined substantially (Weston et al. (2001, 150)). Weston et al. (2001,152) suggest two alternative scenarios to the “breach of trust” argument. Inthe first scenario the higher pre-takeover wages resulted from the regulation ofthe airline industry that was removed before the takeover took place. The argu-ment is based on the presumption that in regulated industries workers are ableto press for relatively higher wages and thereby share in the rents existing insuch non-competitive industries. The deregulation triggers more competition,erodes these rents and make wage cuts inevitable – with or without takeovers.In the second scenario suggested by Weston et al. the high pre-takeover salariesresulted from a failure of the old management to bargain efficiently with workers.Therefore the takeover removed this inefficiency, i.e. it performed its paradig-matic role.

18

3 Tender Offers with a Single Bidder

One of the most often cited papers related to hostile takeovers is the paperof Grossman and Hart (1980). They present a free-rider problem that makesinspection of a target and bidding for it a worthless undertaking since onlythe shareholders of the target profit from the presumably costly activity of thebidder. Their analysis is much more extensive then the content of the nextsubsection that deals only with the very basic arguments.In this section wewill assume that there is only one bidder. The case of several bidders will bediscussed later.

3.1 The Free-Rider Problem

The following situation was analysed by Grossman and Hart (1980): A firm– we will call it T for target – currently has a shareholder value of vi pershare (p.s.).21 The current shareholder value is calculated assuming that theincumbent managers run the firm indefinitely. Uncertainty and taxes are notconsidered and a tender offer is not yet expected. Furthermore, we assumethat every shareholder owns only a marginal number of the shares (atomisticshareholder assumption).

An individual or a group of individuals – called B for bidder – know that ifB obtains the control of T, then the shareholder value will be vb > vi per share.B announces a tender offer with an offered price of vo, vi < vo < vb. Specifically,B announces a conditional22 unrestricted tender offer. The offer is binding, ifmore than 50 % of the shares are tendered.

If the bid is successful, i.e. B gets a controlling proportion of the shares, thenall participants gain. Those who sell their shares receive vo p.s., whereas thosewho don’t tender end up with vb p.s. The raiders receive vb − vo per tradedshare.

But, if vo < vb holds, there exists no incentive for the shareholders to tender.The argument is the following: A representative shareholder may either tenderhis shares or keep it. As he owns only a marginal fraction of the shares hisdecision will not influence the probability p, that the bid will be successful.

21The subscripts i, o and b of v abbreviate respectively incumbent, offer and bidder.22Grossman and Hart consider an unconditional bid. For the sake of simplicity, we analyze

a conditional bid. However the major argument is essentially the same. Grossman and Hartdeduce non-existence of an equilibrium. With a conditional bid there exists an equilibrium,but it has unfortunate features (see below).

19

Thus, if he doesn’t tender, his expected pay-off is pvb + (1 − p)vi p.s. whereashis expected gain amounts to pvo + (1 − p)vi p.s. if he tenders. Since vb > vo

the representative shareholder of T won’t tender. Another way to confirm thisproposition is to inspect the following table:

tender don’t tenderbid is successful vo vb

bid is not successful vi vi

Since a shareholder owns only a marginal proportion of the firm’s shares hisdecision does not have any influence on which of the rows of the matrix will bevalid. He deduces that “to tender” is a (weakly) dominated strategy.

If the offered price vo equals vb the bid may be successful. Actually, in thiscase the shareholders of T are indifferent. However in this situation B’s gainfrom the transaction is zero and there exists no strong incentive to bid in thefirst place. Furthermore if there are transaction costs (e.g. for lawyers) notakeover is worthwhile. The problem apparently is a free-rider problem. Thesmall shareholders want to free ride the improvement that B can implement.

3.2 Dilution

Observe that the shareholders lose a lucrative opportunity. Thus they havean incentive to solve the free-rider problem. As Grossman and Hart noted, apossible solution is to write a dilution amendment into the company’s charter:After the successful completion of the transaction the acquiring group has theopportunity to dilute the value of T by the amount φ p.s.

In this case the matrix that describes the alternatives for a representativeshareholder is the following:

tender don’t tenderbid is successful vo vb − φ


If φ is sufficiently large, viz. φ > vb − vo, then “don’t tender” becomes aweakly dominated strategy, all shareholders will tender their shares and receivevo. The bidder anticipates this behavior and offers vo = vb − φ + ε. Theshareholders of T receive vb − φ + ε and the raider gains φ − ε, where ε is a

20

“marginal but noticeable” amount.23 Note that in equilibrium dilution will notbe executed. The threat of dilution triggers the incentive to tender making thedilution execution unnecessary.

3.3 Cost of Bidding

Until now we haven’t considered the costs of undertaking a bid (e.g. the fees forthe investment bankers and the lawyers). Assume that these costs amount to c

p.s. (“per share” relates to all shares and not merely to the shares tendered).To induce a possible raider to attempt a bid and to bear the cost c, the gainhas to be marginally greater than c. Within the dilution-framework we obtainthe condition φ ≥ c (ignoring ε).

Note that larger dilution implies a smaller bid-price and therefore a smallergain for T’s shareholders. Thus – if dilution is a policy variable of the target’sshareholders – they will set the dilution amount φ = c. This gives the raidersmarginally the incentive to bid, since their costs are covered. The sharehold-ers will enjoy a gain of vb − c. One may interpret the result as follows: Thefounders of the corporation have an incentive to induce a third party (the laterbidder) to monitor and probably replace the incumbent management. Atom-istic shareholders neither have the expertise nor the incentive to perform thistask. However, in order to induce the bidder to bear the costs of figuring out atakeover possibility and exercise it, T’s shareholders have to pay for this service.With dilution of φ = c this is achieved. Since in equilibrium the transfer willtake place for a price of vb − c p.s. the bidder earns c p.s. which compensateshim for the costs.

3.4 Dilution is Useful

From this perspective there is a sound reason for a dilution amendment, butthere is no empirical evidence of such explicit devices. On the contrary: “Muchof takeover bid law implicitly assumes that such dilutions are undesirable”(Grossman and Hart (1980, page 46)). However, even if explicit and visibledilution devices are absent, it is possible that all participants anticipate water-ing to take place. With respect to this aspect the legal system plays an essentialrole. Prior to the Kodex there was a quite weak protection for the minorityshareholders of German firms (Franks and Mayer (1998)). Furthermore Johnson

23In what follows we most of the time ignore the ε and write marginally profitable ormarginal incentive.

21

et. al. (2000) argue that tunneling (as an example of dilution) is an acute prob-lem of developing and even of developed countries. Within our framework theoption of tunneling may enable efficient takeovers and cannot be condemned.Of course opportunistic tunneling is an inappropriate instrument.

3.5 Toehold

Another way to profit from a takeover despite the free-rider problem is to acquire– maybe via a stooge – a proportion α ¿ 0.5 of T’s shares secretly. Thereare legal restrictions that regulate the acquisitions of large stakes24 and it isfurthermore difficult to acquire a large stake without notice. Therefore theassumption α ¿ 0.5 (for example 5%) is sensible. If the raider has secretlyacquired a proportion α of T’s shares, he profits from the increase of the shareprice after the announcement of the takeover bid. He can exercise a marginallyprofitable tender offer with a bid price of vo = vb if α (vb−vi) > c. It is implicitlyassumed that the raider acquires the toehold for vi and that the price containsno takeover anticipation premium.

3.6 Two Tier Offers

Yet, another possibility to circumvent the free-rider problem is to make a twotier offer. This runs as follows. The bidders announce that they are going tobuy in the first tier a fraction 50 % of the shares for vo > vi. In the second tierthey are going to pay only w. We assume that the threat of a post takeoverfreeze-out transaction (or something equivalent to it) with a value w for thenon–selling shareholders is credible. The strategic dilemma for T’s shareholdersis described by the following table.

tender don’t tender

bid is successful, γ ≥ 0.5 tender 0.5γ vo + (1− 0.5

γ ) w w


In a pro rata allocation of the first tier, tendering shareholders sell a fraction0.5/γ of their shares for vo. Independent of γ, the weakly dominant strategy isto tender. Without loss of generality we can assume γ = 1.

24In Germany there is a cascade of thresholds: 5%, 10%, 25%, 50%, 75% (WpUG § 21). Ifthe shareholding of a shareholder surpasses one of the thresholds, (s)he has to report to theBundesanstalt fur Finanzdienstleistungsaufsicht (BAFin), which provides this information onthe internet (www.bafin.de).

22

Consider a bid with 0.5 vo + 0.5 w < vi, then the two tier offer induces aprisoners’ dilemma for the shareholders. In equilibrium the shareholders receiveonly 0.5 vo + 0.5 w p.s., which is smaller than vi. If they could, they wouldcoordinate to achieve vi. If w = 0 and vo = vi then the bidder indeed is araider: He tries to obtain the assets that have at least the value vi for approxi-mately 0.5 × vi. He raids the corporation for much less then the current valueby exploiting a strategic dilemma of the shareholders. Shareholders should co-ordinate in order to avoid the unwanted success of the bid, however individuallythey don’t have an incentive to do so. (Fortunately) such a bid will trigger acounter bid (marginally profitable for the bidder)25 with an aggregate value ofvi. The bid is put forward by a third party A who has no intention to changethe policy of the corporation. Therefore they can obtain merely a value of vi.The counter bid is a two tier bid parallel to B’s bid. For the first tier he offersv′o, for the second tier w and it holds vi = 0.5v′o + 0.5w. The strategic situationof a representative shareholder is given by the following table (we consider onlythe case where a successful bid achieves γ = 1).

tender to B tender to A don’t tender

B bid is successful 0.5 vo + 0.5 w w wA bid is successful w 0.5 v′o + 0.5 w wno bid is successful vi vi vi

There are two Nash equilibria, viz. “all tender to B” and “all tender to A”.But the second equilibrium Pareto dominates the first, since 0.5v′o + 0.5w =vi > 0.5 vo + 0.5 w. We assume that in this situation shareholders are able tocoordinate and achieve the second equilibrium. Note that a one tier bid by Awith vo = vi does not work, as we can check from the next table.26


B bid is successful 0.5 vo + 0.5 w w wA bid is successful vi vi vi

bid is not successful vi vi vi

The reason why a one tier offer does not work as a counter offer is that itmisses to destroy the strategic hedge feature of a two tier offer. Reconsider thefirst table in this subsection. The trick of the two tier offer is that “to tender”provides a hedge against being in the second tier. The counteroffer has the samehedge feature but it is better for the shareholders.

25By a white knight, the management itself (MBO) or any third party.26Jensen (1983, page 32) referring to Bradley (1980) claim that a counter bid will appear

without explaining the design of the bid.

23

The reasoning that a one tier counter offer does not work collapses if weassume that the alternative bidder has access to a weak but noticeable dilutiontechnique, i.e. φa = ε. This is documented by the next table.


B bid is successful 0.5 vo + 0.5 w w wA bid is successful vi − ε vi vi − ε

bid is not successful vi vi vi

With this counteroffer the shareholders would tender to A. To summarize, wecan conclude that raiding a corporation by triggering a coordination failure onbehalf of the shareholders is not easy. If you expected to become rich withsuch dirty tricks we have to disappoint you. We can therefore assume that0.5 vo + 0.5 w ≥ vi holds in a two tier offer. Note that A cannot top a bid with0.5 vo + 0.5 w > vi, since his policy generates only vi. We can conclude that atwo tier offer indeed solves the free-rider problem and gives bargaining power tothe bidder. However regulators and/or judges are reluctant to accept two tieroffers (Weston et al (2001, page 39-40)).

At the margin we note that the analysis offers sound reason why law generallystipulates a minimum length of time a tender offer has to be maintained. If abid arrives there should be a reasonable chance to design a counter bid.

We observed that the two tier offer induces a coordination problem on be-half of the shareholders. A method to circumvent this is to rule that a majorityof the shareholders must approve the bid in a shareholder meeting (Bebchuk(1988), Burkart (1999) and Bebchuk and Hart (2001)). Without such an ap-proval no transfer of control takes place, e.g. no votes are attached to the sharesacquired by the bidder. Consider the following scenario. An “unfair” two tieroffer is made by the bidder B and a shareholder meeting is scheduled. On theshareholder meeting the current management27 makes the following proposal:B’s original bid is not accepted, whereas a bid by B with vo = vb gets a “green-card”, i.e. no further meeting is necessary to approve such a one tier bid. Thecounter proposal of the bidder is shareholders’ approval of the original two tierbid. The outcome is, that the proposal of the current management wins andthe bidder is obliged to offer vb which is marginally profitable for him. In thisscenario the shareholders have all the bargaining power. Therefore the bidderreceives only his reservation value. Bargaining power and correspondingly thedistribution of the takeover gain may be distributed otherwise.

27It does not matter who makes the proposal. Our scenario presumes that the managementshows fight.

24

3.7 Value Decreasing Bids

Another important topic that can be discussed in the framework of Grossmanand Hart is whether value decreasing bids are possible (Burkart (1999, page24ff)). Assume that the bidder offers a conditional restricted bid for 50% ofthe shares. The price offered is vo and dilution is φ. If the bid is successful,the value of a minority share is vb − φ. Furthermore, a bid is value decreasingif 0.5vo + 0.5(vb − φ) < vi. To be at least marginally profitable the condition0.5(vb−φ)− c− 0.5vo +φ = 1

2 (vb +φ− vo− 2c) > 0 must hold, where c denotesthe costs of the bid per share. Consider a bid with vo = vb − φ (+ε ), i.e. thebidder offers the post takeover value of a share. The corresponding payoff tableis

tender don’t tenderbid is successful 0.5vo + 0.5(vb − φ) = vb − φ (+0.5 ε) vb − φ


Such a bid will be successful, if no counter bid arrives. Note the similarity ofthe pay-off structure to that of a two tier offer. As before, the bid triggers aprisoner’s dilemma on behalf of the shareholders (called pressure to tender effect(Bebchuk (1988)). When studying the possibility of success of such a bid it iscrucial which kind of counter bids we consider.

First we presume that two tier bids are not allowed. Later we will observethat two tier bids indeed play a role due to their similarity with conditionalbids. Furthermore we assume that an alternative bidder A has merely access toa very weak but noticeable dilution technique 0 < φA ≈ 0. However, A cannotimprove the operation of the corporation, i.e. his value of v is vA = vi whichhe bids. If the bidder B offers vo = vb − φ + ε < vi then the bid triggers aconditional counter bid of A.


B’s bid is successful vo vo − ε vo − εA’s bid is successful vi − φA vi vi − φA

no bid is successful vi vi vi

There are two Nash-equilibria and we assume that the Pareto superior results,namely all shareholders tender to A. This analysis implies that a bid vo < vi

will fail since it triggers a counter bid.

25

Henceforth we assume vo ≥ vi. Thus the bidder will offer vo = max[vi, vb−φ],where the condition vo ≥ vb − φ is necessary to make “tender” an equilibriumaction. First consider the case that vo = vi, i.e. the dilution is relatively large(φ ≥ vb − vi). Then the condition that the bid is value decreasing or neutralbecomes vb − φ ≤ vi or vb − vi ≤ φ, which is satisfied by assumption. In orderto be marginally profitable the bid has to satisfy vb − vi ≥ 2c− φ. Putting theinequalities together this means that a value decreasing takeover will take placeif the improvement the bidder can implement vb − vi is in [2c − φ, φ] and thelatter interval is non-empty. Quite ugly cases are possible. If φ is sufficientlylarge and c sufficiently small, then a bidder with vb < vi may obtain control of T.It is even possible that a bidder with vb = 0 can acquire control and essentiallysteal (via φ) money from T’s shareholders. For completeness we consider thecase where vb − φ > vi, so that vo = vb − φ. The condition that the bid is valuedecreasing becomes vb − φ < vi, which contradicts the assumption. This casecannot occur.

The danger of a value decreasing bid, i.e. 0.5 vo + 0.5 (vb − φ) < vi, necessi-tates measures to prevent their occurrence. Several measures are possible. Onepossibility is to allow two tier bids. The price A bids for the first tier is v′o andw is the price for the second tier. This counter bid satisfies 0.5v′o + 0.5w = vi.Consider the following table:


B’s bid is successful 0.5 vo + 0.5 (vb − φ) vb − φ vb − φA’s bid is successful w 0.5 v′o + 0.5 w wno bid is successful vi vi vi

Again there are two Nash equilibria and we take the Pareto better. Two tier bidscan prevent value decreasing (restricted) bids. Since two tier bids are restrainedby several legislators we discuss alternative measures to prevent value decreasingbids.

As in the case of the two tier offer in the last subsection, value decreasingbids are possible since coordinating shareholders is impossible. Therefore, anobligatory shareholder approvement would solve this problem. This measure isvery appropriate since it directs straight to the problem, viz. the coordinationfailure. Control share acquisition laws of some US states implement this idea(Burkart, et al. (1998, page 176, Fn 5)).

Does the Equal Opportunity Rule (EOR) or the Mandatory Bid Rule (MBR)prevent value decreasing bids? The EOR is ineffective. It rules that all share-

26

holders are treated equally. This holds if in case of oversubscription allocationis pro rata. But it fails to separate the approval from the tendering decision(Burkart (1999, page 26)). Whereas the EOR is ineffective the MBR indeeddeters value decreasing bids (Burkart (1999, page 27)). Consider a value de-creasing bid and assume that the actions described above (two tier bids andshareholder approval) are impossible. As we saw above the bid satisfies vo ≥ vi.However, the problem is that after the takeover the minority shares merely havea value of vb − φ < vi. Shareholders who have not tendered will exercise theiroption embodied in the MBR and sell for vo. The MBR achieves the objectiveto deter value decreasing bids however it does not secure a high takeover pre-mium (Burkart (1999, page 27)). Yet this is not the major disadvantage of theMBR, which is the fact that it overshoots.28 A perfect rule is a rule that detersthe unwanted and enables the wanted! The MBR deters some wanted takeovers.Suppose that vb−φ > vi, which implies that shareholders gain from the takeover.Suppose that the costs for acquiring 50 % of the shares cres are lower than fora complete takeover ccom, cres < ccom. In this case and if φ ∈ (cres, ccom) holds,bids are deterred under the MBR but are possible otherwise.

The Swiss takeover regulation (Art. 27) and the German takeover law(§16) have implemented another solution that achieves a separation betweenthe approval and the tendering decision (Burkart (1999, pages 28, 34)). This isachieved by a conditional extension of the offer. If and only if until a certainpoint in time enough shares are tendered (in our model 50 %), the bid is con-sidered as approved. The shareholders who have not tendered during the firsttime slot are given the option to tender afterwards. This option destroys thehedge feature of the tendering decision. Even if a shareholder did not tenderduring the first time slot he is not captured in the minority position.

3.8 Voting and the Market for Corporate Control

Until now we have considered corporations with one kind of shares. In this casevoting rights and claims to dividends are proportional. The structure of votingrights determines the way in which control of a corporation can be achieved.The voting structure and the market for corporate control are therefore closelyconnected. The seminal contribution to this aspects is (again) from Grossmanand Hart (1988). Hart (1995) offers a textbook treatment. In what follows wesketch their model.

28Bebchuk (1994) offers a more complete analysis of MBR and EOR.

27

The corporation we consider has two types of shares, namely type 1 and2. We denote by σ1 (resp. by σ2) the fraction of dividends attached to theshares of type 1 (resp. of type 2). Similarly we denote by ω1 (resp. by ω2) thedistribution of votes. We choose the notation so that ω2 ≥ 1/2, i.e. the shareof type 2 carry more voting rights. A constellation with σ2

ω2= 1 is called “one

share – one vote”. Without loss of generality we define “one share – one vote”to be the case iff ω2 = σ2 = 1 holds.

It is assumed that the current management can be replaced and a new policyimplemented if and only if the bidder achieves control of the corporation viatakeover. Furthermore, control is achieved if and only if the bidder owns 50 %of the votes. We allow only conditional one tier bids that are unrestricted (withrespect to the type of shares the bid is made for). Obviously the bidder willtry to acquire only the shares of type 2, since he must pay the post-acquisitionvalue for shares of type 1 – he does not earn money on them and they are notnecessary to achieve control. The role of the design of the voting structure is tofoster competition for the shares of type 2.

To see what can go wrong consider the following situation. The number ofshares is normalized to 1. All votes are attached to type 2 shares and dividendsare distributed evenly. Furthermore vi = 200 and vb = 195, φ = 15. Can thebidder achieve control? He can, if he offers 100.1 for the shares of type 2. First,we consider whether the current management can make a better counter bid:They cannot since they cannot pay more than the dividend value of the shareswhich is 100. Next, we must find out whether shareholders will tender. Considerthe corresponding table:

tender don’t tender

bid is successful 100.1 90 (= 195−152 )

bid is not successful 100 100

The problem with the success of this bid is that shareholders receive only 190.1(the owner of the shares of the second type receive 100.1 and the others 90 asdividends). Without the takeover shareholders had claim on 200.

Now consider the “one share – one vote” case. There is only one typeof shares and any bid below 200 will trigger a successful counter bid by thecurrent management. The bidder will not bid more than 195. Under this votingstructure the bidder is not able to achieve control, i.e. the voting structure hasdeterred the unwanted takeover.

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Managers can use the voting structure to entrench themselves. Change thenames in the example and assume that current managers generates vi = 195and dilutes φi = 15. Managers have designed the voting structure such thatω1 = 0, ω2 = 1, σ1 = σ2 = 1/2. Assume that the bidder is able to generate vb =200 but cannot dilute. Can the bidder achieve control? He cannot. The bidderwill not pay more then 100 for the shares of type 2. The current managementcan make a counter bid of 100.1. On the one hand they would make a loss of10.1 from this transaction, since the value of these share is just 90. Howeverthey can finance this loss by their dilution income. And it is profitable to do so,because they can rescue their dilution income of 15. Their net advantage is 4.9in this case. Since the bidder anticipates this he will not bid in the first place.We can conclude that preferred stocks are an entrenchment device.

Grossman and Hart (1988) and in a related paper Harris and Raviv (1988)have analyzed the voting structure for the general case and offer some (condi-tional) justifications for the rule “one share – one vote”.

3.9 Post Takeover Moral Hazard

The analysis so far considered takeovers as a device dealing with the agencyproblem before the takeover. We only sparely discussed (in the form of dilution)the agency problem after the bidder has achieved control. Burkart, Gromb andPanunzi (1998) have analyzed the effects of the post takeover agency problemon takeovers.

The corporation we consider is widely held and a bidder achieves controlonly by owing at least 50 % of the shares. We assume that a tender offer is theonly admissible mode to gain control. The bidder has a toehold α.

The new feature of the model is, that it endogenizes post-takeover dilution.Assume that the bidder has achieved control and generates an income of vb,i.e. we consider the final stage of the game after the takeover. He must decideabout the degree of dilution. His choice parameter is φ ∈ [0, 1]. His choice ofφ determines the value (1 − φ)vb of shares as financial assets and the dilutionamount d(φ)vb that he receives as a private benefit. The function d : [0, 1] →[0, 1] models the deadweight loss of dilution (diversion). By assumption d ∈C2[0, 1] is increasing and concave with d(0) = 0, d′(0) = 1, d′(1) = 0. If thebidder has achieved control by owning a fraction γ ≥ 1/2 of the shares (hebuys γ − α), he decides about φ. For this he maximizes γ(1 − φ)vb + d(φ)vb.

29

The first important lemma is that dilution φ = φ(γ) depends negatively on γ.29

As his holdings increase the bidder internalizes more of the deadweight loss ofdilution. As a consequence the value of minority shares (1 − φ(γ))vb increaseswith γ which implies that shareholders welcome a large post-takeover stake ofthe bidder.

Next we analyze the takeover process. Because of the free-rider problem abid will only be accepted if vo ≥ (1−φ)vb holds. However, dilution depends on γ

which in turn depends on the outcome of the takeover process. The second im-portant lemma30 describes the possible equilibria. A bid vo ∈ [0, (1−φ(0.5)) vb)always fails. For bids vo ∈ [(1 − φ(0.5)) vb, vb] the bid succeeds and after thetakeover the bidder holds a fraction γ with vo = (1 − φ(γ)) vb. A bid withvo > vb always succeeds and the bidder will obtain all shares.

Finally we must determine the price vo the bidder offers. The third lemma31

states that the bidder will offer v∗o such that v∗o = (1 − φ(0.5)) vb. The biddersfinal holding is just 50 %.

The problem with this outcome is that due to the minimal fraction the bidderholds after the takeover (viz. 50 %), dilution and therefore deadweight loss willbe maximal. Among other things the problem is a commitment problem.

To understand this result note that the bidder must pay the post-takeovervalue of the shares. As a consequence he makes no profit on the shares tendered.In addition to the profit on his toehold he only profits from the private benefit.His total gain is [α(1 − φ(γ)) + d(φ(γ))]vb. By choosing a specific bid price hecan indirectly determine γ. What is the optimal γ? The marginal effect of anincrease of γ is (−αφ′(γ) + d′(φ(γ))φ′(γ))vb = φ′(γ)vb[d′(φ(γ)) − α]. With thefirst order condition d′(φ(γ)) = γ it follows d′(φ(γ)) − α > 0 which in turnimplies that the marginal effect of a higher γ is negative. Therefore the bidderwill choose a minimal γ while guaranteeing control, i.e. γ = 1/2.

The reason for the result is a combination of a free-rider problem and acommitment problem. The tendering decision of a shareholder generates a pos-itive external effect for the other shareholders, since it increases the bidderpost-takeover stake thus reducing dilution which increases the share’s value.However, due to the free-rider problem an attempt to offer more shares for lesswill fail since individually shareholders have the incentive to keep their shares

29Lemma 1 in Burkart et al. (1998, 178). Apply the implicit function theorem to the firstorder condition d′(φ) = γ.

30Lemma 2 in Burkart et al. (1998, 179).31Lemma 3 in Burkart et al. (1998, 180).

30

and profit from the higher value of the shares. In addition, there is a commit-ment problem: Suppose the bidder announces to dilute maximally when havingcontrol. If he does so, the value of the shares is low and the takeover with ahigh γ is possible. However, having acquired many shares, maximal dilution isnot credible. Hence, the announcement of a high dilution is not credible.

3.10 Asymmetric Information

Typically a takeover goes along with a major change of the strategy and/orthe incentive structure of the target. Such changes come with uncertainties.Uncertainty is always a problem but the more so if information is not symmetric.Asymmetric Information generically generates inefficiencies. In this subsectionbased on Shleifer and Vishny (1986a) we assume that B has inspected T andhas found a way to improve the operations of the target. But the shareholdersof T – and the outside participants of the capital market – only know that thevalue of the improvement z = vb − vi has been drawn from the interval [0, zm].They know the density function f of this draw, but not the specific realizationz.

Assume that the bidder announces a conditional and restricted tender offer.The offer is binding if at least 50 % of T’s shares are tendered. In this case50 % of the shares are purchased. In order to be lucrative the bid price vo hasto satisfy

(0.5− α)(vb − vo) + α(vb − vi)

= α(vb − vi) + (0.5− α)(vb − vi)− (0.5− α)(vo − vi)

= 0.5z − (0.5− α)π ≥ 0, (1)

where π denotes the premium on the pre-bid shareholder value and α the toe-hold.32 The shareholders don’t know the true value z of the random variablez, but since the bidder actually bids, they know that the condition (1) is satis-fied. With this information they calculate the conditional expected value of z –contingent on the observation of the bid with the premium π:

z∗(π) := E(z|0.5 z− (0.5− α)π − c ≥ 0). (2)

Since the free-rider problem is acute “to tender” is marginally optimal iff

π − z∗(π) ≥ 0, (3)

32Note that vi is not necessarily the pre-bid price of the shares as the market may anticipatea bid.

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i.e. vo ≥ E(vb). The bidder will try to acquire the shares as cheap as possible.Thus he will choose the minimal premium π s.t. (3), i.e.

π∗ := arg minπ{π|π − z∗(π) ≥ 0}. (4)

These “heuristic” arguments support the content of the following proposition.

Proposition [Shleifer and Vishny (1986a, 468)]: Assume that π∗ < zm

holds. There is a unique pure strategy perfect33 sequential equilibrium. Therespective strategies of the bidder and the shareholders are

αb(v) :=

{don′t bid : 0.5 z − (0.5− α)π∗ − c < 0,

vi + π∗ : otherwise.

and

αs(π) :=

{tender : π − z∗(π) ≥ 0don′t tender : otherwise.

The equilibrium is a partial pooling equilibrium. The cases where 0.5 z− (0.5−α)π∗ − c is greater respectively smaller than zero are separated. But withinthese parameter regions pooling takes place.

We make a step back and consider the situation before the bidder has privateinformation. The acquisition of the information about z will be costly to thebidder. In order to judge whether an information acquisition (or informationproduction) is profitable the potential bidder needs to know the expected pay-off of the takeover. In other words he needs to know the value of the followinglottery: Draw z according to the density function f from the interval [0, zm].Play the signaling game described above and receive the corresponding pay-off.The expected pay-off of this lottery is

(αE(z|z ≥ zc)− c)pr(z|z ≥ zc), (5)

where zc is implicitly given by

0.5zc − (0.5− α)π∗ − c = 0.

Note that due to the free-rider problem a pre-announcement stake of α > 0 is anecessary condition for an incentive to bid. Similar to the result of the precedingsection a bidder profits only from the pre-bid acquisitions (we ignore dilution).

The asymmetry of information – the raider knows the true value z of zwhereas the shareholders just know F – generates a new inefficiency: If the

33A perfect sequential equilibrium is a sequential equilibrium that satisfies the perfectnesscriteria of Grossman and Perry (1986). See also Jager (2002).

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realization of z equals z = c + ε then a takeover is socially beneficial. But forall π ≥ 0 we have

0.5z − (0.5− α)π − c = (−0.5) c︸︷︷︸< 0

− (0.5− α)π︸︷︷︸≥ 0

+(0.5 ε)︸︷︷︸≈0

< 0. (6)

Thus no bid will be made. This occurs even if α is relatively large and c relativelysmall. The latter feature is absent in the case we considered in section (3.5).There the condition for a takeover to take place is α z > c. If z = c + ε thiscondition reduces to α ε > (1 − α)c, which is satisfied for sufficiently smallc. In addition to the welfare improving takeovers that are frustrated by thefree-rider problem some additional takeovers are frustrated by the asymmetryof information.

3.11 Private Benefits for the Bidder

The model in this section is a modification of the model of the preceding sectionand is due to Schuster (2001). In this model a takeover will take place eventhough the bidder has no pre-bid stakes. We again consider a restricted andconditional bid for 50 % of the shares.

The bidder can be of two types. Type g is a “good” bidder. He increasesthe value of cash flows to the shareholders and the shareholder value increasesto vgb > vi. Type b is a “bad” bidder. If he wins the bid, the value for theshareholders decreases to vbb < vi. Furthermore he has a private advantage fromcontrol, i.e. in addition to the shareholder value he receives a private benefit φ.His complete gain is vbb + φ > vi. All these values are known by all players.

As before we assume that the type of the bidder is private information.The a priori probabilities are pb, pg, for the bad respectively the good bidder.Furthermore we assume that the bidder has no pre-bid stake.

If there were no bad bidder we had the situation of Grossman and Hart andthe bidder would be captured in the free-rider situation. However with the badbidder around the good bidder can hide behind the bad bidder. Thus there willbe a pooling equilibrium. Both types bid the same price, namely

pbvbb + pgvgb = pbvbb + (1− pb)vgb = vo.

We assume that vo > vi. With this bid both types of bidders make a profit fromthe raid even though none has a pre-bid toehold!

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Proposition [Schuster (2001)]: In the unique perfect sequential equilibriumboth types bid vo = pbvbb + pgvgb.

4 Multiple Bidders

So far we considered one bidder cases. But it is likely that a bid creates curiosity.A bid may put a corporation into play. With several bidders the situationbecomes an auction. The auction aspect of corporate takeovers is explicitlyrecognized by regulators. Delaware law demands of the target’s managementto react to a bid as would “auctioneers charged with getting the best pricefor stock-holding at a sale of the company” (Cramton (1998, 122)). UnderGerman Law the management is – at least in principle34 – not allowed to pursueany measurement that frustrates the takeover with the explicit exception ofsearching for a counteroffer (WpUG § 33), thereby opening an auction.

Although a takeover resembles traditional auctions it has some specific fea-tures. In a traditional auction the seller designs the auction mechanism anddescribes the item offered. A major aspect of an auction is the commitmentof the auctioneer to a specific mechanism (McAfee and McMillan (1987, 703)).For corporate takeovers the auction mechanism is constrained by takeover regu-lations, however the course of the takeover is usually not determined in advancebut evolves as bids arrive.

Henceforth, we assume that the highest bid wins, if it is above the pre-bid value vi. This means that we ignore the free-rider problem studied in thepreceding section. One justification is that a dilution threat limits the free-ridingproblem.

One may distinguish three aspects: the strategic behavior of the bidders,the strategies of the target and finally social welfare.

4.1 Preemptive and Sequential Bidding

The first model that will be discussed is the model of Fishman (1988). Formotivation, we consider first a traditional English auction: There is a group ofbidders and an item they bid for. The highest bid wins. Bidders make costlessbids and counteroffers, each bid being marginally larger than the previous one,

34Remember the comments in section 1 about the German takeover law.

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until the bidder with the highest valuation wins at the price equal to the secondhighest valuation. This evolution is called the ratchet solution. The problemwith this scenario is that it does not fit the course of events of actual takeoverauctions. Firstly, initial bids are in general significantly above the current val-uation of the corporation. Secondly, successive bids typically involve significantincreases of the outstanding bid.

Fishman (1988) offers an explanation for the high bid premium of the firstbid. In this model the high first bid serves as a preempting device. The sketchof the model is as follows. There are two bidders; bidder 1 and 2. Bidder1 has investigated the target. His valuation of the corporation is v1. Thesecond bidder has to decide whether to analyze the target. His valuation v2

will lie in the interval [l, h], where the valuation is distributed according to thedensity function f2. The second bidder does not know the value v1, i.e. v1 isprivate information of bidder 1. The second bidder believes that the valuationof the first bidder is distributed according to the density function f1 within theinterval [l, h]. The equilibrium of this game has a threshold property. There isa valuation v∗ such that the first bidder bids p∗ > vi iff v1 ≥ v∗ and he bidsvi otherwise, where vi denotes the value under the incumbent management.Thus the bid severs as a coarse signal about the valuation of the first bidder.From a high bid the second bidder infers that the valuation of the first bidderis high. The equilibrium strategy of the second bidder is to investigate and –where profitable – to enter an English auction against the first bidder if the firstbidder bids vi. Otherwise, i.e. if the first bidder bids p∗, the second bidder willnot investigate, i.e. the first bidder preempts a bid of the second bidder.

It is not difficult to understand this equilibrium. Consider first the secondbidder. His payoff is

π2(v1, v2) =

{v2 −min(v2, v1)− c2 if he bids,0 otherwise.

Note that his payoff function does not depend on the initial bid p. Suppose thesecond bidder assumes that the valuation of the first bidder is larger than τ , i.e.v1 ≥ τ . The second bidder will investigate iff

∫ h

τEv2π2(v1,v2)f1(v1)dv1∫ h

τf1(v1)dv1

≥ 0. (7)

Let v∗ be that value of τ such that the preceding inequality is an equality. Thusif the first bidder can signal that his valuation is larger than v∗ then he canpreempt at the margin a bid of the second bidder.

35

Now consider the first bidder. What is his gain from preempting a bid of thesecond bidder? The payoff function of the first bidder for an arbitrary initialbid p is35

π1(v1, v2, p) =

{v1 −min(max(p, v2), v1) if the second bidder investigates,v1 − p otherwise.

The gain of the first bidder from preempting investigation is therefore the dif-ference between bidding high (p′) and low (vi):

Ev2 [v1 − p′]−Ev2 [v1 −min(max(vi,v2), v1)] = Ev2 [min(max(vi,v2), v1)]− p′.

The gain is decreasing in p′. Denote by pm(v1) the maximum price he is preparedto pay in order to preempt, i.e. pm(v1) = Ev2 [min(max(vi,v2), v1)]. Notice thatpm(v1) is an increasing function.

In the equilibrium the first bidder will bid p∗ = pm(v∗) if v1 ≥ v∗ and vi

otherwise. The second bidder will investigate when observing the bid vi andstay out otherwise. To understand this equilibrium: If the first bidder bids p∗

then the second can deduce that v1 ≥ p∗, i.e. the first bidder has a relativelyhigh valuation. Since the first bidder offers p∗ in order to preempt and since forevery valuation v1 < v∗ he would bid less than p∗ to preempt (namely pm(v1)),the second bidder can infer that v1 ≥ v∗. By definition of v∗ the second bidderwill stay out. If the first bidder bids p′ < p∗ then the second bidder reasons thatall types of the first bidder with a valuation larger than p−1

m (p′) < v∗ have anincentive to preempt. However, if the first bidder’s valuation is presumed to liein [p−1

m (p′), h] then preemption will not work and the second bidder will enter.This means that for bids smaller than p∗ the second bidder will investigate.Which in turn implies that the first bidder will bid vi or v∗. The first bidderwill not bid more than p∗ since p∗ is the minimal bid for which the first bidderachieves preemption.

One implication of the model is that a reduction of the costs of investigationc leads to an increase in the expected takeover price (Fishman (1988, 96)). Twoeffects drive this result. Firstly, the threshold v∗ defined in equation (7) islarger and this implies a higher bid pm(v∗). Second the threshold of deterrenceis shifted to higher valuations of the first bidder. Deterrence happens less often,competition is more frequent which results in a higher expected takeover price.To see the latter note that

pm(v) = Ev2 [min(max(vi,v2), v)]35If he bids more than v2 he will win the auction and the payoff is v1 − p. If he bids less

than v2 then he wins the auction only if his valuation is higher and he pays the valuation ofthe second bidder, i.e. his payoff is v1 − v2. If his valuation is smaller then his payoff is 0since the second bidder wins the auction.

36

The function pm(v) is increasing in v thus Ev2 [min(max(vi,v2), v)] is increasingin v. Assuming that the second bidder has investigated, Ev2 [min(max(vi,v2), v)]equals the conditional expected payoff of the target under the condition v1 = v.Suppose that due to a decline of c the threshold increases from v∗ to v∗. Itfollows that for all v ∈ [v∗, v∗] the payoff is higher namely pm(v) instead ofpm(v∗).

The smaller c not only implies a higher average takeover price but also ahigher social efficiency at least if one takes the first bid as given. The socialcost of competition equals the investigation cost c. The social benefit equalsmax(v2 − v1, 0). The social benefit stems from the possible additional valuethat the firm may have. Since the second bidder will in a ratchet solution obtainv2 − v1, his incentive and social optimality are aligned. However, there is aneffect working in the opposite direction: More competition makes investigationfor the first bidder less attractive (see section 4.4).

An implication of the model of Fishman is that an initial premium bid alwaysdeters competition. This conclusion is not in accordance with real takeovers,where an initial high bid is sometimes followed by another bid significantlylarger than the first bid. Daniel and Hirshleifer (1998) approach this problem.Before explaining this model we remark that the outcome of an English auctionis extremely sensitive to small costs of bidding (Hirshleifer and Png (1989),Hirshleifer (1995, 861)). Suppose there are two bidders and it holds vi = 0. Thevaluation of the first (second) bidder is known to be v1 = 80 (v2 = 30). If thereare no costs of bidding the first bidder will win and pay the valuation of thesecond bidder, i.e. 30. If there are small bidding costs ε > 0 then the secondbidder anticipating a defeat in the auction will not bid at all. Therefore the firstbidder will acquire the target for 0.

In addition, bidding costs change auction strategies. Due to this a declineof these costs may reduce the expected price paid for the target (Hirshleifer(Hirshleifer and Png (1989), Hirshleifer (1995, 861)). To understand this resultwe discuss an extreme case, viz. we assume that the bid reversal costs areinfinite. This implies that both bidders bid at most once. In equilibrium thefirst bidder will either bid b1 or b1 depending on whether v1 < v∗ or v1 ≥ v∗,i.e. the equilibrium has a threshold logic as in the Fishman model. The secondbidder will not investigate if the first bidder bids high. Otherwise he investigatesand bids b2 = b1 if v2 > b1. Firstly, we observe that b1 does not depend onc. b1 is optimal conditional on an investigating second bidder. The secondbidder will bid b1 if v2 > b1. Therefore the expected profit for the first bidderis Prob(v2 > b1) 0 + Prob(v2 ≤ b1)(v1 − b1) which is indeed independent ofc. b1 on the other hand is a decreasing function of c. The threshold value v∗

37

is implicitly given by v∗ − b1 = (v∗ − b1)Prob(v2 ≤ b1), i.e. at the thresholdthe bidder by assumption marginally prefers to bid high. If the investigationcost c declines, b1(c) increases, and therefore v∗1 increases. Now we can identifythe two counteracting effects of a decrease of c. Firstly, b1 will increase whichimplies c.p. a higher expected takeover price. Secondly, the frequency of a highbid declines since the threshold is higher which results c.p. in a lower expectedtakeover price. Hirshleifer and Png (1989, section 3) demonstrate that infinitebidding costs are not a necessary condition for this effect to occur. In generalthe effect of a decreasing c on the average takeover price is indeterminate andespecially a lower one is possible.

It is useful to compare this result with the corresponding outcome of theFishman model. As in the Fishman model high bids are less frequent if costsare lower, i.e. preemption happens less frequently. But whereas accommodationtriggers competition in the Fishman model, in the model of Hirshleifer and Pngthe low bid triggers a counterbid bid at par with the first bid and then no furtherbidding takes place due to the bidding costs. This in turn implies that the lowerprice is more frequently paid.

Hirshleifer (1995, 862) remarks that there is empirical evidence for this case.Namely it can be argued that the Williams Act of 1968 and associated legislationreduced the cost of bidding. After this change in legislation the tender offerpremiums decreased.

The result of Hirshleifer and Png should be taken into account when dis-cussing regulations of takeover bids. Bebchuk (1982a, 1982b, 1986) argued thatan optimal regulation must balance two effects. More competition will increaseexpected prices – so is assumed – and the target’s shareholders profit from this.However, more competition may reduce the incentive to investigate in the firstplace and takeovers become less frequent. The model of Hirshleifer and Pngsuggest that the presumption that the expected price increases with competi-tion is in general flawed. Therefore, “at a minimum, our results suggest that thebalance in Bebchuk’s analysis must be tilted in the direction of less facilitation”(Hirschleifer and Png (1989, 600)).

4.2 Toeholds

It is not unusual that a bidder has acquired a toehold in the target. In thestudy of Jennings and Mazzeo (1993) 15 % of the bidders have a toehold wherethe mean toehold is 3 %. Toeholds significantly change the environment of

38

the auction. How drastic the change can be is best illustrated by a numericalexample of Hirshleifer (1995, 870). Suppose that there are two bidders withvaluations known to be 100 and 200. Suppose there are no toeholds and thehighest bid wins. Then the second bidder will win and pay zero if there are anytransaction costs (he will pay 100 in case of zero transactions costs). Supposethat the first bidder has a toehold of α > 0. In equilibrium the second bidderstill wins but he will have to pay 200 − ε, ε > 0, since the first bidder bids upto 200 − ε. The toehold leads to drastic overbidding by the first bidder. As aconsequence the ex ante costs of a takeover increase which in turn decreases theex ante incentive to investigate corporations.

A bidder with a low valuation and toehold may have an incentive to initiatean auction. He has an incentive to sell out to the second bidder forcing him topay a high price. There are claims that some so-called corporate raiders putcompanies in play with the intention to sell out.

A bidder with a toehold is not merely a potential buyer but at the sametime a seller. This affects bidding strategies: On the one hand, a higher bidmeans that in case of winning the auction a higher price has to be paid. On theother hand, a higher price implies that the bidder will be paid a premium forhis toehold if he looses the auction.

We noted above that a bidder with a toehold overbids in order to force theother bidder to offer a high price. The very restrictive assumption that thevaluations are common knowledge is not necessary for overbidding to take place(Burkart (1995)). Assume that there are two bidders with independently dis-tributed valuations36 vk, k = 1, 2 and toeholds αk, k = 1, 2 where valuations areprivate information and toeholds are common knowledge. Why should bidderk bid more than vk? Suppose a bidder overbids by δ and compare the expectedvalue with the expected value when bidding vk. Overbidding has two effects.On the one hand, he gains αkδ if the opponent bids more than vk + δ. On theother hand he risks losing at most δ(1−αk) if the opponent bids less than vk +δ

but more than vk. The order of the loss is of second order, whereas the gain isof first order. Hence the overall effect is positive.

There is empirical evidence that overbidding occurs (Bradley et al. (1988)).Warren Buffet’s statement cited in the first section suggests that overbiddingis a result of hubris. Another explanation of overbidding is the winner’s curse.The model of Burkart provides a fully rational explanation of overbidding.

36Thus we consider a private value auction.

39

So far we assumed that the valuations are independent, i.e. we assumed aprivate value auction. It is sometimes claimed that takeovers resemble morecommon value auctions (Cramton, 1998). The effects of a toehold in a commonvalue auction are more pronounced than in a private value auction (Bulow etal. (1999)). This has to do with the winner’s curse problem of common valueauctions. We noted above that a bidder with a toehold has an incentive to bidmore aggressively. This reinforces the winner’s curse problem of a non-toeholderand he bids less aggressively. The less aggressive bidding by the non-toeholderweakens the winner’s curse problem of the toeholder, so he bids even moreaggressive. Thus we have a reinforcing feedback in case of a common valueauction.

4.3 Strategies of the Target

Despite regulation, the target’s board has a great deal of discretion about thecourse of the takeover auction. It can block an initial offer and it can – if severalbidders appear – treat them asymmetrically.

A device that is common in takeovers are lockups. Coates and Subramanian(2000) report lockups for 80 % of all friendly mergers in the US in 1998. A lockupis a device that promises the bidder a compensation should the merger fail.There exists a variety of lockups: Crown jewel defences, private litigation, lockupoptions, buying assets to cause anti-trust problems are well known examples.The major attributes of a lockup are: (1) They are discriminatory and (2) costlyto redeem, i.e. the commitment to the lockup is credible.

To demonstrate why lockups may be beneficial for target shareholders37, weconsider a full information case (Berkovitch and Khanna (1990, 140)). Supposethere are two bidders with known values of v1 and v2, where v1 > v2. Assumethat bidder 1 has already sunk the investigation and bidding costs whereasbidder 2 must incur c for investigating and bidding. Bidder 2 can anticipatethat he cannot win the auction and therefore he will not bid at all. Bidder 1takes this into account and bids ε. He wins the auction for virtually zero. Now,suppose the management of the target issues a lockup that if exercised reducesthe value of bidder 1 to v1 < v2 but leaving the valuation of bidder 2 unaltered(this is the asymmetry assumption). Suppose bidder 1 bids less than v2 − c. Inthis case the lockup is exercised and bidder 2 wins the auction bidding v2 − c.

37A lockup is a defence device that the management may employ opportunistically. Weignore this for a moment. There is some empirical evidence that justifies this. Butch (2001)finds that average and median return are higher for merger deals with lockup option. Thisconforms results of Comment and Schwert (1995).

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Therefore, bidder 1 will bid v2 − c, a bid of the second bidder is frustrated andthe lockup will not be exercised in equilibrium. The mere threat of the lockupis beneficial for the shareholders of the target.

Note that we used the asymmetry of the lockup. To see why the commitmentto exercise the option is important assume otherwise. Assume bidder 1 bids ε

and the second bidder scenting a chance to win bids v2−c. However, the chanceis illusionary. Bidder 1 bids v2 − c + ε and bargains with the management ofthe target to withdraw the lockup. It is now in the interest of the target towithdraw the lockup. Bidder 1 will win the auction and pay v2 − c + ε. Butbidder 2 can anticipate all this in advance and therefore will not bid in the firstplace.

Greenmail is another measure the target’s management may use to the ben-efit of the shareholders.38 Greenmail occurs when the management of the targetbuys out a bidder for an inflated stock price, usually accompanied by a standstillagreement. How can greenmailing be beneficial for shareholders? Suppose thereis a bid. There are other potential bidders around however they hesitate sincethey suspect that a takeover attempt is not beneficial for them. They couldinvestigate the firm. However, they must take into account the likelihood of awhite knight. In this case it is doubtful whether investigating is beneficial. Therole of the greenmail is to signal that no white knight is around. The fact thatgreenmailing is expensive is necessary to make it trustworthy.39

4.4 Efficiency Aspects

Consider the following framework40: There is a pool of firms, where some ofthese corporations can be improved. The role of searchers is to find these firmsunder all suspects. When such a firm is found it is put into play by a first bid.The ultimate acquirer may of course differ from the first-time bidder.

In this framework there are two dimensions of efficiency that must be takeninto account. Is the incentive for searching optimal and is the ultimate controllerthe best management team for a specific firm? With respect to the seconddimension of efficiency auctions seem to be appropriate as the team with thehighest willingness to pay will presumably win the auction (Bebchuk (1982 a,b)). But auctions affect the incentive to search. Auctions increase the price

38The same footnote as for lockups applies. Greenmailing is a defence that may be usedopportunistically.

39For details see Shleifer and Vishny (1986b) or Rasmusen (2001).40Berkovitch et al. (1989) and Schwartz (1986).

41

paid for targets in successful takeovers. This will reduce the expected gains ofsearchers with the consequence of a reduced incentive to search (Easterbrookand Fischel (1981) and Schwartz (1986)). The problem is that a successfulsearcher generates a positive external effect. By bidding, the searcher signalsthe existence of gains to be made by taking control of the suspect. Otherpotential raiders can free-ride on the effort of the searcher.

The desirability of auctions depends on the desired level of search. On theone hand one can argue that low incentives to search for a takeover target willleave efficient transfers of control unrealized. On the other hand, if there is toomuch search – the overfishing problem – auctions will be desirable.

Related to auctions (but not restricted to auctions) is another source fora divergence between social and private optimality (see e.g. Easterbrook andFischel (1996, 27)). The initial founder of a given corporation will – whendesigning the charter – strive to maximize the value of this corporation. Thedesign will affect the likelihood of a takeover and its premium. The solutionto this optimization problem (the optimal charter) is not necessarily sociallyoptimal. From a social point of view the expected premium is a distributionalvariable, since the premium must be paid by the bidder. What matters for socialoptimality is that the best management team is eventually in charge, leading toa maximal aggregate performance.

A further aspect to be taken into account is a commitment problem (e.g.Easterbrook and Fischel (1996, 27f)). Suppose that the charter contains ananti-auction passus, thus facilitating a takeover by the first bidder so that hiscosts of investigation are expected to be covered. However, after a first bidhas occurred the target’s shareholders have an incentive to circumvent the anti-auction rule in order to increase their premium.41 The question is whether thecommitment to the passus is credible. If not, it is ineffective and the first bidderfaces unexpected competition. This may turn investigation suboptimal.

Berkovitch et al. (1989) point out the fact that lock-up agreements and afinders’ fees may circumvent the search externality problem discussed above.Given such contracts a first bidder can share in the gains of the transfer ofcontrol. Still, facilitating auctions will increase the price that has to be paid.However: “Provisions in contracts written between bidders and targets insurethat first-time bidders share in this price increase. In this fashion, governmentregulations that facilitate auctions may actually increase the incentive to searchand as a result increase the number of value-increasing acquisitions” (Berkovitch

41Suppose that the charter rules that after a bid the management has to withhold allinformation useful for a second bidder. Will the target follow this rule?

42

et al. (1989, 397)). Thus lockups may be socially beneficial. However, sincethey constitute defence devices, the incumbent management may use them toentrench itself.42

The discussion reveals that due to counteracting effects the welfare aspectsof facilitating vs. hindering auctions are ultimately an empirical question.

5 Omitted topics

Some important topics are not discussed in an appropriate manner in the paper.This section will comment briefly the most two important gaps.

Means of Payment

Money is not the only currency used in takeover transactions. Bidders may anddo use stocks instead. There is an extensive literature on this topic and a laterversion of this essay will certainly discuss this topic in more detail.

In perfect markets with symmetrically informed agents, the medium ofexchange chosen to accomplish a corporate combination is economicallyirrelevant; the level and division of the merger-induced gains are the samewhether the transaction is executed by means of an all-cash offer or bysome combination of cash and securities of the combined firm.

Eckbo et al. (1990)

Thus a major problem related to the choice of the “currency” is the asymmetryof information. Hansen (1987) and Eckbo et al. (1990) have analyzed thefollowing situation. There is a bidder with value x. The bidder discovers asynergistic opportunity that requires achieving control of a target. The valueof the target under the current management is vi. The value of the target ifacquired by the bidder is w(x). There is a two-sided asymmetry of information.The management has private information about vi and the bidder about x.

At first, consider the effect of the private information about vi. By assump-tion a bid is successful only if the current management accepts it. The current

42Since auctions increase takeover premiums they may be considered as defence devices,however Bebchuk (1982 a, b) and Gilson (1982) maintain that auctions do not generate thenegative effects other defence measures presumably have. See Easterbrook and Fischel (1996,188).

43

management accepts the offer only if the bid is worth more the vi. The bidderis confronted by an adverse selection problem. The adverse selection problem ismitigated if stocks are the medium of exchange since the target bears some ofthe costs of the adverse selection problem.43 Secondly consider the consequencesof private information about x. The number of shares offered and the mix ofshares and stocks serves as a signaling device that the bidder can use to offera signal about x. Eckbo et al. (1990) derive a completely separating signalingequilibrium. The structure of the bid therefore provides a complete revelationof the value x, where a high value of x is associated with a high amount of cash.Besides theoretical studies there are numerous empirical studies. Eckbo et al.(1990) and Martin (1996) provide empirical support for the theories discussedabove.44

Fishman (1989) discusses the means of payment problem within the contextof competitive bidding. A key difference between a cash and a stock offer is thatthe latter’s value depends on the value of the merged corporation. This affectsthe acceptance decision of the target. It is assumed that the target has privateinformation. Compared with the cash offer, a stock offer has the advantage thatit triggers an efficient acceptance decision of the target. However, a cash offersignals a valuation of the first bidder and therefore is a preempting device. Inequilibrium, the first bidder offers cash if his private information indicates ahigh value and he offers stocks otherwise.

Defence

We touched anti-takeover devices but did not discuss them in an appropriatemanner.45 As the name suggests these devices make tender offers less attractiveand sometimes frustrates them. The literature on anti-takeover measures isvast and there appears to be no consensus. Even though some commentatorvehemently insist that takeovers must be facilitated in order to limit agencyproblems of corporations and that anti-takeover measures destroy shareholdervalue, some sound arguments have been made in support of defence devices.

Consider as an example of anti-takeover measures poison pills. On the onehand they make takeovers more difficult and expensive which presumably trig-gers a deterrence effect. On the other hand they may be used by the management

43De Matos (2001, 207) offers a textbook treatment of this case.44Some of the empirical studies discussed in section 2.3 also deal with the means of payment.45Comment and Schwert (1995), Weston et al. (2001), Drehkopf and Mix (2000) (in Ger-

man) offer surveys.

44

to increase the takeover premium to the benefit of the target’s shareholders.46

In the end it is an empirical question whether anti-takeover devices are ben-eficial or baleful. Comment and Schwert (1995) offer such an empirical study(Burch (2001) is a recent analysis of lockups). The main findings of Commentand Schwert are:

• Poisson Pills are associated with higher takeover premiums, which is due tothe improved bargaining position of the target.47

• There is weak evidence of deterrence from Poison Pills.• The net effect of these two effects is positive.

In addition, Comment and Schwert (1995, 19ff) estimate abnormal returnsof poison pill announcements (using the event study methodology discussedabove). They find negative abnormal returns of about −2 % which is similarto results of earlier studies (e.g. Ryngaert (1988)). The combination of theseresults gives rise to a puzzle (Comment and Schwert (1995, 43)).48 Why arethere negative abnormal returns on the announcements if the net effect of poisonpills is positive?

6 Summary

While research on the market for corporate control has mushroomed, itis, in our opinion, growth industry.

Jensen and Ruback (1983, 47)

This is a long paper and still only the top of the iceberg has been touched.To draw general and undisputed conclusions is impossible. Nevertheless someaspects are so important that is appropriate to repeat them here.

The paradigm: On the market for corporate control the “right to manage”is traded. Several management teams compete. The necessity of such a marketstems from agency problems caused by the separation of control and ownership.The threat of a tender offer improves the incentives of the incumbent man-agement team. Furthermore, if this threat is insufficient, a transfer of controlideally leads to the installment of the best management team and to the install-ment of the best incentive scheme. However, the institution of hostile takeoversin itself is not unproblematic. Well, a tender offer may be the symptom of anagency problem of the bidder and not the solution of one of the target.

46A similar argument was made for lockups.47See the table in section 2.3.48Jager (2002) studies this puzzle in more detail.

45

We studied first single bidder cases and highlighted the free-rider prob-lem. The free-rider problem makes it difficult for the bidder to profit fromthe takeover, likely that the shareholders receive the full increase in shareholdervalue and that the bid price equals the post-takeover value. We discussed dilu-tion, toeholds and two tier offers as devices to circumvent the free rider problem.

Next we discussed auctions, i.e. the multiple bidder case. The major pointshere are firstly preemptive bidding (as a tactic to avoid a competitive coun-terbids) and secondly social efficiency of auctions. Facilitating auctions maygenerate a deterrence effect (bad) and result in the success of the presumablybest management team (good). Regulations and charter amendments may bal-ance pros and cons.

What is the ultimate conclusion? Our claim is: M & A transactions arean important device to match assets and management teams efficiently. Thenecessity of such a device stems from market imperfections. However, theseimperfections make M & A transactions a topic for regulators. For a rationalpolicy a detailed analysis of the strategic environment is obligatory. As regu-lation is complicated due to the counteracting effects of almost all policies anempirical analysis must be added to theoretical priors.

46

References

Laws

[Germany] Gesetz zur Regelung von offentlichen Angeboten zum Er-werb von Wertpapieren und Unternehmensubernahmen, Bundesgeset-zblatt 2001, Teil 1, Nr. 72(http://www.parlamentsspiegel.de/Dokumente/bund gesetzesblaetter.htm).

[Switzerland] Bundesgesetz uber die Borsen und den Effektenhandel(1999), SR 954.1 - AS 1997 68(http://www.takeover.ch, http://www.takeover.ch/ legaltexts/ lbvm de.html).

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