Why bidders like creeping takeovers

Before announc-ing a takeoverbid, bidding

firms sometimes grad-ually acquire shares onthe open market.These types of open-market transactions arecalled creeping tenderoffers. Why do biddingfirms like creepingtakeovers? What arethe benefits and whatare the regulations?

In March 2005, metal min-ing giant Noranda Inc.announced its intention toacquire Falconbridge Inc. By thetime this announcement wasmade, Noranda already owned58.8 percent of the shares of Fal-conbridge, which they hadacquired in bits and pieces overthe period leading up to theannouncement—a classic exam-ple of a “creeping takeover,”which is allowed under Canadianregulations. Many other jurisdic-tions, including the UnitedStates, place regulatory con-straints on firms’ ability toemploy a creeping takeoverstrategy—however, there areincentives for potential acquirersto employ the strategy as muchas possible within these con-

straints. In so doing, they canpartially offset some of the pit-falls that are innate to thetakeover bidding process.

TAKEOVER PREMIUMS

The announcement of atakeover is good news for targetshareholders, especially whenseveral competitors are interest-ed in one target firm. Largetakeover premiums are paid toshareholders of target firms inorder to obtain control over adesired target. It is not uncom-mon for target shareholders toreceive takeover premiums farabove 20 percent.

Exhibit 1 summarizes theresult of 58 different studies,which include a total of 16,642observations of mergers and

acquisitions. The tableshows weighted aver-age abnormal returnsto bidding and targetshareholders. Theabnormal returns areaverages obtained fromthe empirical studiesand subsequentlyweighted by samplesize in calculating theweighted averages.

Exhibit 1 demon-strates that target shareholdersreceive an average abnormalreturn of 25 percent in tenderoffers and 20 percent in mergers.Further, Exhibit 1 shows that tar-get shareholders receive an aver-age abnormal return of 15 per-cent (8,371 observations), whileshareholders of bidding firmsneither gain nor lose (8,271observations), regardless of thetype of corporate restructuring.

Another interesting observa-tion from Exhibit 1 is the lowabnormal returns to target share-holders from open-market trans-actions (creeping takeovers).Target shareholders realize anaverage abnormal return of 7percent on open-market transac-tions, which is 18 percent lowerthan the average abnormalreturns on tender offers. What

In the United States, a firm’s ability to use creep-ing takeover strategies is constrained by disclo-sure requirements. But elsewhere, the restrictionsare less stringent. The authors reveal the averagetakeover premiums paid to target shareholdersunder different takeover strategies. They alsoinvestigate what makes firms overbid—and howcreeping takeover strategies can help curb thatexpensive habit. © 2006 Wiley Periodicals, Inc.

Elizabeth Croft and Han Donker

Why Bidders Like Creeping Takeovers

featu

reartic

le

45

© 2006 Wiley Periodicals, Inc.Published online in Wiley InterScience (www.interscience.wiley.com).DOI 10.1002/jcaf.20182

could be the reason for this enor-mous difference between tenderoffers and open-market transac-tions?

RATIONALES FOR TAKEOVERS

Before we delve intotakeover strategies, we shouldexplain the rationale behindtakeovers from a bidder’s per-spective. Why are bidders will-ing to pay takeover premiums fortarget firms?

The first category oftakeover theories emphasizes thewealth-enhancing effects of cor-porate takeovers, such as effi-ciency increases, operational andfinancial synergy, the replace-ment of inefficient target man-agement, and the acquisition ofundervalued target shares. These

motives go hand in hand withthe popular motto of boards ofdirectors: Focus on the CoreBusiness! Within this context,shareholders of both the biddingfirm and the target firm benefitfrom takeovers as the result ofpost-takeover value-enhancingimprovements inspired by themanagers of the bidding firm.

The second category oftakeover theories refers to thebehavioral aspects of managersfrom bidding firms. In order tomake themselves irreplaceable,managers acquire firms thatrequire their personal managerialskills in order to realize post-takeover value improvements. Inthis way, managers entrenchthemselves and create a strongbargaining position with respectto their own shareholders. Share-

holders become more susceptibleto management’s fads and fan-cies.

Further, the (mis)use of freecash flows as an explanation fortakeovers has considerableappeal. The presence of freecash flows—or a war chest—encourages managers to acquirefirms instead of paying divi-dends to their shareholders. Therationale for this behavior is thequest for independence fromexternal capital markets. Divi-dend payments reduce theresources under managerial con-trol and make managers moresubject to the monitoring by cap-ital markets. Managers haveincentives to use these free cashflows for internal expansion oracquisitions rather than payingdividends. The inner urge ofmanagers to build their ownempire is an additional explana-tion for takeover activities. Larg-er firm size creates more pres-tige and status for the captainsof industry. And last but notleast, firm growth—throughtakeovers—provides additionalexecutive rewards in the form ofcompensation plans and bonusschemes.

Another behavioral explana-tion for takeovers is that bid-ding-firm managers stronglybelieve that post-takeover valueimprovements are present. Theybelieve that they make rationaldecisions and that they areimmune from the arrogance orconceit that arises from exces-sive self-confidence (hubris). Asmanagers are not often engagedin takeovers, they cannot learnfrom their failures. Managerswill not reconsider possibleerrors in their measurements,and persist in their beliefs thatthey have estimated the true val-uation of the target firm. Whenthe valuation of the target firm isuncertain to the management of

46 The Journal of Corporate Accounting & Finance / January/February 2006

DOI 10.1002/jcaf © 2006 Wiley Periodicals, Inc.

Summary of 58 Studies Measuring Abnormal Returns toShareholders of Bidding Firms and Target Firms

Type of acquisition Bidding firms (%) Target firms (%)Tender offers 0.39 25.45

n = 1,529 n = 1,593Mergers 0.08 20.81

n = 2,936 n = 1,454Block trading 1.17 10.07

n = 337 n = 576Open-market transactions – 7.30

n = 45Sell-offs –0.48 2.32

n = 1,118 n = 2,860Privately held targets 1.45 –

n = 281Other M&A studies –1.27 23.33

n = 2,070 n = 1,843Total –0.19 15.21

n = 8,271 n = 8,371

Exhibit 1

the bidding firms, the managermost likely to win will be theone who most overestimates thevalue of the target firm. Hubristheory is closely related to theconcept of the winner’s curse.This idea originates from auctiontheory and predicts that the win-ning bid is made by the bidderwith the largest positive valua-tion error. Bidding firms arepaying too much, which explainswhy they win.

Finally, tax advantages andthe acquisition of market power(monopoly) through horizontaltakeovers could be additionalreasons for takeover activities.

Managerial entrenchmentand empire building arewealth-reducing phenome-na and, therefore, sociallyundesirable. These takeovermotives lead only to atransfer of wealth and cre-ate no wealth themselves.The self-interest of man-agers causes a redistributionof wealth from shareholders tomanagers and reduces sharehold-er value.

BIDDING TACTICS

What kind of takeover strate-gies can bidders use in order toget control over a target firm?How can auction theory apply inthis context?

In English (traditional) auc-tions, bidders start with low bidsand raise their offers bid by biduntil the highest bid stands. Eachbidder may revise its bid withoutany cost as the bid price increas-es. Such auctions are commonfor art and real assets, where in ashort time bids and counterbidsare made under the auspices ofan auctioneer. During a takeovercontest, however, the time inter-vals between the bids are longerthan during a traditional auction.It sometimes takes several weeks

instead of several seconds for anew bid. It should be noted thata bidder can acquire informationabout the target firm after anobserved bid. A bidding firmcan change its original strategy,based on its prior beliefs, andfollow another strategy based onits updated beliefs after observ-ing an offer from another bidder,constituting a so-called strategicinteraction between bidders.Another characteristic oftakeover contests is the presenceof just a few rounds. One or tworounds are common, but three-round auctions are exceptions.The implication is that the first

and second bids are almost finalbids.

What should be the strategyof a bidder facing an attractivetarget with high expected post-takeover gains? In this situation,a bidder can use a preemptivebidding strategy, which providesa rationale for bidding firms tooffer a high (preemptive) initialbid, rather than making a lowinitial offer and raising it littleby little (English auction). Whystart with a high offer and takethe risk of losing cash? With apreemptive bidding strategy, abidder separates itself from othercompetitors. With this tactic, abidder can convince other bid-ders that its synergy gains arelarge and discourage a secondbidder from entering the compe-tition. This form of deterrencecan be effective, because thehigh-valuation bidder lowers thepotential gains for the second

bidder. This bidding tacticexplains why it is more commonto observe a pattern of high ini-tial bid premiums being offeredand paid, rather than a pattern oflow initial bids and subsequenthigher counteroffers. In the lattertype of scenario, the low bid pre-mium of the first bidder indi-cates a low private valuation andencourages a second bidder toenter the takeover contest.

Alternatively, an offerannouncement by a bidder mightbe a signal to other potential bid-ders that there are high non-firm-specific synergistic gainsavailable in the target firm. Thepresence of high potential gains

in the target firm mightattract more bidders whocan generate high net pres-ent value takeovers. In thatcase, competition intakeovers is a signal thatthe creation of wealth isnon-firm-specific. It seemsstraightforward that target

shareholders will gain fromcompetitive bidding becausemultiple bidders will push uptakeover bid premiums. Howev-er, high opening bids by the firstbidder lower the probability thatsubsequent bidders will havesufficient potential gains to bid,which decreases the probabilitythat the bidding process persists.

A common element in thepreemptive bidding models isthat the first bidder tries to dis-courage potential subsequentbidders from entering thetakeover bidding process. There-fore, a bidder makes a hightakeover bid to signal to the mar-ket that it is a high-valuationbidder and to discourage secondbidders from undertaking costlyrevaluation investigations.

A high valuation bidder willnot follow the strategy of a lowvaluation bidder because thebenefits of a low bid are offset

The Journal of Corporate Accounting & Finance / January/February 2006 47

© 2006 Wiley Periodicals, Inc. DOI 10.1002/jcaf

The presence of high potential gainsin the target firm might attractmore bidders who can generate highnet present value takeovers.

by the costs of mimicking. Theopportunity cost of mimickingincludes the loss of post-takeover gains when the takeoverfails.

Overbidding theory explainswhy winning bidders sometimesovervalue target firms. Bidderswith an initial stake may have anincentive to submit a high bid inorder to provoke a high coun-teroffer. Nevertheless, overesti-mation (overbidding) of the tar-get value implies a loss for thewinning bidder and a gain forthe losing bidder, who sells hisshares at a high price.

Other possible explanationsof overbidding are hubris and

the winner’s curse. However, itis not in the interest of potentialbidders that the takeover price isdriven up by counteroffers.Instead of starting a biddingcontest, bidders may considerbargaining with target manage-ment in order to limit overbid-ding or using a creepingtakeover strategy.

CREEPING TAKEOVERSTRATEGY

In order to mitigate hightakeover bids, bidding firms canchoose an alternative strategy.These are summarized in Exhibit2. A very commonly used strate-

gy is that, instead of announcinga tender offer, bidding firmsacquire target shares on the openmarket at favorable prices. Ifacquirers can hide their actions,they can purchase target sharesat low prices prior to thetakeover announcement fromuninformed target shareholders.The bidder tries to keep thesetransactions secret, in order toprevent upward pressure on theprice of the target’s shares. How-ever, financial market regula-tions force bidders to disclosethe percentage of target sharesthey purchase, if they cross acertain threshold. The SecuritiesExchange Act (U.S.) requires



Acquisition Types

Tender OffersTender offers are offers made directly to the shareholders of a target firm. In a tender offer, the bidder makes anoffer that applies to all target shareholders. Almost all tender offers are made at a premium over the prevailingmarket price for a limited time period.

Friendly TakeoversIn friendly takeovers, there will be some preliminary consultation with the target management before a tender bid isannounced. Normally, after negotiation with target management, an official statement is made public, in which thebidder explains its proposal to the target shareholders.

Hostile TakeoversIn hostile takeovers, there is no direct interference by target management. The target management is set aside;they can offer resistance to the hostile bid through takeover defenses.

Open-Market TransactionsOpen-market transactions involve purchases of shares on the stock exchange. Instead of making a public offeringto all target shareholders (tender offer), bidding firms buy target stocks on the open market at market prices, justas any other investor might buy shares.

Creeping Tender OffersA creeping tender offer arises when a bidder gradually buys shares at current market prices on the open market inorder to gain control over a potential target. By using an iterative process, the bidder offers each target shareholderits reservation price instead of one (equal) offer to all target shareholders.

Exhibit 2

that if an acquirer purchases 5percent of a company’s shares,the acquirer has to disclose itsreasons and plans or proposals ithas with respect to the targetcompany. One should expect thata bidder can hardly conceal itsintentions under this regulation,but bidders, in practice, delaytimely disclosure. During thisperiod, bidders can augmenttheir holdings. However, large-scale open-market purchases aredifficult to keep secret, andspeculation can still raise thestock market price.

With an upward-sloping sup-ply curve for target shares (seeExhibit 3), increased demand fortarget shares implies that thetakeover price will be higher onthe supply curve for targetshares. With open-market trans-actions, bidders remain on thesupply curve and offer eachshareholder its reservation price.

Theoretical grounds andempirical findings suggest that

the supply curves for targetshares are upward-sloping. Thereare many theoretical argumentsto support the concept of anupward-sloping supply curve forshares. One explanation is basedon the dissimilarity in tax ratesthat affects capital gains amongtarget shareholders. Heteroge-neous tax rates among targetshareholders will lead to differ-ent reservation prices for targetshareholders, even without dif-ferences of opinion about thevaluation of target shares. Thevariability in tax status impliesthat each shareholder has differ-ent opportunity costs to tender.This means that the premiumwill vary across target sharehold-ers. Another argument for anupward-sloping supply curvestems from the heterogeneity ofbeliefs. Shareholders may havedifferent opinions about theexpected valuation of targetshares if a takeover offer suc-ceeds, and have different

expectations about the probabili-ty of future takeover bids. Targetshareholders may expect higher-valuation bidders to appear in thefuture, and offer a higher price.

Exhibit 3 provides an exam-ple of an upward-sloping supplycurve with dispersed ownership oftarget firms. The supply curveintersects the vertical axis at thecurrent market price Pm. Supposethat q1 is equal to the percentageof shares needed by the bidder toget control over the target. Thetender offer is equal to P and thebid premium is PmPT. Sharehold-ers with high tax rates and highexpectations about future gainswill tender at high reservationprices (they are high up the sup-ply curve). This means that thesupply curve is an ascendingcurve with an increasing slope. Iftarget shareholders do not initiallytender, bidders must offer atakeover premium over the valueof the target shares. It would be inthe interest of a bidder to payeach shareholder his reservationprice. This happens when biddersacquire shares on the open mar-ket; however, if the bidderacquires a large block of shares atone time, he takes the risk ofpushing the target’s share priceupward. Some less sophisticatedshareholders will unwittingly ben-efit from a rapid price rise andobtain more than their reservationprice when they eventually sell.By using a more gradual process,the bidding firm is less likely tocause rapid shifts in the shareprice and will be able to capture agreater amount of the sharehold-ers’ surplus as they move towardtaking over the firm.

In order to obtain corporatecontrol (for example, 90 percent),bidders have to pay a minimumprice P equal to the reservationprice of the pivotal shareholder.This offer price applies for allshareholders, including those



Exhibit 3

Tender Offers and the Supply Curve of Target Shares

with lower reservation prices. Asa consequence, bidders lose apart of their gains (the areabetween the offer price P and thesupply curve). Paying each share-holder his reservation price (onthe supply curve), bidders benefitfrom creeping takeovers in com-parison with a bidder who makesa tender offer. Currently, mostcountries grant controlling share-holders, who own 90 or 95 per-cent of total target shares, theright to buy out the remainingminority shareholders at the priceoffered in the preceding takeoverbid (squeeze-out rule). Thesqueeze-out rule makes takeoversmore attractive to bidders,because bidders prefer 100 per-cent ownership instead of atakeover, which leaves remainingminority shareholders.

REGULATIONS

In the United States,takeover bids are regulated under

the Williams Act by the Securi-ties and Exchange Commission.Disclosure rules provide targetshareholders with more time andinformation in order to makeappropriate tendering decisions.Bidders have an obligation todisclose within ten days theiridentity, shareholdings, andintentions when they acquire 5percent or more of the votingrights of the target firm. TheCity Code (U.K.) and the EUDirective on Takeover Bidsembody similar legal provisionsfor the member states. However,these takeover thresholds mightdiffer between member states.Secret acquisitions of largestakes are limited.

Further, the EU Directive onTakeover Bids and the CityCode (U.K.) include a mandato-ry bid rule that contains an obli-gation for a bidder to make afull mandatory bid to theremaining target shareholderswhen the bidder acquires a cer-

tain percentage of the votingrights that confers to bidderscontrolling power. The triggerthreshold differs between coun-tries and legislation (30–50 per-cent). For example, the CityCode’s mandatory bid rule con-tains a concept of corporate con-trol defined in terms of a thresh-old of 30 percent of the votingrights. The United States doesnot have a mandatory bid ruleand allows for partial (volun-tary) bids without the obligationto make a sequential (mandato-ry) bid to all remaining targetshareholders. The mandatory bidrule offers some protection tominority shareholders, becauseit is no longer possible to use afront- and a (lower) back-endtender offer for target sharehold-ers. On the other hand, mandato-ry bids make it less attractive tobidders, encouraging takeoveractivities. There is a trade-offbetween protection of minorityshareholders and stimulatingtakeover activities.

Exhibit 4 shows the implica-tions of a creeping takeover witha sequential (mandatory) bid ontarget shares. The takeover pre-mium (rectangle SMT) is small-er than the premium (PmPT) paidin the previous case (Exhibit 3),where the bidder makes a tenderoffer to all shareholders withoutbuying shares on the open mar-ket. The benefits of this creepingtakeover strategy are equal toPmPMS.

Mandatory bid rules make acreeping takeover a favoredtakeover strategy; nevertheless,the feasibility of secretly acquir-ing shares on the market shrinkswith strict disclosure rules.

THE BENEFITS OF STEALTH

Firms seriously consideringa potential acquisition and antic-ipating a bidding competition



Exhibit 4

Creeping Takeovers and Mandatory Bids

can enjoy real benefits from pro-ceeding gradually, at least initial-ly, rather than boldly announcingtheir intentions. As we haveshown, the incentives of man-agers and the dynamics of thecompetitive bidding process tendto lead to overbidding, which inturn reduces post-takeover bene-fits from the acquisition for thesuccessful bidder. In fact, thebias toward overbidding creates

a potent argument in favor ofproceeding with the acquisitionvia a creeping takeover, sincedoing so should ensure thepotential acquirer will be betteroff—even if its eventual bid isbeaten or preempted by the com-petition! In the event its bid issuccessful, the acquirer will atleast have gained the surplus thatwould have gone to the share-holders on the portion of shares

they obtained in advance of theirtakeover bid. If its bid is unsuc-cessful or preempted by a com-petitor’s bid, they will enjoy thepremium included in the com-petitor’s bid price on the portionof the shares they hold. Thus, bycreeping toward an impendingtakeover battle, bidders can con-trive to realize shareholderwealth whether or not they even-tually win.



Elizabeth Croft, PhD, is an assistant professor in strategy and international business with the School ofBusiness at the University of Northern British Columbia (UNBC) in Canada. Her research interests includeoutsourcing and offshoring, network strategies, and strategies of financial institutions. Han Donker, PhD,is an associate professor in accounting with the School of Business at the University of Northern BritishColumbia (UNBC) in Canada and a chartered accountant. His research interests include corporate restruc-turing (mergers and acquisitions, spin-offs, equity carve-outs, sell-offs, split-offs, tracking stocks, etc.),positive accounting theory, corporate governance, and international financial reporting standards.

Documents

Why bidders like creeping takeovers