Hostile Takeovers and Merger Arbitrage

Hostile takeovers attract a great deal of attention in mainstream media primarily due to the shock value and audaciousness of the approach. When combined with the potential entertainment value of the ensuing mudsling involving household names the effect is magnified. Despite this attention, hostile bids only ever account for a small proportion of the total mergers & acquisitions market. This also held true during the fourth wave of merger activity characterized by the corporate raiders awash with cash from junk bonds provided by Michael Milken in the 1980’s.

Hostile takeovers and merger arbitrage are a natural fit. The disagreement between the parties allows for greater profit potential although at the expense of greater risk. In fact, in his book, Risk Arbitrage: An Investor’s Guide (part of our investment book list), Keith Moore writes,

“Hostile (or contested) takeovers are among the most exciting arbitrage transactions … They are also the most challenging and, potentially, the most profitable, but an arbitrageur who makes a wrong call in a contested takeover can lose a great deal of money.”

In this article, we answer some of the key questions traders have regarding hostile bid situations and how a merger arbitrage investment strategy can be implemented.

What are Hostile Takeovers?

From the perspective of the acquirer, a takeover approach becomes a hostile bid when the target rebuffs those advances. A target company whose management is unwilling to agree to a merger or takeover can adopt this approach in either a public or private setting. The acquirer may already suspect the target will not welcome its advances, but it is the subsequent response of the target, verbally or in a practical sense, which will signify whether or not a hostile takeover situation exists.

The target has a number of defense options at its disposal both pro-active and reactionary. A simple and yet surprisingly effective tactic is the “Just say no” defense. If the target management receives an unwanted offer, they can simply refuse to engage and dismiss the idea. Should the acquirer continue with the pursuit, the takeover is deemed hostile.

The acquirer however is restricted to just a few options should it wish to proceed with a hostile takeover which we will discuss throughout the remainder of this article. Each of these tactics will have a varying degree of complexity and success and may cause the merger arbitrage spread to oscillate wildly.

What Causes Hostile Takeovers?

A target company may have previously signaled its intention to remain independent through a number of methods. Reactions and public statements to prior indications of interest from alternative suitors, or a strong and repeated commitment to the current or future corporate strategy and objectives, suggests management are not receptive to a takeover. If growth prospects and analysts ratings are high (which in itself is a good reason to acquire the target), management may also be keen to remain independent. Should this be the case, the merger spread will almost certainly stay wider than were the deal viewed as friendly.

Target Performance

On the other hand, management may be mishandling the business and struggling to implement a sufficient turnaround plan (see Red Robin Gourmet Burgers RRGB discussed later) as interpreted by the financial performance. Rather than admit their errors, a company may choose to refuse a takeover approach and continue in a state of denial. The acquirer is then left with no choice than to pursue hostile actions. In this case, the acquirer seeks to remove the ineffective management and / or the board in order to improve target performance.

Bluffing Strategy

In addition, a target may initially force a hostile situation simply to encourage the bidder to raise its offer. An action consistent with the fiduciary duty of the board. These situations, which ultimately lead to a friendly deal, can be extremely profitable for traders. These deals have a very high deal closing probability (DCP) and might only be derailed by external forces such as regulatory issues. Therefore, whilst the deal is in its hostile phase, traders need to research the company and its actions during the period prior to the deal announcement. As Moore writes,

“Developments tend to occur more quickly than in mergers. It is imperative that the arbitrageur drop everything else when a new contested takeover is announced. He or she must try to analyze everything possible about this transaction.”

This will help gauge if management are serious about remaining independent and protecting their own self-interest and job security or genuinely trying to increase shareholder wealth.

Valuation

Comparisons to other deals in the sector will give vital clues as to the level of acquisition premium offered for the company. If this indicates the offer is low, it is possible management and its advisors truly believe the offer undervalues the company and would expect a higher offer. If the offer already includes a large bid premium, and is judged as high when using comparable metrics such as earnings ratios, it is likely the target management are serious about defending their independence.

How are Hostile Takeovers Performed?

At any time during the takeover process, the acquirer may begin to accumulate a toehold position. This may give the acquirer some leverage in the upcoming negotiations. Should the position exceed 5% the acquirer must notify the SEC on a Schedule 13D within 10 days, thus losing the element of surprise. Many services watch and report these filings, which can offer some clues about upcoming mergers and acquisitions.

An acquirer may or may not have initiated a “Casual Pass” approach prior to hostile actions that could help clarify the target’s reaction if not already anticipated. Once the situation becomes clear to the acquirer and they have decided to continue with the pursuit of the target, the acquirer has a limited number options open to them. We will discuss these in turn.

Bear Hug Offer

An acquirer can try to influence the target by sending a letter to the board of directors stating its case for a merger and its intentions should the board decline. This forces the board to respond publicly either for or against the offer. This is often the first time the market officially hears of a bid approach and can gain valuable insight if the communications are made public.

Open Market Purchases

Stock purchased in the open market can strengthen the bidder’s hand. Costs usually prohibit this tactic as well as a substantial loss should the bid not succeed. This is a rare tactic although its frequency can depend on the regulatory environment. Financing, arranged with banks and other lenders is available to buy the company outright and can be secured against target assets. It is unlikely funds will be made available to purchase stock in the open market.

Hostile Tender Offer

If the bear hug was unsuccessful, a bidder generally progresses to a tender offer. The bidder proposes to purchase the target company’s stock at a fixed price generally above the current market price. The conduct of the offer is governed by the Williams Act 1968 and details of the offer are filed with the SEC. It is at this point most arbitrageurs enter the market. Forecast returns, holding periods and risk are all observable assisting arbitrageurs speculate on the likely success of the deal at the tender price.

Proxy Contest

A Proxy contest is an attempt by the acquirer to force change at the target by gaining sufficient influence on the Board of Directors. A proxy method of corporate voting is initiated where the acquirer attempts to get its own people elected. At this stage, the fight becomes more political than corporate. Outcomes of these actions are difficult to predict. Studying the shareholder base can often provide clues. Long-term shareholders for instance tend to maintain the status quo. However, the incumbent will be aware of the challenges faced. Spreads often remain wide due to the uncertainty during this period. For a more in depth review of how proxy advisory services can effect the outcome of a vote see our article Proxy Advisory Firm and Merger Arbitrage.

Litigation

If the tender offer is unsuccessful, the acquirer can try litigation. Accusing the board of improper conduct can be a lengthy and expensive course of action however and the result may be nothing more than a pyrrhic victory. This is a rare occurrence and not one we shall dwell on. Involvement in these types of deals requires specialist legal knowledge and is beyond the realm of most merger arbitrageurs.

What are some Examples of Hostile Takeovers?

One of the most famous hostile takeover examples is the Kohlberg Kravis Roberts acquisition of RJR Nabisco. The deal for which KKR significantly over payed, highlights the attitude of corporate mergers during that period. The largest deal in corporate history, Vodafone’s (LSE: VOD) takeover of German behemoth Mannesmann was also a hostile takeover.

A current example (at time of writing) is Vintage Capital’s pursuit of Red Robin Gourmet Burgers (RRGB). Management have so far refused to engage in dialogue with Vintage and stressed their intention to continue with their own turnaround plan for the company. This is to the chagrin of many shareholders who have seen their investment decline of the past years. In addition, RRGB have also adopted a poison pill defense. This has created an air of management entrenchment, keen on protecting their own livelihoods at the expense of shareholders.

Since the initial offer of $40 per share, the stock has traded as low as $26. It has rallied back since then as another activist investor, VIEX Capital Advisors, spoke publicly about encouraging the board to consider the deal. This is an ideal opportunity for an active arbitrage strategy and one we have commented on many times. The volatility in the spread of this hostile takeover attempt creates many opportunities to buy and sell the stock repeatedly as the battle moves back and forth.

Are Hostile Takeovers Legal?

A hostile takeover is simply a term used to describe an event where management of the target company refuses the advances of a potential acquirer. There is nothing illegal about this action in itself. Acquirers have every right to make such offers and the target company must decide on its response.

There are however laws governing the actions of either side as the situation progresses. For example, the Board of Directors have a fiduciary duty to the shareholders to act in their best interests. As mentioned, the Williams Act 1968 governs the conduct of either party in a tender offer should one be initiated. Geographical considerations also need to be considered. Defensive actions, such as a poison pill defense (discussed in detail in a later section), are legal in the U.S. but are not permitted in the United Kingdom. Should the situation break down completely, litigation may ensue where one side seeks to prove the misconduct of the other in order to win the contest. This generally involves a lengthy court process.

How can Companies Resist Hostile Takeovers?

There are a number of actions a target can follow in order to resist a hostile takeover. Some of these are pre-offer measures whilst others are post-offer or reactionary. We have listed some of the more common examples below. Each of these has a different effect on the DCP and subsequently the merger arbitrage spread.

Pre-offer

Poison Pill

A shareholder rights plan dilutes the holding of an unwanted shareholder once it exceeds a threshold (discussed below)

Poison Put

A Poison put enables shareholders to sell bonds back to the target at the time of a takeover for a high price

Staggered Board

Restricts the number of board members up for re-election at each annual meeting delaying the time needed to obtain majority board control

Supermajority Provision

A Supermajority Provision increases the required majority from 50% to two-thirds (66.67%) or possibly 75%. Can be applied to shareholder or Board of Directors votes

Dual Class Recapitalization

Concentrates control of the firm irrespective of ownership level by separating voting and non-voting stock. Google (GOOG, GOOGL) has a multi-class structure of super voting stock held by insiders and non-voting stock

Reactionary

Greenmail

The company in return for a moratorium of further hostilities purchases the accumulated position of the unwanted bidder at a premium. However, greenmail is no longer permitted in certain juristictions.

Standstill Agreement

Can be used in conjunction with greenmail to prevent further action by the acquirer in exchange for access to confidential target information

Restructuring

Changes the structure of the company to make it less appealing to the acquirer. This may involve taking on significantly more leverage or increasing dividend payments appealing to longer-term investors. Initiating a share repurchase or buyback plan possibly by way of a Dutch Tender can also please investors by returning unused cash reserves and raising the stock price. Additionally, specific assets sought by the acquirer may be disposed of or tied into unfavorable contracts with rivals.

Actions that reduce the deal closing probability increase the merger arbitrage spread. As previously mentioned, traders need to identify how determined the target is to remaining independent. The level of defenses already in place and the speed and level of response can be a good indicator as well as previous actions. If the acquirer is a strategic buyer, the acquirer is often inclined to be a more determined in its pursuit of the target as the purchase could prove vital to their strategic plan. This is opposed to a more opportunistic purchase from a private equity fund whose primary motivation is short-term gain.

Traders must be aware of the level or work and research required to analyse hostile deals. By understanding the effectiveness of each of the above defenses, (and others), and the underlying intention of the target, traders can more accurately judge the attractiveness of the merger arbitrage spread. However, such research and analysis is often above the capabilities of the casual trader. For that reason, Merger Arbitrage Limited develops strategy variants tailored to each situation and offers commentary on specific deals that we feel we can help traders gain an edge.

Using a Poison Pill in Hostile Takeovers

Mergers, Acquisitions, and Other Restructuring Activities by Donald M. DePamphilis, Ph.D. offers the following definition of a poison pill,

A poison pill involves a board issuing rights to current shareholders, with the exception of an unwanted investor, to buy the firm’s shares at an exercise price well below their current market value. Because they are issued as a dividend and the board usually has the exclusive authority to declare dividends, a pill can be adopted without a shareholder vote and implemented either before or after a hostile bid.

A “flip-in” pill dilutes the ownership interest in the firm as the target issues new shares. This discourages the accumulation of large positions. As an example, if a hostile investor buys a 25% stake in the firm, the target may invoke the pill and double the number of target shares in issue. Subsequently, the investor’s ownership stake is reduced to 12.5%. The value of the investor’s investment will also decrease as shareholders buy more shares at a deeply discounted price. The ability of the hostile investor to sell their position is thwarted by the willingness of other shareholders, having acquired shares at a much lower price, to sell and lock in a gain. Similarly, the “flip-over” poison pill dilutes the acquirer’s current shareholders and depresses the value of their investment as more acquirer shares are issued at below their current market value.

Poison Pill Example

A famous example is the poison pill adopted by Netflix (NFLX) that included both flip-in and flip-over rights, on November 2, 2012. This was in response to a 9.98% investment stake in the firm by investor Carl Icahn. Each shareholder, except Icahn, received a right for each common share held as of November 12, 2012, to buy one one-thousandth of a new preferred share at an exercise price of $350 per right if an investor acquires more than 10% of the firm without board approval. If triggered, each flip-in right entitled its holder to purchase by paying the right’s exercise price a number of shares of Netflix common stock having a market value of twice the exercise price

2 * $350 = $700.

At the time of the issue, Netflix common stock traded at $76 per share. Each right would be convertible into

2 * $350 / $76 = 9.2 common shares,

if the pill was triggered. If the firm was merged into another firm or it was to sell more than 50% of its assets, each flip-over right would entitle the holder to buy a number of common shares of the acquirer at the then-market value at twice the exercise price following payment of the $350 exercise price.

Disadvantages

The board generally has the power to rescind the pill. Therefore, bidders are compelled to negotiate with the target’s board. This assumes the board want to negotiate and will generally result in a higher offer price. This increases the likelihood of the target remaining independent. Detractors argue that the pill is designed to entrench management. Disaffected shareholders often sell their stock leaving few to oppose the action. Carl Icahn described the Netflix poison pill as

“any poison pill without a shareholder vote is an example of poor corporate governance”

It is an extremely difficult call to implement a plain vanilla merger arbitrage strategy when a poison pill is involved. Research of facts and the motivations of all concerned must be analysed meticulously in order to arrive at the correct investment decision.

Hostile Takeovers and Merger Arbitrage - Key Points

So there we have it. 7 questions and 7 answers on the most popular aspects of hostile takeovers when trading merger arbitrage. We summarize below some of the key points in the article.

- The disagreement between the parties allows for greater profit potential although at the expense of greater risk
- A target may initially force a hostile situation simply to encourage the bidder to raise its offer
- The acquirer has a limited number options open to them
- There is nothing illegal about a hostile takeover
- A “flip-in” poison pill dilutes the ownership interest in the firm as the target issues new shares.

Hostile Takeovers and Merger Arbitrage – What All Traders Should Know

Hostile Takeovers and Merger Arbitrage

What are Hostile Takeovers?