Letter number 59 of July 2011


News : The failed takeover bid that achieves its objective, or how to combat Machavellianism

Readers may have been surprised to discover in early June that Volkswagen had launched a takeover bid on MAN at €95, when the MAN share was trading at around €98.

What sort of crazy shareholders would tender their shares in an offer at €95 when they could sell them on the market for €3 more? This takeover bid appeared to be doomed to failure from the very beginning. So why launch it then?

Now that’s a question that makes perfect sense and is void of any sense of Machiavellianism!

In order to understand why the Volkswagen bid has little chance of succeeding, unless the MAN share price should fall during the offer period, and why, nevertheless, Volkswagen will be cracking open the Champagne when its offer fails, we need a short crash course in German stock exchange law.

When a shareholder directly or indirectly breeches a threshold of 30% of the voting rights of a German listed company, whether acting alone or in concert, it is bound to file an offer for the balance of the capital that it does not yet hold. 

The price of this compulsory offer must be equal to or higher than:

• the highest price paid by the offeror during the six months running up to the breeching of the threshold;
• the weighted average of volumes over the three months running up to the breeching of the threshold.

In other words, in early May, Volkswagen bought enough MAN shares to breech the 30% threshold (increasing its voting rights from 29.9% to 30.50%) and thus was obliged to launch a takeover bid. As Volkswagen had not bought MAN shares over the last six months, other than this block, the price for the takeover bid is the three-month average, or €95.
Once this formal offer has been made, Volkswagen would be released from any obligation to make a new offer, as the concept of “excessive speed” (obligation to make an offer when investors holding between 30% and 50% increase their stakes by more than 2% per year like in France for example) does not exist in Germany (1).

In a word, the failed offer enables Volkswagen to buy up as many shares as it wants to on the market and to take control over MAN, without paying any control premium.

This scheme has become established practice in Germany.  It is how ACS is taking control of Hochtief, and how Porsche almost took control of Volkswagen.

The transaction is not without risk, as Schaeffler learnt to its cost in 2008.  Schaeffler had acquired a block of Continental shares, then launched a purely formal offer on Continental shares in order to breech the 30% threshold and exercise its obligation. Unfortunately, the Continental share price fell sharply during the Schaeffler offer (with Lehman Brothers collapsing during the interval) and the offer, far from being the hoped-for failure, was a big success, forcing Schaeffler to buy a lot more Continental shares than it could reasonably afford. This would be impossible in the UK and probably also impossible in France, as the regulator has a certain amount of freedom to assess behaviour on the market and a change of control without the payment of a control premium runs against the natural spirit of the market.  It would, however, be possible in Switzerland, for example.

In order to avoid the occurrence of such situations, it would be a good thing if market regulators were to attack the problem at its roots:

• by getting rid of excessive speed clauses (when they exist) that allow investors to increase their shareholdings by a small percentage per year without having to launch an offer. This has already been done in the UK and we really can’t see the point of such clauses, which only make it possible for investors to take control of a company without making an offer and without paying a premium;
• by introducing a clause that would make all offers automatically null and void if, when the offer closes, the offeror has not succeeded of obtaining at least 50% of the share capital and voting rights. This would be incentive for the offeror to make an offer with a premium that would enable it to take control of the target. If the offer fails, i.e., if the offeror obtains less than 50% of the target’s share capital, it will be cancelled and the offeror will remain at just over 30%, as it will not be able to increase its stake without making a new offer, as the excessive speed clause, will also have been removed.  Without wanting to over-praise the way things are done in the UK, we note in passing that this is already the case there. 

In the short term, the losers would be groups in countries that allow this sort of masquerade, which will no longer be able to consolidate their national industries on the backs of shareholders.  But this is a very short-term reasoning, as since nobody likes to be the fall guy, listed shares in countries like Germany seem to suffer from a discount which increases the cost of capital of local players by as much.

(1) See chapter 42 of the 2009 Vernimmen.

Statistics : Working capital of the Eurostoxx 50

16 of the 36 non financial / real estate members of the Euro Stoxx 50 had negative working capital end of 2010. Negative working capital is one of the attributes of a powerful group. So no one is surprised to find that c. 50% of the largest Euro groups enjoy negative working capital. As we have already written (see chapter 11 of your Vernimmen), the level of working capital is evidence of the relative strength of a group versus its customers and its suppliers. Food retail is not the only sector to have a negative working capital!

In average, working capital for top European groups represents 4 days of sales, but there is a wide dispersion between Bayer (88 days) and Iberdrola (-125 days). It is stable compared to last year.

Research : Performance persistence in entrepreneurship

Are there such things as good entrepreneurs? Four US researchers have published an article showing a persistence in the performance of entrepreneurs (1).  By “entrepreneur” they mean creators of companies, and by "success” they mean an IPO or a takeover and they show that entrepreneurs who succeed once have a greater chance of succeeding again.  In other words, success is not only a question of luck.  This econometric study relies on a sample of 3,796 companies set up between 1986 and 2000 (2) in the USA. 

According to Gompers et al, success breeds success through two complementary effects. 

Some entrepreneurs are more gifted than others.  

There’s nothing surprising about this simple idea, but the article makes it possible to quantify the effect.  A business launched by an entrepreneur who already has a successful business under his/her belt has a 30% chance of succeeding, compared with 21% for a new entrepreneur and 22% for an entrepreneur who has had a business fail.  Economically, this difference is relatively small, but it is statistically significant.  Gompers et al assume that it may be under-estimated as there are some successful entrepreneurs who will not launch new projects (3)

2. An entrepreneur’s reputation will have a positive impact on a new project

The fact that an entrepreneur is seen as talented can work in favour of the development of a new company.  Customers and suppliers will be more trusting of previously successful entrepreneurs, financing will be obtained on better terms and it will be easier to recruit the best staff. 

In order to establish the complementary fit between these two effects, the article identifies two types of competencies:

• a market-timingcompetency, which means setting up a company in the right sector at the right time.  This is the case when firms in the sector in question set up in the same year succeeded in large numbers (4). Gompers et al show that this competency is persistent – entrepreneurs who got their industry and their timing right for their first project do even better the next time round.  This cannot be explained by the reputation effect, so it has to be a real entrepreneurial competency. 

• a “residual” competency, measured by the difference between actual success and the probability of success, depending on the industry and the year in which the project was launched.  It comes mainly from managerial competency and the quality of the entrepreneur’s idea.  Part of this residual competency can be attributed to a reputation effect. 
Finally, the article sheds light on previous studies, that show that enterprises financed by the biggest venture capital firms (5) succeed more often. This phenomenon is no longer true when we focus on projects of entrepreneurs who have acquired a good reputation.  The added value of these funds consists in identifying the best projects but this added value is reduced when the entrepreneur enjoys an excellent reputation. 
(1) P.GOMPERS, A.KOVNER, J.LERNER et D.SCHARFSTEIN (2010), Performance persistence in entrepreneurship, Journal of Financial Economics, n°96, pages 18-32.
(2) The sample is necessarily relatively old so that it is possible to evaluate the success of the company (listing or acquisition up to end of 2007). 
(3) Some stay on at their companies after the IPO or the acquisition, others withdraw from business when they have made their fortunes. 
(4) Gompers et al provide an example of IT equipment companies launched in 1983, which had a 52% chance of success, compared with 18% in 1985. 
(5) The biggest is Kleiner Perkins Caufield & Byers.

Q&A : Representation and warranty insurance

Anyone who's ever bought or sold a company, or been involved as an advisor in either of these processes, knows that there comes a time that is psychologically delicate (and financially important) when the issue of guaranteeing the representations and warranties (R&W) arises.

R&Ws protect the buyer against risks that are not disclosed at the time of the sale and that arise after completion of the sale, and which originate in acts or facts that occurred before the sale. For example, a tax audit performed two years after the sale on a financial year ended before the sale, or a customer who fails to pay a commercial debt which has not been provisioned.

In other words, the buyer takes a counterparty risk on the seller who might have become insolvent at the time when the R&Ws should apply, and is accordingly unable to provide financial compensation to the buyer.

And as there is no-one who will readily agree to being suspected of possibly going insolvent, the moment when this subject is raised is always delicate.

The standard methods for hedging against this risk are:

• placing part of the sale price in an escrow account which can be used to pay out any claims under the R&Ws;
• a bank guarantee;
• a first-demand guarantee. 

Over time, insurance has become another method for hedging against R&W risk. Some insurance companies offer to insure this type of risk, for buyers (the buyer can turn directly to the insurance company instead of first having to claim compensation from the seller), or for sellers (the seller will  be protected against the financial consequences of claims made by the buyer under the R&Ws).  The premium paid, for the insurance policy, corresponds to an increase in the price paid or a reduction in the price received for the transaction.

In complicated cases and in as far as the market for this type of insurance is open, it takes a very short time for this sort of insurance to be put in place (from a few days to two weeks).  However, we should be aware that this
segment of the insurance market is small and that it could run dry.  After a very active period at the turn of the century, the market began to contract between 2002 and 2004, as a result of payouts that had no relation to the premiums charged.  The market is currently experiencing a resurgence and is focused on transaction with a equity value between €50m and €300m.

The R&W policy does not cover risks that have already been assessed in the appendices to the R&W contract, areas that have not been subject to due diligence, post-closing pricing adjustments, fines and penalties, and fraud on the part of the seller.

Interested parties should expect to pay premiums of between 1 and 2% of the warranty ceiling with a deductible of 0.5 to 2% of the value of the transaction and a maximum risk taken for the insurance company mostly in the region of €20m / €40m.  With a transaction value of €150m and a warranty ceiling of 25% of this amount (€37.5m), a deductible of €1.5m, the cost is around €1m, or 0.7% of the transaction volume.
(1) mathematical tool which generates multivariate distributions in such a way that various types of dependence can be represented.