Do Independent Directors Matter?

1
Discussion Notes for Presentation at Yale
University October 4, 2001 The Effect of
Takeovers on Shareholder Value
Sanjai Bhagat University of Colorado, David
Hirshleifer Ohio State University, Robert
Noah Analysis Group (Cambridge, MA)
http//bus.colorado.edu/faculty/bhagat
2
The Question

• Do takeovers improve target and bidder firm
  value?
• Other stakeholders not considered
• Employees
• Customers/Suppliers
• Bondholders

3

• Two important challenges to estimating
• value effects of takeovers
• I Truncation Dilemma (of Window Length)
• Short return window Since not all bids succeed,
  return is only a fraction of the value effects of
  successful takeovers.
• Long return window Can capture full value
  effects. But, return includes greater noise, and
  raises questions of benchmark specification.

4

• Two important challenges to estimating
• value effects of takeovers
• II Revelation Bias
• Bidders return at the time of bid gives a wrong
  estimate of the markets valuation of the
  bidders gain from takeover, because
• Some bidders deliberately time bid announcement
  with unrelated negative announcements. Wall
  Streets version of Wag the Dog (WSJ 12/18/98).
• The form of the offer and the very fact of an
  offer may convey information about the bidders
  stand-alone value.

5
It's Wall Street's version of Wag the Dog.

• Over the past week, both Mattel and Coca-Cola
  have announced acquisitions on the same day they
  also issued warnings about disappointing
  earnings. ... No one is suggesting that either
  company unveiled its acquisition solely to divert
  attention from its problems... But it is also
  clear that the acquisitions, like the Iraq
  bombings, helped shift attention away from other
  less favorable developments.''
• WSJ, Heard on the Street', 12/18/98, p. C1

6
Revelation Examples

• Returns to bidding firm shareholders.
• Fact of an Offer
• Good news
• Bidder expects high cash flow.
• Bad news
• Poor internal investment opportunities.
• Bidder management with empire-building
  propensities.
• Cash vs. Exchange Offer
• Stock Offer Bad news, lemons problem with equity
  issuance
• Cash offer Good news that not issuing equity.

7
Goals of the Paper

• Document stock returns associated with tender
  offers in a comprehensive dataset (1962-97 soon
  to be through 2000).
• Develop and apply a method to address the
  truncation dilemma.
• Develop and apply a method to disentangle
  shareholder value improvements from revelation
  about stand-alone value.
• Examine several economic hypotheses about
  takeover contests.

8

• Solution to Dilemma of Window Length problem
• Probability Scaling Method
• Like traditional methods, uses short return
  window.
• Method adjusts return from short window upward to
  reflect the probability of success of bid.

9

• Solution to Dilemma of Window Length and
  Revelation Bias problems
• Intervention Method
• Focuses on the returns to the bidder when
  something happens (while the bid is outstanding)
  that changes the probability of success of the
  bidder.

10
What might change the probability of success of a
bidder?

• Litigation by target firm.
• Arrival of other bidders.
• Objection by a government regulatory agency (FTC,
  Dept. of Justice).
• Defensive measures by target (poison pill,
  lock-up provision).

11
Arrival of a second bidder

• Decreases probability of success of the first
  bidder.
• If takeover is in the interest of the first
  bidder, the first bidders stock price declines
  at the arrival of the second bidder.
• If takeover is not in the interest of the first
  bidder, the first bidders stock price rises at
  the arrival of the second bidder.
• Note Decline/rise in the first bidders stock
  price is not related to the stand-alone value of
  the first bidder, but only reflects value from
  the takeover.

12
Findings

• Value improvements from tender offers are
  positive in 95 of the sample using the
  Intervention Method (89 using the Probability
  Scaling Method), and are on average 50 of
  target value using either method.
• Sample average revelation effect is zero. But
  time variation in revelation effects.
• Average perceived value improvement larger than
  estimates based on short-window returns.
• Bradley-Desai-Kim (1988) 30 of target value.
• Intervention and Probability Scaling Methods 40
  of target value.

13
Findings

• Bidders do not profit from buying targets
  Average premia about the same as the value
  improvement.
• Similar value improvements pre- and post-Williams
  Act.
• Takeover by a large bidder of a small target
  creates a greater value improvement. (gt
  Cultural clashes more severe in marriage of
  equals.)

14
Findings

• Value improvements as a fraction of target value
  not especially high during merger boom of
  1992-1997. However, these takeovers have created
  large dollar increases in value because of their
  large scale!
• Larger value improvements for friendly (business
  complementarities) takeovers compared to hostile
  (discipline of bad managers) takeovers.

15
Illustration of the Truncation Dilemma

• Target Stand-Alone Value
  100
• Target Post-Takeover Value
  140
• Bidder Stand-Alone Value
  200
• Prior probability of successful bid 0
  
• Post-offer probability of success 0.6
• Combined pre-bid expected value 100 200
  300.
• Just after the initial bid 100 200 .6(40)
  324.
• Combined equity return (324/300) - 1
  8.0.
• True percentage value improvement (40/300)
  13.33

16
Illustration of the Truncation Dilemma (2)

• Stock markets prior perception of bidder
  target discounted value
• 100 200 300.
• Stock markets post-bid combined valuation
• 100 250 350.
• Combined bidder/target equity return
• (350 - 300)/300 approx. 16.7

17
Illustration of the Intervention Method

• Case 1 Large Improvement from Takeover
• Target Stand-Alone Value
  100
• Target Post-Takeover Value
  140
• FB Stand-Alone Value
  250
• EPrice FB PaysFB Succeeds
  120
• EPrice FB PaysCompeting Bid, FB Succeeds
  130
• Pr(FB Succeeds) .6
• Pr(FB SucceedsCompeting Bid) .4

18
Stock Price Reaction of FB to Competing Bid

• Stock price when FB announces offer
• 250 .6(140 - 120) 262.
• When competitor appears
• 250 .4(140 - 130) 254.
• FB's stock return
• (254 - 262)/262 - 3.

19
Sources of FBs Return

• FBs price reaction to the competing bid
  reflects
• (1) FB pays more if he succeeds.
• (2) FB has a lower probability of succeeding.
• (2) gt FB return decreases with improvement.

20
Case 2 Zero Improvement from Takeover

• Post-takeover value of target 100.
• Stock price when FB announces offer
• 250 .6(100 - 120) 238.
• When competitor appears
• 250 .4(100 - 130) 238.
• Stock return 0.

21
One-to-One Mapping of Value Improvement to Stock
Returns

• Improvement Stock Return
• 40 -3
• 0 0
• Given the other parameters, 11 mapping.
• Can infer improvement without revelation bias.

22
Specifics of the Intervention Method

• 4 dates
• t 0 Time prior to first bid.
• t 1 Arrival of first bid.
• t 2 Time prior to arrival of competing bid.
• t 3 Arrival of competing bid.

23
y Market value of bidder not related with
takeover. ?t Bidder's profit from takeover
conditional on ?t. Pt Bidder's price at
t. Hence, P1 y ?1 , P3 y ?3 . (11)
24
V0 Non-takeover target value. V1 , V3
Post-takeover target value reflecting takeover
gains. B1 , B3 Price ultimately paid by a
successful first bidder. ? Fraction of
target held by first bidder prior to first
bid. Hence, ?1 Pr(Sq1) aV1 - V0 (1-a)V1
- B1, ?3 Pr(Sq3) aV3 - V0 (1-a)V3 -
B3. (12)
25
Assume, V3 V1 V . See footnotes 16,
17 Also, R3 P3 / P1 - 1. (V/V0) - 1
R3(P1/V0) / Pr(Sq3) - Pr(Sq1) a (1
- a) l(B1/V0) (1 - l)(B3/V0) - 1 ,
(14) where, l Pr(Sq1) / Pr(Sq1) -
Pr(Sq3). Strong Agency / Hubris Hypothesis
(V / V0 ) - 1 0. (V / V0 ) - 1 gt 0. Implies
joint value improvement.
26
The Probability Scaling Method of Estimating
Value Changes Value Improvement Combined
Initial Bidder and Target Return /
(Probability a First Bidder arrives and
wins) (Probability a First Bidder arrives
but a Later Bidder wins) (9)
27

• DATA
• MERC and SDC datasets.
• Table 1 794 tender offers during 1962-1997.
• Figure 2 Percentage of
• Successful takeovers,
• Multiple (two) bidder takeovers,
• Hostile takeovers,
• All cash offers.
• Figure 7 Median dollar shareholder returns to
• Bidders,
• Targets,
• Combined entity,
• over various sub-periods during 1962-1997.

28

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

29
ESTIMATES OF VALUE IMPROVEMENTS (V/V0) - 1
R3(P1/V0) / Pr(Sq3) - Pr(Sq1) a (1
- a) l(B1/V0) (1 - l)(B3/V0) - 1 ,
(14) where, l Pr(Sq1) / Pr(Sq1) -
Pr(Sq3). (V/V0) - 1 IRATIO Joint value
improvement brought by takeover. R3
Bidder abnormal return at entry of second
bidder -.3 (median -.3). P1/V0
Relative size of bidder versus target 4.68
(1.80).
30
Pr(S?1) Unconditional probability of success
of first bidder 530/794
.6675. Pr(S?3) Probability of success of
first bidder given arrival of competing
bid 35/137 .2555. ? Fraction of
target's equity owned by first
bidder .025 (median .000). B1/V0
Average price at which first bidder wins in
full sample 1.435 (1.384). B3/V0
Average price at which first bidder wins
given arrival of competing bid 1.440 (1.421).
31
Table 3 IRATIO 49.6 (median 43.4). 95
of IRATIO estimates are positive. Histogram of
IRATIO Figure 8.
32
SENSITIVITY ANALYSIS 1. Use transaction-specific
probabilities of success using the logit models
of Table 4. Last four rows in Table 3. 2.
Sensitivity of mean of estimated IRATIO to
simultaneous variation in each of the estimated
parameters in the direction of lower IRATIO Mean
IRATIO remains positive with simultaneous 12
shift in all four estimate parameters. 3. Table
3 Parameter estimates from Bhagat-Shleifer-Vishny
(1990). IRATIO 36.7 (21.2)
33

• SENSITIVITY ANALYSIS
• 4. Table 3 Parameter estimates from Betton-Eckbo
  (1998). IRATIO 52.2 (47.0)
• 5. Parametric derivation of distribution of mean
  IRATIO.
• 6. Model Specification Table 10
• If the arrival of a competing bid causes an
  upward revision in the expected post-takeover
  value of the target to the first bidder gt K gt
  1.
• If the first bidder fails to acquire the target,
  the first bidder will successfully acquire
  another similar target at a similar premiumgt g
  gt 0.
• An unsuccessful first bidder can sometimes profit
  by selling its holdings to a successful competing
  biddergt Pr(S2q3) gt 0.

34

• Comparison of the Intervention Method, and
• Probability Scaling Method to
• Traditional Methods
• Table 5
• Traditional Method combined return (CIBR) 28.3
  
• Intervention Method combined return (IRATIO)
  43.4
• Probability Scaling Method combined return
  41.1
• Work to be done
• Estimate revelation effects in different classes
  of transactions.
• Is revelation more adverse when pay with equity
  than when pay cash?
• Different revelation in hostile versus friendly
  transactions?