126 EMJ VOL. 8 NO. 1: March 7990

, ,,i :. ” ’ :_‘.

*‘TakemoverS: U Corporate Val

nlocki 4 ue

Ian Tonks Senior Lecturer in Financial Economics and Econometrics University of Exeter, UK

We rthin the framework of a continuing boom in mergers and acquisitions in the UK, Ian Tonks examines the spectacular bid by Hoylake Investments for BAT (British-American Tobacco). As well as being a case study of a very large take- over bid, he brings out the implications for merger policy, and looks at the motives for mergers, competition in the Single European Market, the use of junk bonds to finance take-overs, and the role of institutional investors, and regulatory powers.

At the beginning of August 1989, Hoylake Investments Ltd, a consortium of businessmen including Sir James Goldsmith, Kerry Packer and Jacob Rothschild, formally announced a gigantic f13.5 billion takeover bid for BAT (British and American Tobacco) plc. Even by the standards of recent “mega-mergers” the scale of this bid represents a transfer of ownership of enormous proportions. The original bid has been delayed in the American Courts and the incumbent BAT management has responded to the bid by suggesting its own restructuring plan. In this article we will examine the logic of the Hoylake bid and its implications for merger policy.

BAT is a diversified conglomerate employing 311,000 people, and with a turnover of over f17 billion is the UK’s third largest company. Hoylake is a company that has been formed solely with the aim of taking over and reorganising the component firms that comprise BAT. Herein lies the central issue of this proposed acquisition. Is it the case that BAT has achieved its size by diversifying too widely, resulting in a corporate form that is unwieldly and inefficient, or does its share price undervalue its true worth as an ongoing concern? In the former situation Hoylake is

seen as a messianic saviour, who will oust the idle incumbent management, rationalise the operations and create a streamlined concern. In the latter case Hoylake are the vandals who will break up a worthwhile company and sell off the undervalued assets to rival firms, who may then close down competing factories with subsequent loss of jobs, while the directors of Hoylake retire with a tidy profit from the venture.

The Hoylake bid raises a number of questions about the whole area of takeovers. What are the motives for such mergers? Is there a need for large UK firms to compete in the European markets after 1992? How legitimate are junk bonds as a method of finance? What are the roles and responsibilities of institutional investors and how adequate is government policy to takeovers through the Office of Fair Trading (OFT) and the Monopoly and Mergers Commission (MMC)?

Figure 1 shows the extent of takeover activity every year since 1983 in terms of the total value of acquired companies. 1986, 1988 and 1989 are characterised by a number of mega mergers, that is, where the value of the acquisition exceeds fl billion. The growing importance of these mega-bids is illustrated by the relative size of the blocks. The value of Imperial Group and Distillers, acquired respectively by Hanson and Guinness in 1986, both were larger than the total value of takeovers in 1983 and together were as large as the total value of UK takeovers only two years earlier. Of course at f13.5 billion the Hoylake bid dwarfs all other bids to date. It used to be the case that a sure-fire defence against a takeover was size. Large firms were immune from acquisition since any prospective bidder would be unable to raise the

Tt3NK.C. TAKF_n\/FR.Q* I INI fM?KING CnRPnRATF VAI I IF 137

Figure 1

necessary finance to buy out the shareholders of the target company. However increased international competition in the banking industry throughout the eighties, and in consequence a less conservative attitude from banks has meant that firms have been able to borrow money to finance an acquisition through a levered buy out (LBO). Banks willing to finance these activities suggests the following strategy for a wily predator: identify a company whose share price undervalues the worth of its assets, borrow the money to finance a takeover, sell off the firm’s assets at their true value, repay the loan and pocket the difference.

One company which has specialised in this kind of transaction is Hanson. In 1986 Hanson paid f2.5 billion for Imperial and subsequently sold off Courage to Elders for 0.4 billion, Ross Foods to United Biscuits for f335 million, HP Sauce to BSN of France for f200 million and Golden Wonder Crisps to Dalgety for f87 million, making the net cost of Imperial only f228 million and still leaving Hanson with the heart of Imperial’s Tobacco business [Gray and McDermott (1989) 1.

An extension of the BLO that has particularly oiled the takover process has been the use of junk bonds. These are a popular form of finance in the United States where they have proliferated since being invented by Michael Milken (who is currently undergoing prosecution by the Securities and Investment Board for insider trading). Milken is regarded by some observers as having “single- handedly restructured Corporate America”. Instead of borrowing from a bank a raider, who need not be a firm but could literally be some aggressive individual entrepreneur, finances the takeover by issuing bonds with a high interest rate secured against the assets of the company being acquired. These bonds are redeemed by selling off the assets of the acquired firm, again with the intention that the difference between the sale value of the assets and the face value of the debt will accrue to the raider. The work “junk” arises because these bonds are not particularly safe assets, in fact they are more like equity with a fixed yield component. The proposed takeover of United Airlines by a consortium including British Airways was aborted in October, when US institutional investors became nervous

128 EMJ VOL. 8 NO. 1: March 7990

about the quantities of debt involved. This resulted in a mini-crash on the US stock markets, as the market began to question whether the bull market fuelled by takeover activity, in turn funded by junk, could be sustained.

The Hoylake bid is financed by a large component of junk bonds, with the mainly institutional investors in BAT being asked to exchange their equity for debt, at an exchange rate that will ensure a sizeahle profit for Hoylake. It has been estimated that the asset sale value of BAT is f17 million, Not surprisingly the institutional investors are unhappy at having their equity in BAT purchased from them at a price well below the underlying value. The Hoylake offer at f13.5 billion represents a f3.5 billion profit for the break up skills of Goldsmith and company. On the other hand before the bid was announced the share price of BAT valued the company at only f10 billion, so the institutuions can thank Hoylake for setting in motion a process which has inflated the value of their investment. But why was BAT’s initial stock market valuation so low? There are two possible reasons.

BAT is an archetypal conglomerate firm. Originally a tobacco company, it recognised the limited horizons of the tobacco industry and diversified into retailing (23% of turnover in 1988) paper and pulp (9%) and more recently insurance and financial services (22%). In doing so it created a vast corporate body with little sense of direction. If BAT’s investors wish to diversify their risks they can do so bv investing in alternative assets or unit trusts, there is no need for BAT to diversify on its shareholders behalf unless it can create a new asset in terms of synergetic effects that can not be replicated by individual shareholders. It is not clear that there exists any complementarities between BAT’s subsideries capable of generating the required synergy. In consequence the market did not value the efforts of BAT management to diversify into independent industries very highly and its share price was low.

Alternatively, it may have been that prior to the Hoylake bid the market was unaware of the value of BAT’s investments, in which case the incumbent management are again at fault for failing to communicate to the market the advantages of BAT’S strategies. This case is illustrated by Pilkington who successfully defeated a hostile bid from BTR in 1986. The publicity and controversy surrounding that bid meant the Pilkington’s share price rose from 428~ in September 1986 to over 7OOp, where it remained after the BTR bid lapsed.

One strategy used by company managers who feel that the stock market is undervaluing their company is a management buyout (MBO) which is a type of LB0 where the incumbent management borrow the

necessary funds and buy out the shareholders, converting the firm into a private company. MBO’s have increasingly become an important method of takeover for medium sized companies. The total value of MBOs in 1988 was f4 billion, with 13 worth over f50 million. One of the most prominent being Virgin whose management bought out the equity capital for f248 million only two years after floating the company on the stock exchange. In part the MB0 is a defensive strategy, since the incumbent management may feel that if their company is undervalued then if they do not take it over a competing group of managers will. The idea of groups of managers competing for the right to run a company in the “market for corporate control” is a thesis originally advanced by Manne (1964) and popularised more recently by Jensen (1988). According to this view management groups will bid competitively for the shares of an undervalued company and this competition will drive up the acquisition price until it approaches the true value of the underlying assets. This is illustrated by the fights between United Biscuits and Hanson for control of Imperial, and Guinness and Argyle for control of Distillers. In both cases a bid price from one participant was subsequently leap-frogged by a higher offer from its rival: the benefactors being the shareholders in the target company who ultimately received the true value for their asset holdings.

This competitive view of the takeover process can explain the well established findings that after an acquisition the merged entity rarely lives up to its predicted performance, and that the gainers in a takeover are the shareholders in the acquired firm, who were bought out at a more than fair price: the raiders are so keen to make the acquisition that they pay well over the odds for the targets assets [Firth (1979), Jensen and Ruback (1983)].

So the Hoylake bid has focused attention on the inadequacies of the current structure of BAT. But whether the Hoylake porposal is the best vehicle to unlock the undervalued assets is the question that the investors in BAT must now answer. The original Hoylake bid has been delayed in the American Courts since the takeover needs the approval of the US insurance commissioners in each of the six states that Farmers Group (BAT’s American Insurance subsidiary) does business. This delay would have meant that the bid violated the timetable for mergers set by the Stock Exchange’s Takeover Panel. However the Panel allowed the Hoylake bid to lapse while it clears the regulatory hurdles in the US, which was reasonable since otherwise UK companies could have developed a defense against hostile takeovers by purchasing US insurance companies.

Ideally the institutional investors would prefer a

TONKS: TAKE-OVERS: UNLOCKING CORPORATE VALUE 129

reorganisation that left the ownership structure unchanged, so that the current investors could reap the benefits of the rise in market values. The BAT management have in part accepted the logic of the restructuring argument and the delay in the takeover timetable has allowed the incumbent management, following pressure from their institutional investors who were unwilling to see the value of their investments revert to their pre-Hoylake days, to propose their own restructuring plans to unlock the assets’ true value. BAT management have won shareholder approval to buy back 10 per cent of its outstanding equity, obtaining the funds by demerging its papermaking and retailing subsidiaries into two separate companies.

A more active involvement in companies’ affairs by institutional investors has been suggested by many commentators, including the Wilson Committee along the lines of the roles played by the banks in Japan and Germany. Up till now it is a role that the institutions have been unwilling to take on. If they wish to protect the value of their investments, it is a course of action they may be forced to adopt in the future.

Will the Hoylake bid succeed? It is unlikely now because of the delay in the US Courts which has enabled the incumbent management to erect a solid defence. Following on from the obstruction in the US courts of the Minorca bid for consolidated Gold Fields in 1988, it looks as though decisions on UK mergers have been abdicated by the UK regulatory authorities to the US legislative system.

The reason for this is that the terms of an OFT referral to the MMC is solely on the basis of domestic competition. There are many issues raised in today’s sophisticated mergers that are outside the scope of the MMC. The US courts are not so generous, and an effective defensive strategy by a target firm is to make use of the tougher criteria required in the US.

The MMC’s domestic competition rule seems redundant, in light of the integrated European Market of 1992. In 1985 the MMC blocked the bid by GEC for Plessey on the grounds that it would result in a reduction in domestic competition, though if UK companies want to compete in the international telecommunications industry they will have to grow bigger fast. The more recent GEClSiemens bid for Plessey which did not generate the hostility of the OFT succeeded. It is instructive to compare the size factor of the BAT bid and the current GEC-Plessey merger. BAT is large, but unnecessarily so since its subsideries operate in unconnected industries. The GEC-Plessey merger benefits from scale economies, and will create one efficient UK firm more able to compete in international markets.

Ultimately merger policy should be directed to whether a proposed merger provides jobs, profits, exports and good quality products at fair prices. The view of the MMC is that these objectives are guaranteed provided that an industry is competitive. This seems to place an enormous burden of responsibility on the market mechanism. Similarly in line with Government philosophy, in September Nicholas Ridley at the Department of Trade and Industry confirmed that bids will only be referred on competition grounds and ruled that Hoylake’s bid should not be referred to the MMC. The DTI has maintained an arms length ambivalence to the BAT situation, even given its size and wide ranging ramifications for British industry. No governmental attempt has been made to influence the course of events in the belief that market forces are the best determinant of whether Hoylake will be given the key to unlock BAT’s asset value.

But the Government should be concerned about the indirect costs of these takeovers: the external effects on other companies’ managements. The direct costs of the Guinness-Distillers merger were estimated at f160 million payable to advisors and banks, and the direct costs of the Hoylake bid may exceed fl billion, but of greater worry are the indirect costs. Among these is the additional uncertainty across the rest of British industry surrounding the environment that managers have to operate in. The fear of acquisition may result in the commitment of real resources by company managements to prevent prospective takeovers of their companies. Instead of senior executives focusing on sales and marketing strategies, exports to the European Community, product innovation and growth policies, they will be more concerned with the negative effects of protecting themselves against hostile bids. Elementary economics tells us that these externalities will not be priced by the market, and in these circumstances the government’s agencies should not hesitate to intervene.

The Hoylake bid for BAT represents a type of takeover that deserves a policy response from the Department of Trade and Industry.

REFERENCES

Gray, S.J. and M.C. McDermott, Mega-Merger