Letter number 4 of March 2005
- QUESTIONS & COMMENTS
The directive first sets forth some basic principles:
- Shareholders in the same category must be treated equally.
- Shareholders must have enough time and information to decide whether the takeover bid is well founded.
- Management of the target company must act in the interest of the company and allow shareholders the opportunity to make up their own minds on the takeover bid.
- Manipulation of share prices is naturally banned.
- A bid must have secured financing before being announced.
- The bid must not keep the target company from operating properly.
In addition to basic principles, the directive sets precise rules in certain areas. Here are the main subjects:
- the principle of a mandatory takeover bid;
- the principle of mandatory buyout and mandatory squeeze-out;
- anti-takeover defences;
- available information;
- takeover law.
Mandatory takeover bids (1)
The directive lays down the principle that a shareholder that has assumed effective control over a company must bid for all equity-linked securities. It is up to individual countries to set a threshold of voting rights that constitutes effective control.
This article in the directive is unlikely to have a major impact on French takeover rules, but it will result in significant changes in the spirit of Dutch law, as well as changes in Spanish law (Spain abstained from the Commission vote on the text). The principle of effective control will guide new national regulations in countries that will soon join the European Union and whose financial markets are in the process of assuming a European identity that will differ in this point from US regulations. For example, in the US (as in the Netherlands currently), an investor can take effective control of a company without offering an exit for minority shareholders. A public listing there does not offer minorities the same protection as in France or the UK for example.
The directive states very specifically the floor price of a mandatory bid: the highest price paid by the new controlling shareholder in the six to 12 months prior to the bid (the exact period is set by national regulations).
A mandatory bid can be in either cash or shares (if the shares are listed and are liquid).
Squeeze-outs and mandatory buyouts
Article 14 of the directive lays down the principle of the right to make squeeze-out offer by shareholders (up to national legislation to decide):
- having obtained at least 90 % of a company’s shares (as is currently the case in Italy and the UK; individual countries have the option of raising the threshold to 95%, as is currently the case in Germany, France and the Netherlands); or
- having obtained at least 90% of the shares that could be tendered in the course of a bid for all the shares.
Interestingly, the fair price for such an offer is, here again, stated very precisely. The price of a squeeze-out can be the same as that of the mandatory bid or of a voluntary bid that has obtained more than 90% of the shares.
In parallel, the text also allows minority shareholders to demand a buyout (in the same cases that allow a squeeze-out).
It is worth pointing out that the directive does not require countries to enact a squeeze-out/buyout mechanism for all cases, but only in the event of a public bid.
Anti-takeover defences (2)
The issue of limiting anti-takeover defences, poison pills and the like, has been more controversial. This is one of the reasons the European Parliament voted down the previous version of the directive. Some countries opposed this article, as they feared that, by limiting anti-takeover defences, Europe would be at a disadvantage to the US, which does allow such practices.
The directive bans the boards of target companies from taking anti-takeover defences during the bid, such as poison pills, massive issuing of shares, etc., without approval from an extraordinary general meeting.
The directive requires clear transparency on the control structure (restrictions in voting rights, multiple voting rights, shareholder pacts, etc.), as well defence measures (contracts with change-of-control clauses, option of issuing shares without AGM approval, golden parachutes, etc.).
Multiple voting rights and/or restrictions on voting rights are valid as of the first general shareholders’ meeting after a bid that has given a bidder a qualified majority of the company. This does not apply to golden shares that have been deemed compatible with European law (3).
The European Parliament left open the option on whether to enforce articles on poison pills and on the principle of “one share, one vote”. The mechanism here is especially complex, with national governments having the choice and then the companies, with special conditions allowed when the bidder is not European.
The contents of the takeover prospectus are specified. It includes information on the bid, the bidder and the bidder’s intentions with the target’s business and employees. Requirements by other national authorities in Europe are similar.
More generally, the directive frames the procedures for public takeover bids in order to give the shareholder enough time and information to decide on whether the bid is well founded. Hence, while the bid normally must last between two and 10 weeks.
The final text of the directive is highly disappointing. In particular, the tight restrictions on anti-takeover defences, which became optional in the last version of the text (under German insistence) will hinder harmonisation of national regulations on this point.
But let’s look on the bright side. Even though the directive is unlikely to have any fundamental impact on most national regulations (France, UK, etc.), it is one step in the right direction, as it generalises the notions of mandatory takeover bids, squeeze-outs, etc. A clause providing for review five years after the directive enters force will be a clear opportunity to update the text in the direction of a more integrated European market.
(2) For more on anti-takeover defences, see chapter 42 of the Vernimmen.
(3) European law strictly limits national government leeway on golden shares in privatised companies. Golden shares are nonetheless still possible in some sectors and special cases, such as the defence industry.
Recall that goodwill is the difference between the price paid for a company and its book value. Goodwill is thus a measure of the value of intangible assets as valued at the date of the acquisition. In financial terms, this corresponds to the future operating profits that are expected to be generated, in addition to the accounting value of the assets acquired. Hence, when a company writes off goodwill beyond normal amortisation, it diminishes the value of goodwill previously booked under assets. It thus acknowledges publicly that it overpaid for the acquisition.
Under future IFRS standards, goodwill will no longer be amortised in the event of a loss of value but rather written off, as has been done since the end of 2001 under US standards. Goodwill write-offs are thus likely to be more frequent in the future.
Hirschey and Richardson have gauged how share prices reacted to 87 announcements of goodwill write-offs between 1992 and 1996, both at the date of the announcement and over a long period, before and after the announcement. Hirschey and Richardson suggest that the announcement of goodwill write-down is a negative signal on the company’s future earnings prospects. A downward revision of the value of intangibles means that expected earnings will be lower than initially thought at the moment of the acquisition. If this information has not already been priced in by investors, in accordance with the semi-efficient market hypothesis(2), then we should see, on balance, an underperformance of share prices after such an announcement is made. If, however, the markets have already correctly priced in the information on the date of the announcement, this underperformance should not last into the long term.
The expectation of a negative market reaction to such an announcement is confirmed by the two authors’ observations. They observed a 3-3.5% underperformance at the announcement of the goodwill write-off. This underperformance is seen in all sectors. The market is thus interpreting the announcement of the write-off as a negative signal on the company’s future profitability, regardless of the sector and regardless of the size of the write-off relative to the size of the company.
The authors also observed that the markets had somewhat priced in the announcement of weaker profitability. On average, the stock underperformed the market by 40% during the 250 days preceding the announcement. The goodwill write-off is thus announced after a prolonged period of underperformance. However, and this is surprising, the authors observed that the negative reaction persisted into the long term, i.e. for 250 days, albeit of to a lesser extent (-11%).
The authors suggest that their findings prove that the markets initially under-react to such an announcement. If so, they are not completely efficient, as they do not immediately price in the announcement of a write-off is a negative signal on the company’s future profitability.
This latter observation is no doubt open to debate, given the methodology used, which does not allow for a possible change in the company’s specific risk over time. It happens that a company having a poor operating performance over a long period sees its specific risk increase (to reflect an increased risk of bankruptcy, etc.), which hurts its stock performance (as the required rate of return rises). It is thus misleading to compare this performance to a market index, whose required rate of return does not move, or moves little (this is, by definition, the risk premium). Unlike the authors, we believe that such persistent underperformance is probably normal, not because of an irrational under-reaction by the market, but rather a significant increase in the specific risk of the portfolio of companies studied.
(2) For more on the theory of efficient markets, see chapter 15 of the Vernimmen.
This provides the company with funds, in the form of equity or equity equivalents, which it can use to finance its growth. It should come as no surprise that this type of investment, which made its first appearance in the 1990s, has really taken off since the stock market slump which followed the bursting of the Internet bubble. To a certain degree, private investors have taken over from stock markets which are (temporarily?) unable to provide companies with the financing they need. These are mainly smallish companies – in the USA, 65% of PIPE transactions in 2001-2002 were carried out by companies with a market cap of less than $50m, and 87% less than $250m.
Recent PIPE transactions include:
- One by Bull as part of its recapitalisation in June 2004. Artemis and an Axa fund subscribed part of the €44m capital increase, taking the place of Bull shareholders (the French state and Motorola) which were not keen to subscribe.
- One by Thomson in July 2004 involving the issue of bonds convertible or exchangeable into new or existing Thomson shares for $500m, reserved for the US private equity fund Silver Lake.
- Another one by the fashion house Escada when the Florida-based private equity firms HMD agreed to invest € 40m in fresh equity to restructure Escada’s debt in August 2003.
Even though a PIPE transaction involves formalities applicable to all listed companies, its private dimension (reserved for one or a small group of investors) means that provisions can be included that are favourable to the company or the investors, which is obviously not what happens when securities are issued to the general public.
For example, the Thomson PIPE transaction includes a number of provisions: the convertible bonds may not change hands without the approval of the Thomson board of directors; they cannot be hedged for five years; the shares resulting from conversion are subject to certain sale or hedging restrictions; contractual interest is paid net of tax (which means that Thomson will pay any taxes owed by the investor on the warrants).
PIPE transactions provide more proof that for a certain number of small- to medium-sized companies, the stock market is, for the moment, no longer the most satisfactory shareholding structure. They are part of a general trend which included delistings, secondary and tertiary LBOs.