Hostile takeovers, bad for whom?

A. Srikanth

THE RECENT hostile takeover attempt at Bombay Dyeing might have disturbed a hornet's nest. But it has definitely given a fillip to the hitherto dull market for corporate control, the key ingredient for restructuring the sluggish Corporate India.

The clamour for protection from hostile takeovers by promoter-shareholders was predictable and comes as no surprise, especially when they are sure of losing substantial control over their companies, when the new management takes over.

There are still unresolved issues in the corporate world about the synergy effect of M&As, the source of higher profitability, the post-acquisition debt burden and the impact on employees. However, as the debate rages, much of the opposition is not to the consequences of such corporate combinations but rather to the mechanism of such combinations. For example, most anti-takeover legislation in the US are only against hostile bids and not against friendly offers. Moreover, most such legislation have been introduced at the behest of influential promoter managers and not as a consequence of any representation made by the ordinary shareholders. It has been political economy rather than of the shareholders that was at play. And the Bombay Dyeing episode appears to have triggered a similar attempt here too. Promoters, managers and industry (promoter) associations have joined hands to represent to the Government for a possible anti-hostile takeover legislation.

But what is wrong with hostile takeovers? Promoters typically defend their opposition to hostile takeover proposals on the ground that they are not in the best interests of the shareholders. But the real intention is anybody's guess. Since the restrictions are meant to prevent only hostile offers, they seem to imply that friendly offers are more favourable to the shareholders. But numerous empirical research abroad has proved that stock prices rise just as much in response to a hostile offer as they do on announcement of a friendly bid. In fact, over the short term, the returns from a hostile offer are much better than in a friendly offer. The premiums are comparable. In other words, hostile offers are hostile only to the promoter-managers and not to the shareholders.

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In fact, hostile offers could serve as a disciplining mechanism for errant promoter-managers and a method for efficient allocation of capital. The discipline theory can be countered by the fact that targets of hostile takeovers were no way financially inferior compared to the targets in a friendly offer. But this does not rule out the scope for a better management and a more efficient use of resources.

The source of abnormal gains in a hostile takeover was a mystery until it was found (in the US) that most targets during the 1980s were trading at substantial discount to the replacement cost of their fixed assets. This is very true for the Indian corporate sector now. With most of the erstwhile bluechip Old Economy companies quoting at steep discounts to their book values, it is possible that the Bombay Dyeing episode could serve as a precursor to a bust-up takeover wave. This could be similar to what was witnessed in the US in the 1980s, when the conglomerate mania failed as raiders tried to arbitrage the disparity between the target's stock and asset values.

As Michael Jensen's `Free Cash Flow Theory' predicts, there is an inherent tendency for the promoter-managers' preferences to deviate from those of the shareholders. There are numerous instances of unrelated diversification and empire building in the Indian context. And if the market is valuing these companies to be below their ``break-up'' value, it is because it expects such inefficient investments to continue. With the promoter-managers failing to sell the assets at the appropriate time, their companies are saddled with these non-performing assets. These assets do not find their way to their best user until the company's bust-up permits this potential asset value to be realised. And when a friendly takeover does not take place to rectify this situation, a hostile bid fills the gap and facilitates this process.

There are other evidence too to prove the efficacy of hostile takeovers. A systematic study was done of the investment activities of six well-known corporate raiders -- Carl Icahn, Irwin Jacobs, Carl Lindner, David Murdock, Victor Posner and Charles Bluhdorn. No doubt, these six raiders were pursuing their own self-interest. But what the research showed up was that their pursuit of self-interest also increased the wealth of other individuals. Their takeover offers were associated with abnormal increases in the wealth of the target company shareholders. The activities of the raiders in the target firms over the next two years were also consistent with wealth increases for other stockholders.

A small initiative for restructuring Corporate India has come in the form of hostile takeovers. This should not be nipped in the bud through legislation. But what could be the likely outcome of the tussle? The efforts of the promoter-managers to kill hostile takeover attempts amounts to a form of rent-seeking by such groups. They are likely to be effective because they are a politically cohesive and visible force, while the shareholders are dispersed nationally. It is equally likely that hostile takeover attempts are dismissed as mere speculation.

As shareholders, investment bankers, corporate raiders and promoter-managers apply pressure on all directions, it would be optimistic to expect a satisfactory legislative solution. Stalemates and piece-meal compromises are likely to be more common. Any legislative hurdle for hostile takeovers could stifle innovation and hamper the restructuring process. However, as shareholder and institutional pressure increases, promoter-managers could try leveraged buyouts as is now happening in Japan and South Korea.