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THE TAKE-OVER'S CODE ...
TO BE or NOT TO BE ...WHAT IS THE QUESTION?
The takeover code is clearly 'to be'! And for many, it is not before time. There is a wide spread perception among many investors that takeover situations often involve conduct between the participants which is immoral and manifestly unfair. The Montana situation is but one example, and the most recent. The outcome of that particular takeover by Lion Nathan was manifestly unfair, in so far as some shareholders where treated differently to others. Contact Energy has all the hallmarks of shaping up the same way.
So what is the question? The question is clearly the morality or fairness of sharing a control premium attached to a substantial shareholders interest in a company. It is commonly accepted that a controlling stake of a company, which can be as low as 20-30% in some instances, will command a premium on the market and minorities feel that it is appropriate that this premium should in part, be shared with them.
The proposed takeover code will not eliminate the control premium, but will in certain circumstances result in that control premium being shared with all shareholders. Substantial security holders will still be able to sell 20% of the total issued stock of a company, at whatever price they wish on a private treaty basis, without the acquiring party being required to make a similar offer to all shareholders. If however and acquiring party wishes to proceed above the 20% threshold, they must then proceed to 51%, and make a pro-rata offer for the additional 31% to all other shareholders. This allows minority shareholders to share in the premium. Be that as it may, shareholders in general meeting can vote to waive the takeover code if they can be satisfied that a substantial security holders intention to sell, and a new substantial security holders to buy, is in theirs and the company's best interests. In effect this will force disclosure of material facts and plans to the shareholders at large. So much for the question, and for that matter, the answer. Now I would like to descend into an exercise of financial hierarchy.
The entire code has started with the premise that control premiums are paid, and that control premiums should be shared based on fairness and morality. While I cannot deny that control premiums are paid, I would contest that in many circumstances where a control premium is paid, it is based on some immorality, illegality, or other sharp practice. When a control premium is paid with honest intent, other shareholders are unable to differentiate between such an honest intent, and the more probable dishonest intent in respect of such premiums. On this basis, a premium to market will rarely be an honorable control premium.
Let's now look at some commonly held beliefs, many of which are facts, and others, while logical are fallacies.
1. We all accept that when valuing a particular enterprise or company, that a 100% stake in that company is worth what it is worth. There is neither a discount nor a premium applied to a value that is based on a 100% acquisition.
2. For those of us that value shares in company's, and prepare appraisal reports and such like, when arriving at the value of an individual share, we commonly accept that a parcel of shares which represents a controlling interest will have a premium attached to it, and a minority parcel will have a discount. While we commonly accept this it, by default, has become a fact, but it is neither logical nor fair.
3. It follows that the control premium in absolute dollars will be equal to the minority discount. For example, if a company is worth $100 and we value a 51% stake in that company at $70.00, conversely the 49% should be worth $30 and the minority discount and control premium are equal. Quite clearly then, the control premium paid to acquire a company is clearly at the expense of the minority holder, and hence the perceived need for a code to equalise that imbalance.
4. I guess we can also accept that the value of an enterprise today is the sum of its future cashflows, discounted to a net present value, based on an assumption of the risk associated with that enterprise.
5. We can also accept that collectively the shareholders of an enterprise own these future cashflows, pro-rata with their shareholding, and that once those future cashflows are realised and available to be taken by shareholders, after the event all shareholders have also taken the same risk. If we accept this, then the value of 1 share is exactly the same value of another share whether or not it is part of a controlling parcel or part of a minority parcel.
6. Many market commentators believe that sharemarkets are perfect. They assume that all information that is available on a particular company, is known to the market at large and all shareholders, or intending shareholders. They also assume that all shareholders instantaneously interpret this data to price the shares, and that they do so in a rational and similar way, resulting in a share price that accurately reflects forward cashflows of an enterprise and the known risks. This capital markets pricing arrangements, prices a share irrespective of control or not.
Quite clearly this commonly held view or belief, is a fallacy. At any point in time all information available will not be known to all shareholders, and some information will be known by only a few. In addition not all shareholders are rational, and do not interpret the available data necessarily in the same way. Additionally different investors have different risk profiles and whether rational or not, will approach and measure risk in different ways. The advantage of an efficient market, is that the bid price and ask price for shares are quoted daily, and those bid and ask price are the sum of experience and thought processes and dissemination of available information by many participants. All of this should result in an efficient market if it has enough volume, and if it where being run by logical disciplined humans rather than the manic depressives among us which will be overly optimistic when optimism is in vogue, and overly pessimistic when pessimism is in vogue.
Ignoring the fallacies spread among these commonly held beliefs, if these commonly held beliefs
can be strung together then the only logical outcome is that there is no commercial rational for a control premium or a minority discount. If all shares receive the same cashflow and take the same risk, and all shares are valued based on return and risk, all shares have the same value and there is no rational for a control premium or discount.
We all know that control premiums are paid. In some instances control premiums are honorably paid and in other instances less honorably so. I would contest that an honorable control premium is rare.
Honorable Reasons
1. A party acquiring a party stake in the company believes that post the acquisition that they will be able to add valuable cashflows to the business, but will only be able to do so by having control. In such a situation, the outcome is that the business will post the new shareholders acquisition, have more available cashflow for the benefit of all shareholders. The minority's position is thus improved.
2. The acquiring party believes that they can reduce the risk associated with the investment by their acquisition of a controlling stake, due to their ability to access information quickly, particularly bad news, and react to it in a favorable fashion. This reduces the risk associated with the investment, for the benefit of all shareholders, assuming that they are right and that they make rational decisions which correct the effects of bad news quickly. This is the classical 'we are a better manager' argument. The problem for small shareholders is that they don't know whether or not this particular substantial shareholder is any better than the previous, or any better than the entrenched existing management.
Less Than Honorable Reasons
1. Generally during an acquisition of a controlling interest, the acquiring partner will complete substantial due diligence. Accordingly, the acquiring shareholder will have available to them information that is not readily available to the market at large. This was probably the case with Shells takeover of Fletcher Energy, and would also have been the case where a major shareholder seeks to privatise compulsory or otherwise, an investment that they substantially own. A not quite so recent example of this would have been Milburn's acquisition by its controlling shareholder. Hello! ... I thought trading on inside information was an offence!
2. The acquiring party may well have a plan that should they succeed in obtaining control, that they will access more of the company's cashflows for themselves at the expense of minority shareholders. ie, the acquiring party doesn't have any particular plans to increase the wealth of the company, but simply has plans to strip some of that wealth for themselves without reference to minority shareholders. For example:
(a) They plan to grant to themselves a distribution agreement for the company products on favorable terms (unless such a decision was a major transaction, the board could make this decision without reference to shareholders).
(b) They plan to asset strip the company by acquiring company assets on favorable terms to themselves, again provided they acquire the assets in small incremenal steps over a period of time, the transactions involved are unlikely to be major transactions and unlikely to require the approval of shareholders.
(c) They plan to procure for themselves a management contract from the company, and to skim off the top of the income earnings for themselves.
(d) They plan to sell assets to the company from themselves on terms that are favorable to them for which they can be paid in cash from the company's existing earnings flows.
(e) They plan to use the company's infrastructure to subsidize their own operations on favorable terms. For example they will access management capacity within the investee company or buying privileges or market distribution arrangements, or other infrastructural assets to advance their own operations.
The list goes on ... and on ... and on ! There are endless methods for skimming a company's cashflow if you are in a position to control managerial decisions.
So Which Is It ?
We all know that in negotiations to purchase a business (or a share) you pay for what the vendor has got on the table, and you do not pay for the potential that you as a purchaser might bring to the table. If this is the case, and it is my view that it is, the only basis on which a control premium is paid is the belief by the acquirer that they either have insider information which isn't available to the general market, or that the acquirer has developed a plan to skim value off the top of the enterprise of the target company, and that they are therefore pocketing sufficient of the company's return to justify a premium at the expense of the minority.
Clearly, one of these items is already illegal, and the other is immoral. I therefore conclude that in many instances a control premium in a takeover situation is more often that not an immoral premium.
The only flaw in this financial hierarchy is the assumption that all market participants interpret all available information in the same way at the same time. They clearly don't. Each investor will have a different risk profile and a different attitude to risk and a different perception of available returns. These attitudes and perceptions are reflected in a sharemarket real time, but in addition, human nature being what it is, markets are manic both ways.
Sometimes when a market stand is made, it is simply because a share is seriously under valued, and accordingly what appears to be a premium is not a premium at all. All that has happened is that someone has recognised the value in an enterprise before the market has. In this instance the price paid by such an acquirer is simply the reversal of a manic market discount.
In other instances, shareholders heavily discount a shares price on the market because of the added risk to their investment, of what is perceived to be an unpredictable major shareholder. In this instance the market is pricing a minority discount rather than a majority premium, and when an offer is made at a premium to the already discounted price, it is not a control premium but rather a reversal of a minority discount. Shares such as Trans Tasman Properties and CDL Hotels are all companies where the share price reflects a minority discount.
Presumably this minority discount is applied as the minority shareholders in such companys believe it is as likely as not that the majority shareholder is skimming profits, or using insider information to their advantage. Whether such company's are or not is irrelevant, the perception is that they might be.
In conclusion, when a premium is paid in an on market stand, it will rarely be a control premium. It will either be:
(a) The reversal of a minority discount applied by the market due to the past excesses or
performance by an existing majority holder. Or,
(b) A premium based on insider information or perception that an extra return can be taken off the table in same way. Or,
(c)An investor has a plan to add value to an investment, or to reduce the risk of an investment, and is pricing that investor value added into the price that they are prepared to pay now - I think not! Or,
(d) They are buying well in a depressed market without any access to non-public data, and they have just interpreted what is available more rationally than other investors, in which case good luck, and maybe other investors should follow such an investors lead by holding or acquiring stock in the target company. Typically strategic holders in this position are known corporate raiders and are easily identifiable.
And so ... the question ... again
Is the sharing of a control premium, which is at least as likely as not, going to be motivated by a morally questionable purpose, or paid based on a already legal act (insider trading), fair? |
